We began 2022 expecting volatility across financial markets. We certainly got it, and it has come from multiple sources, including a worsening macroeconomic outlook, shifts in policy, and geopolitical unrest. In these conditions, predicting what may lie ahead—in the second quarter and beyond—is a challenge, as the range of possible outcomes is wide.
For example, equity investors seem to have put the January and February selloffs behind them. But the bond market has flashed a warning sign in the form of an inverted yield curve, considered by many a harbinger of recession. So who should investors believe? In our view, neither—at least, not in isolation. We think the best approach involves monitoring and take cues from a broad set of barometers while making note of the unique insights and limitations of each one.
Yield curve inversion is noteworthy because it has historically indicated that investors expect growth to slow (and possibly push the economy into recession) and interest rates to fall. But it is helpful to keep in mind that the US yield curve has been flattening for about a year now, culminating with some widely watched metrics (the 2y–10y and 5y–30y spreads) dipping into negative territory.
But the picture has been muddied a bit by a few factors. First, the Federal Reserve in recent years has been a large buyer of US Treasuries to expand its balance sheet and keep overall borrowing costs low to support growth. Second, foreign demand for US Treasuries remains strong because these assets still offer higher yields—even with Fed purchases—than other developed-market government bonds. As a result, long-end interest rates may be pushed lower than expectation-based theories may suggest. That makes it more difficult to use the yield curve as a recession predictor. Also, the recent rise in 2-year Treasury yields rates is likely the result of the vast acceleration in the expected number of Fed rates hikes rather than tighter financial conditions.
On the credit side, investment grade and high yield spreads have moved back to levels seen in the fourth quarter, and default risk measures remain generally low. To be sure, quantitative easing and the pandemic-related relief measures have kept credit conditions very accommodative for all firms for many years—the profitable and the unprofitable. As conditions tighten, some firms may face challenges. But so far, markets have not materially priced in recession, although recession models generally point to higher probabilities when the forecasting horizon is extended further.
Even so, we think there are reasons to tread cautiously when it comes to risk assets. The market appears to have priced in more than 200 basis points of rate hikes by year end, with the near term hikes likely to come in doses of 50 basis points each. And the rare combination of rising rates, inverted yield curve, and geopolitical tension has historically been associated with bear markets. There have been three instances of this combination in the past 50 years: January 1973–October 1974 (-48% equity selloff), November 1980–August 1982 (-27% equity selloff), and March 2000–October 2002 (-49% equity selloff). Today, we are again standing at the crossroads of a Fed hiking cycle and an outbreak of military conflict, both of which still seem open-ended at the moment. This raises the question: have we just seen a bear market rally?
To formulate expectations on asset prices, one should consider—but look beyond—models of economic recessions. By definition, recessions are characterized by two consecutive quarters of negative real GDP growth, whereas bear markets describe periods in which equities sell off by 20% or more from recent highs. Although there are some correlations, recession is neither a necessary nor a sufficient condition for a bear market. Bear markets that are associated with cyclical downturns or asset bubbles tend to have a closer link with macro fundamentals and last longer. Event-driven bear markets, on the other hand, tend to be shorter without necessarily being linked to weakening in fundamentals.
A few prominent examples include December 1961–62 (-28% equity selloff, the Kennedy Slide), February–October 1966 (-22% equity selloff, credit crunch), and October–December 1987 (-32% equity selloff, Black Monday). We also saw a “near-bear” market in 2018 when equities sold off 19+% amid concerns that the Fed was tightening faster than expected, although real GDP growth remained positive throughout this period from 2015~2019.
Source: Bloomberg, NBER, Goldman Sachs Global Investment Research, Goldman Sachs Asset Management.
This year we have seen rapid repricing of growth and the path of interest rates. The number of market-expected rate hikes increased from three to nine, whereas the consensus estimate for Q1 GDP growth has dropped quickly from nearly 4% to just over 1%, well below the 2.8% per annum rate as highlighted in the Fed’s March Statement of Economic Projections. Communications from the central bank have focused on curbing inflation and a fairly optimistic outlook on the economy.
In the near future, fighting inflation appears as daunting as ever, the result of renewed supply-chain pressures from China and expected food-and-energy shortages tied to the war in Ukraine. In light of these challenges, the Fed’s hawkish stance may be exactly what’s needed to keep inflation expectations anchored. However, the risks of a hard landing and demand destruction would rise if the central bank were to deliver nine rates hikes while simultaneously unwind the balance sheet. Assessing the growth impact of policy tightening requires watching for signs of demand destruction, especially in lower-income brackets.
As measured by the Cyclically-Adjusted Price-to-Earnings ratio, the S&P 500 is trading at a 36.3x multiple. That puts it at the 97th percentile of its historical range—a level last seen in the years leading up to 2000. Therefore, it would not be surprising to see some challenges to equity valuations as interest rates continue to rise, especially in the high-duration sectors. Investors can’t rely on the “Fed put” either; the central bank is not incentivized to provide any further easing of financial conditions given its focus on fighting inflation. If anything, equity selloffs may help to tighten financial conditions in line with the Fed’s objectives.
The mixed signals from recession models, valuations, and the forward-trajectory of policy actions, make this market a very difficult one for making directional calls. Geopolitical risk may complicate things further, as may the mid-term election cycle in the US. History suggests that price action can get more volatile in the second half of a mid-term election year than the first. As such, we will continue to monitor changes in macro fundamentals and price action, and intend to maintain a neutral outlook for now.