This week the Fed raised interest rates by 0.50% which follows the March increase of 0.25%. Heading into 2022, the consensus was that the Fed was going to raise rates a total of 3 times during the year with an expected ending Fed rate of 0.75%. Now, the expectation is for a total of 10-11 rate hikes with an ending Fed rate of 2.50%-2.75%. This quick reversal of expectations has caused the increased volatility we are seeing in both the stock and bond markets. It is rare that these two asset classes move in tandem so severely and history would indicate that the high correlation between the two is likely short-term rather than an enduring trend. The pace of the rate hikes is faster than in recent years, but the expected year end levels would be considered “neutral” to the economy, meaning not overly simulative or restrictive. Events outside of the Fed’s control such as the ongoing war in Ukraine and COVID lockdowns in China continue to strain the supply chain preventing further elongating the inflationary pressures within the global economy. These pressures will ultimately subside, but successfully predicting when has been elusive.
The impact of rising rates has spilled into the equity markets with the largest impact felt in the more expensive portions of the market with growth stocks, particularly in the technology sector, feeling the greatest pain. The more growth oriented NASDAQ composite index is down over 20% YTD while more traditionally value oriented, blue-chip stocks as represented by the Dow Jones Industrial Average is down under 10%. A drawdown of this magnitude in stocks (S&P 500 is down roughly 14% YTD) is actually in-line with historical intra-year drops, but the big difference is that since this has happened at the start of the year it feels a bit different.
Flying in the face of falling stock prices, corporate earnings have continued to be positive with over 80% of the S&P 500 companies that have reported beating their earnings estimates and delivered 7% earnings growth. The expectation is for S&P companies to deliver 10% earnings growth in 2022, which would typically be a strong indicator for positive equity returns. Coming off the strong rebound post the initial pandemic equity market stumble, stock valuations peaked, trading at 24x forward earnings. With the recent pullback in stock prices combined with increased earnings, stocks are now trading at 18x forward earnings which is just above long-term averages.
We continue to be cautiously optimistic on equity markets maintaining allocations while shifting towards lower volatility stocks and incorporating hedging strategies to protect against prolonged negative returns. We believe much of the initial shock of rising rates is priced into the bond market, but remain cognizant that more rate increases are on the table and could be accelerated should inflation fail to abate. We have shifted towards shorter duration bonds focusing on quality corporate credit with strong balance sheets and floating rate notes which can benefit from a rising rate environment.
While it is difficult to stomach the market volatility we have seen over the past few months, investors with a long-term focus are encourage to stay the course. Where the market will bottom out is impossible to predict and not advisable to time. Average investors have historically been ill-advised by their emotions and tend to exit after experiencing the pain only to miss the recovery. Maintaining a disciplined investment approach guided by a solid financial plan continues to offer the best long-term potential for meeting and exceeding financial objectives.