by Liz Ann Sonders, Jeffey Kleintop, Kathy Jones, and Kevin Gordon, Randy Frederick, Charles Schwab & Company Ltd.
In recent weeks, it has felt like the U.S. stock market slips a gear every so often, dropping sharply as investors search for traction in uncertain terrain. Many of the individual stocks in the major U.S. stock indexes are down 20% or more from their peaks this year, creating the equivalent of a stealth bear market, even if the indexes themselves haven’t hit that point. At the same time, investors are bracing for the Federal Reserve to start raising interest rates in March. Other major central banks are already doing so, representing a remarkable policy shift from only a few months ago.
From a global perspective, although investors generally believe rising U.S. rates often lead to a downturn in emerging-market stocks, that isn’t always the case. Meanwhile, the tense Russia-Ukraine situation has affected the Russian stock market, but if history is a guide, the impact is unlikely to spread.
U.S. stocks and economy: Stealth bears lurk
Economic data has been murky lately, although it should become clearer moving forward, as the worst impacts from the COVID-19 omicron variant continue to fade. In the near term, we are still grappling with some distortions, including weakening consumer spending, and the most rapid inflation we’ve seen since the 1980s. The picture is further complicated by the Federal Reserve’s plans to begin raising short-term interest rates.
Among the murkier recent economic reports was the January jobs report. Total job growth surged beyond expectations, the prior two months’ job gains were revised upward and the labor force participation rate increased. However, omicron dealt a large hit to the average number of hours worked—which fell to the lowest point since April 2020—and the number of people calling in sick rose to a record 3.6 million.
Omicron led to fewer hours worked and rising illness reports
Source: Charles Schwab, Bureau of Labor Statistics, Bloomberg, as of 1/31/2022.
In response to the apparent tightness in the labor market, investors now expect the Fed to be more aggressive in raising interest rates. Not only are five hikes now expected this year—in addition to the Fed beginning to shrink its balance sheet—but there is growing talk the Fed might raise its benchmark rate by half a percentage point in March, instead of the quarter point previously envisioned.
The Fed’s firm stance on controlling inflation undoubtedly has contributed to increased market volatility. Weak market breadth also has played a role. Market breadth reflects the number of stocks in a given index whose price is rising versus the number whose price is declining. Although an index may be rising or holding steady, if many of the individual stocks within that index are down by 20% or more, it leads to what is known as a stealth bear market.
Deteriorating breadth was an issue in 2021 but has become more acute in 2022. For example, more than 40% of the stocks on the Russell 2000 index have experienced a drawdown of a least 20% from a recent peak so far this year. For the Nasdaq index, the total is closer to half. These stealth bear markets are having an effect at the index level, with the Nasdaq recently experiencing a maximum drawdown of 17% from its November 2021 peak and the Russell 2000 down (at its worst point) 21% this year from its November 2021 peak.
Bear markets are getting less stealthy
Source: Charles Schwab, Bloomberg, as of 2/4/2022. Past performance is no guarantee of future results.
The rapid increase in volatility at the start of the year has coincided with a compression in the S&P 500 index’s forward price-to-earnings (P/E) ratio, which divides the current market value of the index by the likely earnings per share of the companies in the index for the next 12 months. Sometimes that measure falls for good reasons (i.e., earnings are rising rapidly, as was the case for the period starting in late 2020). However, falling stock prices are now contributing to the decline in the index’s forward P/E ratio.
While a falling ratio normally makes stocks appear less expensive, the rub in the current environment is that—with prices now under pressure—earnings growth is decelerating, earnings expectations have weakened, and companies may face threats to profits later this year due to possible supply gluts and a decelerating inflation rate (which may cause them to cut prices for their products, thus hitting profits). In the face of tightening financial conditions, that may make stock market gains more challenging in the future.
The P/E ratio is compressing amid tightening financial conditions
Source: Charles Schwab, Bloomberg, as of 2/8/2022. The Goldman Sachs (GS) U.S. Financial Conditions Index is a weighted average of riskless interest rates, the exchange rate, equity valuations, and credit spreads.
Fixed income: A rapid policy shift
The selloff in the bond market has intensified in recent weeks as investors face the prospect of a synchronized global central-bank tightening cycle. Since the Federal Reserve signaled in mid-December that it planned to tighten policy, the Bank of England has raised short-term interest rates and the European Central Bank has indicated it intends to cut back on its bond buying program and exit its negative-interest-rate policy.
The speed and magnitude of the policy shift is unlike any cycle in recent history. Central banks had set policy assuming that very weak economic growth and deflationary pressures would persist due to the pandemic, and have been caught by surprise by the rapid recovery and inflation surge. With a rapid change in the outlook, volatility has jumped. Two-year Treasury yields have surged in just the past six weeks in major developed countries. The U.S. markets are pricing in five rate hikes this year. With economic growth rebounding and inflation running high, we expect the trend toward higher rates to continue.
Global two-year yields are surging
Source: Bloomberg. U.S. (USGG10YR Index), Germany (GTDEM2Y Index), Italy (GTIT2Y Index), Greece (GTGRD2Y Index), U.K. (GTGBP2Y Index), Canada (GTCAD2Y Index). Daily data as of 2/7/2022.
With little doubt about the direction of interest rates in the months ahead, the focus is shifting toward the destination. Based on the “dot plot,” the Federal Reserve’s longer-run projection for the federal funds rate is 2.5%. Market-based measures of inflation expectations are generally in line with that outlook. The expected inflation rates derived from the Treasury Inflation-Protected Securities (TIPS) market have been falling ever since the Fed signaled it was moving toward tightening policy. It’s a vote of confidence in the Fed that markets are pricing in the likelihood of lower inflation longer term. Consequently, 10-year bond yields may not move much above that 2.5% level if the Fed succeeds in reducing inflation down the road.
TIPS breakeven inflation rates have been falling
Source: Bloomberg. U.S. Breakeven 10 Year (USGGBE10 Index) and U.S. Breakeven 5 Year (USGGBE05 Index). Daily data as of 2/7/2022.
In addition, real interest rates (adjusted for inflation expectations) should move back into positive territory as the Fed exits its easy policy stance. They have moved sharply off recent lows but there is still room to go for many maturities. Thirty-year Treasury yields are now positive in real terms by just a few basis points, but short- and intermediate-term yields have more room to rise. In addition to rising real rates, the yield curve should continue to flatten—which is typical of tightening cycles.
Real yields are still in negative territory but are climbing
Source: Bloomberg. US Generic Govt TII 10 Yr (USGGT10Y INDEX) and US Generic Govt TII 5 Yr (USGGT05Y INDEX). Daily data as of 2/7/2022.
One concern we have is that the rapid shift from easy to tight policies will drain liquidity rapidly from markets, leading to higher volatility. If the Fed moves ahead with its plans, it’s possible that its bond holdings will fall by $500 billion or more this year and over $1 trillion by the end of 2023. When combined with higher short-term interest rates, this one-two punch may reduce the attractiveness of riskier assets such as high-yield bonds. Because these markets also tend to have less liquidity, bouts of volatility can be expected. In recent weeks, the yield spread of high-yield bonds relative to Treasuries has moved up, although it remains low by historical measures.
Overall, we believe investors should be prepared for higher yields and higher volatility in the bond market as the tide of easy money policies ebbs.
Global stocks and economy: Rates hikes and emerging-market stocks
It is a misconception that emerging-market (EM) stocks always suffer losses when the Federal Reserve hikes interest rates. This perspective developed in the 1990s, when the MSCI Emerging Market Index fell during the one-year periods after the Fed began to hike rates in 1994 and again in 1997. However, history shows that EM stocks posted gains during the first year of the other four rate hike cycles since former Fed Chair Alan Greenspan ushered in a period characterized by more transparent money policy. In fact, the start of rate-hike cycles preceded gains for EM stocks, on average.
Fed rate hikes and EM stock performance
Source: Charles Schwab, FactSet data as of 2/3/2022. Returns in U.S. dollars. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance is no guarantee of future results.
Why the mixed track record? We found EM market performance when measured in U.S. dollars is largely attributable to movements in currencies, not stock performance. It was the drop in the EM currencies versus the U.S. dollar in the 1990s that led to losses measured by the dollar-based MSCI Emerging Market Index. When the index is instead measured in local currency, EM stocks did not suffer those losses.
The 1994 Mexican peso crisis and the 1997 Asian financial crisis were both initiated by the Federal Reserve abruptly tightening monetary policy. The sudden shift boosted the broad trade-weighted value of the dollar by about 20% in both occurrences. This pressure on EM currencies weighed on emerging-market stock market performance measured in dollars and spread rapidly through EM economies, which, dependent on dollar-based financing, struggled to fund wide current account deficits and support fixed exchange rates.
Fortunately, most EM countries no longer exhibit these vulnerabilities. Those countries making the news with weak currencies—mainly Turkey and Chile—amount to less than 1% of the MSCI Emerging Markets Index. The big EM economies of China, Taiwan and South Korea make up more than half of the index, and more importantly, do not have Turkey or Chile’s internal political risks or their challenges in funding national trade and budget deficits amid high debt levels.
Not all EMs share the same burdens
Taiwan current account as percentage of GDP is 14.3% as of Q3 2021 but placed at top of chart so it can be seen.
Source: Charles Schwab, Bloomberg and CEIC data for latest period as of 2/4/2022.
Unlike the plunges seen in the 1990s, most EM currencies have been stable even as the market prices in multiple rate hikes by the Fed for this year. As you can see in the chart below, the MSCI Emerging Market Currency Index (which measures the total return of emerging market currencies relative to the U.S. dollar) has remained relatively flat for the past year, where the weight of each currency is equal to its country weight in the MSCI Emerging Markets Index.
EM currencies have been stable for the past year
Source: Charles Schwab, Bloomberg data as of 2/4/2022. Past performance is no guarantee of future results.
Despite the expectations for aggressive rate hikes by the Fed, many EM central banks have already hiked rates, supporting their currencies. More notably, ample foreign currency reserves, the lack of fixed exchange rates and balanced current accounts across many emerging markets are key differences from the 1990s, lowering the likelihood of a repeat of poor performance during those periods of Fed rate hikes.
Russia-Ukraine: What investors should know
Recently, markets have appeared to be reacting to military developments in Ukraine. Russia’s stock market usually trades in sync with oil prices. But recently, despite oil prices reaching new highs, Russian stocks have fallen into a bear market, likely tied to the rising risk of a Russian incursion into Ukraine.
Stocks and oil prices have diverged
Source: Charles Schwab, Bloomberg data as of 1/28/2022. Past performance is no guarantee of future results.
Russia’s buildup of military forces around Ukraine is larger in scope than the exercises of March 2021 and echoes the Russian invasions in Georgia in 2008 and Ukraine in 2014. As in 2014, both the U.S. and NATO have communicated that they are not considering the deployment of their forces to Ukraine to repel a Russian invasion.
The human costs of military action are unmeasurable. Yet the stock market reaction to an incursion or invasion of Ukraine may echo those of the past, with little measurable impact for diversified investors. Previous incidents involving Russia had little impact on the markets. For example, Russia’s invasion and subsequent annexation of Crimea from Ukraine in 2014 saw the S&P 500 and other developed- and emerging-market indices around the world dip less than 2% on the day it occurred and rebound at least partially during the following five days.
Historical geopolitical events involving Russia
*Turkey is a member of NATO, now and at the time of the event.
Source: Charles Schwab & Co., Inc. and FactSet. Data retrieved 1/28/2022. All price performance is in USD. Past performance is no guarantee of future results.
Bottom line: We don’t believe that diversified investors need to take actions to protect portfolios from the market risks tied to potential invasion in Ukraine.
Kevin Gordon, Senior Investment Research Specialist; Michelle Gibley, CFA®, Director of International Research; and Heather O’Leary, Senior Global Investment Research Analyst, contributed to this report.
