The S&P 500 Index—which had pushed steadily higher throughout 2021, seemingly impervious to headline risk—was down three weeks in a row to start the year and officially entered correction territory during intraday trading on Monday, off by more than 10% since its recent high on January 3.
It’s difficult to point to a single catalyst that’s sparked the risk-off trade. The U.S. Federal Reserve’s (Fed’s) hawkish policy shift suggests that a key tailwind for stocks may be fading faster than originally expected, putting pressure on risk assets. Meanwhile, escalating tensions between NATO forces and Russia over the latter’s troop buildup on the Ukrainian border has certainly spooked some investors. Finally, Omicron remains rampant in much of the world and has led to widespread staffing shortages across a variety of industries, contributing to a potential “air pocket” in economic growth in Q1. While these proverbial “bricks in the wall of worry” continue to mount, we think the fundamental case for owning stocks remains intact for three reasons.
The U.S. Leading Economic Indicators are still very much in positive territory at +8.5% year over year as of December, suggesting we’re not near a recession; rather, we’re likely looking at a Q1 air pocket in economic growth. The Fed will no doubt raise rates this year to dampen inflation, but we believe the economy will be strong enough to continue growing even with the headwind of rate hikes. Weaker-than-anticipated growth to start the year may diminish some of the Fed hawkishness and could in fact be a good thing for stocks and the economy more broadly.
YoY change in the LEI (%)
Source: The Conference Board, as of 12/31/21. The Composite Index of Leading Indicators (LEI) is published monthly by The Conference Board and tracks 10 economic components whose changes tend to precede changes in the overall economy. YoY refers to year over year. Past performance does not guarantee future results.
In addition, high-yield spreads (the additional cost of debt for low-quality bond issuers) are still very low in a historical context, suggesting there is still ample liquidity. U.S. high-yield spreads are just over 3%, suggesting very little distress in the corporate bond market. On a similar note, liquidity, as measured by cash on the sidelines, is still significant. Money market assets remain near an all-time high at $4.5 trillion, consumer savings in bank accounts has reached $18.0 trillion, and corporate balance sheets are in the best shape in history with trillions of dollars in cash available.1
High-yield option-adjusted spreads, 2002–2021 (%)
Source: Bloomberg, as of 12/31/21. Spreads are calculated based on the Bloomberg U.S. Corporate High Yield Bond Index, which tracks the performance of the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Finally, U.S. corporate earnings are still likely growing. Forward-looking 12-month earnings estimates continue to move higher, as corporations still have recovery potential as the pandemic subsides. Ultimately, stocks follow profits, and we’re likely to see mid to high single-digit earnings growth in 2022. For investors who have dry powder available, the market’s January pullback may represent an attractive entry point, particularly for areas of the market offering high-quality and reasonable valuations.
Stock prices and earnings estimates have moved higher in tandem
Source: FactSet, as of 12/31/21. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Earnings per share (EPS) is a measure of how much profit a company has generated calculated by dividing the company’s net income by its total number of outstanding shares. YoY refers to year over year. No forecasts are guaranteed. Past performance does not guarantee future results.
Stock market volatility is a good reminder to revisit bond allocations
The recent turbulence in equities is as good a reminder as any that fixed-income allocations can’t be an afterthought. One bit of good news on that front is that correlations between stock and investment-grade bond prices have been trending down lately, meaning that bonds are doing a better job offsetting equity risks. Meanwhile, longer-term yields have been ticking higher since the start of the year, potentially creating a more attractive entry point.
We also see bonds starting to look more attractive relative to other opportunities. First, U.S. yields still dwarf global yields, likely creating a bid from foreign buyers. Similarly, U.S. investment-grade corporate bond yields are now 2.8% (the same level they were before the pandemic), outyielding the S&P 500 Index dividend yield of 1.3%.2
While we don’t expect any policy changes at this week’s meeting, markets will be hyper-focused on the details around the Fed’s approach to liftoff as it begins the removal of the ultra-accommodative monetary policy of the last two-plus years. Overall, we believe the Fed will grow less and less hawkish as the year goes on, particularly as inflation recedes and growth slows. We’re penciling in two or three rate hikes along with modest quantitative tightening in 2022 as we see growth and inflation moderating. As this is less hawkish than what the market currently anticipates, we could see a bid for bonds if expectations are recalibrated.
1 Federal Reserve Bank of St. Louis and Morningstar, as of January 24, 2022. 2 FactSet, as of January 24, 2022.
Views are those of Emily R. Roland, CIMA, co-chief investment strategist, and Matthew D. Miskin, CFA, co-chief investment strategist, for John Hancock Investment Management, and are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index.
Composite Index of Leading Indicators is published monthly by The Conference Board and tracks 10 economic components whose changes tend to precede changes in the overall economy. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. It is not possible to invest directly in an index. Past performance does not guarantee future results.