- Headlines are dominated by the tragic situation in Ukraine.
- Market impact will be felt through inflation and thus the Fed, in our view.
- While we believe that stocks will be higher by year-end...active asset allocation can be the best defense against volatility.
It is hard to believe, but the end of the first quarter is nearly here, and a lot has changed in the minds of investors. In late January, as COVID-19 cases started to wane, the economy was re-opening and the market was hitting new highs, I remember thinking… “Why wouldn't I want to own stocks?” Today, with the Federal Reserve (Fed) raising rates and the largest invasion since World War ll occurring in Europe, many are now asking the opposite question… “Why would I ever want to own stocks right now?” The sudden change in sentiment makes this a good time to revisit our views on some of the key topics affecting the market.
We believe the direction of inflation and the Fed’s response remain the key market drivers: Inflation dictates the magnitude and pace of future Fed rate hikes, which ultimately impacts borrowing costs for consumers and the valuations assigned to stocks, bonds, commodities, and real estate. Barring a dramatic escalation of the Russia/Ukraine crisis, we believe that the future direction of inflation will be the most important determinant of financial returns in 2022 because it will determine the magnitude of interest rate increases. The impact of the events in Ukraine is that it makes the Fed’s job more difficult and increases the potential for a policy mistake.
Unfortunately, regarding inflation, there has been little evidence of improvement. February’s consumer price index (CPI) report, for example, was higher than January and is now rising at a 7.9% annual rate. The recent jump in energy prices following Russia's invasion will likely cause this number to continue to rise in next month's report.
For those looking for a glimmer of hope, February's core producer price index (PPI) rose at the lowest rate since November 2020 at 0.2% month/month. The reduction may be a result of consumers and businesses 'hunkering down' amidst the stock market sell-off and Russia news. Changes in PPI often trickle down to CPI in later months, but it is far too early to determine if the most recent reading indicates a change in the longer-term trend. Ultimately, we expect inflation to reduce as supply and demand imbalances self-correct but recognize that may not happen as quickly as we originally anticipated.
The Fed raising rates should not end the bull market: As expected, the Fed raised interest rates for the first time in over two years and signaled to the market that six more increases in 2022 were likely. Coincidently, seven - 25 basis point rate hikes equate to a Fed Funds rate of 1.75% - 2.00%, which is slightly below where the Federal Funds (Fed Funds) rate was before COVID-19. Given that the economy could handle a higher Fed Funds rate prior to COVID-19, we believe it should be able to handle a similar rate today with the economy fully recovered and the employment rate nearly recovered. As we noted in
our 1/10/22 Strategic View: Let the Fed Do the Worrying , we viewed the Fed's decision to raise rates as an endorsement for the economy’s health - a market positive, in our opinion. While few investors appreciate Fed hikes, we believe that overall, the market prefers certainty to uncertainty, and may explain why stocks were up significantly following the announcement.
Stock Valuations have become more attractive: At the beginning of the year, one of the least attractive things about the stock market was its’ high valuation. For that reason, our base case return scenario for US stocks was a modest 6-8% with high volatility, despite our expectation for a relatively strong economy. At the time, the S&P 500 was around 4800 and was trading for roughly 21 times 2022 estimated earnings. Today, the market multiple is about 2 multiple points cheaper (19x), making stocks more attractive to us. Not only has the broad US stock market gotten cheaper, but the valuations on some of the most speculative stocks have been eviscerated. Over the long run, we view that as a good thing, because it lessens the likelihood of a 'mega-bubble bursting', ala the 2000 tech bubble, which brought down the entire stock market and the economy.
The stock market's lower valuation is a mirage if earnings subsequently collapse, and thus we are watching analyst earnings revisions closely. However, so far earnings forecasts have stayed robust. It is interesting to note that research analysts continue to expect earnings growth over the next twelve months. Currently, analysts estimate the S&P 500 12-month forward earnings at close to $230 per share, a meaningful increase over the last year (Chart, below).
S&P 500 12-Month Forward Earnings-per-Share Estimate
Volatility is here to stay: There is a reason that the cover of our 2022 Outlook was adorned with a photo of John Travolta atop a mechanical bull in the 1980 film Urban Cowboy- we expected markets to 'buck' heavily in 2022 and try to throw investors out of their portfolios and carefully constructed financial plans. Thus far, the 'bucking' has been the result of stubbornly high inflation and Russian aggression, neither of which we anticipate disappearing from the radar screen anytime soon.
Message to investors: We believe that the investing landscape will remain challenging throughout 2022. While challenging, we continue to expect that stocks will end the year at prices above where they started. The prospects for investment grade bonds, on the other hand, seem far less attractive, in our view. Low starting yields and rising interest rates make meaningful returns unlikely. Additionally, we do not think that bonds should be relied upon to provide much downside protection while the Fed is raising interest rates since principal depreciation may more than offset the income a high-quality bond generates. In a challenging, volatile environment, we think active asset allocation becomes even more important. Given this is RiverFront's business model, such a recommendation may not be surprising. Our rationale is that volatile markets can influence investors into abandoning their investment plans at the worst times. Active asset allocation is designed to navigate these environments by increasing and decreasing equity exposure in a manner that gives an investor the confidence to stick with their plan. Mistakes will be made, and course corrections will be required, but we believe that these shifts will make a difference in portfolio returns and allow investors to sleep at night.