Volatility returns with a vengeance
Over the last month we have seen a continuation of the significant market volatility that has dominated much of 2022. This comes in the wake of what looked for all the world to be a bear-market rally that saw the S&P 500® Index climb 18% off its mid-June lows and bonds rally significantly as interest rates fell from their mid-June highs. Case-in-point: the U.S. 10-year Treasury yield fell from a June 14 high of 3.50% to an Aug. 1 low of 2.53%. It seems a reasonable assumption that these rallies were driven by the expectation that the more aggressive monetary policy of the U.S. Federal Reserve (Fed) and other central banks would successfully curtail inflation.
Stronger-than-anticipated inflation numbers point to more aggressive Fed
That has all ended over the last month, with hotter-than-expected U.S. CPI (consumer price index) numbers, the most recent of which showed that core inflation climbed 0.6% in August on a month-over-month basis. The report challenged the notion that aggressive monetary policy will tame inflation soon, and therefore set the stage for a more aggressive Fed than was expected during the summer.
A more aggressive Fed, when policy was already aggressive to begin with, also contributes to the fear that potentially highly restrictive monetary policy will drive the U.S. economy into a recession as the lagged impacts of this policy fully hit the economy over the next 18 months. Think of monetary policy as the brakes on a supertanker—it takes time for the effort to have a full effect. The net result of all of this is that U.S. equity markets, as represented by the benchmark S&P 500® Index, are down 7.88% and interest rates, as represented by the U.S. 10-year Treasury yield, are up 0.61% over the last month.
Inflation concerns vs. recession woes: Market tug-of-war continues
Essentially this is just the latest phase of the tug-of-war going on in financial markets that we have seen all year: inflation fears vs. recession fears. Lately, inflation fears have driven markets and, as happened in the first half of the year, both equities and bonds have sold off. These ebbs and flows are common in periods of great uncertainty and these times clearly fall into that category, and are extraordinarily difficult to predict with confidence.
Considerations for investors
We have been advising clients to be neutral to their strategic asset allocation, particularly as it relates to their equity and fixed mix for most of this year. We said this at the June market lows and we said it again at the August market highs. We said this when the 10-year U.S. Treasury yield was at 3.50% in June, and again when it was at 2.53% in August.
In addition to advising our clients to remain neutral, we also told them that we saw volatility as inevitable. From mid-June to mid-August we saw the good side of volatility, and over the last month we’ve seen the bad side of volatility. Meanwhile, the fundamental issue of uncertainty around inflation and recession risks remains uncomfortably in place. We strongly believe that investors need to have a high level of certainty to deviate from their strategic asset allocation.
The value of adhering to a strategic asset allocation during times of uncertainty
At Russell Investments, we use our cycle, valuation and sentiment process to guide us as it relates to that certainty. Right now, this framework is telling us not to be certain about much at all. I would argue that those with strong opinions at this time should question the confidence that they seem to have given the unprecedented nature of what we are dealing with.