What happened?
Stocks and bonds fell together on Tuesday as concerns about rate hikes, weak corporate earnings and geopolitical tensions weighed on sentiment.
The S&P 500 fell 2% in a broad-based decline. After strong (seasonally adjusted) January retail sales data released last week suggested resilience in US consumer spending, results from major retailers pointed to a more negative outlook. Home Depot forecast earnings will contract by a mid-single-digit percentage this year, compared to consensus forecasts for a slight increase, while Walmart also pointed to lower-than-expected earnings.
As we returned after the President’s Day holiday, concerns were surfacing in the minds of investors that the Federal Reserve will need to keep raising rates and staying there longer. US 10-year Treasury yields rose 14 basis points to 3.95%, a new high for the year. Market expectations for the terminal federal funds rate implied by futures markets rose a further 6 basis points to 5.37% in July, while the December implied rate rose to 5.19%.
Geopolitical tensions remain elevated amid US President Joe Biden’s visit to Europe and pledges of continued support for Ukraine. On Tuesday, Russian President Vladimir Putin said Russia is suspending its participation in the new START treaty, which limits the number of strategic nuclear warheads countries can deploy.
What do we expect?
Market sentiment continues to be driven by expectations of whether the US economy is headed for a ‘hard’ or ‘soft’ landing.
In January, equities and bonds rallied on hopes of a soft landing, fueled by signs of rapid disinflation, upwardly revised global growth expectations and central banks on the verge of suspending rate hikes. Better-than-expected jobs data and firmer-than-expected US consumer price inflation data ended the rally in early February.
Initially, equity markets appeared to be focused on near-term strength in the US economy and held up relatively well amid strong support from both Fed interest rate expectations and US 10-year Treasury yields. But with signs that corporate earnings are under pressure from both the prospect of falling demand and ongoing cost pressures, particularly labor costs, stocks continued to suffer.
Expectations for the Fed’s bullet interest rate have risen by about 50 basis points since early February, and US 10-year Treasury yields have risen by a similar amount. The S&P 500 has given back almost half of its annual gains. Market expectations for the Terminal Fed Funds Rate are now ahead of the median estimate from the Fed’s December forecast, suggesting the Fed could raise its assumptions at the March FOMC meeting.
There are several combinations of growth and inflation trajectories that can occur en route to the landing that the economy ultimately experiences. But we can say with some confidence that both US growth and inflation rates should fall from their current levels throughout 2023, with the main uncertainty being by how much. Historically, high-quality bonds have typically performed well in macro environments of slowing growth and inflation, while stocks and riskier credit have posted low or negative returns.
Regarding the geopolitical tensions, press reports have highlighted that the US has warned China not to militarily support Russia. In our view, however, it seems more likely that China’s next step will be to propose a peace plan, which could be difficult for the US to accept at this point given President Biden’s repeated support for Ukraine.
How do we invest?
Markets are caught between the two possible outcomes of a hard landing and a soft landing. Stocks are trading well above the October lows, but they also lack conviction to go much higher.
In our year-ahead report, we said 2023 would be a year of turning points for inflation, monetary policy and growth. We believe this is still the case, but as we have pointed out, markets were too far ahead earlier in the year pricing in a favorable soft landing outcome.
Today’s sell-off reinforces our belief that this remains an environment that rewards selectivity and our positioning reflects this. We incorporate a combination of defensive, value and income opportunities that should outperform in an environment of high inflation and slowing growth, as well as select cyclical stocks that should perform well as markets begin to anticipate the turnaround.
In the US, this is consistent with our most preferred asset classes being high quality and US investment grade corporate bonds, while US equities and US high yield corporate bonds are both our least preferred. Instead, we favor emerging market equities and German equities, which are more attractively valued and could benefit from an earlier growth turnaround in China and Europe. We expect value stocks to outperform growth stocks on concerns about continued inflation and higher interest rates, and think it’s a good idea to maintain some defensive exposure given the risks to the US economy.
Geopolitical events often only have short-term effects on financial markets, but years of war in Ukraine continue to have a significant and long-term impact on security considerations. Increasingly, we expect governments and companies to prioritize safety and sustainability of supply over price and efficiency considerations. This creates opportunities in the areas of raw materials, green tech, energy efficiency, agricultural yields and cyber security.
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