U.S. equities have been at or near bear market levels in recent trading sessions, as tightening monetary conditions and fears of persistent inflation drove the S&P 500 Index to its lowest level since February 2021. A seventh straight week of losses marked the worst losing streak for stocks since 2001. The NASDAQ Composite and similar growth indexes entered a bear market in April as long-duration technology and related growth assets bore the brunt of sharply rising interest rates. We recently spoke with ClearBridge Chief Investment Officer Scott Glasser about managing through the current market turbulence.
Q: What have been the primary catalysts of the selloff?
A: Markets are transitioning away from a decade with ample and easing liquidity where volatility was almost nonexistent to a much tighter, potentially restrictive, liquidity environment. I have long believed and consistently expressed a view that changes in liquidity are the primary determinants of bull and bear markets. Rising interest rates and a shrinking Federal Reserve balance sheet are draining liquidity from the system while rising commodity prices and widening credit spreads create an incremental burden on corporate profits and disposable incomes.
We are currently in a bear market, which, almost by definition, includes valuation multiple compression, especially for longer-duration equities such as growth stocks where valuations had become excessive and, in some cases, speculative. Correlations among stocks are high, pointing to deleveraging and wholesale liquidations in the market. In many cases today, there is little differentiation between companies with strong and weak fundamentals, although I expect differentiation as an important component to any durable market bottom.
Q: Does the current environment display any resemblance to past bear markets?
The current bear market is unique but using the 2000-2003 bear/bull cycle is appropriate in many ways. In both cases, the market is correcting speculative excesses built up in prior years. However, it is important to highlight that the excesses were much more significant in the 2000 top as compared to the recent market highs. In both cases employment was below 4%, interest rates were heading up and liquidity overall was tightening. In addition, both environments were accelerated by exogenous events that weakened corporate profits. Back then it was 9/11 and the ensuing war while today it is the war in Ukraine. Of course, COVID-19 has had a huge impact in the current environment as well.
There are also some elements of the 1970s like inflation in today’s mix, which is a new factor for most people currently managing money. Unlike the 1970s, we are not coming off a decade of economic and political malaise, so inflation is not as deeply rooted and extreme as that period.
In sum, today’s backdrop is a combination of those two periods with elements of both impacting equities. It is important to note that the 2000 market top was more of a financial market event than an economic event. During that time, the U.S. only experienced two non-consecutive quarters of negative growth and the slump was relatively minor from a GDP perspective.
Q: What indicators are you watching to determine the near-term outlook of the economy?
Looking at credit spreads in the bond market has always been a helpful tool in assessing the economic outlook. Today those relationships point to an environment that is consistent with past crises but not at recessionary type levels. We also always look to the yield curve, which has a very strong track record of foreshadowing recessions. It also is not forecasting a recession -- yet. Manufacturing PMIs are probably the best way to forecast corporate profit trends and while analyst estimate revisions have not yet changed much, it is clear the PMIs are heading down and with it will come EPS revisions. Putting it all together in terms of GDP and economic impact, I see a slowing economy in late 2022 into 2023 with the good possibility of a mild recession. Perversely, shutting down the economy in 2020 due to COVID-19 may have allowed enough pent-up demand across the economy to save it from a deeper recession.
Q: What about your outlook for equities?
We are currently in a bear market that likely extends through most of 2022 for the reasons already addressed. It is likely that we get a significant rally, perhaps through the summer and then a decline back to current or lower levels before a durable bottom is established. The last two significant bear markets (2008/2009 and 2001/2002) each included at least one period with a significant sustained rally before making a final low. Today, the environment remains highly uncertain. There are few times I can remember in the last 30 years with such a wide range of potential outcomes.
Q: How are you managing portfolios in this environment?
While volatility and declines are unsettling and emotionally draining, they do reset the market environment and provide opportunities for future, longer lasting gains. We have all been pacified by easy money and high returns over the last decade which resulted in lower than historical levels of volatility. We are now focused on using the volatility to our advantage. That means high grading our portfolios by upping the quality; upping the growth potential at more reasonable valuations; adding dividend-oriented securities for those clients that seek income; or simply rebalancing risk and reward where it makes sense. The goal is to be better prepared and positioned to achieve long-term goals when we emerge from this difficult period.
For more, watch Chief Investment Officer Scott Glasser share his views on the current equity drawdown, the outlook for the economy and why volatility is likely to continue.
In the latest Anatomy of a Recession update, Jeff discusses where equities ultimately bottom will depend on how well the economy and earnings hold up.Read full article