Catalysts to quell volatility-what, how and when?

Bottom line up top

• Fear or fundamentals: what’s driving volatility??As baseball legend Yogi Berra observed, “Ninety-nine percent of the game is half mental.” Perhaps he’d have said something similar about investing in 2022, with sentiment, psychology and non-fundamental factors holding sway of late. Put buying, fund outflows, investor bearishness surveys and the S&P 500’s failure to maintain key technical support levels all point to fear levels rising. Even as earnings growth has remained solid this year, stock prices have dropped sharply, pushing valuations significantly lower (Figure 1).
• A room with a (medium-term bullish) view.?Despite the technical noise, economic fundamentals remain generally sound, warranting guarded optimism about the medium-term outlook for markets. We expect recent turbulence to continue in the meantime, however. Greater clarity and further improvement in certain fundamental factors, if they materialize, are the likeliest potential catalysts for lowering market volatility
• Inflation.?April’s 8.3% Consumer Price Index reading disappointed investors hoping and expecting inflation to cool more. Instead, it plateaued, driven by steep increases in airfares, hotel rates, rents and durable goods. But some underlying details — falling used car prices, less spending on goods and signs of easing supply chains — offer hope for more meaningful relief in May.
• The Fed.?May’s CPI report is due before the next FOMC meeting in June, so there’s another chance policymakers could see a degree of inflation moderation that’s been elusive thus far. Markets are likely to welcome any evidence of decelerating inflation or data showing that high prices, constrained supply and rising interest rates are leading to demand destruction, but the Fed would need to see more than one month’s worth of data before it considers tempering its tightening.
• Jobs and consumers.?Reduced personal consumption could help bring inflation down in the near term, yet consumer spending drives demand over the long run. What might a balance of these objectives look like? More workers employed in growing areas of the economy where job creation is strong and the demand for labor is not so excessive as to trigger a wage/price spiral. This is the environment we currently see in the manufacturing sector, where PMIs remain firmly expansionary and April marked the 12th consecutive month of job gains, yet increases in average hourly earnings have been moderate.

Portfolio considerations

Within?equities,?we prefer a defensive tilt toward?dividend growers.?Historically they have outperformed the broader U.S. equity market during Fed rate hiking cycles (Figure 2) and in periods of heightened volatility.

As we’ve seen throughout 2022, duration assets have failed to provide a cushion against risk-off market declines. But we think it’s?still too early to increase exposure to interest-rate sensitivity,?as the Fed has only recently embarked on its hiking cycle. Additionally, in periods of higher inflation, core bonds have typically struggled to generate real returns. Within?credit,?yields have improved substantially.?High yield?is once again high yielding at around 7.5%, and spreads are relatively attractive versus history. And while the recent widening reflects increased perceived risks in the economy, it also offers a potential buying opportunity (and a yield cushion if markets sour further). Overall, we see strong fundamentals across corporate sectors, but?in the below-investment grade space?we believe it’s?prudent to stay up-in-quality (BBs).

Tax-sensitive investors?can still take advantage of dislocations in the?municipal bond?market. At the front end of the muni curve, yields are the highest they’ve been in years, and at the long end, muni/Treasury ratios exceed 100%.

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