Weekly View: All Aboard the Mechanical Bull: FAQ on Recent Market Volatility

SUMMARY

• We anticipated greater volatility in 2022 and are now seeing it.
• In our view, this volatility is linked to expectations that interest rates will rise faster than previously expected.
• While our risk discipline has caused us to make portfolio adjustments, we remain constructive on stocks for the year as a whole.

After an abnormally relaxed 2021 – a year that saw historically low volatility and outsized gains in stocks around the world – so far 2022 is bucking like the proverbial mechanical bull featured on the cover of our 2022 Outlook Summary- Riding the Recovery (Outlook). In the Outlook we predicted higher market volatility, and January obliged…with the US leading the rest of the world’s markets down in one of the worst months since 2020.

In collating this week’s Frequently Asked Questions (FAQ) from our clients, we provide context for our views surrounding what is happening and why, what we have done about it in our Asset Allocation portfolios, and what risk factors we are watching going forward.

Why Is the Market Selling Off? Fed’s Views Have Turned Hawkish

The market is increasingly alarmed by the persistence and magnitude of inflationary trends, as epitomized by the most recent headline Consumer Price Index report (CPI) of 7%, the highest reading since 1982. This high level of CPI is exacerbated, in our opinion, by current factors such as the spread of the Omicron COVID-19 variant and its impact on the supply chain, as well as geopolitical tension in the Ukraine, which has intensified spikes in energy prices. Inflation itself isn’t necessarily bad for stocks, as it tends to be positively correlated to corporate earnings growth, especially for cyclical companies. Where inflation hurts stocks, in our opinion, is when it causes the US Federal Reserve (Fed) to tighten monetary and interest rate policy faster than the market was expecting, causing downward pressure on stock valuations; rising interest rates negatively impact the value of future earnings, and can slow the economy.

The Fed's body language around rate hikes has turned much more hawkish over the last month, in response to unexpectedly persistent inflation

• The vertical axis on the chart above displays the expected future Federal Funds Rate (Fed Funds), as interpolated by signals in the Fed Funds futures market. The horizontal axis shows where that anticipated Fed Funds rate is expected to be at various points over the next two years.
• Currently, the Fed has kept the Funds Rate at zero but, given their guidance from the Federal Open Market Committee (FOMC) press conference held on January 26, it is all but guaranteed to hike rates in the near term. By comparing the position of the various lines on the vertical axis, one can see how dramatically higher the expected future Fed Funds rate is today (darkest blue line), versus one or three months ago (lines are same analysis but conducted 1, 3 and 6 months ago, respectively).
• Effectively, we think the market went from pricing in 2-3 rate hikes just a few months ago in 2021 to now more like 4-5 hikes.

What Is Our View on This Weakness?

• Our Outlook ‘base’ case scenario remains that, despite Fed hawkishness, the economy and corporate earnings will stay on track in 2022, more than offsetting any valuation contraction due to higher rates. Thus, we think modest stock market gains are still possible by the end of the year (2022 Outlook).

• We also believe that US inflation will peak in the first half of 2022, which may take some pressure off the Fed to continue their hawkish leanings. To this end, leading indicators of global inflation such as global shipping rates for raw materials are already moderating (see chart below), and inflation expectations imbedded in various parts of the bond market are declining.
• While we tend to favor a more cyclical and value-oriented industry allocation in our portfolios, we also believe that certain areas of 'growth', including a number of large, highly profitable tech companies, will continue to be strong earnings growers and attractive investments.

However, in the spirit of Riverfront’s investment motto of 'process over prediction', we acknowledge that the direction of Fed policy and inflation is currently trending more towards our 'Bear' case thus far in 2022, even as macroeconomic strength is closer to our ‘Base’ case. We acknowledge that the recent violation of the S&P 500’s 200-day moving average may represent an important negative trend change in the near-term. (See chart, below). This caused us to make changes in the portfolios, as outlined below in the Portfolio Strategy section.

Risk Indicators We Are Monitoring

Important technical levels (see chart, above)

• The 200-day moving average (red line, chart above) on the S&P 500 was violated for the first time since the pandemic recovery on 1/22; this suggests to us that we may be in for our first meaningful correction in quite some time.
  
• The next important support for the S&P 500 is around 4,200, in our opinion (green line); we would view a decisive violation of this level as a negative.
• Yield curve (spread between short and long-term interest rates): bond investors traditionally have watched the relationship between the 2-year and 10-year treasury bond yield as a gauge for the economic cycle. When the 2-year rises above the 10-year, it can indicate an impending recession. This is not currently the case.
• Credit Spreads: starting to widen but no signs of deep distress yet, in our opinion.
• Longer-Term Inflation Expectations: still below 3% across a variety of instruments.
• Earnings Revisions: revisions remain positive in US and Europe, though to a lesser extent than in 2021; slightly negative in Emerging Markets.
• Crowd Sentiment: short-term crowd sentiment now in 'pessimism' territory, but not yet at the extreme levels we would normally associate with a contrarian buying opportunity.

RiverFront’s Balanced Portfolio Strategy Given This Backdrop

In last week’s trades we took some risk reduction action across our balanced asset allocation portfolios, staying consistent with a similar approach we took in mid-December. We remain overweight stocks and cash relative to bonds, given our view of the unattractive nature of bond prices at current levels. Our risk indicators remain on high alert as triggers for further potential portfolio risk management action, with a focus on our two shortest-horizon portfolios.

• In our two shorter-horizon, more risk-adverse portfolios, we reduced risk by trimming equity long-term corporate bond exposure by roughly 3.5 percentage points last week.
  
• In our three longer-horizon, more risk-tolerant portfolios, we reduced exposure to high-volatility US equites and international growth equities, replacing them with positions we believe will have less potential downside should the environment remain challenging.
  
• Across all our balanced portfolios, we also have a heightened level of cash (roughly 6-8% of portfolio) as ballast against further negative returns in both stocks and bonds.
• Emphasizing cyclical/value assets: our last few trades in the balanced portfolios have been to focus more on cyclical areas of equities such as energy.
  
• Bullish on covered call strategies: in 2021, we instituted and have subsequently raised our position size in covered call ETFs, in anticipation of more volatile markets (see disclosures at end for more information on covered calls).
  
• Focused on more specific security selection: we believe this is an environment that rewards more specific selection strategies, vs. more passive, broad exposures; this may mean more individual stocks going forward and/or more industry and geography-specific ETFs, especially in the longer-horizon portfolios.

In General, We Are:

• Emphasizing cyclical/value assets: our last few trades in the balanced portfolios have been to focus more on cyclical areas of equities such as energy.
  
• Bullish on covered call strategies: in 2021, we instituted and have subsequently raised our position size in covered call ETFs, in anticipation of more volatile markets (see disclosures at end for more information on covered calls).
  
• Focused on more specific security selection: we believe this is an environment that rewards more specific selection strategies, vs. more passive, broad exposures; this may mean more individual stocks going forward and/or more industry and geography-specific ETFs, especially in the longer-horizon portfolios.