From Buying the Dips to Fading the Rallies

by Erik L. Knutzen, CFA, CAIA, Chief Investment Officer—Multi-Asset Class, Neuberger Berman

Equity markets are higher than they were on the eve of the invasion of Ukraine, but here’s why we think there is more volatility, and potentially more downside to come.

Neuberger Berman’s Asset Allocation Committee (AAC) has just held its second-quarter meeting, its first since Russia’s invasion of Ukraine on February 24.

Unsurprisingly, the changes to our market views are just as dramatic as they were when the COVID-19 pandemic emerged two years ago. Behind those views is a profound change in the way we think about the asset allocation challenge, which we will discuss in the full Outlook next week.

Today, however, we will focus on one key decision: a downgrade to underweight in our 12-month outlook for equities.

Caution

Our view on U.S. large caps remains unchanged, but it was already negative due to stretched valuations and the interest rate sensitivity baked into that segment’s growth-oriented profile. Our view on smaller companies has been downgraded to neutral, and our views on non-U.S. markets are downgraded to underweight. As a result, our view on global equities overall has turned distinctly cautious.

At first glance, this might appear counterintuitive.

The S&P 500 Index is more than 6% higher than it was on the day Russia invaded Ukraine. This fits the historical experience that Joe Amato wrote about last week, which suggests that violent geopolitical events generally have only a short-term impact on financial markets.

So why the caution on equities for the next 12 months?

Because, as Joe also pointed out, structural, fundamental economic forces are ultimately the ones that matter for markets, and the Ukraine crisis directly exacerbates the fundamental challenges that investors were already facing: high and problematic inflation amid softening economic growth.

Fading the Rallies

Higher inflation generally demands higher interest rates and tighter policy from central banks.

Just last week, we heard U.S. Federal Reserve Chair Jerome Powell fretting about the “extremely tight” U.S. jobs market and entertaining the idea of a 50-basis-point rate hike and a shift to restrictive policy. Other Fed rate-setters, traditional doves and hawks alike, echoed his sentiments over the following days. This messaging, which followed similar hawkishness from the European Central Bank, pushed fed funds futures markets to price for seven rate hikes this year, including at least one of 50 basis points.

High inflation, rising rates and slowing growth is a potentially poisonous mix for equity investors. Higher rates mean lower valuation multiples, while lower growth and rising costs eat into many businesses’ revenues and profits. For that reason, we think it is time to revisit the “buy-the-dip” mentality of the past two years and instead look to “fade” equity market rallies and carefully manage risk exposures.

Within equities, we favor lower beta exposures, with a bias toward higher quality and higher dividend yields. Growth stocks may appear to be the more intuitive exposure as we head into a slowdown, and indeed they have led the recent rally, but we still believe they could suffer from high relative valuation and sensitivity to rising rates. A value orientation can be given a defensive tilt with high-quality, cash-generative income stocks, which are available at relatively attractive multiples.

Discredited

What would ease our concerns and make us less cautious?

Last week, both Powell and the St. Louis Fed President James Bullard referred to the “soft landing” that the central bank achieved with its 1994 tightening cycle. That is the current objective, and any sign of success, such as a meaningful reduction in inflation with a negligible loss of industrial activity or jobs, would see us revisit our stance.

But that is a very narrow tightrope to cross. In our view, it depends a lot on the increasingly discredited view that the current, elevated rate of inflation is entirely transitory. The alternative outcomes—an aggressive tightening that induces a recession or a surrender to a long period of stubbornly high inflation—appear more likely paths forward.

Notwithstanding the recent market rally, we think that leaves investors with a backdrop for equities that is highly uncertain—and potentially very challenging.

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