Equity sell-off gathers momentum

Originally published as a CIO Alert by Mark Haefele, Chief Investment Officer for UBS Global Wealth Management

What happened?

US equities fell 3.6% on Friday, the largest one-day drop since June 2020, with the tech-focused Nasdaq losing 4.2%. The S&P 500’s 8.8% decline in April represents the index’s worst monthly performance since March 2020, while the Nasdaq’s 13.2% fall is its worst since October 2008.

The drivers for Friday’s decline appear to be a combination of disappointing mega-cap earnings, signs of wage inflation heightening fears of a Fed-induced recession, China’s COVID-19 lockdowns, and the war in Ukraine.

Amazon’s first-quarter results, released after the close on Thursday, weighed on sentiment as the online retailer reported its slowest-ever revenue growth and rising costs.

Negative sentiment was exacerbated by the US Employment Cost Index (ECI) data showing that wages increased 1.4% quarter-over-quarter in 1Q22, above consensus expectations and a record high under the current methodology, which started in 4Q96. Bond yields rose due to inflation fears. Yields on 2-year and 10-year US Treasuries both increased by around 10 basis points on Friday, for respective monthly increases of 39bps and 59bps.

With the Federal Reserve meeting this week to decide on its next move on interest rates, concerns have increased that the central bank might opt for a more aggressive 75bps move, rather than the widely expected 50bps increase. Fed funds futures markets are now pricing in more than 280bps of tightening this year, raising concerns about the economy’s ability to withstand this pace of tightening without slipping into recession.

Growth concerns have been compounded by China’s ongoing struggles to contain COVID-19—further restrictions were announced for Beijing this weekend—as well as the impact of restrictions on the flow of Russian oil and gas on Europe’s economy.

The US dollar (DXY index) retreated 0.6% on Friday after reaching near 20-year highs, but still gained 4.7% on the month, supported by the expected pace of Fed tightening relative to other central banks and safe-haven flows.

What do we expect?

As we highlighted in our latest monthly letter, “Positioning for inflation” published 28 April, the central question for investors is whether the Fed can steer both inflation and growth closer to trend without provoking a recession.

Our base case is that inflation is likely to fall from current levels but remain above pre-pandemic ranges. We expect growth in 2022 to be slower than last year, but not tip over into recession. Our view remains that the right strategy is to position for inflation—a clear and present fact—rather than recession, which is still only a future possibility.

We hold this view for three reasons:

The Fed is unlikely to induce a recession this year.?The quarterly ECI data simply confirmed what other timelier wage indicators are telling us: that wage growth is around 2 percentage points too high for the Fed to hit its inflation target in the long run. But the Fed’s inflation target of 2% is a long-run average, not a short-term ceiling. In our view, as long as there are reasonable prospects of inflation dropping to 2.5% by the end of 2024, the Fed will not feel compelled to step hard on the brakes in order to get inflation down faster.

Some commentators point to the housing market as a reason for the Fed to act more aggressively. But while the official measure of rent inflation is likely to remain elevated, it is a lagging indicator that is still adjusting to upward pressure on rents from higher wages and tight housing supply. The Fed is aware of this and, in our view, will not feel compelled to act if timelier data is showing waning pressure on rents. In addition, we expect the more than 2-percentage-point increase in mortgage rates to start cooling the housing market, but this has yet to show up in the data.

US earnings have generally been solid.?There have been high-profile disappointments, of which Amazon is the latest. But with more than half of the S&P 500 having reported, overall the results and guidance have been good. More than 70% of companies are beating sales estimates and 80% are beating earnings estimates. In aggregate, earnings are beating by 5.5%. The weakness is mostly in consumer segments, and in some cases reflects payback after strong growth during the pandemic. Enterprise segments are faring better.

Looking ahead, management team guidance for 2Q is holding up, and corporate profits are on track to grow roughly 10% on nearly 12% sales growth, though we will be watchful for the potential effects of cost pressures on margins, and of supply chain challenges and geopolitical concerns on revenues. The bottom-up S&P 500 consensus estimate for 2Q is unchanged since earnings season began.

China could shift from global headwind to tailwind.?Reflecting the effects of COVID-19 lockdowns, we recently reduced our GDP growth estimate for China to 4.2% for this year and lowered our full-year 2022 earnings growth forecasts for MSCI China by 2 percentage points to 11% to reflect lower profit growth in consumer discretionary, communication services, and industrials. However, in the last week there has been clearer guidance from policymakers at the highest level, including the Politburo, that supportive measures will be stepped up in terms of infrastructure investment, property sector policy easing, transport, logistics, and “healthy development” of platform companies, as well as easier monetary policy. We expect 2Q to mark the trough in Chinese GDP and expect a sequential improvement in 2H.

What would make us become more negative on the outlook?

We acknowledge that uncertainty remains high over the pace at which inflation is likely to recede and how resilient US growth proves. The following factors could prompt us to take a more cautious view:

1. Signs that inflation has not yet peaked. Our view is that inflation may have peaked in March
2. Evidence of accelerating wage growth
3. Signs that companies are unable to pass on higher costs, leading to lower corporate margins
4. A prolonged cessation of Russian gas supplies to Europe, which we would expect to tip the Eurozone into recession

How do we invest?

Given our base case of moderating growth and inflation, we think equity markets will finish the year higher than current levels. But active portfolio management is also important, and we favor areas of the market that should outperform in an environment of high inflation, rising rates, and elevated volatility.

Invest in value. With inflation high and interest rates rising, we think the economic and market environment is favorable for value investing, while growth-oriented sectors of the equity market have come under pressure. We recommend investors, who have been underallocated to value after a long period of underperformance, to add to long-term positions in value stocks or value-oriented sectors and markets including global energy and the UK.

Manage high inflation and rising rates. In fixed income, rising yields mean areas of value are emerging. We have removed our least preferred stance on high grade and US government bonds. We see an opportunity in environmental, social, and governance (ESG) engagement high yield bonds. We retain a preference for areas of private credit, such as first lien loans to middle-market companies.

Build up portfolio hedges.?Amid heightened uncertainty, adding some portfolio hedges can reduce volatility and risk. Broad commodities have performed well historically during inflation regimes, and we think they represent an effective geopolitical hedge given the risk of further supply disruptions. We see room for another 10% move up in total return for broad commodity indexes over the next six months and prefer active commodity exposure.

We also believe the US dollar can continue to act as a good portfolio hedge in the near term. It is likely to benefit from safe-haven flows given geopolitical and growth uncertainties, from rising US real interest rates, and from the US’s position as a net energy exporter.

Adding exposure to defensive equity sectors like healthcare can also help reduce overall volatility. The pharmaceutical segment is traditionally relatively resilient during risk-off moves, and valuations look undemanding, in our view. The MSCI All Country Pharma index is at a 14% discount to the MSCI All Country World index on a 12-month forward price-to-earnings basis.

Stick to your Wealth Way plan. From a broader perspective, the high uncertainty we are currently experiencing can drive investors to make emotional decisions that can be detrimental to achieving financial success. To stay on track and create long-term wealth, the UBS Wealth Way framework is designed to help you contextualize market volatility and make better decisions relative to your personal situation by using Liquidity. Longevity. Legacy. strategies. Together, these strategies enable you to understand the purpose of your wealth and reframe losses relative to the time horizon of your objectives and goals.

During times of uncertainty, a Liquidity strategy—made up of cash, bonds, and your borrowing capacity—is designed to fund your spending needs for the next 3–5 years. Once you have confidence that you can meet near-term spending needs, you are better equipped to avoid reacting to market volatility and selling the assets in your Longevity strategy, which are positioned for long-term growth. Bear markets are notoriously unpredictable, and so are the subsequent recovery rallies. Trying to time the market by selling with the intent of getting back in “when markets settle” tends to lock in otherwise temporary losses.

UBS Wealth Way is an approach incorporating Liquidity. Longevity. Legacy. strategies that UBS Financial Services Inc. and our Financial Advisors can use to assist clients in exploring and pursuing their wealth management needs and goals over different timeframes. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved. All investments involve the risk of loss, including the risk of loss of the entire investment.