War, inflation and hawkish policy pressure the financial markets

War, inflation and hawkish policy pressure the financial markets

Barbara Reinhard

Barbara Reinhard, CFA

Managing Director, Head of Asset Allocation

Paul Zemsky

Paul Zemsky, CFA

Chief Investment Officer, Multi-Asset Strategies and Solutions

Despite our view that a U.S. economic contraction is avoidable in the near term, the outlook for equities has deteriorated since the beginning of the year and we think this sour spot is likely to last as monetary policy becomes tighter.

The world and markets continuously change, but over the first three months of 2022 there have been shocking shifts in the landscape and asset prices. Russia’s invasion of Ukraine caught many off-guard. Beyond the terrible hardships this war has already caused for those directly involved, the distressing circumstances have cast a dark shadow of uncertainty over Europe and exacerbated existing risks. Geopolitical tensions between the West and the rest are as strained as they have been in decades. Stresses have been felt most acutely in the energy arena, as Russia produces about 10% of global oil and provides Europe with more than 40% of its natural gas. This disruption makes it more difficult for policy makers to quell inflation, which the Federal Reserve now admits is not transitory. Even stripping out food and energy, core CPI and personal consumption expenditures (PCE) are up 6.4% and 5.4% year-over-year (YoY), respectively. Labor markets are extremely tight: job openings now exceed estimates of unemployed workers by nearly 2:1 (Figure 1). As a result, the Fed has set a more hawkish tone in recent communications and left investors wondering how aggressive it will be.

The situation has not been favorable for stocks. Except for Latin America, a commodity-centric region, most major markets sold off during the quarter. In the United States, larger-capitalization, more value-oriented stocks outperformed smaller, growth-oriented stocks. Overseas, countries most exposed to the war, either geographically or economically, struggled. What made this a particularly painful period, however, was the lack of safety generally offered by bonds. The move-up in yields was astounding, not only for the size of the move — the 157 basis point increase in the two-year U.S. Treasury yield was a five-standard-deviation move — but also for the speed at which it occurred. Rising rates, along with wider yield spreads across the quality and product spectrum, caused core bonds to underperform stocks during a risk-off period, which is highly unusual.

Tactical Indicators

tactical indicators

Figure 1. U.S. job openings exceed the estimate of unemployed workers by nearly 2:1
Unemployment versus job openings
Unemployment versus job openings

Source: Bloomberg, as of 3/31/22.

Figure 2. The long end of the yield curve has slightly inverted. The short end is still steep, but expected to flatten
U.S. Treasury par yield curve rates
Figure 2. The long end of the yield curve has slightly inverted. The short end is still steep, but expected to flatten

Source: U.S. Department of the Treasury, Voya Investment Management, as of 4/11/22.

Figure 3. Global earnings revisions are rolling over in every region of the world
Citi Earnings Revisions index, four-week moving average
Figure 3. Global earnings revisions are rolling over in every region of the world

Source: Bloomberg, Voya Investment Management, as of 4/8/22.

Portfolio positioning
Portfolio positioning

Investment outlook

We know growth is slowing, but is a U.S. recession on the horizon? The probability has risen but we don’t think a recession is imminent or inevitable over the next twelve months. As the effects from the pandemic continue to fade, mobility has picked up and formerly left-behind sectors — travel, leisure and lodging — should become recipients of an increased amount of consumer spending in the spring and summer months. Demand for labor remains strong — the unemployment rate fell to 3.6% in March and could go lower. The labor force participation rate has increased recently, and we think higher wages will increase participation more, at some point softening an extremely tight labor market. We do, however, acknowledge our later stage position in the business cycle and are aware that policymakers need to take action to reel in prices. This involves cutting aggregate demand in a manner that results in a soft landing. The war and sanctions on Russia have made that task more difficult; particularly in Europe, which imports significant energy resources from Russia, making it probable Europe will experience a recession. The U.S. is essentially energy independent and thus more insulated against prolonged disruption in Russian oil and gas supplies. What’s more, the winding down of Covid will provide inflation relief on consumer prices for autos and shipping costs. We also realize the yield curve has inverted in spots (Figure 2) on several occasions, most notably in the long end, and has a concerning track record of forecasting future recessions. Not all yield curve segments have the same predictive ability, however; the Fed has published research suggesting the short end of the curve is a better indicator. The short end doesn’t incorporate a term premium and is currently significantly negative. Moreover, the current level of policy accommodation needs to be considered. A good measure of this is the difference between the real Fed funds rate and the estimate of the neutral rate (R*), which is still clearly negative. In our view, the key to maintaining positive U.S. growth this year will be a transition from accommodative fiscal and monetary policies to a period of increased private sector investment that leads to productivity enhancing technologies such as robotics and automation, the adoption of which already were accelerated by the pandemic.

Despite our view that a U.S. economic contraction is avoidable in the near term, the outlook for equities has deteriorated since the beginning of the year and we think this sour spot is likely to last as monetary policy becomes tighter. If the Fed can anchor long-term inflation expectations, there could be room for equities to outperform, but global earnings revisions reflect the slower growth future and are rolling over in every region of the world — most meaningfully in the emerging markets (Figure 3). There are also several tail risks that appear uncomfortably fat; and in light of a smaller equity risk premium and other not particularly appealing valuation measures, we have reduced our allocation to stocks and now hold a neutral to slight overweight in most portfolios. We continue to prefer U.S. assets over the rest of the world, as its relative geographic and economic insulation provides a layer of defense against some of the most material risks. Within the U.S., large cap stocks remain our favorite asset class. Larger companies are in a better position to absorb high wages, pass through inflation to consumers and maintain margins in an environment where earnings multiples are likely to be pressured. Although earnings growth is coming down, our models forecast mid-teen earnings growth in 2022. This butts against the Fed tightening financial conditions and the likely countervailing force of contracting multiples. Taken together, we think U.S. large caps can deliver positive, albeit modest returns over the balance of 2022.

IM2124137

Past performance does not guarantee future results.

This market insight has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of

an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults (5) changes in laws and regulations and (6) changes in the policies of governments and/or regulatory authorities.

The opinions, views and information expressed in this commentary regarding holdings are subject to change without notice. The information provided regarding holdings is not a recommendation to buy or sell any security. Fund holdings are fluid and are subject to daily change based on market conditions and other factors.

The distribution in the United Kingdom of this Market Insight and any other marketing materials relating to portfolio management services of the investment vehicle is being addressed to,

or directed at, only the following persons: (i) persons having professional experience in matters relating to investments, who are “Investment Professionals” as defined in Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the “Financial Promotion Order”); (ii) persons falling within any of the categories of persons described in Article 49 (“High net worth companies, unincorporated associations etc.”) of the Financial Promotion Order; and (iii) any other person to whom it may otherwise lawfully be distributed in accordance with the Financial Promotion Order. The investment opportunities described in this Market Insight are available only to such persons; persons of any other description in the United Kingdom should not act or rely on the information in this Market Insight.

In addition, please be advised that Voya Investment Management is a non-Canadian company. We are not registered as a dealer or adviser under Canadian securities legislation. We operate in the Provinces of Nova Scotia, Ontario and Manitoba based on the international adviser registration exemption provided in National Instrument 31-103. As such, investors will have more limited rights and recourse than if the investment manager were registered under applicable Canadian securities laws.

The Capital Markets Authority and all other Regulatory Bodies in Kuwait assume no responsibility whatsoever for the contents of this Market Insight and do not approve the contents thereof or verify their validity and accuracy. The Capital Markets Authority and all other Regulatory Bodies in Kuwait assume no responsibility whatsoever for any damages that may result from relying on the contents of this Market Insight either wholly or partially. It is recommended to seek the advice of an Investment Advisor.

Voya Investment Management does not carry on a business in a regulated activity in Hong Kong and is not licensed by the Securities and Futures Commission. This Market Insight is issued for information purposes only. It is not to be construed as an offer or solicitation for the purchase or sale of any financial instruments. It has not been reviewed by the Securities and Futures Commission.

Voya Investment Management accepts no liability whatsoever for any direct, indirect or consequential loss arising from or in connection with any use of, or reliance on, this insight which does not have any regard to the particular needs of any person. Voya Investment Management takes no responsibility whatsoever for any use, reliance or reference by persons other than the intended recipient of this insight. Any prices referred to herein are indicative only and dependent upon market conditions. Past performance is not indicative of future results. Unless otherwise specified, investments are not bank deposits or other obligations of a bank, and the repayment of principal is not insured or guaranteed. They are subject to investment risks, including the possibility that the value of any investment (and income derived thereof, if any) can increase, decrease or in some cases, be entirely lost and investors may not get back the amount originally invested. The contents of this insight have not been reviewed by any regulatory authority in the countries in which it is distributed. The opinions and views herein do not take into account your individual circumstances, objectives, or needs and are not intended to be recommendations of particular financial instruments or strategies to you. This insight does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction. You are advised to exercise caution in relation to any information in this document. If you are in doubt about any of the contents of this insight, you should seek independent professional advice.

This material may not be reproduced in whole or in part in any form whatsoever without the prior written permission of Voya Investment Management.

Top