Volatility is rising again after a pause in late March.
Headwinds for markets include Fed uncertainty, slowing earnings, and the lockdown in China.
Despite these risks, we view the downside as limited from current levels.
Stocks are struggling again this month following a late March rally. There is a convergence of headwinds for markets right now. The Federal Reserve (Fed) is in the early stages of a rate hike cycle, there are concerns about slowing earnings growth, and the latest lockdown in China is adding to worries about a slowing global economy. We acknowledge these risks. In particular, there is a high degree of policy risk from the Fed. The economic situation could worsen if the Fed raises rates too aggressively, pushing up the chances of a recession. On the other hand, there are risks if the Fed raises rates too slowly because inflation is at a 40-year high. Surging inflation is negatively impacting consumer spending and the economy is slowing as a result. Markets are already feeling the sting. The S&P 500 is back in correction territory, which is a decline of more than 10%. The Nasdaq and Russell 2000 have both returned to bear market territory (decline of 20% or more).
Although market volatility is on the rise, there are reasons to be cautiously optimistic that the downside is limited from these levels. The underlying economic fundamentals are strong. We feel the economy can withstand less stimulus, which propped consumer spending in the initial stage of the expansion. Consumer balance sheets are healthy because consumer debt servicing costs are low and wages are rising at a fast pace relative to pre-pandemic levels. Additionally, business investment remains strong. Today’s durable goods report from the U.S. Census Bureau showed a 1% rise in core capital goods spending last month and a 10% increase compared to a year ago. Firms are increasing this capex spending for anticipated growth and to improve productivity. The 2-10 yield curve briefly inverted earlier this month adding to concerns about a potential near-term recession, but other key data points aren’t raising red flags at the moment. The ISM Manufacturing and Services PMI readings remain firmly in expansionary territory, although they have slowed from very high levels reached last year. Labor market data is very strong – the unemployment rate is just 3.6%, continuing claims for unemployment benefits are at the lowest level since 1970, and there is a record 5 million more job openings than unemployed individuals seeking employment. Historically, the Leading Economic Index (LEI) trends lower and declines year-over-year ahead of a recession, but the most recent reading in March rose to a new high and is up more than 6% versus a year ago.
Market momentum has shifted in 2022. The S&P 500 closed at a record-high 70 times last year and stocks have trended lower since reaching the lone S&P 500 record high this year on January 3. The good news is valuations have adjusted lower because of the correction in stock prices. The price-to-earnings ratio for the S&P 500 based on projected earnings declined from above 21 in December to 18 as of yesterday’s close. Mid and small cap indices are trading at an even steeper discount relative to projected earnings and their historical average. About a quarter of S&P 500 companies have reported Q1 earnings. While earnings growth has slowed to 7%, more than 80% of firms beat earnings expectations and, earnings growth is expected to exceed 10% for 2022 according to the latest FactSet projections. Despite the confluence of market headwinds, a prolonged bear market is unlikely in our view. To have a prolonged bear market, you need a sharp selloff and a recession. We are not expecting a recession this year and the S&P 500’s correction is close to the average intra-year max drawdown of 14% since 1980.
Despite the selloff and spike in the CBOE Volatility Index (VIX), high yield bond spreads have not increased sharply. Nevertheless, we are in uncertain times and markets are facing less confidence as market headwinds have appeared. It is important to work with us to help navigate through periods of volatility. We continue to recommend a diversified allocation to help dampen volatility risk.
This report is created by Cetera Investment Management LLC.
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