The anticipation for extremely aggressive monetary policy from the Federal Reserve as it tries to rapidly normalize interest rates is impacting many corners of the financial markets – especially higher growth assets whose perceived earnings are not expected until further out into the future. While investors in stocks seem to have initially shrugged off the recent inversion of the yield curve, concerns over decelerating economic growth have mounted and are being amplified by energy security concerns in Europe and COVID-related lockdowns in China. Not surprisingly, a popular survey of investor sentiment recently revealed the lowest level of optimism going all the way back to 2008, even below the depths reached during the Great Financial Crisis. Clearly when inflation reigns supreme, investor confidence is more easily undermined as uncertainty around asset prices naturally increases. Conversely for patient investors willing to ride out short-term volatility, opportunities are improving as prices retreat.
Typically, high levels of investor pessimism serve as a positive catalyst to higher future returns. After all, when sentiment is fairly compressed there is often only one way for it to move in a major direction – and with it, stock prices often follow suit. If only it were that easy. At the current moment, first quarter earnings reports have thus far been mixed, which clouds the picture as inflation is likely in the process of peaking and still threatens to weigh on corporate profitability. We are encouraged that many areas that were under acute inflation pressure such as used car pricing, shipping container rates, and energy prices are beginning to come off the boil.
Meanwhile, bonds have shocked many investors by declining almost as much as stocks this year and are currently approaching double-digit losses as expectations for a dovish Federal Reserve have been completely turned on their head by generationally high inflation readings. Investors are now expecting a pace of rate hikes not seen since the mid-1990s, with close to 300 basis points (3%) of rate increases over the next 12 months. In our view, the bond market has already largely moved in anticipation of this as the yields on the Bloomberg Barclays Aggregate U.S. Bond Index have climbed back above 3% from almost 1%. As such, we believe a majority of the bond market carnage is likely behind us as a variety of contributing cyclical factors are beginning to fade: supply chain shutdowns, abundant fiscal stimulus, and overly accommodative monetary policy, for instance.
Overall, we are still neutral on stocks, viewing the pros and cons as roughly balancing out one another at the current moment. While earnings have decelerated, they still are positive, and we are not in a recession yet as the labor market remains healthy at the current moment. Our biggest worries for stocks would be if stagflation takes hold, but there are encouraging signs that the Fed has now awakened to the dangers of inflation and will follow through on what the market has priced in for rate hikes, which should eventually tame inflation. While our elevated holdings of cash and inflation hedges (real assets and inflation-sensitive bonds) have helped, there’s no denying it has been a tough environment for investors this year, with both mainstay stocks and bonds under pressure. (Please see the chart below for an example of how many asset classes have performed year-to-date.)
In the absence of a clearer outlook, we think it is prudent for investors to stay invested but remain diversified. Most income producing assets from bonds to stocks are now providing much more cash flow than just one year ago, and that should provide support to the market, although it doesn’t guarantee that any final short-term bottom has been reached. The JNBA Investment Committee continues to be guided by our long-term fundamental investment philosophy and will continue to allocate capital into areas with improving outlooks or where prices have returned to fair value, including higher-yielding bonds and cheaper stocks with superior cash flows and/or dividend yields.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from JNBA Financial Advisors, LLC.
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