Schwab: Downshifting

Markets have become more volatile as economic growth slows and investors worry that the Federal Reserve will overshoot in its effort to control inflation, potentially raising interest rates sharply enough to tip the economy into recession. If the Fed sticks to the plan its officials have been suggesting, it will be one of the most aggressive rate-hiking cycles in recent history. Meanwhile, international stocks outperformed U.S. stocks as yields climbed and investors sought out stocks with more immediate cash flows, which tend to be more prevalent overseas.

The latest economic and market volatility has been intense, to say the least. The economy has slowed amid a multi-decade high in inflation, aggressive monetary policy tightening by the Federal Reserve, and persistent global supply chain crises courtesy of the COVID-19 pandemic and war in Ukraine.

In turn, the U.S. stock market has deteriorated markedly this year. Individual stocks have swung widely, both up and down, and the net result has been weakness for the traditional indexes. The percentage of stocks making new 52-week lows within the S&P 500, Nasdaq, and Russell 2000 has spiked during the past few months.

While market breadth hasn’t deteriorated to the levels of the pandemic-induced bear market in March 2020, the breakdown has been prolonged, with a growing number of stocks now in severe bear markets. In fact, as of May 6, 2022, the average member’s maximum decline from a 52-week high was -27%, -48%, and -47% for the S&P 500, Nasdaq, and Russell 2000, respectively.

The problem with any prolonged weakness in stocks is that, given households’ record-high equity exposure, a sustained drop may weaken both consumer confidence and eventual spending power—further dampening consumer demand and economic growth.

Stock price fragility has come at a difficult time, because the strength of household savings has waned considerably over the past year. The personal savings rate has fallen well below its five-year average to its lowest point since 2013. While consumers have been able to use some of their accumulated savings to fuel consumption, the flow of savings has weakened, reducing firepower in the future. This may pose a risk to economic growth if inflation continues to run hot while income growth slows.

Another pending risk to the economy is a potential stalling (or outright weakening) in job growth. As of the April nonfarm payroll report—which showed an increase of 428,000 jobs and an unchanged unemployment rate at 3.6%—there aren’t yet signs of weakness at the headline level. However, one blemish worth noting was the decline in the labor force participation rate, to 62.2% from 62.5%. One month doesn’t make a trend, however, and the dip wasn’t strong enough to break the still-impressive upward trend in participation. Another blemish was the outright decline in household employment (a separate survey from which the unemployment rate is calculated).

A risk to labor participation (and the broader labor market) is that the Fed may be unable to deliver a hoped-for “soft landing,” in which the central bank raises rates enough to slow economic growth and control inflation, but avoids a recession. In prior downturns—such as the recessions in 2001 and 2007-2009—a severe tightening in financial conditions was consistent with a downshift in labor force participation. Conditions aren’t as tight as they’ve been in previous crises, at least not yet. If inflation proves especially durable, drawing more restrictions from the Fed, the situation could deteriorate.

The Fed ramped up the pace of its policy tightening by raising the target for the federal funds rate by 50 basis points at its May meeting, to a range of 0.75% to 1.0% (a basis point is 1/100%, so 50 basis points is half a percentage point). It was the first increase of that magnitude in more than 20 years, and Fed Chair Jerome Powell indicated that he expected the committee to vote for two more such hikes at the next few meetings. In addition, the Fed announced it will begin the quantitative tightening process in June by allowing bonds on its balance sheet to mature without reinvestment. If the Fed sticks to the plan, it will be one of the most aggressive rate-hiking cycles in recent history.

The initial market response was relief that the Fed didn’t raise rates even more aggressively. Short-term yields, which are most sensitive to expectations about Fed policy, dropped. However, yields for intermediate-to-long term bonds are now approaching the 2018 highs, which was the last time the Fed was in tightening mode.

The most significant shift in the market is that real yields—that is, nominal yields minus inflation—are rising; this is a sign that financial conditions are tightening. The Fed appears to be getting message across: It will tighten until inflation falls.

Other signs of tightening financial conditions abound. The dollar has moved sharply higher, credit spreads are widening—especially for lower-rated bonds—and equity prices are falling. In addition, volatility has picked up. By some measures it is as high as during the financial crisis in 2009.

Since the Fed’s goal has been to tighten financial conditions as a way to slow demand and cool inflation pressures, none of these trends should be surprising. However, aggressive policy tightening could result in a downturn in the economy as investors, consumers and businesses pull back.

For bond investors, an inflection point may be on the horizon. While a move up to 2018 highs or above in yields is possible in the near term, the market has already gone a long way toward discounting the effects of tighter monetary policy down the road. Late in an interest rate cycle, yields tend to converge, with short and long-term rates near the peak of the federal funds rate. Given the Fed’s guidance and the market signals, yields near 3% to 3.25% may represent the upper end of the range for this phase of the cycle.

Given all the uncertainty about the economic outlook and persistence of inflation, we expect volatility to remain high and see potential for further spikes in yields. However, potential opportunities remain. For investors with the risk capacity, we suggest looking for opportunities in high-credit-quality bonds, such as investment-grade corporate and municipal bonds. For the first time in several years, income investors can find bonds with higher coupons, often trading below par.

Yields on government bonds in the U.S., Europe and Japan have been rising, climbing to the highest levels in about five years by early May. At the same time, investors strongly favored shorter duration stocks, meaning those with more immediate cash flows, as yields climbed. This has been consistent since global bond yields bottomed in August 2020, but was an especially dominant factor in April as yields jumped to multi-year highs.

The preference for lower price-to-cash-flow stocks aided international stock market performance, as these stocks are much more prevalent in international benchmarks. In fact, April saw the strongest month of European stock market outperformance versus U.S. stocks since January 2015. The U.S. S&P 500 Index was down -8.8% compared to a loss of only -1.2% for the STOXX Europe 600 Index.

Historically, when long-term inflation expectations are rising, international stocks tend to outperform U.S. stocks with turning points lagging by about two years, as you can see in the chart below. This suggests we may now be at a turning point favoring the relative performance of international stocks due to their greater yield/inflation sensitivity.