What happened?

Equities and bonds fell in tandem on Tuesday as rate hike concerns, poor corporate earnings, and geopolitical tensions weighed on sentiment.

The S&P 500 fell 2% in a broad-based decline. After strong (seasonally adjusted) retail sales data for January released last week suggested resilience in US consumer spending, earnings results from big-box retailers pointed to a more negative outlook. Home Depot forecast earnings to contract this year at a mid-single-digit percentage rate, compared with consensus forecasts for a slight rise, while Walmart also guided toward lower-than-expected profits.

Returning after the President’s Day public holiday, concerns that the Federal Reserve will need to hike rates further and hold them there for longer appeared prominent in investors’ minds. Yields on 10-year US Treasuries rose by 14 basis points to 3.95%, a new high for the year. Market expectations for the terminal federal funds rate implied by futures markets increased by a further 6bps to 5.37% in July, while the rate implied for December rose to 5.19%.

With US President Joe Biden visiting Europe and pledging further support for Ukraine, geopolitical tensions remain elevated. On Tuesday, Russian President Vladimir Putin said that Russia was suspending its participation in the New START Treaty, which limits the number of strategic nuclear warheads that countries can deploy.

What do we expect?

Market sentiment continues to be driven by expectations over whether the US economy is headed for a “hard” or “soft” landing.

In January, equities and bonds rallied on hopes of a soft landing, fueled by signs of rapid disinflation, global growth expectations being revised higher, and central banks close to pausing rate hikes. Hotter-than-expected labor market data and stickier-than-expected US consumer price inflation data brought the rally to an end in early February.

Initially, equity markets appeared to focus on the near-term strength in the US economy, holding up relatively well in the face of a sharp back-up in both Fed policy rate expectations and 10-year US Treasury yields. But with signs that corporate earnings are under pressure both from the prospect of falling demand and ongoing cost pressures, particularly labor costs, equities have come under further pressure.

Expectations for the terminal Fed policy rate have risen by around 50bps since the start of February and 10-year US Treasury yields have risen by a similar amount. The S&P 500 has given back nearly half of the year’s gains. Market expectations for the terminal fed funds rate now exceed the median estimate from the Fed’s December projections, suggesting anticipation that the Fed may increase its assumptions at the March FOMC meeting.

There are multiple combinations of growth and inflation trajectories that could occur on the way to whichever landing the economy ultimately experiences. But with some confidence, we can say that US growth and inflation rates should both fall from their current levels during 2023, with the main uncertainty being over just how much. Historically, in macro environments of falling growth and inflation, high-quality bonds have typically performed well, while equities and riskier credit have produced low or negative returns.

Regarding geopolitical tensions, press reports have highlighted that the US has warned China against supplying military support to Russia. But, in our view, it seems more likely that China’s next step is to propose a peace plan, which, given President Biden’s reiteration of support for Ukraine, may be difficult for the US to accept at this stage.

How do we invest?

Markets have been caught between the two potential outcomes of a hard and a soft landing. Equities are trading well above the October lows, but also lacking the conviction to move much higher.

In our Year Ahead report, we said 2023 would be a year of inflections for inflation, monetary policy, and growth. We believe this is still the case, but as we have highlighted previously, at the start of the year markets ran too far ahead in pricing in a benign soft-landing outcome.

Today’s sell-off strengthens our conviction that this remains an environment that will reward selectivity, and our positioning reflects that. We incorporate a combination of defensive, value, and income opportunities that should outperform in a high-inflation, slowing-growth environment, alongside select cyclicals that should perform well as and when markets start to anticipate the inflections.

In the US, this is consistent with high-grade and US investment grade corporate bonds being among our most preferred asset classes, while US equities and US high-yield corporate bonds are both least preferred. Instead, we prefer emerging market equities and German stocks which are more attractively valued and stand to benefit from an earlier inflection in growth in China and Europe. We expect value stocks to outperform growth stocks given concerns about sticky inflation and higher interest rates, and we think it’s a good idea to keep some defensive exposure considering the risks to the US economy.

Geopolitical events often only have a short-lived impact on financial markets, but the year-long war in Ukraine continues to have a meaningful and long-term impact on security considerations. Increasingly, we expect governments and businesses to prioritize security and sustainability of supply over considerations of price and efficiency. This creates opportunities in commodities, greentech, energy efficiency, agricultural yield, and cybersecurity.