The vernal equinox, which marks the beginning of spring, often coincides with stormy, unpredictable early spring weather. This spring, the Federal Reserve (Fed) had its own equinox moment when it pivoted to a more aggressive expected pace of short-term interest rate increases to quell surging inflation.
Like volatile early spring weather, this somewhat unexpected news from the Fed caused a major storm in the bond market and squalls throughout the capital markets.
The atmosphere in the bond market has been unsettled for some time due to the converging pressures of changing pandemic dynamics, surging inflation, and now the tragic war in Europe and its impact on the global economy and financial system. Since the beginning of the year, yields on two-year maturity treasury bonds have surged, while 10-year maturity treasury bond yields are up significantly but much less so than short-term yields, which are driven more by Fed rate hike expectations.
As a result, the yield curve, or difference between long and short rates, has “flattened” dramatically. A flattening yield curve oftentimes concludes with an inverted yield curve (short-term yields higher than long-term yields), which has historically been a precursor to economic recessions and declining stock prices.
Meanwhile, since the beginning of the year, credit spreads in the investment-grade corporate bond market and the more speculative high yield bond market have widened significantly, with investors demanding great compensation for higher risks.
All of this has contributed to decisively negative total returns for bonds, the biggest decline from a peak for bond prices in more than two decades.
These returns have been about equal to the negative returns of the equity markets year to date. This has been the rare time when bonds have not proven to be a good buffer when stocks falter. The significant increase in bond yields has been a considerable headwind for the equity market, especially the high growth and high valuation sectors of the market that are more sensitive to higher rates, which impacts valuation.
Same environment, differing effects
There are three major longer-term themes that are affecting the environment and markets:
- Fed Policy has swiftly shifted to a potentially aggressive tightening bias. The common thread in all three themes is their effect or reaction to the worrisome level and direction of inflation.
- Geopolitics has morphed from standard diplomatic tensions to a far more dangerous and drawn out “hot” war in Europe.
- Covid, although retreating from pandemic status to a less threatening endemic issue, continues to impact the global economy, particularly through supply chain disruptions.
Although broad bond and stock market indices have shown surprising uniformity in performance year to date with similar levels of decline, there actually has been meaningful dispersion of returns across sub-sectors of the market.
For example, the long lagging value sector of the equity market has outperformed the growth sector of the market by a wide margin in the first three months of the year. Commodities, especially oil prices, have seen significant returns thus far, continuing a major rally that commenced in 2021. Commodity-oriented equity sectors have generated substantial returns as well, with energy stocks leading the market.
Meanwhile, the long running “champion” Technology sector is down more than the overall market. This sector makes up nearly 25% of the overall S&P 500® and is thus the main reason for negative broad equity index returns.
Inflation seems to be an issue that has staying power. While inflation is likely to decline later this year from peak levels, we expect it to remain higher than the low levels seen over the past decade. Once wage demands begin to set in, it is more challenging for inflation statistics to decline. Already there is widespread statistical and anecdotal evidence of the breadth and persistence of inflationary pressures. Financial markets have not had to factor in inflation greater than 3% for over 30 years, thus the current pivotal environment will remain volatile, with continued divergence of returns across asset classes.
Market implications in a challenging and changing environment
Four key areas are being impacted by the changing dynamics of the market, including:
Cash. It has been years since money market funds, as a group, generated any yield at all. It is astounding that nearly $5 trillion still sits in money market funds. Investors in those assets will have to continue to be patient to earn anything, even as the Fed begins to raise rates. The reason is that many funds were forced to waive advisory fees when yields went effectively to zero. As short rates rise, these fee waivers will be discontinued, thus delaying the point when higher rates will be paid to money market fund shareholders. It will likely take at least 50 basis points of additional rate increases before highly liquid assets, such as money market funds, will begin to offer a return.
Bonds. The bond market has quickly grasped the reality of the changing environment. It is already pricing in at least six to seven additional rate hikes, including the potential for the next rate hike to be 50 basis points. Credit spreads have also widened quite a bit in reaction to a perceived riskier environment. However, long maturity bonds still are trading at yields significantly below current levels of inflation. Therefore, the best risk/reward ratio in the bond market is shorter maturity securities, especially shorter maturity corporate securities that are now generating nice incremental yield over treasury bonds. High yield bonds, with their shorter durations and significantly higher coupons, currently seem fairly priced.
U.S. equities. It remains a challenging environment for higher risk assets, such as stocks, especially after the surprisingly strong market performance over the past few years. However, corporate earnings are expected to remain strong even while stock prices have declined. Therefore, valuation, from a P/E (price to earnings) standpoint, is now more attractive (although rising interest rates have contributed to this “cheaper” valuation). Patient and disciplined investors are usually rewarded for maintaining long-term exposure to equities during periods of crisis and even inflation.
The conventional wisdom currently is that growth stocks, especially the highly valued Technology sector, will underperform relative to the value sector due to economic uncertainty and rising interest rates. Value stocks may be poised to continue to do well, but the growth sector has some fundamental advantages that may be beneficial to performance.
Many technology companies operate with significantly fewer employees relative to other industries and are thus less affected by surging wages. Nor do these companies have the problem of surging raw material costs that need to be passed on to consumers. They have proven to have pricing power. Also, growth stocks tend to perform best when economic growth slows, and earnings growth is scarce. In short, being meaningfully “short” the growth sector, with its heavy weighting to technology, is a risk to long term performance.
International equities. Both developed and emerging market equity indices have modestly underperformed U.S. equities year to date. However, within emerging markets, both Chinese and Russian stocks declined substantially for obvious reasons. Russia will no longer have an impact on emerging market indices due to sanctions and the collapse of the Russian market. Chinese equities will continue to have a major influence on the emerging market sector. China remains problematic given its recent history of insinuating government policy into corporate strategies and finances. That being said, emerging markets from a valuation perspective are as cheap as they have been in nearly 10 years.
Developed markets are heavily influenced by European equities. The war in Ukraine has dashed hopes for a solid economic showing in Europe after the challenges of Brexit and the migrant crisis. The geopolitical realities of Europe’s reliance on imported oil and gas make investments on the continent more tenuous.
International markets have underperformed relative to the U.S. market for a number of years. The current political and economic realities make it difficult to justify an overweight exposure to this area. However, valuation in international markets is significantly cheaper than the U.S. market. For that reason, some exposure is warranted, but should be at a modest level.