What happened?
The S&P 500 rose 2.5% on Friday, for a weekly gain of 6.6%, as data on US inflation and spending revived hopes that an economic soft landing remains possible. The rise in the index ended seven consecutive weeks of declines, the longest losing streak since the dotcom bust of 2000. The tech-heavy Nasdaq rose 6.8% for the week, after a 3.3% climb on Friday.
Market sentiment has turned swiftly since the prior Friday, 20 May, when the S&P 500 came close to entering a bear market, with a fall of more than 20% on an intraday basis from its all-time high in early January. Stronger than expected results from top US retailers, from Dollar Tree to Macy’s, helped allay worries that consumer spending was on track to weaken.
Such optimism gained ground on Friday after data pointed to a 0.9% rise in consumer spending for April, versus forecasts for 0.7%, while figures for March were also revised higher. That called into question the reliability of consumer survey readings, which show the weakest sentiment since 2011. Such surveys appear increasingly influenced by political partisanship.
News on inflation was also encouraging, with the Federal Reserve’s favorite gauge – the personal consumption expenditures (PCE) index rising just 0.2% month-on-month in April. That was the smallest gain since November 2020 and followed a 0.9% jump in March. The core PCE measure, which excludes volatile food and energy prices, has now climbed by 0.3% for the past three months. The year-on-year increase in the core measure, 4.9%, was the smallest rise since December.
Rising confidence that inflation has passed its peak caused investors to scale back some expectations for the pace of Fed tightening. Fed funds futures now imply around 253 basis points (bps) of rate rises for 2022, versus around 265bps at the start of the week and a peak of around 285bps earlier in May. Earlier in the week the release of the minutes of the Fed’s last meeting contained hints that policy makers may be willing to slow or pause rate hikes later in the year. The minutes showed that “many participants” judged that front-loading rate hikes “would leave the Committee well positioned later this year to assess the effects of policy firming.”
Improving sentiment sent recent safe haven flows into the US dollar into the reverse. Having reached a near 20-year high earlier this month, the DXY dollar index fell 1.2% last week and is now around 3% off its recent peak. Meanwhile, broad commodity indexes have closed in on February highs with Brent crude oil prices almost reaching USD 120/bbl.
What do we expect?
Last week’s developments were positive, and in line with our view that inflation will decelerate but remain above central bank targets, economic growth should slow below trend growth but remain above zero, and markets will end the year higher.
But a week of positive developments is not sufficient to call an end to recent volatility. While the VIX measure of implied stock volatility is down from a peak of 35 earlier this month to 25.7 as of the close on Friday, this is still above the long-term average and is consistent with daily moves of around 1.6% in the S&P 500.
Uncertainty remains elevated regarding the outlook for rates, recession, and geopolitical risk.
On rates, recent developments have been consistent with our view that the Fed will be able to ease the pace of tightening later this year as inflation and growth moderate. Markets appear to be gaining confidence in the Fed’s ability to contain inflation, with the 10-year breakeven inflation rate falling to 2.6%, down from 3.0% earlier in the month. The April PCE data also supports our expectation that inflation has passed its peak, with pandemic bottlenecks easing and year-on-year comparisons becoming more favorable. But worries over a possible wage-price spiral will likely persist until investors see further evidence of a cooling labor market. Initial jobless claims have started to rise, and high frequency job postings have been pointing to a fall in openings. However, the three-month moving average of the median wage increase ran at 6% in April, from 3.2% a year earlier, based on the Atlanta Fed’s wage tracker.
On recession risks, recent data has also been positive. The latest consumption data reinforces our view that the unexpected 1.4% decline in first quarter US GDP was an aberration, largely caused by a widening trade deficit. A repeat of that disappointment seemed less likely after data showed the US goods deficit narrowing 15.9% to USD 105.9 billion in April, as imports fell. The positive news on consumer spending from April should also calm recession fears. But consumer sentiment could remain fragile, especially as inflation raises the cost of living. Households appear to be dipping into reserves to fund spending, with the savings rate falling to 4.4% in April, the lowest since September 2008, from 5% in March.
Finally, geopolitical risks continue to linger. Russia’s invasion of Ukraine looks increasingly set to turn into a prolonged conflict, adding to the potential for more severe disruptions of energy and food supplies and thus higher commodity prices. Last week, EU energy commissioner Kadri Simson warned that any country was at risk of losing access to Russian energy. Russia's Gazprom has already cut supplies to Poland, Bulgaria, and Finland. Meanwhile, in China, the zero COVID policy continues to weigh on economic activity and investor sentiment. While there were indications last week that the restrictions in Shanghai - which have lasted now for several months - are starting to ease, curbs to activity in Beijing have been maintained despite falling case numbers.
How do we invest?
While recent developments support our view that markets can end the year higher, we believe this is a time to focus on investment strategies that are more resilient in volatile markets.
First, prepare for volatility. Large swings are inevitable as market expectations shift between different economic outcomes with every new data point, no matter how small. Use options to improve payoff structures and consider drawdown management strategies. Conversely, a surge in volatility – particularly in currency markets – can also be used to enhance returns of excess cash positions. We advise making use of the strong USD by selling the currency’s upside for yield. We believe commodity-linked currencies (AUD, NZD, NOK, and CAD) offer the most appealing risk reward for such strategies.
Second, invest in value-oriented strategies. On balance, we think the “higher inflation” outcome is more likely than a recession, and value stocks have historically outperformed in environments where inflation has been above 3%. We think value will outperform growth, which favors sectors such as energy or healthcare.
Third, build up defensive strategies. We have advocated investing in quality income, dividend-paying stocks, and healthcare, all of which should outperform in case of a recession and help insulate portfolios from volatility. We had also recommended the US dollar, but now think the greenback has priced much of the Fed rate hike cycle. After years of low and negative yields, we are now seeing select opportunities in fixed income, including in shorter duration investment grade credit, which can offer portfolio resilience in a recessionary scenario.
Fourth, invest in an era of security. As the war in Ukraine continues, governments and businesses are adapting to this era of security, in terms of energy, cyber, national defense, and food supplies. In the near term, a focus on food and energy security is leading to tightness in various commodity markets—a move we think will support higher raw material prices in the months ahead and speaks for a broad asset class engagement. Longer term, we think demand for automation and robotics, carbon-zero, cybersecurity, and agricultural yield enhancement will all be boosted in this new world.
Fifth, diversify with alternatives. Not many investments can help improve the quality of a portfolio regardless of the scenario that materializes, but we believe a diversified allocation to alternatives may be one of them. Assets like infrastructure, real estate, and private markets could improve the inflation resilience of a portfolio, while some hedge fund strategies – especially macro strategies - can perform well in recessionary scenarios and help mitigate portfolio volatility if equity-bond correlations rise.
CIO Alert: Stocks rally on soft landing hopes
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