Sometimes, financial markets are tripped up by long-gestating risks that unfold in plain sight. Other times, they’re blindsided by sudden shocks. Through the first four months of 2022, global markets have been jolted by both. Vexing inflation, spiraling energy prices, the outbreak of war and the opening stanza of a Federal Reserve tightening cycle have weighed on equities and fixed income. Though the U.S. economy still has considerable positives going its way, the amalgam of headwinds underscored the financial hazards in a world undergoing rapid change.
Russia’s invasion of Ukraine tops the list of unknowns, both for its immediate impact and for the financial and geopolitical effects that could reverberate into the future. Western allies imposed a stairstep of punishing economic sanctions that included export controls, severed U.S. trade ties and freezes of Russian assets held abroad. In the near term, much could depend on the length and intensity of the war, and how successfully the West can contain energy prices, given Europe’s heavy reliance on Russian crude oil and natural gas.
The common theme among the forces weighing on the markets is the barnacle-like accumulation of inflation. Consumer prices were already slammed by overwhelmed supply chains and the easing of pandemic fears. The war is exacerbating inflationary pressures, with a spike in commodity prices aggravating manufacturing and transportation costs.
The result has been a pronounced jump in interest rates and heightened resolve at the Federal Reserve. The central bank raised interest rates in March and signaled as many as six more hikes this year. Fed chairman Jerome Powell followed with a suggestion that policymakers could undertake one or more half-point hikes in place of their conventional quarter-point moves, with the first such move expected at this week's Fed meeting.
Despite the Fed’s ministrations, rising consumer prices may remain a problem. Rate hikes can defang inflation over time. But they’re essentially a time-release formula that yields results only gradually, and it won’t be known for some time if the central bank can engineer a soft landing that doesn’t squelch growth. The consensus view among Capital Group economists is that inflation could remain persistent this year, while the risk of an economic downturn has risen.
On the flip side, the U.S. has a number of forces going its way. The job market has been kinetic, with unemployment just a tick away from the half-century low registered before the pandemic. Wages have climbed, and even the labor force participation rate inched up recently, which could make it easier for businesses to find workers. Several dynamics — including a drop in the savings rate, depleted consumer sentiment and old-fashioned sticker shock — could lighten inflationary pressure on the margins.
Meanwhile, corporate earnings are rising solidly as companies wield newfound pricing power. Businesses across the board have been able to pass along higher input costs. Improving profits have in turn helped moderate stock valuations. Depending on the region, price-earnings ratios are now near or below their five-year averages.
As for the war’s effect on the stock market, armed conflicts have historically had little to no lasting effect on share prices. It’s too soon to tell whether that pattern will hold today, given the specter of prolonged hostilities and the lack of clarity on energy costs. Share values fell in the run-up to the war and as fighting erupted. However, equities staged a partial rebound afterward as investors took comfort in the relative strength of the U.S. economy, the absence of worse-than-feared financial developments and the opportunity to buy technology stocks after their pullback.
In many ways, the past two years represent a watershed for the global economy that’s reflected in the volatile and sometimes contradictory movements of the stock market. The pandemic upended a variety of once-sacrosanct financial and operational assumptions. That includes an unquestioned faith in the wisdom of globalization and the benefits of far-flung supply chains that, while financially efficient, are vulnerable to political tensions and logistical breakdowns.
At a minimum, the years-long embrace of globalization — the ideal of unfettered free trade enabled by legions of cross-border supply and distribution networks — appears poised for a reset. The war in Ukraine may accelerate a reassessment, with greater attention paid to the resilience of supply chains and a heightened push for renewable energy.
In the stock market, the extremely long period of dominance by U.S. stocks has continued. Domestic shares have bested their overseas counterparts for more than a dozen years, a significant deviation from historical patterns. The dichotomy stems partly from solid U.S. economic growth and the outsize influence of tech stocks in domestic indices.
Not surprisingly, the superior results of U.S. stocks have caused their relative valuations to swell in comparison to international rivals. Our managers have tended to be drawn to overseas shares for their comparative value.
The market’s recent volatility may be most apparent in the energy market. Oil prices collapsed when the coronavirus caused demand to sink and companies to cut costs by slashing exploration and production budgets. After a lengthy period of subpar results, the long-awaited easing of the pandemic boosted petroleum demand and, with it, share prices. Energy was the top-performing sector in the S&P 500 last year and one of only two sectors to rise in the first quarter of this year, with a whopping 39% gain. The hostilities in Ukraine and uncertainty over European sourcing have only caused energy prices to swell further.
However, energy is a highly cyclical business, and share prices can swerve dramatically, which is one reason our portfolio managers have limited exposure to the sector. Oil prices and share values typically collapse during recessions. Energy is also a commodity-reliant industry that, on the whole, exhibits few of the characteristics our portfolio managers favor, such as steady earnings, long-term secular growth prospects and the ability to stand out via superior management or innovative products.
One of the potential impacts of the Ukraine conflict is that Europe will accelerate its shift toward renewables as part of its effort to reduce reliance on Russian gas. Furthermore, mounting concerns about climate change and the effort to slash reliance on fossil fuels pose questions about the energy sector’s long-term appeal. The rapid evolution of electric vehicles and other forms of renewable energy is likely to be a long-lasting competitive threat, particularly as technologies improve and costs come down. Additionally, the emphasis on environmental, social and governance (ESG) investing principles could be an ongoing drag on oil-related stocks.
Our portfolio managers also have been cautious about banks, given the cyclical nature of the business at a time of economic uncertainty.
Bank stocks came into favor in the past year as interest rates rose. Higher rates pad banks’ bottom lines by allowing them to quickly boost the rates charged to borrowers while ratcheting up those paid to depositors at a decidedly slower pace. In financial parlance, that’s known as a widening of net interest margins.
However, the industry’s recent spell of good fortune follows the decidedly less salutary backdrop that prevailed for more than a decade following the 2008 global financial crisis. The era of ultra-low rates compressed net interest margins and squeezed bank profitability. That coincided with a tougher competitive landscape as digital payment rivals and newly emergent fintech businesses gained traction. In fact, the bank stocks’ rally was helped along by the sector’s relatively modest showing since the financial crisis.
Banks have benefited from other factors recently, including elevated market volatility that boosted securities trading and the nationwide housing boom that electrified mortgage lending. Banks also got a boost from having to stash away less money to cover anticipated future losses. With borrower defaults near record lows, banks set aside less in rainy-day funds known as loan-loss reserves. In fact, in many cases, excess reserves enabled them to transfer money out of those accounts, with the effect of boosting reported earnings.
Like energy companies, however, banks are highly cyclical, and their profitability could be jeopardized if the forces that propelled them recently tail off. Economic weakening would likely eat into loan demand and push up delinquencies.
On a more fundamental level, banks’ main business — lending money — is relatively generic. It’s hard to lure customers from rivals without offering more favorable lending terms that can pinch the bottom line. There are exceptions, especially for institutions that are well managed, focused on profitable niches or situated in fast-growing regions producing organic loan growth. On the whole, however, our investment team prefers other areas of financial services with potentially brighter prospects and less cyclicality, such as digital payments, insurance and securities exchanges.
Technology has also experienced swift reversals in investor sentiment — so much so, in fact, that over the last year the sector has swung from leader to laggard from one quarter to the next.
Big-name tech companies continue to enjoy creative ferment and expansive growth prospects. But their collective success is itself a risk. The top five businesses — Apple, Microsoft, Amazon, Tesla and Google parent Alphabet — make up a combined 23% of the S&P 500. Depending on how it’s measured, the concentration of tech exceeds the peak of the dot-com era.
Given their powerful earnings and global footprints, today’s tech giants have much better fundamentals than their counterparts from two decades ago. Nevertheless, individual companies remain vulnerable to broad market selloffs as well as business-specific missteps. In light of that, our portfolio managers have tended to maintain underweight exposure to some of these companies.
The potential downside was shown as interest rates rose in the past year. Rising rates tend to weigh heavily on pricey growth sectors because valuations are often based on expectations of significant profitability in the future, which could be crimped by higher interest costs or less favorable economic conditions.
Since the start of 2021, the sector has swung between good and bad quarters. Tech rallied in the second and fourth quarters of last year, but trailed notably in the first and third quarters, and again at the start of this year.
The steep rise in rates over the course of the quarter weighed heavily on fixed income, with negative returns across classes, including taxable and municipal bonds. Several interlocking factors hurt fixed income — including soaring commodity prices caused by the Ukraine war and the Fed’s increasingly assertive rhetoric targeting inflation.
Their sensitivity to Fed rate policy has caused yields on short-term Treasuries to climb sharply, in some cases exceeding those on longer-term securities. That dynamic, known as an inverted yield curve, has sometimes foreshadowed recessions. However, several factors may make the indicator less telling today, including the Fed’s enormous intervention in the market in recent years, which has shaken up some of its long-standing dynamics.
Though rising rates can cause short-term pain, that can benefit portfolios over the long term. As securities mature, our investment team is able to replace older bonds with low yields with newer, higher-yielding securities. That’s one reason bonds have tended to do well even in rising-rate environments. Bonds also have tended to go up when stocks have declined, as rates could retreat in the event of an economic slowdown or recession.
Fixed income continues to play a central role in balanced portfolios. Bonds can offer diversification from equities, income generation and capital preservation. These three traits are especially important given the shadows in the global economy and stock market.