If the last few weeks are a sign of things to come, we’ve clearly entered a different market environment which deserves attention from investors. Higher and more persistent inflation, slower economic growth, and geopolitical events have fueled a significant rise in volatility across all asset classes.
We expect this dynamic to remain for the foreseeable future, given the complexity and entrenchment of its underlying components. Below we provide additional detail on current market conditions, their causes, and recommendations on better navigating this challenging investment landscape.
Current Market Conditions
As of February 24, 2022, U.S. equities across the market capitalization spectrum are down significantly from their cyclical highs of last year. For example,
- The S&P 500 Index is down 11.9% and the tech-heavy NASDAQ Composite Index is down18.8%—well within market “correction” territory of a minimum decline of 10% from recent peaks.
- The Russell 2000 Index (which includes the 2,000 smallest companies of the Russell 3000 broad market index) is down by 20.9%—officially defined as a market “crash.”
This market sell-off has led to the Chicago Board Options Exchange (CBOE) Volatility Index (VIX) (below) reaching its highest level in nearly two years. The VIX is a measure of the market’s expectations of the S&P 500 Index price volatility over the next 30 days. The index rises as expectations of increased price volatility grow.
CBOE Volatility Index: February 24, 2021 – February 24, 2022
Source: Bloomberg Finance L.P.
Inflation fears and slowing growth have led to higher rates in the bond market and flattening of the yield curve (when short-term rates increase more than long-term rates). Since early January the rate spread between the 2-year and 10-year Treasury bonds has compressed nearly 60% from a spread of 1.0% to 42 basis points (0.42%).
This rate dynamic has resulted in elevated volatility within the treasury market. The chart below illustrates the Merrill Lynch Option Volatility Estimate(MOVE) Index, which is a measure of the market’s expectations of selected Treasury bonds’ price volatility over the next 30 days. The index rises as expectations of increased price volatility grow.
MOVE Index: February 25, 2021 – February 25, 2022
Source: Bloomberg Finance L.P.
Credit spreads are another measure of risk in the securities markets. For example, when the spread between lower-credit corporate bonds and higher-credit Treasury bonds widens, investors are requiring more yield to hold lower-credit (and the relatively higher-risk) corporate bonds.
While credit spreads have remained relatively calm despite surges in equity volatility over the past year, this is changing in 2022. Credit spreads between corporate bonds and Treasury bonds have widened by over 80 basis points (0.80%) from 2.78% to 3.59% since January.
Excess Yield of U.S. Corporate High Yield Index (Rated BB or below) v. Treasury Bond Curve: February 24, 2021 – February 24, 2022
Source: Bloomberg U.S. Corporate High Yield Average (OAS), Bloomberg Finance L.P.
In short, after the markets’ robust two-year rebound from March 2020, our new normal is anything but. This confluence of disparate factors discussed in detail below significantly heightens risk and adds uncertainty across the broader investment landscape.
Inflation & the Fed
In the face of persistent and growing inflationary pressure一now at its highest rate in 40 years一the Federal Open Market Committee (the Fed) has assumed a more hawkish policy posture. However, concerns about slowing economic growth will complicate the Fed’s approach.
Currently, the market is expecting six rate hikes for 2022, but this figure remains fluid. The Fed will need to enact as many rate hikes as necessary to bring inflation under control一but without leading the country into recession. We believe the uncertainty surrounding this unprecedented challenge will keep market volatility elevated across all asset classes.
Corporate Growth Is Slowing
Topping off a stellar corporate revenue and earnings growth trend, 20214Q numbers didn’t disappoint. For example, with 93% earnings announcements complete,
- Average revenue growth came in at 29.2%
- Average sales growth is 16.3%.
- Average earnings growth topped 30%.
Thus far, companies have protected margins by passing on higher costs to consumers, such as wage hikes and commodity shortages. However, predictions for 2022 clearly expect this practice to stall. Earnings estimates for 2022 are in the single digits, with 6.0% for 2022Q1 and 4.8% for 2022Q2. Such concerns over shrinking corporate margins will help keep market volatility elevated.
Increasing Geopolitical Instability
Russia’s ongoing invasion of Ukraine has added to surging energy costs and overall market weakness. An extended conflict would likely disrupt the global flow of oil from Russia, pressing inflation fears even more and causing further market instability.
In addition, China’s escalating dispute over Taiwanese independence continues to raise the specter of potential future military action in East Asia. Together these factors will continue to roil world markets.
Will the Coronavirus Pandemic Surge Beyond Omicron?
For now, the worst of the Omicron variant seems to be behind us一at least in the West. New case counts and deaths are declining, mask mandates are ending, and some businesses are welcoming back employees.
Still, a comprehensive national reopening remains elusive, and many are resisting a return to work without increased wages or work-life flexibility一if they’re returning at all. Supply chain disruptions are still with us, and policies and protocols on travel, attending school, and other activities continue to evolve.
In short, the overhang of uncertainty remains. While a new variant of concern has not emerged recently, complete victory over the pandemic appears unrealistic. Conventional wisdom suggests we will need to “live with the virus” indefinitely, but what that will entail, no one is sure.
Advice From the Pros at Hilton
Unstable markets can be challenging, but there are ways of managing through the volatility that work better than others. “While elevated levels of market volatility can be uncomfortable, they can also provide the opportunity for tactical wins that can make meaningful differences to portfolio performance,” says Hilton Co-Chief Investment Officer Alex Oxenham. “Our investment approach is centered on producing superior risk-adjusted returns through deploying a combination of strategies and disciplines一regardless of market conditions,” he adds.
Here are a few additional steps to potentially help ease the impact of market instability.
Review Your Long-Term Investment Plan
If your long-term goals haven’t changed and you have a sound investment plan in place that accurately reflects your short-term tolerance for risk, think carefully before making significant revisions related to current market conditions.
Maximize Your Opportunity for Compounding Returns
Long-term investment horizons generally include market downturns, and history suggests withdrawing funds in down markets ultimately reduces the opportunity to recover losses later. Investing in strategies that outperform during periods of market drawdowns better positions your portfolio to leverage the positive impact of compounding returns over time.
Diversify Your Portfolio
The first line of defense for any long-term investment plan is to diversify your portfolio across low-correlating asset classes. This enables your portfolio to better withstand drawdowns in any one asset class with less price decline (or even price appreciation) across others. The level of diversification can vary depending on investment goals and risk tolerance, but the principle is fundamental to surviving impetuous markets.
Be Disciplined About Rebalancing
Diversification works best when asset allocation ranges are strictly observed. While it may seem illogical to sell appreciating assets, timing the market to optimize a sale price is extremely difficult and not recommended. Instead, focus on disciplined rebalancing when your allocation veers away from targets. This helps ensure your portfolio is appropriately positioned to capture rebounding returns.
Explore Active Management
Passive investing refers to a long-term buy-and-hold strategy of purchasing a portfolio that (usually) mimics the returns of a given stock or bond index. Passive management’s lower fees reflect an expected investment performance that hugs the benchmark, no more, no less.
Active management enables a manager to make investment decisions resulting in a portfolio that can differ markedly from its benchmark一if it even tracks one. The opportunity for wider variation in returns, positive and negative, is greater.
A skilled active manager has the tools to navigate around一and even benefit from一volatile markets. By relying on investment analysis, experience, and judgment, they can often better manage risk, limit tax consequences, and increase income compared to benchmark performance.
When considering active management, be sure you select the right active manager. This includes careful analysis of the manager’s portfolio structure, philosophy, performance, and fees. If you are unfamiliar with active management, consulting a professional for advice may be appropriate. You can also see this article from Morningstar to get you started.
Past performance is not indicative of future results.
