It feels like someone turned the switch from risk-on to risk-off at the turn of 2021. After more than doubling from the Covid low of 2,237 in March of 2020, to 4,766 at the end of December 2021, the S&P 500 index dropped almost 20% from the end of December 2021 through the end of June 2022. Market volatility shot up in 2022, with the VIX index (which measures the volatility of the broad market) shooting up to an average of 26 from January through the end of June 2022, from an average value of just under 19 in the second half of 2021.
The weakness in equity markets and elevated volatility can be traced to potential reversals in some long-term investment trends: the end of the relentless decline in bond yields, the rise of inflation, the end of the Fed Put, reversal in globalization, and the underinvestment in commodities. Many of these trends are interrelated and accentuate each other. There are also some more recent trends that are impacting markets like the rise and fall of Covid-19 and the Russian invasion of Ukraine.
End of the relentless decline in bond yields
Government bond yields have been declining for close to 40 years in the US, with the 10-year government bond yields peaking at 15.8% in September of 1981 and dropping to a crisis low of 0.5% in August of 2020. This has been a great tailwind for bond investors which has now turned into a headwind and is likely to be neutral at best going forward. Highlighting this change in trend, the average 10-year government bond yield over the last 10 years has been rangebound with a mean of 2%.
The rise of Inflation
Headline inflation in the US is now over 8% year-over-year, compared with a 20-year average of 2.3%. Core inflation (excluding the volatile Food and Energy components) is over 6% compared with a 20-year average of 2.1%. This spike in inflation which started in March of 2021 has unpleasant economic and financial implications. Higher prices of everything from used cars to rent, food, and gas are a negative shock to consumers’ wallets and have resulted in a big hit to consumer sentiment. The University of Michigan Consumer Sentiment Index has collapsed from 88 in April of 2021 to 50 in June of 2022. Inflation is also hurting bonds and equities. The only equity sector that is up year-to-date is Energy.
End of the Fed Put
The Fed Put refers to the belief that the Federal Reserve will step in to protect markets if there is a crisis and financial markets correct beyond a certain level. In other words, Central bank policies will effectively set a floor on equity valuations. This has been the case for almost 35 years, starting in 1987. This was possible so long as inflationary pressures were contained. However, the current high level of inflation limits the leeway the Fed has to cut rates. Other Central Banks are also raising rates which is draining liquidity from financial markets. The Fed is just getting started with rate hikes, and may have a ways to go before it pauses.
Weakened embrace of Globalization
The increased cross-border mobility of capital and the increasingly globally integrated product markets have been a boon for providers of capital. This has rewarded shareholders immensely as capital has been able to benefit from increased investment opportunities globally. Labor in emerging markets benefitted as production shifted to those markets. On the other hand, labor in developed countries has suffered as jobs were outsourced to cheaper locations. The hope that developed market labor will move up the food chain, do more “higher value-added” jobs and get compensated more has not panned out as expected. The idea that laid-off workers will retrain and move up the value chain has not borne fruit. Lack of an adequate safety net, easy access to training, lack of motivation and guidance, and the opioid crisis may all have contributed to this.
Now there is a backlash against globalization in developed economies. The election of Donald Trump as President, Brexit, and the increasingly hardened stance of America against China are signs that the disenfranchised labor in developed markets is finally causing a pause in further globalization. Tariff barriers have been going up in the US and the export of technology to countries like China is being restricted.
Increasing globalization has contributed to keeping a lid on inflation in developed economies as real wages in developed markets stagnated in sectors where jobs could easily be exported to cheaper locations. Globalization going into reverse will provide a tailwind for inflationary forces as production moves to higher wage countries causing disruption to existing supply chains. The need for some level of onshoring became clear due to the disruptions caused by the Covid pandemic and the Russian war. Protecting intellectual property from autocratic governments and ensuring access to semiconductors in case of potential disruptions in South-East Asia also plays into the need for onshoring.
Commodity underinvestment
Several factors have contributed to an underinvestment in commodities over the last decade. In the US, the large investments in shale oil and gas were made starting in 2005 which led to ramp up in production. The sharp drop in crude oil prices in the second half of 2014, and again in April 2020 when oil futures briefly went negative as demand collapsed due to the Covid pandemic meant that the investment did not earn adequate returns. As a result, investments in adding more capacity have dwindled. A move towards electric vehicles and increasing environmental concerns have also held back commodity investment. The CRB index of commodity prices dropped from a high of 462.7 in June 2008 to a low of 117.2 in April 2020. Materials and Energy sectors lagged the S&P index over all of those years.
Commodity prices have rebounded sharply since their 2020 lows, and the CRB commodity index is up over 2.5 times, rising from 117 in April 2020 to over 290 by June 2022. These increases are contributing to increased inflation globally. Commodity sectors have rebounded since March of 2020, and Energy has strongly outperformed the US market.
The rise and fall of Covid-19
The sudden onset of Covid caused major disruptions in the global economy, creating instant winners and losers. Technology, Media, and Telecommunication (TMT) sectors were beneficiaries as they enabled remote work and provided an outlet for people stuck at home. Video game and social media usage exploded. Travel, Hospitality and Energy sectors were losers as demand evaporated due to Covid-related restrictions. After a brief surge in defensive sectors (Health Care, Consumer Staples, and Utilities) which lasted through mid-March of 2020, these sectors lagged the market through late-2021. Consumer Discretionary sector underperformed initially but the massive fiscal stimulus from the government in the form of relief checks for consumers and businesses allowed the sector to outperform for a year.
Covid lockdowns resulted in many companies within the TMT sectors seeing new demand, e.g., Zoom Video, DocuSign, and Peloton. Other companies such as Netflix, Amazon, Facebook saw demand being pulled. Airlines, Hotels and Oil companies saw demand evaporate. Many companies in the former set got bid up to extreme valuations as the market failed to discern the pulling forward of demand. The market assumed that the growth rates would be permanently high and not revert to normal when the pandemic abated. The latter set saw valuations compress as there was no visibility on when demand would return.
China’s Covid policy has marched to its own tune. The government adopted a zero tolerance policy towards Covid-19 and implemented draconian isolation policies to prevent its spread. When the new, more contagious Omicron variant became prevalent, the Chinese government imposed severe lockdowns in major cities resulting in a hit to the economy. This also had global implications due to China being a major exporter of goods. Supply chains have become stretched, and shortages of materials have contributed to sharp prices increases across the world.
Russian mis-adventure and food prices
The buildup of Russian troops outside Ukrainian borders was well-telegraphed. However, the fact that Russia followed through with an invasion came as a shock. It inflicted untold misery on the Ukrainian people and led to death of thousands of Ukrainians as well as Russian soldiers. Russia and Ukraine are major exporters of wheat, cereals, seed oils, etc., and the war brought that trade to a standstill. This has led to the price of agricultural goods exploding worldwide. Russia has been the leading supplier of oil, gas, and coal to the European Union (EU), supplying a quarter of EU’s energy needs in 2020. The price of oil, gas and coal have all surged, causing inflationary pressures in Europe and a hit to consumer incomes. Even harder hit are emerging markets where a greater share of income goes towards necessities. Except for a handful of countries, the world united against Russia and imposed severe sanctions of the economy.
Investment implications
Inflation will likely persist and continue to cause increased volatility in financial markets. Wage pressures in the US and housing price inflation will take time to settle down. Supply chain disruptions due to China’s severe lockdown policy and the Russian invasion have contributed to inflation and will be slow to correct. Inflation beneficiaries will likely continue to do well. This includes commodity producers, especially energy.
The end of the Fed Put has also contributed to increased volatility. The Fed has just started to raise rates, and given the high inflation rate, is not likely to stop, barring a serious financial accident that threatens the economy.
Fed tightening and the increase in bond yields will continue to support low-duration stocks relative to high-duration growth ones. Venture Capital and private equity will come under pressure as cost of capital increases. Alternative assets such as cryptocurrencies and meme stocks such as AMC have collapsed and will likely continue to languish. Value will continue to outperform growth as value stocks tend to have lower duration until bond yields peak.
Increasing yields will continue to pressure bond prices. In such a scenario, bonds will provide low nominal and real returns and may not prove to be a hedge when stocks become volatile. Increasing bond yields have already put pressure on the housing market will likely continue to do so.
Commodity underinvestment means that commodities will be a good investment in the near to medium term. This ought to benefit Energy and Materials sectors, as well as countries in Latin America and the Middle East. Commodity importers such as China, India, Taiwan, and Korea will bear the brunt of higher import costs.
Russian invasion of Ukraine will cause commodities to continue to be elevated. There will also be a risk premium in Europe related to the aggressive Russia stance. Europe’s reliance on Russian oil and gas will adversely impact economic growth. Defense stocks are likely to continue to benefit as Europe increases defense spending in response to Russian hostilities.
The ECB is torn between supporting growth and containing inflation much more so than the Fed. Inflation in excess of 8% in many countries is putting pressure on the ECB to hike rates aggressively. European equities have underperformed US equities since the Great Financial Crisis, and this trend is likely to continue.
As China’s regulatory crackdown and Covid-related shutdowns ease, Chinese stocks and bonds will do well. This will be aided by the government loosening monetary and fiscal policies to stimulate growth. Valuations have become reasonable due to the sharp underperformance of many Chinese companies. After sharply lagging the US market between February 2021 and March 2022, Chinese equities have started to outperform the US, and we expect this to continue.
The US dollar has appreciated over 13% in the last 12 months as measured by the DXY index. This could be a reflection of weakness in Europe due to the Russian invasion, disruptions in China due to the strict Covid-19 policy, and the toll on other emerging market economies from Covid-19. This has been a headwind for Emerging Market equities and will continue to pressure US exporters going forward.
We expect continued volatility in equity and fixed income markets until inflationary pressures ease and Central Banks adopt a less hawkish stance.