August 30, 2022
Paul Christopher, CFA, Head of Global Market Strategy
The Fed speaks, and the market pivots — Stay defensive
- A common theme in equity markets since the Federal Reserve’s (Fed’s) July policy meeting has been that policy would pivot — perhaps soon — from interest rate hikes to cuts.
- But the message from a global central bank economic symposium last week at Jackson Hole, Wyoming, is that stubborn inflation will require continued aggressive policy in most countries. The Fed’s message for the U.S. was especially clear on this point.
What it may mean for investors
- We have been expecting more volatility in U.S. and international equity markets. The magnitude of market weakness in the coming months should depend on how quickly the economy slows and liquidity conditions deteriorate. We offer factors to watch and reiterate our guidance to play defense in portfolios.
Our 2022 Midyear Outlook report in June described the economy as like a patient who, in March, began a prescription of rising interest rates to break a high inflation fever. Nearly six months later, inflation is still high and forcing consumers to opt increasingly for low-cost alternatives to brand-name goods.1 At the same time, the full impact of higher interest rates may not be noticeable for several months more. Sometimes the effects of a serious medical treatment develop slowly, and that gradual pace has encouraged several equity market rallies on the persistent and sanguine view that inflation might retreat quickly and limit the “dose” of rate hikes.
Inflation peak matters less than persistence
Inflation is heading in the right direction but is likely to be sticky and difficult to lower quickly.2 The Fed and other global central banks now are saying clearly that aggressive rate hikes will be necessary to regain price stability. That means U.S. inflation between 2%-3%. In his August 26 speech from the Jackson Hole summit, Fed Chairman Jerome Powell confirmed the prescription, saying, “Restoring price stability will likely require maintaining a restrictive policy stance for some time.” His speech was unusually short and focused on this point, and is something we have been saying since March.3 Equity markets reacted with a sharp pullback, finishing a week that erased the S&P 500 Index gains so far in August.
The multiple equity market rallies this year have seemed like disbelief and an open challenge to the Fed about the need for such strong medicine. A common theme during the June-August rally has been that the Fed could pivot from “doses” of extended and aggressive rate hikes to a weaker prescription and even rate cuts by early 2023. It now seems that the pivot will come from the markets, which we expect to refocus in the coming months on the slowing economy and tightening financial conditions.
And the economy continues to slow
The airports and the roads were full of people over the summer, but below the bustle, the economy is still slowing. Earnings, borrowing, and housing are three key leading indicators to watch.
- Average weekly earnings growth, after subtracting inflation, are dropping faster than at any time since the 1980 recession.
- As wages lag inflation, households are stretching for other resources. Savings rates have dropped to pre-pandemic levels, and inflation-adjusted credit-card debt was at a 16-year high in June. Much of that was distressed borrowing. The credit-card delinquency rate for June climbed for the first time since December 2020.
- The percentage of families who qualify for the median-priced home in June had its largest drop in decades, after higher mortgage rates combined with the surge in home prices. Rising unsold home inventories are starting to dent home construction, which weighs on economic growth.
The labor market remains a bright spot for the economy, but is usually one of the last indicators to turn negative. Meantime, a persistent shortage of workers is keeping upward pressure on average wages and product price inflation. While inflation runs faster than wages, spending and revenue growth are likely to squeeze corporate earnings from the revenue side, while rising labor and materials costs complete the pincer on earnings from the cost side. We believe weaker earnings growth is likely for the balance of 2022.
Financial conditions are showing cracks
We can think of liquidity as cash available for different kinds of economic activity. For households, it may be cash in checking accounts, and for banks, cash available to lend. Financial market liquidity refers to the ability of bond and equity market participants to issue new debt (including government debt) or corporate equity, and for traders to buy and sell these securities, without individual transactions disproportionately and permanently altering market pricing.
Stressed households are running out of resources. Even beyond limited savings and credit, falling equity market prices limit households’ ability and willingness to convert paper profits into cash. Among the 11 S&P 500 Index sectors, only Financials and Energy have increased their free cash flow4 since the beginning of this year.
Banks typically hold securities to sell in order to raise cash to lend. This year so far, lending growth has been very strong, but banks’ securities balances have slid rapidly, leaving banks with fewer assets to convert to cash for lending. Liquidity in the banking system has eroded at the fastest pace since March 2008.
In addition, cracks in financial market liquidity are appearing. The Federal Reserve Bank of New York’s measure of stress in corporate fixed income markets shows that corporate bond market functioning appears healthy, but there are some signs of strain in both the high-yield and investment-grade segments (Chart 2).5 This stress reflects higher yields compared to benchmark U.S. Treasuries and lower volume of transactions across issuers and traders, among other factors.
Fed and U.S. Treasury policies also are setting up to remove liquidity. The Treasury will issue fewer securities as the federal deficit shrinks. As the economy slows, investors may choose to give up cash to hold more of these high-quality securities. For its part, the Fed plans to double the rate at which securities mature and roll off its balance sheet. While the Fed’s balance sheet contracts, the liabilities (cash) also will shrink. What is not clear yet is how much that runoff will compound the economic impact of the rate hikes. What is clear is that financial conditions are tightening.
Summary and investment guidance
The S&P 500 Index rallied to 4,305 in mid-August, but we see few signs that the recovery is sustainable. Such signs would include narrowing credit spreads, rising long term bond yields, strengthening industrial commodity prices and housing sentiment, new manufacturing orders outpacing inventories, and bottoming (if not improving) corporate earnings revisions.
Instead, the next few months could be choppy or lower for equity markets, while economic data weaken, financial conditions tighten, and financial markets eventually accept that the Fed and other global central banks will raise and hold rates until price stability returns. We expect the S&P 500 Index to break below 4000 and, after that, 3,900 is the next key level of support. Below that brings the June intraday low of 3,636 back into the conversation.
The extent of further volatility will depend heavily upon the track of the global economic slowdown and central banks’ efforts to reduce the cash that drives spending. A widening of yield spreads between corporate and Treasury securities could signal further deterioration. A much stronger U.S. dollar is also a warning indicator. International investors may shift into the dollar and U.S. Treasuries as international conditions worsen, causing the dollar to appreciate.
For the U.S., we still expect a moderate recession through the middle of 2023. We stand by our year-end S&P 500 Index target ranges of 3,800 to 4,000 for 2022, and 4,300 to 4,500 for 2023. Our single and consistent message since early 2022 has been to play defense in portfolios, which practically means making patience and quality the daily watchwords.
Holding tightly to those words implies that long-term investors, in particular, can use patience to turn time potentially to an advantage. As we await an eventual economic recovery, the long-term investor can use available cash to add incrementally and in a disciplined way to the portfolio. At these intervals, capital preservation steps include reallocating to quality asset classes and sectors and seeking exposures that diversify or that offer a partial hedge against inflation:
- In equity markets, we favor U.S. over international markets; U.S. large- and mid-cap over small-cap equities; and the Information Technology, Health Care, and Energy sectors. We continue to favor reducing exposure to low-quality cyclical equities, which may have gained in price during this recent rally, in favor of our preference for higher-quality assets.
- In fixed income, we prefer to stay in the shorter and intermediate investment-grade maturities (including in municipal securities) and would not seek yields in non-investment-grade credit.
- As a partial inflation hedge, we favor taking a broad-based commodity exposure, over and above long-term, or strategic, weights.
- Finally, the Global Macro and Relative Value alternative investment strategies may provide returns and income (via the Relative Value strategy) that diversify portfolios because of low correlations with equity markets.6
1 “From gadgets to burgers, consumers buy cheap”, by Hilary Russ and Nicha Raidu, Reuters, July 26, 2022.
2 For more details on how and why we think inflation will be much slower to fall than it was to rise, please see our report, “What’s next for inflation, and investment implications”, August 8, 2022.
3 “Revising our guidance and most of our 2022 year-end forecast targets”, March 10, 2022.
4 Free cash flow per share is calculated as cash flow from operations, minus capital expenditures, all on a per-share basis.
5 A Corporate Bond Market Distress Index is calculated and updated regularly by staff at the Federal Reserve Bank of New York. The index offers a single measure to quantify joint dislocations in the primary and secondary corporate bond markets. The index includes weekly data on issuance volume, primary market pricing, issuer credit ratings, as well as measures of secondary market trading volume, spreads and default-adjusted spreads. See “Measuring Corporate Bond Market Dislocations”, Nina Boyarchenko, et al., Federal Reserve Bank of New York Staff Report No. 957, June 22, 2022, for complete details.
6 Alternative investments, such as hedge funds, private equity, private debt and private real estate funds are not appropriate for all investors and are only open to “accredited” or “qualified” investors within the meaning of U.S. securities laws.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Municipal bonds offer interest payments exempt from federal taxes, and potentially state and local income taxes. Municipal bonds are subject to credit risk and potentially the Alternative Minimum Tax (AMT). Quality varies widely depending on the specific issuer. Municipal securities are also subject to legislative and regulatory risk which is the risk that a change in the tax code could affect the value of taxable or tax-exempt interest income. The commodities markets are considered speculative, carry substantial risks, and have experienced periods of extreme volatility. Investing in a volatile and uncertain commodities market may cause a portfolio to rapidly increase or decrease in value which may result in greater share price volatility.
Alternative investments, such as hedge funds, private equity/private debt and private real estate funds, are speculative and involve a high degree of risk that is suitable only for those investors who have the financial sophistication and expertise to evaluate the merits and risks of an investment in a fund and for which the fund does not represent a complete investment program. They entail significant risks that can include losses due to leveraging or other speculative investment practices, lack of liquidity, volatility of returns, restrictions on transferring interests in a fund, potential lack of diversification, absence and/or delay of information regarding valuations and pricing, complex tax structures and delays in tax reporting, less regulation and higher fees than mutual funds. Hedge fund, private equity, private debt and private real estate fund investing involves other material risks including capital loss and the loss of the entire amount invested. A fund's offering documents should be carefully reviewed prior to investing.
Hedge fund strategies, such as Equity Hedge, Event Driven, Macro and Relative Value, may expose investors to the risks associated with the use of short selling, leverage, derivatives and arbitrage methodologies. Short sales involve leverage and theoretically unlimited loss potential since the market price of securities sold short may continuously increase. The use of leverage in a portfolio varies by strategy. Leverage can significantly increase return potential but create greater risk of loss. Derivatives generally have implied leverage which can magnify volatility and may entail other risks such as market, interest rate, credit, counterparty and management risks. Arbitrage strategies expose a fund to the risk that the anticipated arbitrage opportunities will not develop as anticipated, resulting in potentially reduced returns or losses to the fund.
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