The stock market had an epic run after the 2008-09 financial crisis, thanks in part to rock-bottom interest rates, which encouraged investors to pile into equities as “There Is No Alternative” (TINA). Now that the Fed is raising interest rates again, many worry stocks are losing their lustre. Should investors exit stocks?
Stock markets have tumbled this year, with the S&P 500 falling 20% from its highs, as investors expect the Fed to bring rates to around 3% by early 2023 from near zero at the start of 2022, its most aggressive campaign of interest-rate increases since the 1980s. Considering the investment implications, although the recent rise in government bond yields has increased bond appeal in the portfolio diversification equation, there is little empirical evidence that bond returns could overtake equities’ return profile over the longer term, particularly now, as the inflation backdrop is starting to improve.
Worst start to the year
We’ve seen a significant increase in volatility in stocks so far this year. The Goldilocks narrative of strong growth and low inflation has faded quickly, with investors forced to pay greater attention to global risks involving tighter monetary policy worldwide as a result of a record rise in prices, particularly in the West, and the effects of Chinese Covid lockdowns on supply-chain disruptions, which are hindering the recovery in global growth and contributing to the rise in prices.
The S&P 500 posted its seventh consecutive week of losses in mid-May, for the first time in history. Easy money policies that sent shares soaring and encouraged people to keep putting money into the stock market are coming to an end as the Fed is determined to rein in inflation. The shift is not only inflicting pain on markets as losses mount, but it is also having an important implication for how investors view risk assets. Since early 2021, the worst-performing parts of the stock market have been the most expensive, least profitable ones.
Investors have been moving their money out of stocks and into safe havens that had largely been unloved for the past decade. For many, the rise in yields over the past eighteen months has created an alternative to equities, with 10-year US government bonds now yielding around 2.7%. Similarly, holding cash has also become surprisingly popular on Wall Street today as recession fears mount. 47% of global fund managers surveyed by Bank of America in April said they had larger than average cash positions in their portfolios—the highest level since April 2020.
How close are we to a recession in the US?
Looking back at history, the Federal Reserve has done a poor job of cooling the economy without pushing it into recession. The Fed has only managed a soft landing in 3 of the last 14 hiking cycles, and arguably this one is among the trickiest – the odds are not on their side for a soft landing. However, one must admit that recessions are extremely difficult to predict. And so far, spending in the US is strong and broadly in line with its pre-pandemic trend, and both labor and housing markets are showing little sign of weakness.
Historically, housing has led us in and out of recessions, as the multiplier on housing is huge. Therefore, the continued strength in both the housing and labor market and the pent-up demand for summer travel that has been delayed since Covid looks to be enough to carry us through this year. As such, it is fair to disregard the hypothesis of a near term recession, at least in 2022. And on the inflation side, economic data are starting to show signs of a peak. Last week, the Fed’s preferred inflation gauge, the PCE Price Index fell for the second month, implying price increases for non-food and energy products are starting to subside. Moreover, Shanghai appears to be exiting from lockdown, suggesting the worst is likely behind us in terms of supply chain and production disruptions, and therefore prices. The Fed has said that its monetary policy is data-dependent, and it could review its strategy should core prices continue to fall.
If there is one risk to mention here, one that is tricky to predict is oil prices. If energy prices and in particular oil continue to see upward pressure, this could render the inflation problem stickier, and as such increase the risk of a recession in 2023.
What is still working?
First, let’s get one thing out of the way, historically (except in 2009), and particularly in the US, stocks have always outperformed bonds over the long-term and more specifically during hiking cycles. Looking at the past three decades, the return on US stocks (MSCI US) has been significantly higher than a portfolio of US government, corporate bonds, and Mortgage Back Securities (Bloomberg US Aggregate). More importantly, bonds tend to underperform the most during hiking cycles. Therefore, TINA seems to apply the most when the Fed starts raising rates.
Second, the weakness experienced in stock markets since the start of the year has been shockingly well organized. This downturn is different from those that we've known since 2008. It is more about specific debates around fundamentals (growth and risk premiums) than existential questions such as whether the banking system or the European Union will survive. While that difference has many potential implications, one specific one is that it is less problematic for high-quality companies with steady margins, strong balance sheets, and positive cash flow businesses. The sentiment is also playing an important role. Last week (23/05/22), the S&P 500 had its best week since November 2020, as negative sentiment, light positioning, and oversold prices turbocharged the advance. Lately, the investor sentiment reading (AAII net bull indicator) reached -33, the lowest reading since its inception, indicating very poor market sentiment.
The Golden Rule
To conclude, let’s point out the golden rule for investing in the stock market: stay bullish on stocks unless you have good reason to think that a recession is around the corner. Markets are indeed going through turbulent times, however, investors may not overreact to these changes. Even though the background is no longer as universally positive as it was at the start of 2021, housing and labor markets still provide a solid foundation. Nonetheless, going forward, sector selection and company fundamentals are set to have a larger impact on returns than a broad market rally. And while cash-type instruments and bonds do offer attractive yields, especially compared to the recent past, the compensation for staying investing in equities should remain much larger over the long term.