Inflation and threat of Ukraine invasion fuel outlook for greater equity volatility

A turbulent start to the year for U.S. equities has entered a new phase in recent days, as investors weigh up positive news about corporate earnings and the labor market against the lingering challenges of high inflation, rising bond yields and geopolitical uncertainty.

A takeaway from last week in the markets is that 2022 is starting to look like many predicted at the start of the year. Stocks have generally fared better than in January, when they fell sharply in anticipation of tighter monetary policies, but are still rocked by contradictory trends that should keep prices volatile.

The driving force behind many market moves remains the rise in US government bond yields, fueled by escalating expectations for the level to which the Federal Reserve will raise short-term interest rates this year.

Yields, which rise when bond prices fall, are a basic indicator for investors because they help dictate borrowing costs on everything from mortgages to corporate debt. They are also a major component of financial models used to value stocks and other assets. All else being equal, the ability to earn higher yields on risk-free bonds makes future corporate earnings less valuable, leading to lower stock prices.

For much of January, analysts widely agreed that this simple relationship was paramount for stocks. The yield on the benchmark 10-year US Treasury rose from 1.496% at the end of last year to 1.866% on January 18. Stocks fell, led by technology companies, many of which are particularly sensitive to rising rates because their value is largely driven by their potential earnings down the road.

Since then, the relationship between bonds and equities has become more nuanced. Stocks may have rebounded in a period when bond yields stabilized, but still rose overall even as yields rose sharply on Feb. 4, following a better-than-expected jobs report. Still, stocks fell on Thursday after Consumer Price Index data showed inflation hit a new four-decade high last month, and stocks extended their decline on Friday amid concerns growing concerns about a possible Russian invasion of Ukraine.

At the end of the day on Friday, the S&P 500 had recorded its fourth weekly decline in the last six weeks, down 1.8%. The 10-year yield stood at 1.951%, down from 2.028% on Thursday, setting up a week in which investors will follow the latest developments on the Russian-Ukrainian situation, earnings from ZoomInfo Technologies. Inc.

and Airbnb Inc.,

and hints from Fed officials about their plans for the March policy meeting.

“It’s upside down,” said Jackie Cavanaugh, portfolio manager of the Putnam Focused Equity Fund at Putnam Investments. “It’s a very uncertain time in the markets because we’re facing a lot of cross-currents that, frankly, a lot of current-generation investors haven’t seen before.”

In recent weeks, several factors have helped stocks, according to investors and analysts. One of them was a strong run of fourth-quarter corporate earnings. Strong jobs data further bolstered the economic outlook, while January’s fall in equities made prices more attractive to some investors. On top of all this, inflation-adjusted yields on Treasuries remain negative even with impending rate hikes, prompting a search for yield in riskier assets.

Few, however, found silver linings in Thursday’s inflation data, a reminder of hard-to-predict economic trends that could keep investors nervous this year. Reports that Russia is set to invade Ukraine added another blow, sending stock and bond yields plummeting as investors rushed to safer assets.

Rising US Treasury yields continue to be a driver of many stock market swings.


Photo:

Stefani Reynolds/Agence France-Presse/Getty Images

Such volatility, however, is to be expected, said Bob Doll, chief investment officer at Crossmark Global Investments. His prediction, unchanged since the beginning of the year, is that investors oscillate between optimism about the economy and pessimism about rising rates.

“We’re going to go through thousands of Dow Jones Industrial Average points, but we may not make much progress from point to point,” he said.

The basic dynamic facing investors this year is not unique. Whenever the Fed has started raising interest rates, investors have typically had to balance the downsides of tighter monetary policy with the benefits of a growing economy.

Generally, the early years of rate hike campaigns worked for investors. In the past six times the central bank has raised rates, stocks have generated positive returns every time in year one and five out of six times in year two, according to a November Bank of America report. The one exception came when rate hikes may have helped burst the tech bubble around the turn of the millennium.

US government bond yields influence the cost of borrowing, from mortgages to student loans. WSJ explains how they work and why they are so crucial to the economy. Photo illustration: Tom Grillo/WSJ

Some analysts have noted that this rate hike cycle could be more dangerous than others as equities have entered high valuations. S&P 500 companies traded at the end of last year at nearly 39 times their cyclically-adjusted earnings, higher than at any time outside the tech bubble.

Valuations, however, are not as high by other measures and are now lower after January’s sell-off. S&P 500 companies traded late last month as low as 19.3 times expected earnings over the next 12 months, according to FactSet, falling below 20 for the first time since April 2020. That was down from a multiple of 21.5 at the start of the year, though still above the five-year average of 18.9.

“We know markets don’t like uncertainty, but we believe this cycle will play out like any other where the economy and corporate earnings are strong enough that we are higher at the end of the year. than we are right now,” said Jeffrey Buchbinder, equity strategist at LPL Financial.. “The market will feel comfortable with the trajectory of rate hikes, we believe, likely in the coming months.”

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Buchbinder said LPL Financial remains broadly bullish on the US stock market and has talks of buying shares of tech companies in the near term. In particular, he said the team sees opportunities to buy software companies and chipmakers, companies which he believes have strong fundamentals and attractive valuations after the recent sell-off in shares of growth.

Still, Christopher Harvey, head of equity strategy at Wells Fargo Securities, said he advised clients to be cautious.

“We are selective, we are disciplined and we would buy weakness, but we don’t chase things,” he said. “We think the upside is limited because…growth will slow and the Fed will become more aggressive.”

Write to Sam Goldfarb at [email protected] and Caitlin McCabe at [email protected]

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