Policy changes at the Fed

Coming up, policy changes at the Fed – what are the market implications in this challenging and changing environment?

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From Thrivent Asset Management, welcome to episode 26 of Advisor’s Market360^TM. A podcast for you, the driven financial advisor.

The vernal equinox, which marks the beginning of spring, often coincides with stormy, unpredictable early spring weather. This spring, the Federal Reserve, or Fed, had its own “equinox moment” when it pivoted to raising short-term interest rates more aggressively to quell surging inflation.

And like volatile early spring weather, this somewhat unexpected news from the Fed caused a major storm in the bond market along with squalls throughout the capital markets.

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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 shocking war in Ukraine 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 ten-year maturity treasury bond yields are up as well – though much less so than short-term yields – which have gone up more than twice that of long-term yields. This has caused the yield curve to “flatten” dramatically. A flattening yield curve often concludes with an inverted yield curve – meaning that short-term yields are higher than long-term yields – which has historically been a precursor to economic recessions and declining stock prices.

Meanwhile, since the beginning of 2022, credit spreads in the investment-grade corporate bond market have widened, as have the spreads in the more speculative high-yield bond market.

All this has contributed to decisively negative total returns from bonds. 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.

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There are three major longer-term themes that are affecting the environment and markets. The first is Covid. And although retreating from pandemic status to a less threatening endemic status, it continues to impact the global economy.

The second is geopolitics which has morphed from standard diplomatic tensions to a far more dangerous and drawn out “hot” war in Europe. And third is Fed policy which has swiftly shifted to a potentially aggressive tightening bias. The common thread in all three of these themes is their effect, or reaction to, the worrisome level and direction of inflation.

Although broad bond and stock market indexes have shown surprising uniformity in performance year to date, 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 in the first three months of the year.

Commodities, especially oil prices, have seen significant returns thus far, continuing a major rally that started in 2021. Commodity-oriented equity sectors have generated substantial returns as well, with energy stocks up significantly. Meanwhile, the long-running “champion” technology sector has trended downward, and since this sector makes up nearly 25% of the overall S&P 500®, it’s the primary reason for negative returns for broad equity indexes.

Inflation seems to be an issue with staying power. That’s because once wage demands begin to set in, it is challenging for inflation statistics to decline. Already there is widespread statistical and anecdotal evidence of the breadth and persistence of inflationary pressures. Remember, financial markets have not had to factor in inflation greater than 3% for over 30 years, so the current pivotal environment will remain volatile. We anticipate a continued divergence of returns across asset classes.

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So, what are the market implications in this challenging and changing environment? And where could investors look in response? Let’s look at some options:

First up is cash. Considering money markets funds as a whole, it has been years since these have generated any yield at all. It is astounding that nearly $5 trillion is still parked in money market funds. And 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 effectively went to zero. As short rates go up, these fee waivers will be discontinued, thus delaying the point when higher rates will be paid to money fund shareholders. It’s likely that it will take at least 50 basis points of additional rate increases before highly liquid assets, such as money funds, will begin to earn a return.

Next up is 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 from the Fed. It has even factored in 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. 

We now turn our attention to U.S. equities. Currently 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 price to earnings, or P/E, standpoint – is now more attractive. Although it should be noted that 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. 

Currently, the conventional wisdom 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 remain attractive, and 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, so they tend to be less affected by surging wages. These companies also do not have the problem of surging raw material costs that need to be passed on to consumers. Plus, they have proven to have pricing power. That’s why being meaningfully “short” the growth sector, with its heavy weighting to technology, is a risk to long-term performance.

Finally, let’s look at international equities. Year to date, both developed and emerging market equity indexes performed modestly worse than U.S. equities. However, within emerging markets, both Chinese and Russian stocks, declined substantially – for obvious reasons. Russia will no longer have an impact on emerging market indexes due to sanctions and the collapse of the Russian market.

On the other hand, 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 ten years.

Developed international 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 challenging.

For a number of years, international markets have underperformed relative to the US market. 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.

From a market perspective, this spring has proven to be stormy and unpredictable. To help your clients prepare for whatever the coming months hold, whether calm or choppy, be sure to communicate with them frequently to lead them to a summer of confidence.

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Thanks for listening to this episode of Advisor’s Market360™. All episodes are available on Apple Podcasts, Spotify, and Google Podcasts. We’d like to hear from you! If you’ve got questions or comments about the podcast, or have an idea for a topic, email us at podcast@thriventfunds.com. You can also learn more about us at thriventfunds.com and find other items of interest to you, the driven financial advisor. Bye for now.

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All information and representations herein are as of March 29, 2022, unless otherwise noted.

Actual investment decisions made by Thrivent Asset Management, LLC will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

Past performance is not necessarily indicative of future results.

Thrivent Asset Management, a division of Thrivent, offers financial professionals a variety of investment products to help meet their clients’ needs. Thrivent Distributors, LLC, is a member of FINRA and SIPC and a subsidiary of Thrivent, the marketing name for Thrivent Financial for Lutherans.