Special market commentary: Risk on, risk off

Executive Summary

The U.S. stock market rallied sharply on Wednesday after the Fed’s rate hike announcement and Jay Powell’s subsequent press conference suggested that policymakers may not move as aggressively in the coming months as some had feared. That positive mood turned sour yesterday, as investors further digested the potential repercussions of a Fed misstep. The risk is two-sided: the potential that the Fed does too little —allowing inflation to persist — offset by the potential that they do too much — in turn choking off growth. It illustrates the two sides of risk that the market sees today. Can the Fed find the middle ground needed to cool inflation without bringing a premature end to the expansion? That question has brought volatility back to the markets — not only for stocks but for bonds as well.

The Fed set the expectation and delivered

There were no real surprises in the FOMC’s policy announcement earlier this week. In their public comments, various Fed governors had done a yeoman’s job of setting the table in recent weeks, making the formal announcement of a 0.5% rate hike and the much-anticipated start of quantitative tightening almost a nonevent. The market seemingly embraced the move and were further encouraged by Fed Chair Powell’s subsequent press conference comments. Equities advanced, as investors cheered his suggestion that a more aggressive 0.75% rate hike wasn’t currently under consideration. On Wednesday, that was music to the market’s ears.

It didn’t last.

The sharp reversal in equities yesterday erased Wednesday’s gains, with few safe havens to be found. In fact, 95% of all publicly traded stocks on the NYSE declined. The S&P 500 dipped by 3.6% for its second worst day this year — just one day after its best single-day return since 2020. Technology stocks were hit particularly hard, continuing their recent slide. The Nasdaq’s 5% drop took the index back to its lowest point since November 2020. Long-term treasury yields rose, and the yield curve steepened, with the 10-year Treasury topping 3.0% for the first time since November 2018.

What changed in less than 24 hours?

Some might point to the exceptionally weak manufacturing data out of China and the resulting risk to the global economy. With China’s Zero-COVID policy still constraining production, not only does it weigh on growth in the world’s second largest economy, but a constricted flow of goods may exacerbate global inflation.

Beyond that, yesterday’s news was limited. Instead, it appeared that investors and traders had the opportunity to sleep on yesterday’s news and wake up today with a different mindset. For those most concerned about runaway inflation, the fact that Chair Powell said that a three-quarter point increase in June wasn’t even being considered may have been viewed as too dovish. More broadly, it appears that the greater concern is that even if more aggressive increases are unlikely, the Fed’s forecast still represents a significant degree of tightening in a compact time frame.

Broadly, the market remains concerned about the Fed’s ability to effectively navigate the path that lies before them. Growth is already slowing naturally, as the explosive growth that accompanied the reopening of the economy fueled by a tidal wave of fiscal stimulus fades. Still, labor market conditions are exceptionally tight. As one measure of labor market strength, unemployment is back down to 3.6%, less than two years into the current expansion. (By contrast, it took nearly 10 years in the last expansion for the jobless rate to reach that point.) Inflation recently reached a four-decade high of 8.5%, although it is forecast to peak and begin to fall later this year. Against that backdrop, the Fed has little choice but to tighten, and to do so more aggressively than was necessary in the last cycle.

Growth is already slowing naturally, as the explosive growth that accompanied the reopening of the economy fueled by a tidal wave of fiscal stimulus fades.

The challenge is that, as we’ve discussed previously, the current inflation is a result of both excess demand (largely fueled by more than $5 trillion of fiscal stimulus in 2020/2021) and supply constraints that linger from the COVID-19 pandemic. Both in the United States and worldwide, production and distribution obstacles remain problematic. In the United States, record job openings illustrate the strength of the economy, while the lack of workers to fill those jobs reflects the exodus of workers in 2020 that have yet to fully return to the workforce. Through tightening, the Fed can drain some demand out of the economy but can’t address the supply-side challenges. That may limit the central bank’s ability to bring inflation back to its 2.0% target.

The risk, of course, comes from the Fed’s mixed history of success in guiding an overheated economy to a soft landing. Central banks have often erred by raising rates with the goal of choking off inflation, only to do too much and tip the economy into recession. The execution of monetary policy is a delicate art; there is no simple formula to dictate the “right” answer at any given point in time. The fact that the effects of interest rate changes only become evident with a considerable lag increases the difficulty in sticking the proverbial landing.

The result? Two conflicting sources of concern in the market: (1) the worry that the Fed may do too little, resulting in a simmering inflation that will remain uncomfortably high for even longer, and (2) the concern that the Fed may move too aggressively and not only rein in inflation but kill growth. Investors are in essence caught in the middle, even though the primary driver of the U.S. economy — consumer spending — remains on a solid trajectory, a key support for the broad economy. Moreover, the United States has never slipped into recession when monetary policy was so accommodative. Even with Wednesday’s rate increase, the Fed’s policy rate remains exceptionally low, particularly in inflation-adjusted terms and well below their estimated neutral rate.

Implications for bonds

Bond yields have been moving up since the beginning of the year in anticipation of Fed tightening and rising inflation. Volatility in rates last month led to a temporary inversion of the curve as the two-year Treasury yield rose above the 10-year yield for a brief period, leading to some questions about what that might mean for the expansion, which we addressed at the time.

The uptick in long-term interest rates continued yesterday, as the yield on the 10-year Treasury surged above 3.0% for the first time since 2018. The yield curve steepened modestly, increasing the spread between long-term and short-term rates, which tends to be a positive sign the economy.

Beyond the implications for the growth outlook, rising rates have weighed heavily on year-to-date bond returns. However, on a forward-looking basis, bond return expectations have improved considerably. Higher effective yields mean the income being generated by bonds in both dollar and percentage terms is considerably better than it was late last summer. This is true for both taxable and tax-exempt portfolios.

The fact that bonds have experienced downside at the same time that stocks have sold off is unusual but explainable given the underlying drivers for recent volatility. Nonetheless, bonds remain a reliable source of income in a portfolio, and with higher yields now a reality, the future cash flow and return outlook for bonds has improved considerably in a relatively short period.

Implications for stocks

For stocks, the crosscurrents are strong. Despite a negative first-quarter GDP print, economic forecasts are for growth to be sustained through 2022. Of course, economists have a generally abysmal record for calling turning points in the cycle in advance. As a practical matter, it’s impossible, although economic data can provide valuable clues about the strength and direction of the economy.

Equity markets typically don’t wait for the onset of a recession to begin to price it in. Midcycle corrections are commonplace, and stocks will often pull back as sentiment sours about the potential for a turning point in the cycle. That may result in a head fake for the market and a recovery if those recession fears are overblown. With more discussion of the “R word” in recent weeks, equity markets appear to be repricing to reflect a greater possibility of a more pronounced slowdown.

Additionally, equity markets are pricing in a more aggressive series of Fed rate hikes over the rest of this year than had been expected in late 2021. Higher long-term yields also play a role in equity market pricing, increasing the competitiveness of bonds as a source of return. This is particularly apparent in the tech sector and other high-growth stocks that pay relatively little in dividends and are reliant upon hearty long-term revenue and earnings growth as the sole source of return. Higher interest rates reduce the future value of cash flows for stocks as well, which is most notable for stocks that pay little or no dividend. That was a tailwind as rates fell and has become a headwind as rates rise. With that, it’s not particularly surprising that long-duration, high-growth names have been among the most volatile stocks this year.

Finally, we’re seeing a notable shift in sentiment away from many of the names that benefited the most during the days of pandemic lockdowns, when most Americans were shopping online, working from home, leaning on social media to stay connected, and streaming multimedia for entertainment. The overnight surge in reliance on technology boosted revenue and earnings for those companies, but as America becomes more mobile and pivots away from social distancing, those same companies are feeling the effects. That doesn’t mean that the long-term prospects for the technology sector is now poor or that new technologies won’t play a defining role in our lives in the future, but it may require a period of adjustment in stock prices to reflect changes in near-term expectations for growth and for interest rates.

We’re seeing a notable shift in sentiment away from many of the names that benefited the most during the days of pandemic lockdowns.

Final thoughts

If the whipsaw of the last few days illustrates anything, it’s how quickly market sentiment can change, even in the absence of significant news. Making significant changes to one’s investment policy — to materially change one’s exposure to stocks or bonds — in response to market volatility creates an additional source of risk, as the probability of getting the timing right is exceptionally low and the cost, both in taxes and the opportunity cost of missing out on upside when the market turns, can be quite high.

We also know that opportunities are often created during periods of volatility. We’ve adjusted our client portfolio allocations on multiple occasions since early 2020, and we’ll continue to monitor developments and consider additional changes in light of changing conditions and individual goals and portfolio positioning.

We recognize that periods like this can be challenging or create a greater sense of uncertainty. Please don’t hesitate to reach out with any additional questions or concerns.