By Veronica A. Fulton, Research Analyst, GLOBALT Investments
The Russell 3000 is down -13.78%, at the time of this writing. The Bloomberg Barclays U.S. Aggregate Bond index is down a historical -9.50% for the year. Indicators to which we look in order to determine overall market health show no signs of internal strength. The Fed has begun its tightening path in pursuance of taming inflation. Russia/Ukraine tensions do not appear to be subsiding, driving prices for key commodities higher. All things considered; it should be no surprise that sentiment is showing signs of extreme pessimism. Investors are nervous. Below we address what we perceive to be our clients most pressing concerns:
1. The Feds’ rate hikes
The Fed has plainly telegraphed its intention of raising the FOMC discount rate and has already begun with an initial hike in March of 25 bps. The market is pricing in 10 hikes in 2022, 25 basis points each, totaling 2.75% for the year. In addition to discount rate hikes, the Fed intends to begin reducing its $9 trillion balance sheet by letting their bonds mature without replacement. Eventually, the reduction in its holdings of Treasuries and mortgage-backed securities is expected to reach $95 billion per month. Some analysts believe this balance sheet reduction is equivalent to 2-3 additional rate hikes. With the Fed utilizing every tool in their belt, we believe they could cool or even slow the economy faster than consensus expectations, thereby reducing the number of hikes necessary to achieve the Fed’s targets.
2. Inflation & GDP
Inflation remains persistent, admittedly more persistent than we anticipated. While economists were expecting inflation to moderate this year with signs of supply shocks easing, Russia’s invasion of Ukraine and recent lockdowns due to China’s zero-COVID policy derailed much of that optimism. It is difficult to predict the duration of war as well as the trajectory of COVID, making it almost impossible to quantify the effects these developments will have on supply in the short-term. Demand, however, can not only be estimated but easily manipulated by fiscal and monetary tools. Last year, much of the blame for inflation was placed on the enormous amounts of pandemic relief from Congress and the Fed keeping rates ultra-low to encourage spending. Now we find ourselves in the opposite position. The government has halted much of the federal stimulus and the Fed has started a tightening path – essentially the punchbowl has been taken away. With large amounts of liquidity being sucked out of the market – demand could suffer. Inflation in the absence of demand, which appears to already be weakening as measured by GDP shrinking 1.4% at the end of the first quarter 2022, is an unwelcome concept we are already seeing in Europe – Stagflation.
3. Bonds at a crossroad – Bulls and Bears
The bullish case for bonds revolves around inflation peaking soon and the Fed slowing their tightening cycle. This would take the pressure off yields as expectations of further hikes decrease and the Fed continues to unwind its balance sheet. The bearish case revolves around inflation staying relatively high for the foreseeable future and demand for bonds from foreign investors declining. Technically speaking, the bond market is oversold, sentiment is pessimistic, and 10 year-yields have broken out of 40-year resistance. Even if yields ultimately continue higher, we believe we are overdue for a correction in recent yield gains. We are bullish here.
4. Positioning. Time is a far better ally than timing
At the end of 2021, we cautioned “Don’t Put All Your Eggs in One Bubble” and highlighted some of the distortions and extremes within the market. Since then, the market has been on a roller coaster that mostly goes down every day. The only asset class that appears to be working is commodities – primarily due to geopolitical tensions and supply shocks which could subside as quickly as they emerged. It is difficult to be a buyer here. Our recent newsletter highlighted the difficulties in attempting to time the market. Particularly when the best and worst days are usually within close proximity. On balance, our research continues to highlight the uncertainty in the markets. During times of heightened volatility, and what appears to be crisis after crisis we remain defensive. Although we are underweight bonds, we rely on our TLT position as a safe-haven and protective asset. We have positioned ourselves in a way that despite the historical rise in yields, many of our strategies are still outperforming their peers and benchmarks. Our portfolios are constructed based on a weight of the evidence approach with a goal of protecting investors under different market and economic scenarios.
Sources: CNBC, FactSet, Strategas
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