By Michael Mackenzie
May 12, 2022
Anyone checking their investment accounts at the moment will presumably recoil in shock—and then think about putting more money to work.
After all, history reveals periods of intense Wall Street fear are ultimately good buying opportunities, a pattern that’s duly nurtured a generation of investors primed to “buy the dip” during major equity and credit market routs. One of the most memorable, short-lived dips in asset prices was the pandemic low of early 2020, and that’s a good starting point for investors trying to make sense of what ails markets today.
The culprit stirring up market volatility and punishing asset prices isn’t hard to spot. A soothing tide of fiscal and monetary stimulus that started in 2020 is now retreating as central banks try to counteract the highest pace of inflation in four decades. The hawkish shift from the US Federal Reserve has been dramatic, with the central bank this month delivering its first half-percentage-point hike in 20 years. And that’s only the opening act. In June the Fed will start shrinking its $9 trillion portfolio, which was amassed buying bonds to help keep interest rates low.
The extent of this year’s losses in equities and bonds should hardly come as a surprise—no, really!—given that both asset classes began 2022 at very expensive levels. Because of hefty stimulus, both equities and bonds effectively borrowed from their future performance. So a reset in prices may be welcome, especially if you’re a young investor looking for better returns over the long haul. But let’s not get ahead of ourselves. Wall Street is renowned for taking the market elevator down several floors at a time and looking very cheap before a bottom is truly established.
With bond yields climbing, many previously hot areas of the equity and credit markets favored by retail traders—SPACs, crypto, FAANGs, meme stocks, and Cathie Wood’s ARK Investment funds, to name a few—are significantly lower this year because of the inflation and rate shock.
While technology stocks have taken some of the biggest hits, equity losses are broadening. From its all-time high on Jan. 3, the S&P 500 index had fallen 18% as of May 11, close to the 20% decline generally considered to define a bear market and almost matching the nearly 20% peak-to-trough drop seen in 2018, the last time the Fed raised rates. Of course, back then, inflation was trundling along at 2%. So here’s another note of concern: To date, equities haven’t experienced the same volatility that’s rattled the bond market, a sign that stocks haven’t yet hit bottom.
Indeed, the bond market has been setting the pace—in particular, the 10-year yield, which influences borrowing costs for homeowners and companies like a polestar. Not only are long-term household and corporate borrowing costs sharply higher, but the bullish case that owning equities is the only way to make money also loses its appeal when bond yields suddenly become attractive. A pressing question is whether the Fed will see the doubling in the 10-year yield this year, to above 3%, as enough to stem a hot housing and jobs market. So far, prices aren’t cooling. In April the consumer price index rose 8.3% from a year earlier.
The Fed is trying to engineer a soft landing that keeps the expansion ticking along with minimal damage to the labor market, hoping inflation settles down once global supply chain issues are resolved. The central bank’s ability to nail this Goldilocks outcome rests on how soon inflation peaks, the trajectory of its decline, and the ensuing fallout for the economy—all very uncertain developments, to put it mildly.
One argument in play is that tightening financial conditions for a highly indebted economy will inevitably slow growth, as they did in late 2018, and therefore arrest a rising trend in Treasury yields. Also contributing to a “growth scare” this time is the prospect of food and energy inflation damping consumer spending. That outcome could pull long-dated interest rates down and support the case for buying the dip in equities and credit.
But inflation just might stick around for longer, in part because of high rents in the red-hot US housing market, and keep investors (and the economy) on edge. “Inflation is not transitory,” says Rob Arnott, founder of Research Affiliates, a global asset manager. “This central bank is now on a path of ending the economic expansion.”
Under those conditions, dividend stocks are the equities to own, wrote Gargi Chaudhuri, head of iShares investment strategy for the Americas at BlackRock Inc., in a recent note. Such stocks, she said, are “an alternative source of quality offering outperformance over the broad market, attractive yield for income, and diversified exposure to sectors benefiting from the current macro regime of high inflation and slowing growth, including healthcare, utilities, and energy.”
One conclusion from the volatile-market action is skepticism that the Fed and other central banks can navigate that soft landing. Also nagging away at investor sentiment is a fundamental break with the past. Namely, a Fed forced to keep tapping on the monetary brakes until the back of either inflation or the economy is broken. A generation of investors conditioned to buy the dip may need to adjust to no longer having the central bank on their side. After years of ignoring high-flying asset prices when consumer inflation was slumbering, the Fed appears to have a new game plan: ignoring sliding asset prices because that’s the price required to tighten financial conditions and bring inflation down.
So how should investors navigate one of the most challenging periods in decades, particularly when this year’s reset in markets doesn’t preclude the threat of a bigger reckoning?
“It is extremely hard to predict what happens tomorrow, next week, or the next quarter,” says David Giroux, head of investment strategy at T. Rowe Price Investment Management. “What I have found is that market corrections like we have seen this year are buying opportunities for the next three to five years.” Should equity and bond markets take the elevator lower from here, Giroux says, T. Rowe Price managers will put more money to work because they’ll “feel better about forward returns than we do today.”
© 2023 Bloomberg L.P.