After posting strong gains over the last couple of years, asset prices have stumbled in the first 5 months of 2022 as financial markets digest higher inflation, rising interest rates, and geopolitical uncertainty. Both stocks and bonds have experienced broad declines while asset categories that benefit from higher inflation, such as commodities, have generated gains. Financial markets have seen a notable shift from the benign volatility environment observed throughout much of the past several years. Between January 1, 2022 and May 13, 2022, over 85% of days have seen the S&P 500 trade in at least a 1% daily range.
The economic and geopolitical backdrop remain highly uncertain—therefore market volatility is likely to remain elevated. As a result of higher commodity prices and tightening monetary policy, economic growth is set to slow. Despite this deceleration, we believe the risk of a near-term (next 12 months) recession is still relatively low given healthy consumer and corporate balances sheets and a strong labor market.
As of the date of posting, corporate profits (as measured by reported earnings) have remained resilient. Yet, valuations have discounted a good bit of bad news. According to BCA Research, global equities are trading at less than 16-times forward earnings, which is down from more than 20-times late last year. Outside of the US, stocks are trading at less than 13-times forward earnings. We’d also note that some of the forces that have pushed down stock prices may start to abate. For example, the inflation data has at least become less bad. In the US, core goods inflation fell by 0.4% month-over-month in April—the first outright decline since February 2021. And in China, the 7-day average of new Covid cases has fallen by more than half since late April. China’s domestic production of Pfizer’s Paxlovid anti-Covid drug is also starting to ramp up, which should allow for some easing in lockdown measures later this year.
In the current environment, we continue to believe that proper diversification is as important as ever. In terms of tactical portfolio positioning, we continue to target an underweight position to core/investment grade fixed income, but recommend adding to municipal bonds given recent weakness and more attractive yields. We also maintain an underweight to US stocks on valuation concerns while emphasizing higher quality companies. We advocate adding to emerging markets stock positions given recent weakness and more attractive valuations. We also continue to target an overweight position to “real assets” like commodities and energy-related stocks given the risk of stickier inflation, but recommend trimming exposures back to targeted weights on recent strength.
Please see the attached presentation that provides our assessment of the market backdrop and shares our views on portfolio strategy going forward.