MARKETS AND INVESTING
February 18, 2022
Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
After bouncing from oversold levels, the S&P 500 stalled out at 4590 and is currently pulling in to the midpoint of its recent ~4600-4200 trading range on Russia/Ukraine concerns. The geopolitical uncertainty comes at a time when the Fed backstop is being removed- where negative headlines are likely to come with more market volatility (rather than shaken off quickly when the Fed was ultra-accommodative). Additionally, the market has been anxious this year over high inflation and the Fed’s rate hike cycle ahead- and a potential Russian oil embargo would only add to those inflation concerns, while also being a negative impact on global economic growth.
This supports our belief that the market is likely stuck in a back-and-forth trading range right now that might take awhile to play out. Pullbacks and corrections can be time as much as degree. We think time is the more likely path right now as opposed to the need for a greater degree (% decline) than seen at 4222. We have likely had the downside, but now time needs to pass in our view. Along the way, investors will receive more information surrounding Russia/Ukraine, but more importantly inflationary pressures. If inflation can moderate as the year progresses (as we expect), this should provide upside to a market pricing in 6-7 hikes this year.
The US 10-year Treasury yield (10yr) has risen to its pre-pandemic level around 2%, and the sharpness of the recent rise has been a negative influence on equity valuations to begin the year. While we expect the 10yr to grind higher over the next 6-12 months, we are not convinced it is set to rise appreciably higher. The moderation in economic growth this year may act as a headwind to bond yields; and technically, we note 35-year downtrend resistance for the US 10-year Treasury yield at ~2.19%.
This is important because low interest rates can support equity valuations. The S&P 500 P/E is above average (albeit approaching its pre-pandemic level), but remains attractive vs. bond yields in our view. The differential in S&P 500 earnings yield (4.7%) and US 10-year Treasury yield (2%) currently stands at 2.7% (vs the 60-year average of 0.6%). On average, when this equity risk premium has been between 2.5-3%, the next 3-year annualized return has averaged 8.3% with a high of 17.6% and low of -2.4%. So, odds favor healthy forward equity market returns for long-term investors (while acknowledging the potential for further volatility in the short term)- particularly if our base case expectations for above trend economic growth, 15% earnings growth, moderating inflation, and grind higher in interest rates prove accurate.
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