Stocks fall as central banks get tough on inflation

The S&P 500 fell 5.8% last week, the biggest weekly decline since March 2020, as central banks around the world took more aggressive steps to combat inflation. The index now stands 23.4% below its January peak, and has entered bear market territory for the first time since the early stages of the pandemic.

The Federal Reserve raised policy rates by 75 basis points, the largest hike since 1994, and indicated that the faster pace of tightening could continue at the July meeting. In the FOMC's twice-yearly monetary report to Congress, policymakers characterized their commitment to restoring price stability as “unconditional.” The Swiss National Bank surprised investors by raising its policy rate by 50 basis points, the first increase in 15 years. The Bank of England hiked rates for the fifth time since December, with only the Bank of Japan sticking with an ultra-easy monetary stance.

These moves added to the perception that elevated inflation is central banks’ number one concern, and that they are willing to tighten monetary policy swiftly—even if it increases recession risks.

The VIX index of implied US stock volatility closed the week at 31, consistent with daily moves of around 2% in the S&P 500. Bond markets, too, remained volatile; the 10-year US Treasury yield climbed to 3.48% before settling at 3.23%.

Alongside worries over monetary tightening, investors have become increasingly concerned about the potential for further disruptions of energy supplies from Russia. Gazprom, the state-controlled energy company, reduced gas flows to Germany through its Nord Stream pipeline by 60% last week. While Gazprom cited technical problems, Berlin has said the decision was political. This increases the risk of a recession in Europe’s largest economy and adds to the challenge of bringing down inflation, which hit 7.9% year-over-year in May. Russia has also been reducing gas supplies to Italy and Slovakia.

What do we expect?

The more aggressive line by central banks adds to headwinds both for economic growth and for equities. The risks of a recession are rising, while achieving a soft landing for the US economy appears increasingly challenging.

The Fed's messaging is likely to continue to be hawkish until we see clearer evidence of a deceleration in inflation. The stubbornness of inflation and the shift in the central bank's reaction function have pushed up expectations for the terminal rate, which at the time of writing was priced at just under 4%. Although the Fed may not need to hike all the way to 4% in practice, the risk that it will do so has increased, and with it the risk of a recession.

The more aggressive line by central banks adds to headwinds both for economic growth and for equities.

Taking this into account, we forecast 10-year US Treasury yields to trade at 3.25% by December and acknowledge they may trade even higher in the interim. Volatility in bond markets is likely to continue with each policy announcement and each new data release on inflation and inflation expectations. We anticipate yields will decline more sustainably only in 2023 as inflation fears subside and the market begins to consider the possibility of future rate cuts to support growth.

With the Fed—and other major central banks—putting even greater emphasis on fighting inflation, the risks to economic activity are rising. Tighter financial conditions—a result of higher yields, wider credit spreads, and stock market drawdowns—are likely to weigh on output. The rise in US mortgage rates to their highest level since 2009 is cooling the housing market. And US economic indicators are pointing to a loss of growth momentum: The Atlanta Fed's GDPNow forecast for the annualized quarterly growth rate of real GDP in 2Q has dropped from a recent high of 2.5% on 17 May to 0%.

Against this backdrop, we now see less upside for equity markets for the remainder of the year. To reflect this, we have lowered our base case December price target for the S&P 500 to 3,900. This reflects a 2% cut to our 2023 earnings estimate, to USD 235 per share, and a cut in our estimate of the fair forward price-to-earnings ratio to 16.6x from 17.9x, owing to higher expected bond yields.

In the Eurozone, growth momentum is slowing, while renewed uncertainty about the future of Russian gas supplies and the risk of bond market fragmentation are adding to macro risks. We have cut our base case December EuroStoxx 50 targets by 15% to 3,400 (around current levels).

How do we invest?

1. Manage your liquidity.

• In volatile markets, effective liquidity management can help mitigate the risk of forced selling to meet obligations and enable investors to capture longer-term opportunities as they arise. We recommend that investors consider holding a high-quality bond ladder that aligns with their planned cash flow needs over the next 3–5 years. By setting up a ladder, investors can take advantage of higher rates while helping shield themselves from bond market volatility.

2. Build up defensive strategies.

• With volatility likely to remain high and growth slowing, investors can focus on more defensive parts of the market that can help mitigate market swings and should also outperform in the event of recession. We particularly like quality income, dividend-paying stocks, and the healthcare sector.

3. Position for an era of security.

• As the war in Ukraine continues, governments and businesses are adapting to the new era of security—in terms of energy, data, and food. Over the longer term, we think this will spur demand for carbon-zero, cybersecurity, and agricultural yield solutions.

4. Add to value-oriented strategies.

• Within equities, an environment of rising interest rate expectations and high inflation is favorable for value sectors relative to growth sectors. Historically, during periods when inflation has been above 3%, value sectors have outperformed. We favor the energy sector and the UK market, which is heavily weighted to value stocks. Both have outperformed the broader market this year, and we expect that outperformance to continue. By contrast, periods of rising real yields tend to be negative for growth stocks. We hold a least preferred view on growth and on the consumer discretionary sector.

5. Prepare for further volatility.

• High volatility environments may present opportunities to gain market exposure to potentially attractive alternative payoff structures using structured investments and options. A dynamic approach to asset allocation, or structures with a degree of capital protection, may also help investors manage downside risks.

6. Diversify with alternatives.

• The potential for hedge funds to provide uncorrelated returns is particularly valuable when interest rate fears lead to higher equity-bond market correlations. Some hedge fund strategies, such as macro, can also perform well in recessionary scenarios. Meanwhile, the sell-off may be creating an opportunity to build up long-term private equity allocations. The average annual return on global economic growth buyout funds launched a year after a peak in the MSCI All Country World index has been 18.6%, compared with 8% for vintages launched two years before a peak in public stocks, according to Cambridge Associates’ data since 1995.

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