- We think headwinds are changing across stocks, foreign currency, and interest rates.
- Technical price trends right at critical levels, in our view.
- We believe risk action may be necessary.
A Rough Week for Stocks, Interest Rates and Foreign Currency
Last week there was no rest for weary investors, as restrictive central bank policy, negative economic data, and political troubles overseas underscored the difficult fundamental backdrop that investors face. The S&P 500 fell close to another 5% last week, bond prices dropped, and market volatility as measured by the VIX spiked back to the upper end of its 2022 range on Friday. The Federal Reserve raised the fed funds target rate by 75bps for a third consecutive time, downgraded their forecasts slightly for the US economy, and increased the Council’s aggregate estimate for future interest rates. Taken individually, none of these decisions were surprising… but during the Q&A session Chairman Jay Powell reiterated his willingness to sacrifice everything -including the economy and employment - in order to tamp down inflation. Powell’s actions were mirrored by a host of other central banks also raising rates last week.
Our number one tactical trading rule here at RiverFront is ‘Don’t Fight the Fed.’ While we applaud Powell’s clarity and conviction, we concede that a restrictive fed funds rate is likely to remain a headwind for both stocks and bonds in the near-term. US economic data last week was also negative, as the Atlanta Fed’s GDPNow GDP forecast for Q3 decreased to +0.3% year over year as housing data continued to decrease.
Unusual Foreign Currency Weakness Points to Further Volatility
Adding to the global feeling of ‘doom and gloom’ was the continued weakness of European currencies and the Japanese yen relative to the US dollar (see chart, right). Concerns on Friday around the new UK government’s aggressively stimulative economic plan, at odds with Bank of England’s mission to rein in inflation, sent the British pound down to under $1.09, its lowest level since the 1980s. The Euro, for its part, is now meaningfully below ‘parity’ with the dollar as it continues to hit record lows. Finally, the Japanese yen failed to stabilize even as Japan’s Ministry of Finance (MoF) directly intervened in currency markets for the first time since 1998, in what may prove to be a futile attempt at stabilizing the yen.
While there are some economic advantages for the US, a strong dollar can be a headwind for corporate earnings for US companies who have meaningful revenue exposure overseas. Outside the US, the sheer magnitude of the moves could create contagion risks for the entire global economy. We believe these moves uniquely place various European economies at risk for deeper, longer recessions. Since energy and commodities are generally priced in US dollars, huge foreign currency drops are effectively ‘exporting’ inflation into these commodity-importing nations, making an already difficult inflation situation for Europe even worse. This dynamic also increases the likelihood of financial dislocation in Europe and Asia, in our opinion, making us increasingly concerned about contagion risk spilling over to an already uneasy US economy.
Just to add an exclamation point to the already unsettling geopolitical landscape, Euro risk appetite is also being impacted by the increasingly desperate rhetoric from Vladimir Putin and his army’s poor performance in Ukraine. While we have taken prior steps to help shield our portfolios from foreign currency weakness, including underweighting foreign assets and hedging currency, we may further reduce exposure if these forces continue.
Technical Update: Double Bottom, Or Continuation of the Downtrend?
The powerful summer rally of the S&P 500 that began in June is now at risk, with previous support at 3900 and now 3750 (see red lines on chart, right) now broken. Friday’s closing level of 3679 is now uncomfortably close to June’s closing low of 3,667. If this level is materially breached on a closing basis, then the market downtrend will be clearly reestablished, decreasing the odds of establishing a durable market bottom in the near-term, in our view. The fact that international markets and the Dow Jones Industrial Average have eclipsed their 2022 lows makes a violation of support on the S&P 500 more likely. For this reason, all our balanced portfolios are therefore keeping risk management on high alert.
Volatility makes Risk Management Moves Especially Difficult
Stocks are down significantly for the year and, not surprisingly, so is investor sentiment, which is now at pessimistic extremes. Given such pervasive pessimism among both stock and bond investors, we believe the risk of swift reversals are extraordinarily high, putting undue influence on timing of any risk moves. To place this in context, crowd sentiment as defined by NDR Research’s Crowd Sentiment Poll is currently on one of its longest streaks of pessimism since data started in 1995 (source: NDR Research).
In other words, a lot of bad news has been built into prices. For this reason, a rally in the near future – even if it is just a bear market rally - is increasingly probable. This complicates any sort of risk management strategy, and so we plan to move portfolio risk levels methodically but incrementally to try and mitigate timing errors. No risk discipline is foolproof.
Counterpoints to Ponder: All About Earnings from Here
At a 16.8x forward price-to-earnings multiple, large cap US stocks have shed roughly five multiple points since the beginning of the year. This is an increasingly attractive valuation in our opinion, but valuation in and of itself is not a timing signal; things may very well get worse before they get better. However, since there is so much pessimism, it’s important to not lose sight of what could go right. In our mind, the biggest mitigating factor is that corporate earnings in the US have so far remained relatively resilient, whether you look at S&P 500 earnings-per-share (see chart, right). Shading represents historical recessions) or broader data from public and private businesses from the Bureau of Labor Statistics. It suggests earnings may be boosted by inflation and prove more resilient than bears believe. As you can see in the chart to the right, the ‘inflation recessions’ in the 1970s and early 1980s (see red circles) saw relatively mild downturns in corporate earnings, compared to the much starker drops in earnings in the 2000 and 2008 recessions. Importantly, in contrast to the 1970s, we do not expect a collapse in P/E multiples or a significant rise in bond yields from these levels.
We are analyzing corporate earnings closely via both our team’s ‘bottom-up’ research of individual companies, as well as tracking what we believe to be macro leading indicators of future corporate earnings. Earnings growth may be slowing, but if earnings can deliver a positive surprise in Q3, we believe the market may be able to find some footing, though volatility is likely to remain high.
Conclusion: Weighing Short Term Risks against Long Term Opportunities
Our message this week is nuanced. We must balance the meaningful risks presented by the current situation with the possibility that both stocks and bonds are playing out the final act of this bear market, thus presenting long-term opportunities.
For all the reasons outlined in this piece, our shorter-horizon portfolios, which tend to be more risk-adverse, maintain an underweight positioning to both equities and interest rate sensitivity. These shorter-horizon portfolios also maintain a slight overweight to cash for tactical flexibility. With interest rates now at higher levels, we may look to reinvest this cash opportunistically by extending maturities on the fixed income side. Since our risk management disciplines are on high alert, any further deterioration in stock prices may prompt additional risk mitigation efforts on our part, even though our intermediate-to-long term view on markets remains positive, particularly in the US.
For investors with a longer time horizon, short-term volatility cannot be ignored but should not outweigh long-term opportunities and themes. To this end, our longer horizon, more risk-tolerant portfolios, are less underweight equities than our shorter-term ones, with a higher portfolio yield than benchmarks. In these portfolios, we maintain a focus on security selection as well as risk mitigation through alternative yield strategies and foreign currency hedging. Furthermore, we have conviction in shorter-maturity high yield fixed income. While currently a volatile asset class, we believe the yield advantages will outweigh this volatility over time. On the equity side, we maintain an underweight to consumer themes and an overweight to sectors such as energy and high-quality technology, very different business models whose earnings nonetheless we believe can continue to grow against an inflationary backdrop.