What’s driving the volatility in markets?

On the latest edition of Market Week in Review, Chief Investment Strategist Erik Ristuben and Director of Institutional Investment Solutions, Greg Coffey, discussed key drivers behind the latest bout of market volatility. They also chatted about the outlook for U.S. inflation and how central banks around the world are responding to the surge in pricing pressures.

Is an aggressive Fed spooking markets?

Coffey noted that after a brutal April for U.S. equities, May hasn't fared much better, with the benchmark S&P 500® Index sinking to a new low for the year on 12 May before rebounding the next day. U.S. government bonds have also continued their 2022 selloff, he observed, with the yield on the 10-year Treasury note at one point topping 3.1% the week of 9 May.

The volatility in markets is directly attributable to the U.S. Federal Reserve (Fed)'s plans to corral inflation by aggressively raising interest rates, Ristuben said. "Essentially, markets are realizing that a very active Fed may trigger a recession down the line," he stated, explaining that the U.S. central bank has been extraordinarily clear that tamping down inflation is its number one job right now - not preventing a recession. The Fed's signal that it will fight inflation at all costs means that central-bank leaders are potentially willing to endure a small recession in order to bring pricing pressures under control, Ristuben added.

Recent remarks by Fed Chair Jerome Powell make additional 50-basis-point rate hikes likely at both the central's bank's June and July meetings, he said. This would take the federal funds rate to 1.75% by late July, which Ristuben said will likely cause the risks of a 2023 downturn to increase. "I expect recession risks to rise throughout the summer and into the fall, as the U.S. gets deeper into the rate-hiking cycle," he remarked, adding that he believes the second half of 2023 is the most likely time for a recession to occur.

U.S. headline inflation cools slightly in April

As the Fed puts the pedal to the metal to tame inflation, the release of April's consumer price index (CPI) showed that pricing pressures still remain very elevated, Ristuben said. "Headline inflation climbed by 8.3% last month on a year-over-year basis, which was slightly better than March's increase of 8.5%, but probably wasn't quite the step back markets were hoping for," he said, noting that consensus expectations called for price gains to decelerate to 8.1%.

On a more positive note, the latest numbers show that U.S. corporate earnings remain solid, Ristuben said. With over 90% of S&P 500 companies reporting first-quarter results, roughly 80% have beat earnings expectations, he noted. The blended earnings growth rate for the first quarter now stands at 9%, versus initial expectations for 4.5% growth, Ristuben added. "This is essentially double what market expectations were coming into first-quarter earnings season - and that's quite good," he stated.

Ristuben noted that the April jobs report also pointed to ongoing strength in the U.S. economy, with 428,000 non-farm payrolls added last month. This is an area the Fed will be watching very closely over the next several months, he said, as the central bank attempts to slow the demand for labour by increasing the cost of money. "Central-bank leaders are going to want to see a little less heat in subsequent job reports," Ristuben said, "and while ideally, they don't want job growth to turn negative, I think they're probably willing to withstand that in order to bring down inflation." Of particular focus for the Fed will be wage inflation, which is showing signs of plateauing, he said.

Ultimately, Ristuben believes that while inflation will continue to move in a downward direction, it will likely still be higher at year-end than what the Fed prefers. "At the conclusion of 2022, I think inflation will be hovering around 3%, which would be a vast improvement compared to the 8% readings we're seeing now, yet still well above the central's bank 2% target," he remarked.

Global central banks united in push to defeat inflation

Noting that pricing pressures have skyrocketed across the globe, Coffey asked Ristuben what other central banks' tightening plans for the year are. Ristuben said expectations for rate increases among almost all global central banks have ratcheted up since the start of the year, with markets now pricing in 11 25-basis-point rate hikes from the Bank of Canada, 10 from the Reserve Bank of Australia and eight from the Bank of England. Even the European Central Bank is now expected to increase borrowing costs three or four times this year, he noted - a sharp reversal from late last year, when President Christine Lagarde stated that a 2022 rate hike was very unlikely.

Ristuben said that the only two major global central banks not expected to lift rates this year are the Bank of Japan, where inflation remains below 1%, and the People's Bank of China, which is likely moving toward policy easing to blunt the economic impacts of the nation's zero-COVID policy.

"At the end of the day, inflation is the top concern for almost every developed central bank in the world - and they all have the same goal of extinguishing it, even if doing so puts economic growth at risk," Ristuben remarked. He added that because of the reserve currency status of the U.S. dollar, the U.S. tends to be a key source of global inflation. "Ultimately, if the U.S. can bring its inflationary pressures under control, that will help other countries," he concluded.

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