Market rebound loses momentum

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

The S&P 500 fell 2.01% on Tuesday, giving back part of last week’s 6.5% rise, as continued worries that elevated inflation will weaken consumer spending and growth.

The expectations component of the Conference Board consumer confidence index fell to 66.4 for May, its lowest level since 2013. The Conference Board observed that the reading is pointing to weaker growth in the second half of 2022, and a growing risk of contraction by the end of the year. That follows a record-low for the University of Michigan sentiment reading for June, released last week. While such surveys have become distorted by political polarization, in our view, the releases do chime with other indications that household budgets are under pressure, including the first fall in retail sales in five months for May.

News on US industrial conditions was also discouraging. Manufacturing activity in the central Atlantic region of the US contracted for the second consecutive month in June, according to the Richmond Fed survey, with the weakest reading since May 2020.

Fixed income markets continued to reflect worries over slowing growth. The yield premium offered by the 10-year US Treasury over the 2-year bond fell by 1 basis point to just 7 basis points. This part of the yield curve has briefly inverted several times in recent months, a development seen by some as a recessionary warning sign. The yields on the 3-, 5-, and 7-year Treasuries are all higher than on the 10-year. Forward inflation expectations, such as the 10-year breakeven inflation rate, have fallen to 2.47%, contributing to the decline in the 10-year yield as the market foresees peak inflation alongside a 75-basis-point rate hike in July. The PCE inflation report on Thursday and the ISM data on Friday will give a peek of what’s ahead.

Finally, the conflict between Russia and NATO has remained in focus. The organization’s Secretary General has said that a deal had been reached to admit Sweden and Finland as members after resolving concerns from Turkey which had been holding up their membership. Meanwhile, G7 members meeting this week said they were exploring ways to impose a “price cap” on Russian oil.

What do we expect?

In our view, high levels of volatility are to be expected given current uncertainty over the outlook for inflation, worries over recession, and continued political tension. A sustained improvement in market sentiment looks unlikely until investors get convincing evidence that inflation has peaked. The VIX index of implied US stock volatility, which had fallen as low as 26.6 earlier on Tuesday, rose to 28.4, consistent with daily moves in the S&P 500 of around 1.8%. That was still down from a peak in the middle of June of around 34.

While the market scaled back the expected pace of tightening by the Federal Reserve last week, federal funds futures are still pointing to around 335 basis points of rate rises for 2022, almost 100 basis points more than at the start of the second quarter in April. Recent Fed statements have confirmed the hawkish bias. Fed Chair Jerome Powell said last week that further inflation surprises “could be in store,” and that policymakers would need to be “nimble,” suggesting that rate rises could become more aggressive if needed. Further, even if inflation slows, our view is that the Fed will need to be convinced that labor market conditions are cooling before considering pausing the rate hiking cycle.

While we still see an economic soft-landing as the most likely single scenario—which would be consistent with the S&P 500 ending the year around current levels of 3,900—the potential upside for the major indexes has been diminished by slowing growth and higher government bond yields. Meanwhile, in the event of a more abrupt slowdown, we would expect US earnings to fall by around 15%, in line with the average during prior recessions, with the S&P 500 ending the year around 3,300.

How do we invest?

Against this uncertain backdrop, we advise investors against positioning for any one scenario with high conviction. Instead, we recommend adjusting portfolios for resilience under various scenarios.

We advise investors to:

Consider increasing exposure to value stocks.?While we expect inflation to moderate through 2022, we expect it to remain above central bank targets. Based on analysis from 1975, value sectors tend to outperform growth stocks when inflation is above 3%, which we expect to be the case for some time. We think value would perform particularly well in our soft-landing scenario, as increased confidence that corporate earnings can stay resilient supports some of value’s cyclical sectors, including financials and energy. We also favor the UK market, which has a high weighting toward value sectors.

Add to defensives and quality, make use of volatility.?To build up defenses against a potential “slump,” in which weaker economic data drives lower corporate profit expectations and further downside in stocks, we believe investors should add exposure to quality-income stocks, the healthcare sector, resilient credits, and the Swiss franc. Capital-protected strategies may also allow investors to use volatility to work in their favor and mitigate potential downside risks.

Manage a Liquidity*?strategy and diversify with alternatives.?As the basis of a strong portfolio, to manage the risk of forced selling, earn yield, and prepare for potential future opportunities, investors should build and manage a Liquidity portfolio, sized to meet 3–5 years of cash flow needs. This will likely consist of a mix of cash, cash alternatives, and short duration bonds. Investors should also ensure an adequate allocation to hedge funds, which have the potential to deliver performance, even if both bonds and equities are falling.

*Timeframes may vary. Strategies are subject to individual client goals, objectives and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

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