Stocks remain volatile as rally fades

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

What happened?

Equity markets had another volatile day on Wednesday, amid renewed worries that inflation could crimp profit margins and cause central banks to tighten policy more aggressively. A 4.04% decline in the S&P 500 reversed the 2% rally on Tuesday. Concerns over slowing growth, meanwhile, contributed to an 10-basis-point decline in the 10-year US Treasury yield to 2.9%.

Heightened uncertainty over the economic outlook has sent volatility rising, with sentiment shifting quickly on fresh information. The main trigger for the swing on Wednesday appeared to be anxiety over the impact of high inflation on corporate earnings and consumer demand. Shares in Target lost as much as 25% of their value after the retailer missed profit forecasts and warned of a hit to margins from rising fuel and freight costs as well as a larger-than-expected shift in consumer spending away from stay-at-home categories like furniture and TVs. That, in turn, weighed on the share prices of other leading US retailers; Walmart had also highlighted margin risks on Tuesday.

Inflation was also brought back into focus by UK data showing consumer prices rising by 9% in the 12 months to April, the fastest pace in 40 years, and up from 7% in March. A fractional downward revision to Eurozone inflation for April, to 7.4% from 7.5% year-over-year, still left an increase that matched the fastest pace of price increases since the single currency was created in 1999.

The earnings news and inflation data build on underlying worries over risks to global growth posed by central bank tightening, the war in Ukraine, and pandemic-related lockdowns in China. While an interview with Fed Chair Jerome Powell published on Tuesday was not notably more hawkish than his other recent statements, he did underline that the central bank “won’t hesitate” to raise rates to levels that restrict growth if that is needed to bring down inflation. Markets are now pricing in around 280bps of tightening by the Fed in 2022 overall.

US housing starts for April also fell 0.2%, with construction backlogs at the highest level since 1974. It remains to be seen how far the recent rise in mortgage rates will curb housing activity and prices. The 30-year fixed-rate mortgage averaged 5.3% in the week to 12 May, the highest since 2009, based on data from mortgage finance agency Freddie Mac.

What do we expect?

This year’s sell-off in equities can in part be explained by the rise in real rates from deeply negative levels to reach positive territory (US 10-year TIPS yield currently 17bps), which has driven a derating of valuations.

As inflation has proved more persistent, concerns have broadened from the impact of yields to include the possibility of a Fed-induced recession.

Tuesday’s better-than-expected US retail sales data had supported the view that US consumer demand is robust. But Wednesday’s price action, with consumer stocks leading the equity decline and Treasury yields easing back, suggests that fears remain about the impact of inflation on consumer demand and hence growth, as well as on the profitability of retail stocks in an environment of rapidly shifting consumer spending priorities.

That said, even if profit margins do fall back from current near-record levels, at least some downside to earnings is already priced in. Looking at the relationship since 1992 between changes in the MSCI All Country World index and consensus forward earnings growth estimates, we find that global equities are pricing a 10% decline in forward earnings estimates by the end of this year. For comparison, bottom-up consensus is currently forecasting 10% earnings growth, and the average peak-to-trough fall in earnings during recessions since 1956 has been 20%.

How to invest?

Recent volatility shows that attempting market timing in periods of economic uncertainty can be expensive and risky. It is almost impossible to know which trading days will be the worst, and by trying to avoid those days, investors may also miss the recovery. As such, we believe that investors should stay calm and stay invested through the current volatility. We expect equities to end the year higher than current levels.

Volatility is likely to continue until there is greater clarity on the likely extent of Fed rate increases, the chances of this tightening pushing the US economy into recession, and on risks such as the Ukraine war and China’s COVID lockdowns.

We continue to position for an uncertain environment. First, we favor positioning in value stocks, which tend to outperform in environments of high inflation and rising policy rates. Second, by positioning in healthcare, investors can mitigate recession risks; healthcare stocks tend to be less sensitive to economic fluctuations. And finally, by positioning in commodities and energy stocks, investors can manage geopolitical risks.

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