March Madness

It was so nice to see the NCAA college basketball tournament (often referred to as March Madness) kickoff with the stands full of excited fans once again. After two years of a global pandemic, it’s finally starting to feel like life is returning to normal (at least in the United States). Financial markets seemed a bit normal last week as well with the VIX, a measure of stock market volatility, falling to its slowest level since February 17th (prior to the Russian invasion of Ukraine, see figure 1).

This line chart shows the Chicago Board Options Exchange Market Volatility Index (VIX) from January 2021 to 2022 year-to-date. U.S. equity market volatility came down sharply after the March Fed meeting

This may reflect several factors: 1) investors gained some clarity on monetary policy, 2) oil prices continued to ease with West Texas Intermediate (WTI) crude oil prices falling 4.2% during the week, and 3) an increasing number of headlines suggesting that a Russia / Ukraine cease fire may be possible. Each of these factors are likely adding to a more risk-on tone, but it is hard to feel overly confident that market headwinds have permanently eased with supply chain disruptions caused by the Russia / Ukraine conflict and renewed COVID-19 lockdowns in China unlikely to be resolved quickly. Likewise, the path for Fed policy will be highly dependent on the inflation pressures caused by these disruptions.

As our colleagues in Citi Research suggest, the Russia / Ukraine conflict is a straightforward negative supply shock which has caused them to revise down their global growth forecast by 0.6 percentage points to 3.3% for 2022. On the flip side, their forecast for global inflation has been raised upward from 4.8% to 6.1% for 2022. In Europe, the conflict may shave off a full percentage point from 2022 growth – bringing down growth estimates from 3.3% to 2.3% for 2022. A Euro Area recession is expected to be avoided but can’t be ruled out.

In the United States, the debate about a potential recession is heating up, but we think such talk is still a bit premature. We understand why investors are concerned that the Federal Reserve may accidently tip the U.S. economy into a recession with the Fed projecting six additional rate hikes by the end of 2022 and another three to four rates by the end of 2023. However, the yield curve has yet to invert, and even if it does, recessions still take time to form with equities often moving higher prior.

Let’s look at the spread between the 10-year U.S. Treasury yield and the 2-year U.S. Treasury yield. Currently, the spread remains positive but has been narrowing in anticipation of additional Fed tightening. Traditionally, a 10s2s inversion has been a reliable indicator of a potential recession, with a recession occurring post-inversion 4 out of 5 times since 1985 (see figure 2). On average, a recession occurred about 14 months after yield curve inversion.

This line chart shows the 10-Year U.S. Treasury Yield Minus 2-Year U.S. Treasury Yield (%) from 1995 to 2022 year-to-date.

However, even with the prospect of a recession on the horizon, equities have typically moved higher. During the last five inversions, the S&P 500 rose an average of 19.4% over nine months before peaking (see figure 3). With the Fed seemingly giving its “the buck stops here” speech on inflation at this week’s National Association of Business Economics (NABE) conference, the Fed appears adamant that inflation warrants a strong monetary policy response, but we suspect that there is still some upside left for U.S. equities. For a deeper dive into the trends driving markets over the past week, please see our, CIO Strategy Bulletin | Understanding an Extraordinary Week in World Events.

This graph shows the S&P 500 Returns After Yield Curve Inversion. The S&P 500 tends to peak about nine months after yield curve inversion.

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