Stocks rally

Originally published as a CIO alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management

What happened

Equities rallied Tuesday in a continuation of the rebound that took hold late last week. All S&P 500 sectors finished the session higher with the exception of consumer staples. The IT, materials, financials, and consumer discretionary sectors all rose more than 2.5%.

Two-year US Treasury yields rose 14 basis points while the 10-year yield rose 11bps, flattening the 2-year/10-year yield curve to 28bps. Markets continue to price in over 200bps of additional Federal Reserve rate hikes by the end of 2022.

Few new information drove the rally, though the US retail sales and industrial production data both suggested the economy remains relatively robust. Outside the US, there was incremental positive news flow out of China on tech regulation and an easing of lockdown restrictions in Shanghai, which also helped risk sentiment.

What do we expect?

Broad-based market recoveries like the one seen today are a potent reminder of the value of staying invested; the market’s best-performing days often tend to occur alongside the worst. In just the last five days, the S&P 500 has rallied over 4% from its low, while the Nasdaq has recovered nearly 5.5%.

Investor sentiment and confidence remain shaky, and as a result, we are likely to see volatile and choppy markets until we get further clarity on the 3Rs—rates, recession, and risk. We therefore continue to recommend investors tilt portfolio exposures to the segments of the market we expect to outperform in an environment of high inflation, rising policy rates, and elevated volatility, namely value stocks, commodity and commodity-linked stocks, and defensives.

Rates. Though the April CPI reading was above consensus economist expectations, it is another reaffirmation that inflation has likely peaked. We continue to expect moderating demand for goods that spiked during the pandemic, coupled with base effects, to lead to lower inflation readings over the remainder of the year.

Recession. Recent economic data has been mixed. First-quarter GDP growth in the US and the UK were negative, while industrial production and retail sales data for April, released today, were both above consensus. Large revisions to prior retail sales figures reinforce our view that a US recession is unlikely in the next 6–12 months.

Risks. News flow out of China recently has been positive in both the tech regulation and pandemic control areas. Positive developments like these, coupled with our expectation of policy stimulus and the recent cut in mortgage rates for first-time buyers, are all helping to improve sentiment in the region. In Europe, the war in Ukraine continues, and the intention of Finland and Sweden to join NATO is likely to keep tensions in the region high.

How are we positioned?

Despite our expectation of falling inflation and sustained growth, we believe investors should brace for further equity volatility ahead amid significant moves in key economic variables and bond markets. We continue to favor areas of the market that should outperform in an environment of high inflation:

Invest in value. Stocks with relatively low valuations (value) tend to benefit from rising real rates. Since 1975, value has outperformed growth across the cycle in periods when inflation is 3% or more. We advise investors who have been under-allocated to value after a long period of underperformance to add to long-term positions in value stocks or value-oriented sectors and markets, including global energy and the UK.

Build up portfolio hedges. Broad commodities have performed well historically during inflationary regimes, and we think they represent an effective geopolitical hedge today given the risk of supply disruptions.

We also believe the US dollar can continue to act as a good portfolio hedge in the near term. It is likely to continue to benefit from safe-haven flows, rising US real interest rates, and the US’s position as a net energy exporter.

Adding exposure to defensive equity sectors like healthcare can also help reduce overall portfolio volatility. The pharmaceutical segment is traditionally relatively resilient during risk-off moves, and valuations currently look undemanding, in our view.

Manage high inflation and rising rates. In fixed income, areas of value have emerged following the rise in yields in recent weeks. We see an opportunity in environmental, social, and governance (ESG) engagement high yield bonds. We retain a preference for areas of private credit, such as first-lien loans to middle-market companies.

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