April’s gloomy market days did not give way to a bounce back in May, as US equity markets finished flat. As boring as that sounds, at least it was not “sell more in May and go away.” It was anything but an uneventful month. After seven straight weeks of declines and volatility, we briefly reached bear market territory. Then came a sizeable rally last week, and there was hope that we had reached a bottom and not just a bear market rally. Whether that rally is sustainable remains to be seen, but there are certainly opportunities beginning to show.

The main theme continues to be the global central bank policy landscape amid stubbornly high inflation, the war in Ukraine, COVID lockdowns, and supply chain issues. Talk of recession, stagflation (high prices, slow growth), and a risk-off mentality permeated across all asset classes. International markets were slightly positive after a terrible start to the year.

The US Treasury yield curve steepened, and global bond yields rose broadly, reflecting tighter monetary policy around the world. Economic data in the US is persistently strong with decent earnings reports and an ultra-low unemployment rate, but outside of the US, many countries are nearing recession. Wage and input inflation costs are starting to really eat into profit margins.

Despite the headwinds, inflation sensitive and traditional sectors are proving to be anchors in these volatile times. Energy, utilities, banks, financials, and commodities/materials all led the way for the month. The rotation to “value” stocks from “growth” has been historic and could be sustainable for quite some time after years of high-flying growth and technology outperformance. This was a boon for our portfolios as we have remained defensive and overweight value, quality, and inflation sensitive in our factor exposure.

After the early-May Federal Reserve meeting, it became clear that Fed Chairman Jerome Powell and the Committee were determined to tackle inflation making that the singular focus going forward. The so called “Fed Put” seems to be gone, and the central bank will lean on the tightest US labor market in history to sustain rising rates and quantitative tightening (decreasing bonds on the Fed’s balance sheet). Several 50 basis-point rate hikes are expected.

The question endures – can the economy withstand the hawkishness of a necessary and abrupt change in course after years of stimulus? The answer is unclear, but most Wall Street analysts are feeling dubious of the assumption that the US can avoid recession or, at a minimum, much slower growth in the next 6-12 months.

The weak and fragile supply chain remains deeply damaged by COVID lockdowns and the war. Lack of supply has firmly been established as the driving force behind inflation. The US consumer continues to spend though, with higher wages and steady paychecks in hand. First quarter earnings were largely reflective of that. Retail sales were surprisingly strong and service sector revenue increased. The consumer is spending more for just about everything, and we are seeing reduced savings and higher debt levels. Manufacturing figures are stabilizing but are still too low, especially across Asia as restrictions in Shanghai ease.

With supply not able to meet demand, the Fed is essentially forced to destroy demand and cool off the economy with tighter policy, thereby slowing growth. Per FactSet, a recent Financial Times analysis showed that central banks were raising rates in the most widespread tightening in more than two decades. Skyrocketing food and energy costs since Russia’s invasion of Ukraine has compelled many countries to sharply reverse course and restrict monetary policy.

Global interest rates hike…

Global interest rates, still low by historical standards from decades of easing and accommodation, may only be at the beginning of a tightening cycle. We have recently seen over 60 rate hike announcements, unmatched since at least 2000, in response to record and multi-decade high inflation. Even negative rates should be going away in Europe with the European Central Bank (ECB) set to hike in the coming months for the first time since 2011. It is anticipated that more than 75% of the major central banks will tighten monetary policy over the next six months, with the US and UK leading the way.

Emerging Market countries are further along in their business cycle, hopefully peaking in inflation and tightening. They may look to ease monetary policy soon as recession sets in. This should create buying opportunities towards the back end of the year. China’s zero-COVID policy has weighed on growth and EM volatility should continue in the short term as restrictions ease. US dollar strength also hurts international performance, but the commodities boom has offset some of those headwinds.

High oil and energy costs have deeply hurt the Euro Zone economy along with other developed markets. Proximity to and reliance on Russian and Ukrainian core commodities are greatly heightening the bloc’s risk of a deep recession. We remain underweight international exposure until there is more clarity and risks begin to abate.

The best news might be coming out of the fixed income markets. With steep price declines and many of the central bank rate hikes already priced in, bonds eventually will be bonds again. When prices fall, yields rise. Higher interest rates will kick off more consistent income for investors with less risk than the equity markets along with the prospect of price appreciation from the next business cycle. Bonds, especially investment grade and treasuries, tend to outperform in slowing growth or recessionary environments and will be an extremely important cushion to market volatility.

As we move along in the cycle and if credit conditions deteriorate, we will look to increase duration and increase exposure to bond strategies with less default risk. There are already sectors in the global bond market showing steep discounts. Potentially peak inflation and a cooling labor market are also reasons for optimism.

Looking ahead, we will pay close attention to the jobs and inflation data for the month of May, as well as the Federal Open Market Committee (FOMC) meeting in mid-June. The early stages of Fed balance sheet run off (QT) are here as well, and we will monitor its effects on the back end of the yield curve (longer dated bonds). Even Fed President Powell has stated that he is very unsure of the outcome for bond yields as they unwind their balance sheet. The program is unprecedented and is not being as closely watched as the direct short-term interest rate hikes.

The current business cycle post-COVID, is moving much faster than the prior decade, so we are being cautious and tactical alongside our philosophy of long-term strategic investing. Despite this, periods of slowing growth and central bank tightening are normal and even welcome for creating opportunities. We will look to seize on them as they emerge always keeping risk and your goals in mind. Enjoy the beginning of summer!

Questions? Comments? Contact us.