The global stock market rout continued last week with the MSCI AC World Index falling 2.7% (it is down 13.4% year-to-date). In the United States, the S&P 500 tumbled 3.3% while the NASDAQ shed 3.9% on weaker-than-expected technology company earnings. Markets overseas were not spared with European stocks declining 2.6% and Japanese stocks slipping 1.4%. The nominal 10-year U.S. Treasury yield was little changed at 2.93% while the real 10-year U.S. Treasury yield turned positive at 0.1%. The recent sharp rise in the real 10-year U.S. Treasury yield has likely been a contributing factor to the dramatic sell-off in technology shares.
The Federal Reserve’s anticipated “fast and furious” monetary policy tightening cycle has upended financial markets with both stocks and bonds suffering losses year-to-date as investors weigh the prospects of a “hard landing” for the U.S. economy. Other headwinds like the ongoing conflict between Russia and Ukraine complicate matters further.
Rising uncertainty may be weighing on financial markets, but that does not mean that investors cannot have asset class convictions. In this short commentary, we provide a brief summary of how we think the economic outlook may unfold and the asset classes that we feel may be appropriate in the current environment.
Fast and Furious
Charlie Munger, who is the Vice Chairman of Berkshire Hathaway, once said, “If you’re not a little confused by what’s going on you don’t understand it. We are in uncharted territory.” 1 In our view, his quote accurately describes how investors are feeling right now with several different headwinds buffeting the global economy (including “fast and furious” U.S. central bank tightening, an ongoing conflict between Russian and Ukraine, renewed COVID-19 lockdowns in China, and elevated inflation). These headwinds have resulted in heightened market volatility with the Dow Jones surging by over 600 points one day and then falling by over 900 points the next (see figure 1).
With the global economic outlook very murky right now, it is increasingly difficult to make predictions, but that should not prevent investors from having asset class convictions. Below is a summary of how we are viewing the U.S. economy and our recommended portfolio tilt:
- The first quarter 2022 U.S. gross domestic product (GDP) print of minus 1.4% annualized was not a recession signal. The report was greatly impacted by a surge in imports and a deep trade imbalance that resulted in a minus 3.2% contribution to real GDP. Absent the trade imbalance, GDP would have been modestly positive with consumer spending rising 2.7% on an annualized basis and business spending on research, equipment, and development surging 9.2%. Leading economic indicators also suggest that a U.S. recession is not imminent (see figure 2).
- Inflation may be plateauing. The personal consumption expenditure (PCE) price index rose from 6.3% in February to 6.4% in March – a touch below the consensus expectation of 6.7%. The core PCE price index also came in a tick under consensus expectations. This might mark a plateauing of inflation with business surveys like the Institute for Supply Management (ISM) manufacturing price paid component also suggesting that the pace of price gains may be leveling off (see figure 3). If accurate, this could take some pressure off the Fed in the back half of 2022 and result in smaller rate hikes than the 50-basis-point rate hikes that are currently being priced in.
- We see the probability of a U.S. recession at about 25%-30%. That probability will climb if the Fed follows its trajectory and inflation does not break, but the Fed may still pivot down the road in the face of likely economic weakness to come, which could raise the odds of a “soft landing.”
- Our global equity overweight is largely in commodity hedges like natural resources, oil field services, and other defensive equities. Hedges are designed as insurance…one hopes that they don’t need it. However, if Europe embargos Russian oil and natural gas, then investors may benefit from owning these types of hedges. Away from commodities, we prefer companies with a solid track record of earnings and dividend growth. While the S&P 500 is down 14.3% year-to-date and the NASDAQ is down 21.5% year-to-date, our preferred strategy of Dividend Growers is down just 6.9% year-to-date (see figure 4). We also believe that investors may wish to consider adding long-duration Treasuries (such as the 30-year U.S. Treasury) with yields likely to peak in 2022. We think that this type of defensive portfolio tilt will likely remain appropriate until investor uncertainty fades. Several events could cause this to happen including a resolution of the Russia / Ukraine conflict or an end to China’s lockdowns, but we suspect that the most important factor to turn investor sentiment will be a sense that the Fed’s “fast and furious” approach to the rapid rise in inflation is starting to slow.
What Should U.S. Investors Watch in the Week Ahead?
The Federal Reserve will announce its rate decision on Wednesday at 2PM EST. It is widely expected that the Fed will raise the federal funds rate by 50-basis-points and signal its intent to move “promptly and quickly” to stem the rise in U.S. inflation. It will be interesting to hear their assessment of the current economic environment, but we doubt that the Fed will express serious concerns about the U.S. economy at this stage. Investors will also receive the April employment report, which is expected to the show the economy adding 391,000 jobs during the month. The unemployment rate is expected to fall from 3.6% to 3.5%. Most signs continue to point to an extremely tight labor market.
|Index||Weekly Chg change in percent||YTDyear to date change in percent||12 Months 12 month change in percent||Div. Yield division yield in percent|
|Instrument||Weekly Chgchange||YTDyear to date||12 Months12 month change||Level|
|10-Year Treasury Yield (%)||3.4 bps||142.3 bps||129 bps||2.93%|
|Index||Weekly Chg change in percent||YTD year to date in percent||12 Months||Div. Yield division yield in percent|
The Week Ahead
|5/3||10:00||JOLTSJob Openings and Labor Turnover Survey Job Openings||MarMarch||11200k thousand||11266k thousand|
|5/3||10:00||Wards Total Vehicle Sales||AprApril||14.1m million||13.33m million|
|5/4||8:15||ADP Employment Change||AprApril||385k thousand||455k thousand|
|5/4||10:00||ISMInstitute for Supply Management Services Index||AprApril||58.5||58.3|
|5/4||14:00||FOMC federal open market committee Rate Decision (Lower Bound)||5/4/2022May 4, 2022||0.8%||0.3%|
|5/5||8:30||Nonfarm Productivity||1Q Pfirst quarter period||-5.0%||6.6%|
|5/5||8:30||Unit Labor Costs||1Q Pfirst quarter period||10.0%||0.9%|
|5/6||8:30||Change in Nonfarm Payrolls||AprApril||391k thousand||431k thousand|
|5/6||8:30||Average Hourly Earnings YoYyear-over-year||AprApril||5.5%||5.6%|