Volatility has picked up noticeably in recent weeks, with rather large swings higher and lower. To make matters more painful for portfolios, bond prices have moved lower, suggesting they have not offered the kind of diversification benefits investors have come to expect. Below, we offer some perspective on the recent market turbulence, address the issue of inflation expectations, and discuss a silver lining that has emerged in the wake of this year’s challenges.
Global equity markets have had a poor year thus far. But, periods of market weakness are not uncommon. In fact, the U.S. equity market, which is the most widely followed, has averaged at least one sizeable decline (ie. 10% or more) every year since 1975, with the average fall being nearly 20%. Yet, the U.S. equity market still managed to generate a positive annual return in 35 of the past 46 years. In other words, dealing with market volatility is part of the investing experience.
A question investors may be asking is whether the declines year-to-date signify the start of something potentially more serious that would cause a durable impact to the future trajectory of the global economy and the path of corporate earnings. After all, these two factors, which themselves are intertwined, tend to be the predominant drivers of longer-term equity returns.
There is certainly no shortage of concerns: the war in Ukraine and the knock-on effects via commodities, and China’s various lockdowns that threaten its growth outlook and exacerbate the problems facing global supply chains. But, the primary culprit behind the weakness seen in markets is inflation, which has been elevated and rising. The bigger risk is that it becomes embedded in the expectations of consumers and businesses and becomes self-fulfilling. A longer lasting period of elevated inflation could present a meaningful headwind to economic growth and corporate earnings.
Inflation expectations have indeed been creeping higher. This explains the relatively aggressive actions undertaken by central banks who have been raising interest rates rather forcefully. Yet, there may be some relief on the horizon. Recent inflation readings in the U.S. have hinted that growth in core prices, excluding food and energy, may be on the verge of starting to slow. In other words, inflation may remain elevated but close to peaking, marking an important change in trend as we move into the second half of the year.
Equity markets have been under pressure, but so too have bonds. In fact, bond markets have had one of their worst starts to a year. While it’s easy to focus on the poor returns of late, there is a silver lining. Given the sell-off in global bond prices, the yields offered by government and corporate bonds have risen meaningfully. As a result, there is now an opportunity to lock in future returns in fixed income that are significantly higher than levels seen over the past decade. Many investors had shunned fixed income in recent years because of very low yields. However, the potential for future returns from the asset class has now arguably changed, for the better.
Periods of market turbulence, such as the current one we are experiencing, can understandably cause some angst. Yet, it’s a relatively normal phenomenon that occurs from one year to the next. The key risk remains whether inflation becomes entrenched in the expectations of businesses and consumers. We’ll be watching this closely, in addition to the odds of a U.S. recession which remain low for the time being. In the meantime, we’ll be considering opportunities in fixed income in our portfolios given the improved prospects for the asset class that have finally emerged.
Should you have any questions, please feel free to reach out.