Understanding Markets and Inflation

The sharpest “about face” in Fed policy in modern history has propelled a record combined drop in equities and fixed income, with both US stocks and long-term US Treasuries falling more than 10% in the last six months for the first time ever. In fact, there are only five previous periods in the past 60 years when both asset classes have lost more than 4% during the same time over half-year periods. Following joint declines in both US stocks and bonds, returns were solidly higher for both in the six months that followed on average. The five periods since the 1960s show 5.5% average gains for US equities and 10.9% for 10-year US Treasuries.

More notable is that the forward returns for the 10-year US Treasury note were higher after all five periods when both stocks and bonds fell together. The returns for US equities were higher in only three of the five. What delineates these five periods is the path of corporate earnings.

• During periods when earnings were about to decline significantly, equities severely underperformed bonds. Meanwhile, the unusually high inflation rates during some of these periods never hampered the bond market from rebounding. And this is why CIO believes “bonds are back.”
• With the economy facing supply shortages, a recession will not bring the war in Ukraine to a more rapid conclusion, nor the end of the pandemic. Yet, the medicine the Fed wants to apply – ever higher rates – may have painfully little impact on inflation. At the moment, the Fed’s patience is short. Despite the Fed’s acknowledgement of exogenous shocks, the speed at which the economy is rebalancing demand and supply is not bringing down inflation fast enough for the Fed.

Portfolio Considerations

• With corporate profitability far above trend – earnings-per-share (EPS) gained 47% last year – profits are vulnerable to retrenchment. This fear of a decline in corporate profits is one factor driving the sharp decline in equities. Extreme bearishness is typically a contrarian indicator. But CIO is not inclined to relax our defensive bias in equity markets now. 
• CIO has backed consistent dividend growers with high quality balance sheets and is also overweight essentials such as pharmaceuticals and cyber-security providers. In CIO’s view, growth equities in essential, durable demand areas will eventually feel relief from valuation pressures as government bond yields peak.
• If the Fed hits the right combination of higher rates and Quantitative Tightening, it can induce a slowdown without a recession. If the Fed errs or deliberately crushes the economy to fight inflation, a recession is likely to ensue. But one way or the other, corporate profits could be lost in the process. Given the rapid rise in rates and the fiscal tightening underway, the data to support a peak in bond market yields is greater than the data suggesting that a stock market bottom is at hand. After the largest drawdown in history, CIO believes long-term US government bonds are asymmetrically priced with valuations bottoming this year in 70% of the team’s scenarios.