March was madness
This year “March Madness” wasn’t just limited to basketball. When looking at the capital market performance for the first quarter of 2022, the price behaviour of bonds, stocks, and commodities rivalled the madness usually found in bracket-breaking upsets and Cinderella teams coming through in the NCAA tournament.
Markets had to absorb a lot of big macro news from the war in Ukraine and associated sanctions on Russia, Covid flare ups, and the troubling property crisis in China. Sprinkle in some high inflation and central bank pivots and this pushed many equity markets into their first corrections (i.e., a drop of 10% or more) since the pandemic-induced bear of Q1 2020. However, in what may end up being a classic case of markets “climbing a wall of worry,” equity markets rose in March to offset much of the early damage.
The fixed-income market has been the area for most of the excitement lately. Back in the summer of 2020, the US 10-year bond yield was hovering around 0.70%, as the economic fallout of the pandemic remained unknown. But since then, yields have been rising, initially because of the improving economy and never-ending stream of fiscal/monetary stimulus. But now yields of late have accelerated to the upside, as it would appear the stimulus may have been left on too long (too much punch bowl). With inflation running hot, the U.S. Federal Reserve and other central banks appear to have embarked on an aggressive tightening path.
Unlike most periods of equity market weakness, this one has been accompanied by bond weakness as well. This has certainly muted the benefits of the bond/equity portfolio mix—clearly supporting evidence for diversifying beyond traditional asset classes. The short-duration stance of most portfolios limited the drag from bonds but this is still the first time in years investors are losing money from bonds.
In March, the Federal Open Market Committee (FOMC) executed their first-rate hike since 2018 and laid out a path to begin to normalize interest rates. While probably too late, this was welcomed by the market, as both equities and bond yield rallied. It is also important to note that a week earlier (March 9th) the FOMC ended their quantitative easing program, which had been aggressively in place since the pandemic began.
The punch bowl left the party pretty quickly. Since that date, bond yields have moved up aggressively, with the U.S. 10-year touching 2.5% and the yield curve between 2- and 10-year bonds inverting for the first time since 2019. More on this later.
If you had been given the tip that in March that we would see an inverting of the yield curve and bond yields moving higher by 25%, all things being equal, you would likely predict this would be negative for equities. However, that wasn’t that case. This might be more a result of the fact that we entered the month with many markets already negative in double digit terms for the year, but not many expected these events to be bullish. This is where many market watchers come out doubting this market move and calling it “madness.”
The explanation for the move higher in risk equities for March won’t be determined until we see how everything plays out in April, but it certainly feels like other forces were at play—be they a counter trend rally, a short squeeze, or just an oversold bounce.
The move during the month for the commodities is also notable. Energy, and oil, in particular, had a great move to the upside, justifying the gains in the equities and helping the TSX manage this tough quarter in a stellar fashion. Prices were clearly driven higher as a result of the lack of capital provided to this sector over the past few years and the sanctioning one of the largest commodity-producing countries.
Overall, the world seems to be coming to terms with the realization that the transition to clean energy will not happen over night and we will need a period of energy transition. Energy has been the leader, but we should see strength across the materials sector going forward.
Gold may be the next commodity to move higher. After a disappointing performance in 2021, this may be the year to get the yellow metal back on track. One of the most dramatic sanctions enacted by the world on Russia was the ‘voiding’ of overseas central bank reserves. After years of central banks treating U.S. treasury bills as the world’s safest assets, this may come into question. Or maybe just for those countries with plans to invade their neighbour. Still, the events of 2022 are causing many countries to re-think diversification—whether it be in energy sources, food sources, supply chains, or even central bank reserve assets.
Even after the quarter comes to a close, it will take time to fully understand what has taken place. Headlines that would normally dominate the narrative for a year are occurring on a weekly basis. Investors and markets are reeling from the volatility and may have used the month end move to reset positions. But don’t be fooled, the volatility is far from over. You don’t get moves like we saw in fixed income and commodities and not find out there was collateral damage that won’t come out till later. 2022 is likely going to remain a bumpy year.
Correction #1 done, now what?
Despite the ongoing conflict in Ukraine and expectations of aggressive monetary tightening campaign, markets have had an impressive bounce since mid-March. The S&P 500 has gained just over 10% from the lows. The revival of growth stocks is impressive with the FANG+ index rallying by more than 25% since the low on March 14. In Canada, the bounce back returns have been less impressive, but we managed to avoid the correction altogether.
So, is it a bear-market rally? Well, for that to be the case, the overall market would have first had to enter a bear market, which it certainly did not. Though it may technically be premature to declare the end of the correction at this point, the worst appears to be over. What’s interesting is that it’s very rare to see a rebound occur at a faster pace than the initial drawdown. Over two months to get to the low in the S&P 500 and the index has already made back nearly two thirds of what was lost in just a couple of weeks.
Stranger things and weird market behaviour
Outside of the initial pandemic months in 2020, the past quarter has been the most volatile period for investors in years. Cross-asset volatility continued to rise over the first quarter led by the bond, commodity, and currency markets and while equity volatility spiked, the VIX is now back below 20.
This divergence in cross-asset volatility is certainly strange, and rather rare. The last time we saw this market behaviour to this magnitude was back in the taper tantrum of 2013. The chart below plots the spread between the Move Index (bond volatility) and the VIX Index. After reaching a high a few weeks ago, the VIX Index started to fall in a very controlled, almost linear fashion.
Volatility is...typically volatile, and the lack thereof is abnormal especially around the same time as bond yields are surging. Aspects of the market appear broken – normal relationships are not behaving as we would expect.
Steep and bumpy path
As we welcome a new quarter, markets appear confident that the worst of 2022 is in the rear-view mirror. However, we are still very cautious regarding the outlook for risk-markets over the course of the next 12 months. Recession talk aside, the path higher for bond yields and central bank rate hikes is disquieting.
Central banks are under pressure to quickly normalize rates to tackle inflation, which may be challenging if this inflation is truly supply driven. We don’t know exactly where “neutral” rates sit but the long-term overnight rate going back to 1960 is around 4.8%. The market is discounting lots of rate hikes this year as can be seen in the chart below.
It’s aggressive, and some strategists doubt they will be able to pull it off. The one thing that could tame the hawkishness is sustained weakness within financial markets. This inflation is different, it’s not the 40s or 70s but the central bank playbook to tackle it is the same. To tame inflation, you must dampen economic growth. Stock expectations just don’t seem to be reflecting this.
Coping with a path of financial tightening is sure to induce some stress pockets. How the market deals with potentially multiple 50 bp moves remains to be seen. It’s been 22 years since these have happened and one could argue the market is more sensitive to these moves today given asset prices and debt levels. Besides rate hikes, there are numerous other reasons to remain cautious, such as, a U.S. mid-term election, China slowdown, rampant inflation, potential global food shortages, and of course a prolonged war in Ukraine with no lasting resolution in sight.
We don’t doubt this relief rally could keep going or even make new highs. But 2022 is the year of volatility and we believe another correction looms. Earnings expectations are high, and it’s our belief that given the difficult macro backdrop, equity fundamentals face a major down risk.
In the fall, we wrote about how monetary stimulus being pulled back is in effect draining the punch bowl. Over the rest of the year, we’ll see how markets handle the punch bowl punching back. We doubt they will be as cool and collected as Chris Rock was during the Oscars.
Reports of my death are greatly exaggerated
Don’t worry, we are aware this is a Mark Twain misquote, but with all the talk of a recession it does seem apropos. The current economic expansion is slowing or will begin to slow very soon for several reasons.
The ongoing war in the Ukraine, with the associated sanctions and impact on energy plus food prices, is a clear headwind. This will be most apparent for the European economy given the proximity of the conflict, reliance on imported energy and greater sensitivity to global trade (relative to the U.S.).
Beyond Europe, higher energy prices and food prices are the equivalent of a tax on the global consumer, disproportionately impacting lower income households who also have a higher propensity to spend. Inflation was raising prices before the war erupted and have since accelerated. Add to this, most central banks are raising their respective overnight rates and longer-term bond yields are rising. For now, let’s call these headwinds a Beaufort wind force 4, Moderate Breeze.
Grabbing additional headlines are several common rules of thumb that are flashing, or nearly flashing, a recessionary warning signal. The rapid rise in oil prices is one such culprit.
Historically, spikes in energy prices of this degree have preceded recessions in the U.S. and often material global slowdowns (left chart below). The world consumes about 90 million barrels of oil per day, so even if paying ‘crude’ prices for energy, the $40 increase so far this year would be an annual $1.3 trillion tax on the consumer.
Just to play some more with big numbers, the world economy is about $95 trillion. While this may make the $1.3 sound small, if that spending is taken out of spending on goods and services, the economic drain over a year would be a big hit to overall growth.
Then there is consumer sentiment, which recovered following the pandemic recession but has been degrading for a year now (right chart below). Even before inflation and the war, the consumer was not happy even though job gains were strong and wages rising. Maybe Covid makes people complain or maybe it’s the inflationary data. Whatever the reason, sentiment this low has coincided or preceded recessions.
And then there is the yield curve. An inverted yield curve is perhaps the most popular recessionary canary these days and for good reason. The U.S. yield curve inverted before the 1974, 1980, 1982, 1990, 2001, 2008 and even the 2020 recessions. Respect. At the moment, with the 10-year Treasury yielding 2.40% and the 2-year yielding 2.35%, it is dangerously close to inverting.
So, is it time to batten down hatches and prepare for a recession (or strong gale to keep with our sailing theme)? Not so fast. These warning signs are as serious as red skies in the morning but let’s visit them individually for a moment.
As the global economy has evolved, it has become less oil intensive. Plus, the all-important U.S. consumer used to spend 7-9% of total consumption on energy in the 1970s and 1980s. This has been on a long declining trend thanks to higher incomes and better energy use. Currently, about 4% of consumption is spent on energy, so not as biting as it used to be in the past. Add elevated savings over the past year, perhaps the consumer is better positioned to weather higher energy prices.
As noted earlier, the consumer sentiment data has been at odds with improving employment trends for a while now. We would also highlight that it has been at odds with actual spending patterns, given solid spending over the past year. Survey data is what is called soft economic data. Literally, people are contacted and asked about their spending intentions. It can provide more timely insights into the future of hard economic data, such as GDP or consumer spending, but also tends to be influenced by other factors. Perhaps consumers have been in a negative mindset because of the pandemic, or inflation and now war. Actual spending has remained solid, and sometimes actions speak louder than words.
Now for the yield curve’s apparent perfect record of forecasting recessions. The 2s vs 10s inversion, which is the one commonly highlighted today because of its near inversion, is less timely and less accurate than the 10s vs 3-month yields.
The 2s & 10s inverted in 2005, about two years before the actual recession. Also in 1998, two and a half years early. The 2-year yields are also very influenced by this scarcity inflation environment that the world supply chains are wrestling with, creating a rather unique scenario.
If you look at other countries yield curves, the inversion signal has been much more hit and miss. We certainly will take note if the 2s vs 10s inverts but will hold off sounding the R alarm given the 3-month vs 10s remains plenty steep for now.
Yes, these signals are concerning, and we are certainly heading into a slowing economic growth world. But calling for a recession appears very premature. Let’s look at the other side of the ledger.
Inventories are very low and manufacturing activities are very robust. Unemployment continues to fall. Leading indicators are still rising. Earnings growth remains positive. Many of these are equally accurate at predicting recessions. And the data today does not support the recession talk. Could the data change in the coming quarters? It most certainly will—but it could change in either direction. For now, it’s a slowing of growth.
Market cycle analysis
There are always many moving parts to the markets and the economy. This is why we use a broader-based market cycle approach, that includes all the aforementioned indicators, plus many more. The good news is with 75% still bullish, our recession/bear market alarm bells remain quiet.
Given the heightened concern over the economy, we have shared the breakdown of which indicators are bullish and which bearish. We have also included whether the measure is improving or deteriorating. Given we use the 3-month/10-year yield curve, this remains bullish. The U.S. economy also stacks up well with many more bullish checkmarks vs bearish. We would note the data points are roughly even split with 10 improving and 10 deteriorating vs last month. The global economy remains decent as well.
This has us in the camp – economy slowing yes, stopping no. Slowing economic growth could actually be a positive development over the coming months. It would help alleviate some of the inflationary pressures and could open the door for the market to forecast a less hawkish path for central banks, given how far the pendulum has swung in the hawkish direction of late. This is going to be a bumpy ride for the data and the markets, expect overreactions in both directions at times.
— Craig Basinger is the Chief Market Strategist at Purpose
— Derek Benedet is a Portfolio Manager at Purpose Investments
— Greg Taylor is the Chief Investment Officer at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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