Following a strong start to 2023, volatility has returned to both stocks and bond markets, dampening their momentum.
Despite the markets trending higher in the last few days, year-to-date returns for the S&P 500 Index have gone from being some 9.0% higher earlier in the year to around 5.0%. As for the S&P Value Index… it is now flat relative to this time last year.
Meanwhile, the bond markets (both at the short end and the long term) have reacted as one might have expected: government bond yields have moved significantly higher in recent weeks. Indeed, the US two-year Treasury yield is approaching highs not seen in decades – incredibly, it remains inverted against all maturities up to 30 years out.
Growth stocks have led the US equity market rally so far this year, halting the outperformance of the value stocks in 2022. However, central banks will most likely keep interest rates higher for longer, which will reduce the value of future cash flows, weighing more heavily on growth stocks. This will make value stocks a more attractive proposition.
At the same time, while having a preferential tilt towards value, quality growth at a reasonable price (“GARP”) is also attractive. Both should be considered in a well-thought-out portfolio and a sensible asset allocation.
The past decade or so has seen the world's leading central banks use quantitative easing as a way to stabilise the economies through several crises, including the Global Financial Crisis, the Eurozone crisis, Brexit and the pandemic.
But we now find ourselves operating under a new regime, and it is not a typical business cycle. So we now need a new playbook. Why? Because higher interest rates, stubborn inflation and a steeper yield curve all combine to create a different set of head and tail winds for most asset classes.
This latest bout of volatility to hit asset classes has been catalysed by several factors: stronger than expected labour and inflation data and a repricing of expectations for additional Federal Reserve Bank interest rate hikes. This has put further pressure on both the equity and bond markets.
We may have seen some softening in energy prices recently, and disinflation may well be underway for some good… but the same cannot be said of services. Any inflationary pressure is therefore more to do with the services sector. Inflation first started to surge a couple of years ago in the wake of the pandemic – at a time when consumers were locked down and unable to spend on services. Demand was therefore focused on goods.
Now that consumers have been unleashed into shopping centres and can flash some of the cash that they have managed to save during the pandemic, services such as shops, restaurants, pubs, travel and leisure have all benefited.
Evidence would suggest that we have reached an important juncture. Sure, inflation has declined, but the jobs market remains tight and the consumer robust. This will trouble the Fed, so it is unlikely to pivot any time soon. All of its monetary policy over the coming months will be data-driven.
Rising food prices globally are also a source of concern: the United Nations Food and Agriculture Organisation's global food index soared by 14.3% last year. The pandemic severely hampered global food production: many food-producing countries limited their exports, retaining their crop harvests for their own food security.
Climate change has increased the likelihood of extreme weather conditions, which also impact global crops and food prices. Hurricanes in Florida, droughts in California and heatwaves in Europe and the UK have all taken their toll.
And then there is geopolitics and how it affects food prices. Before Russia's incursion, a third of the world's wheat and barley came from Ukraine. Ukraine also produced a significant percentage of the world's corn and fertiliser products, as well as some 70% of its sunflower oil.
Wall Street may be thinking that things are looking fairly good at the moment. The people on Main Street, however, are thinking the exact opposite.
The job market remained buoyant throughout 2022 against a backdrop of soaring inflation. This meant that despite the emerging cost-of-living crisis people could still afford higher prices and go out to restaurants, stay in hotels and travel. Lower-paid workers, needless to say, felt the pinch of rising consumer costs before others.
Four major events over the next couple of weeks will be key in determining whether this year's stock-market rally gets derailed… or whether we continue into a fully-fledged bull market phase. Personally, I believe the market bottomed out last October. But the current economic backdrop is delicately poised.
On 6 March, US Federal Reserve Bank Chair Jerome Powell will deliver his two-day biannual monetary policy testimony on Capitol Hill. Traders and investors will be looking for an indication as to the future direction of travel for interest rates.
A few days later on 10 March, the February jobs report will be published, swiftly followed four days later by the Consumer Price Index for February. Another hot reading on employment growth and inflation could dash any hopes of the Fed pivoting any time soon.
Then on 22 March, the Fed will issue its policy decision and quarterly interest rate projections at Jerome Powell's press conference. So by the end of the month, we should have more of an insight into whether what lies ahead will be more bullish… or more bearish.
If the US terminal rate increases from 5.0% to 5.5%, this will be a headwind for the markets. But it is unlikely to result in the stock market cratering in the way it did last year. Any good news on unemployment or inflation could also lead to a strong rally in both the bond and equity markets.
As always, it is important to remember that being resilient and having a long-term time horizon will see you through periods of market volatility or economic uncertainty.
The old adage – “it’s not about timing the market, but about time in the market” – has been proven true over the years. Those who stay invested over the long run in a well-diversified portfolio will generally do better than those who try to profit from turning points in the market. That said, we would strongly recommend using periods of volatility to diversify and review your portfolio to take early advantage of any changing economic or monetary backdrop that could affect the longer-term ratings for financial assets.
