Macro views
Macro views

Staying invested today: Resiliency in the face of tightening

February 3, 2022 | 7 min read
Seema Shah
Chief Global Strategist

Financial markets have had an extremely rocky start to 2022. After a month of trading, several major global equity market indices have fallen into correction territory—a drop of 10% from their recent all-time highs—as investors adjust expectations in the presence of United States Federal Reserve (Fed) tightening, elevated inflation, and softening economic growth.

While short-term market pullbacks are normal and inevitable, many investors are concerned about what these fluctuations might mean for the year ahead. After several decades characterized by low inflation, low market volatility, and strong returns, investors must brace themselves for a very different environment. A focus on fundamentals can help fade the noise, identify the risks, and seek out the market opportunities that this correction will likely generate.

The pullback that pundits warned of…

Investors enjoyed a remarkable market recovery from the market low in March 2020 through to the fourth quarter of 2021, with the S&P 500 more than doubling in value. In 2021 alone, U.S. stocks gained 29% with dividends, small caps rose 15%, and international developed markets gained 12%. Investors who stayed overweight risk assets were handsomely rewarded as the economy reopened and policy stimulus hit unprecedented levels.

Since the start of the year however, broad equity markets have tumbled. With the Fed confronted by both surging inflation and bubbling wage pressures, it is compelled to tighten monetary policy as soon as possible. Meanwhile, Omicron, fading fiscal support, and escalating geopolitical tensions between Russia and Ukraine are conspiring to soften global growth.

Are conditions for equity market outperformance becoming more challenging? Yes. But fears are likely exaggerated and do not accurately represent the still-supportive backdrop for risk assets.

Staying invested, even in the face of more challenging conditions, is rarely the wrong decision. And while the pullback in Fed liquidity means risk assets will lose some of their allure, in today’s environment, there are three key reasons why investors ought to stay invested: short-term market pullbacks are normal; the most acute price pressures should soon start fading, easing the Fed’s urgency to tighten; and, the fundamental economic backdrop remains solid, driving opportunities.

Short-term pullbacks—uncomfortable, but not uncommon

While the recent global equity pullback has triggered significant unease, such drawdowns are more common than the stable image portrayed by the last few quarters. As recently as 2020, the S&P 500 experienced 12 market pullbacks—the highest count since the 2008 crash—but there are typically four or five market pullbacks of 5% or larger each year. Thus, the fact that the S&P 500 is down over 3% and the NASDAQ nearly 8% yearto-date may seem significant but is standard market behavior

There are often several market pullbacks each year
Number of 5% S&P 500 pullbacks, 1980 – present

Bar chart showing the 5% S&P 500 market pullbacks from 1980 to 2022, with 4.5 per year being the average

Clearnomics, Standard & Poor’s. Data as of February 2, 2022.

Amidst the markets swings and roundabouts in the month and quarters ahead, equity returns will likely be lower this year than years prior, but should be positive nonetheless.

Fed tightening: Imminent, but measured

The Fed will likely begin its hiking cycle at the March Federal Open Market Committee (FOMC) meeting (March 17, 2022) and our current forecasts call for six rate hikes over 2022-2023. The Fed is also likely to begin passively reducing the size of its balance sheet (permitting maturing assets to roll-off) in the second half of this year and at a faster pace than previously.

A Fed tightening which is no steeper than recent cycles
Target range lower limit

Line graph showing the Fed rate hikes from 2004 to 2024 (forecasted)

Clearnomics, Federal Reserve, Principal Global Investors. Data as of February 2, 2022.

While Fed tightening is to be expected at this stage in the business cycle, and usually signals healthy economic conditions, equities still often react poorly to sharp changes in the interest rate environment. But, provided tightening expectations are not too onerous, the period of adjustment is often temporary. This was true in 2013 during the Fed taper tantrum, in 2015 when the Fed announced its first rate hike that cycle, and even last year, when the market began to understand that Fed tapering was rapidly approaching.

This time, investors are concerned that the Fed has been far too slow to respond to inflationary pressures and, as a result, many are questioning whether even five hikes this year will be sufficient.

With inflation at its highest level in almost four decades and inflation expectations elevated, the Fed must prioritize fighting inflation. Yet, the most acute upward price pressures should soon start to unwind, pulling U.S. Consumer Price Index down to around 3% by year end. Not only is the economic reopening novelty temporary, but supply chain relief will likely arrive as demand slows and vaccinations enable greater COVID tolerance. This should result in a softening in the Fed’s policy stance through the latter half of the year—market rate expectations, like inflationary pressures, are close to peaking.

Most importantly, despite their haste to put the inflation genie back in the bottle, the Fed will try to avoid precipitating a recession. At Fed Governor Brainard’s confirmation hearing in mid-January, she noted the desire to sustain a “recovery that includes everyone.” Furthermore, Chair Powell’s own comments at his confirmation hearing on January 11, emphasized that the Fed needn’t rush to get to a neutral stance of policy.

With market expectations for Fed tightening so hawkish, the bar for a positive surprise from the Fed is low—it would take just a few reassuring words about the importance of sustaining growth to improve sentiment.

Economic growth: Slow, but solid

While once-in-a-lifetime levels of GDP growth and job gains kicked off the economic recovery, the coming years should experience a steadier pace of growth. Currently, economic data suggest that, even in the face of elevated labor and intermediate input costs, corporate profits are the strongest in decades. Resilient consumers, backed by a war chest of excess savings, imply a continuation of the strong demand conditions of 2021. Greater pandemic resilience indicates a gradual normalization of supply chains, which will provide a boost to both inventories and production.

There is also little sign of a recession in market pricing. Shortterm credit spreads have not risen meaningfully relative to long-term credit spreads, suggesting that market participants remain unconcerned about near-term default risk. The relative performance of cyclical and defensive stocks suggests market participants expect healthy economic growth, while the recent underperformance of pandemic “stay at home” beneficiaries points to a market that is anticipating a normalization of activity.

Of course, the recent bond market rout which has driven real yields sharply higher can be a risk to economic growth and are a valuation headwind. Yet, even after the sell-off, real yields are still in negative territory and financial conditions remain historically easy. If market expectations for five Fed rate hikes this year are fulfilled, that would likely still leave real rates negative. While a softer economic outlook is likely, it’s worth noting that, since 1954, there has never been a U.S. recession when real rates were this low.

Turning adversity into opportunity

Despite the underlying economic support for risk assets, there still remains significant challenges ahead. Global growth has peaked, elevated inflation could persist through the first half of the year, and markets are facing a trilogy of tapering, rate hikes and quantitative tightening all in one year. That said, after the fastest drop in equity markets since March 2020, valuations are starting to look less stretched and opportunities are growing.

Five rate hikes would still leave policy rates below 1.5%
Implied fed funds rate and number of hikes/cuts at each Fed meeting

Bar char showing the number of hikes/cuts and implied federal funds rates from March 2022 to Feb 2023

Clearnomics, Bloomberg, Principal Global Investors. Data as of February 2, 2022.

Sustained, material drops in equity prices are typically associated with recession. But, while global growth has likely peaked, recession is not in the cards.

Quality

Over the past two decades, quality factors have tended to outperform during periods of slowing growth and worsening market conditions. The companies that can be classified as quality often place emphasis on the stability of earnings, the sustainability of margins and the strength of balance sheets, while pricing power also tends to be strong. These are attributes that will help companies as conditions become more challenging in the coming months.

U.S. outperformance

Although global market upheaval largely stems from happenings at the U.S. Federal Reserve, it is traditionally emerging markets that struggle the most with the resulting tightening in liquidity conditions. During the 2013 taper tantrum, while the U.S. promptly recovered and even delivered positive returns within a few months, emerging markets plunged into a prolonged decline. Where are many quality companies found? The United States.

Diversification across sectors

While growth typically outperforms in a slowing economy, it underperforms in a rising rate environment (vice versa for value). Growth remains historically expensive—but value is also expensive relative to its history. With these considerations in mind, market rotations across styles can occur suddenly and violently. Since it is difficult, if not impossible, to predict the timing of these shifts, investors may want to hold an appropriate amount of each, diversifying across styles.

In the period ahead, one which will likely be wrought with bouts of sharp volatility, investors would be well suited to stay invested with an eye toward factors that will not only participate in further equity market expansion but can help reduce volatility.

Disclosure

Risk considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards.

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