The S&P 500 officially fell into bear market territory during the month of May, although a late-month bounce allowed it to finish the month flat. Regardless of the finish, the tone of the market has changed, and it doesn’t appear to be calming down anytime soon.
When looking at the performance of the large-cap tech stocks, it seemed inevitable that the broader market would touch bear market levels. What has occurred in the tech sector marks one of the largest reversals of fortune in market history. After leading U.S. equity markets for most of the epic bull run that began in 2008, these stocks have collapsed and been the largest drag on markets this year. Many tech companies have seen their share prices fall over 50% and may never again see the levels reached last year.
For the last decade, to have a winning balanced portfolio all you needed to hold were large cap technology stocks (remember FAANG?) and long-duration government bonds. But this year that is exactly what you don't want to do, as both of those asset classes are amongst the worst performers year to date, shown by the Nasdaq 100 off over 22% and TLT (US Long Bond ETF) off over 20% year to date.
The return of inflation and the realization that global central banks are very behind the curve has caused a dramatic move higher in bond yields. Prior to the pandemic, there was over $10 trillion worth of bonds around the world that had a negative yield, leading many to wonder how the financial system would work with negative rates. Those fears seem long gone now as bond yields have turned much higher, and many investors are losing money on their bond investments for the first time in years.
Bonds are traditionally looked at as the safest part of a portfolio and are expected to protect portfolios in times of equity market turmoil. This year, that’s not the case. When this reverts back to normal will be an ongoing debate, but it probably won’t happen in the near term as the next big event for bonds will be the beginning of quantitative tightening (QT) in June.
Central bank balance sheets have expanded well beyond anyone’s expectations, but it’s time for them to reverse course and attempt to shrink back to a more appropriate level. QT has never been attempted on this scale, and the implications are unknown, which should keep markets volatile through the summer.
One area of the market that has provided investors some relief has been the commodities. This group has been a direct beneficiary of a rapid increase in demand for goods at the same time when there are few supply options available. The resulting cash flow boom and dividend increases have caught the attention of investors around the world. A rotation towards the resource sectors has allowed Canadian equity markets to escape most of the damage in this selloff, as the S&P/TSX Index is only down 2.3%, supported by the energy sector, which is up over 65%. But does this mark the start of the “Great Rotation” many have been calling for?
Markets tend to move in cycles and once bull markets end, it’s seldom the previous winning sectors that lead the next cycle. The conditions have never been better for resources to move to the front of the line. After years being shunned by investors and starved of capital, there has been a lack of new exploration and project development in the resources sector. New project development will take time to be built and come online. Plus, most of the world sanctioning Russian energy extends this concern. Energy companies that learned to operate in the lean years are now seeing margins explode higher.
The relief rally that ended the month of May has given investors a chance for a do-over. The big debate will be if this is the beginning of the end of the selloff, which will probably depend on the economy and inflation outlook.
Recent comments from large consumer companies like Walmart and Target has caused concern that consumers may pull back on spending. This would go a long way to help relieve inflation and allow the FOMC the cover to slow down their plans for rate hikes. Unfortunately, we remain in a market that has not proven it can stand on its own and is highly dependent on central banks.
So far, the correction that equity markets have experienced has been a valuation reset. Earnings multiples rose to the higher end of historical averages and have now returned closer to normal. Bears will point out the next move lower will be around negative earnings revision. Strategists are still expecting earnings growth for most markets this year. If earnings turn lower and the economy enters a recession, this selloff may be far from over.
The most optimistic scenario will see inflation calming down by the fall combined with the Fed executing a soft-landing, which could mean that we have seen the lows for the year. Whether this is feasible will be the debate of the summer. Every economic data point and earning release will be scrutinized for signals to answer this question. The only thing safe to predict is that volatility isn’t going away anytime soon.
— Greg Taylor is the Chief Investment Officer at Purpose Investments
Sources: Charts are sourced to Bloomberg L.P.
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