U.S. stocks suffered another day of losses Monday, as the market continued to weigh the risk that the Federal Reserve’s aggressive anti-inflation campaign could push the economy into recession. No industrial sectors save the more-defensive Consumer Staples sector were spared, with Technology, Consumer Discretionary and Energy among the hardest hit. Bitcoin also felt the pressure, falling nearly 12% during the day. The cryptocurrency has lost half its value since it touched its all-time high back in November.
Investors appear increasingly concerned the Fed will have a hard time battling back historically high levels of inflation without crushing economic growth. Our view is that the Fed is likely to raise its benchmark interest rate in half-a-percentage-point increments at its next few meetings, before easing back to quarter-point hikes later in the year. The Fed want to raise rates to a “neutral” level by the end of the year, which could be around 2.5%, based on current projections.
However, markets see the rate hitting 2.6% at year-end and then rising as high as 3.2% by next July. Separately, a survey released Monday by the Federal Reserve Bank of New York showed that households’ three-year expectations for inflation increased to 3.9% in April. If households bring forward purchases because they think prices will continue rising, rising prices could become a self-fulfilling prophecy, complicating the Fed’s efforts.
“Stock prices already reflect some economic weakness, but they haven’t priced in the possibility of a recession,” says Liz Ann Sonders, Schwab’s chief investment strategist. “That means stocks could fall even more if growth deteriorates from here.”
“Investors aren’t likely to find much reward in risk-taking in the near term, and should remain focused on quality,” she adds. “Periodically rebalancing your portfolio is one way to take advantage of volatility while maintaining your strategic allocation.”
U.S. stocks: Volatility likely to persist
- Stocks are likely to remain volatile as the Fed pushes interest rates higher.
- The benchmark S&P 500® Index is now down more than 7% since the last Fed meeting, making for one of the worst post-meeting stretches in history. Large-cap technology and growth-oriented stocks continue to suffer, exacerbating the impact on market cap-weighted indexes.
- The tech-focused NASDAQ and small-cap-oriented Russell 2000 are in bear markets. The S&P 500 remains in severe correction mode for now.
- Recession risk is high and sector volatility is likely to remain elevated. We continue to recommend a sector-neutral approach and a focus on high-quality factors such as strong balance sheets, high free cash flow yield, and positive forward earnings revisions.
Global stocks: Less drama overseas
- Massive lockdowns in China related to its “zero-COVID” policy are weighing on global growth. However, more Chinese cities are transitioning to frequent testing, which could result in shorter, targeted lockdowns in the coming months.
- Energy prices fell, as the EU’s plan to ban Russian oil stalled and Saudi Arabia cut prices due to lower global demand. Despite the potential peaking of inflation, markets appear increasingly concerned about economic growth.
- We believe shorter duration stocks—those with more immediate cash flows rather than cash flows in the distant future—could still outperform over the intermediate term. Broad-based declines across countries and sectors suggest investors aren’t using fundamentals to make decisions.
Bonds: Inflation concerns continue to drive yields
- Despite comments from Fed officials that rate hikes will likely come at a steady pace, the Fed funds futures market is implying a slower pace of hikes now that the decline in risk assets is tightening financial conditions on its own. Treasury yields fell as a result.
- Treasury yields from 3 years out to 30 years are settling in between 2.75% and 3.25%, slightly above the Fed’s estimate of “neutral.” Historically, Treasury yields converge near the neutral rate during a rate hike cycle, implying there likely isn’t much upside in Treasury yields from here.
- We suggest investors focus on higher-quality bonds such as Treasuries and investment-grade municipal and corporate bonds, as riskier segments of the market typically don’t do as well during tightening cycles. Investors should proceed with caution with high-yield bonds.
- Short-term borrowing costs may rise as the Fed hikes rates. Home equity loans, adjustable-rate mortgages (ARMs), and auto loans are often tied to short-term interest rates.
Trading takeaways: Volatility is likely to continue
- The S&P 500 broke below technical support around 4,050 and has fallen to a new 13-month low. The NASDAQ remains solidly in bear-market territory and has fallen to a new 18-month low.
- Volatility remains elevated. For the second consecutive day, the Cboe Volatility Index, or VIX, went above 35 during the day, but closed slightly lower at 34.70. At its current level, the VIX implies daily moves in the S&P 500 index of 72 points in either direction. However, it has moved more than that in each of the last four sessions.
- Given current volatility expectations, option premiums are historically high, making downside risk protection relatively expensive. Traders should consider offsetting hedging expenses by employing multi-leg strategies, such as collars or vertical spreads.
- Equity traders should consider reducing their average share and dollar amounts per trade. While equities could experience sharp bounce-backs at any time, large downside moves may be just as likely. When equities have declined more than 10%, the risk of margin maintenance calls increases accordingly.
What should long-term investors do now?
Market volatility is unsettling, but historically not unusual. If you’ve built an appropriately diversified portfolio that matches your time horizon and risk tolerance, it’s likely the recent market drop will be a mere blip in your long-term investing plan.
However, it can be hard to do nothing when markets are rough. Given what has been happening recently, consider a few of our investing principles:
Don’t try to time the markets. It’s nearly impossible. Time in the market is what matters. While staying the course and continuing to invest even when markets dip may be hard on your nerves, it can be healthier for your portfolio and can result in greater accumulated wealth over time.
Build a diversified portfolio based on your tolerance for risk. It’s important to know your comfort level with temporary losses. Sometimes a market drop serves as a wake-up call that you’re not as comfortable with losses as you thought you were, or that a portfolio you assumed was appropriately diversified in fact isn’t. Schwab clients can log in and use the Schwab Portfolio Checkup tool to quickly assess whether their portfolio is still in balance with their target asset allocation. If you’re not a client, or haven’t yet established an investment plan, our investor profile questionnaire can help you determine your profile and match it to an appropriate target asset allocation.
Rebalance your portfolio regularly. Market changes can skew your allocation from its original target. Over time, assets that have gained in value will account for more of your portfolio, while those that have declined will account for less. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and moving the proceeds to positions that have become underweight. It’s a good idea to do this at regular intervals. Schwab clients can log in and use the Schwab Portfolio Checkup tool to identify areas of their portfolio that may have drifted away from their target asset allocation.
Build in protection against significant losses. Modest temporary losses are one thing, but recovery from significant losses can take years. Traditionally defensive asset classes, such as cash investments and short-term bonds, tend to perform better when stocks are down. When used for diversification, they can help buffer a portfolio against the effects of up-and-down markets. You’ll also want to consider defensive assets for shorter-term goals or accounts from which you expect to draw money within the next few years.
© Charles Schwab
Read more commentaries by Charles Schwab