At the beginning of the year, we argued that the risks of market corrections had been increasing (https://www.fynsa.cl/newsletter/estrategia-internacional-2/), due to higher interest rates as a result of the monetary normalization process undertaken by the Federal Reserve.

Fast forward to today, and the S&P 500 has accumulated a 6.0% decline for the year (which was nearly 10% just a week ago), while the Nasdaq, given its greater sensitivity to interest rates, has doubled the S&P 500's losses. And even though the overall outlook for corporate earnings remains solid, concerns persist about the Federal Reserve's tightening and fears of stubborn inflation, which continues to feed back into highly stressed supply chains, energy prices pressured by geopolitical tensions (oil is already trading at $90 per barrel), and wage pressures that were more evident in this week's employment data.

To complicate matters, it is not only the Federal Reserve that has been raising the tone regarding an earlier and probably faster withdrawal of stimulus measures, but most of the major central banks (with the exception of China) are accelerating their withdrawal.

First (among the major banks) was the Bank of England, which surprised investors with a rate hike in mid-December (after promising not to do so), then this week ended QE (asset purchases) and raised rates again.

Also this week, European Central Bank (ECB) President Lagarde signaled an aggressive policy shift given heightened inflation risks, with a substantially earlier policy exit now expected.

Even speculation about monetary policy normalization has reached Japan, the most moderate of all developed countries.

In practice, in the case of the US, the market is already pricing in five rate hikes by the end of the year (and a 25% probability of a 50 bp hike in March), asset purchases would end in March, and an early start to QT (balance sheet reduction) is even being considered.

Against this backdrop, interest rate pressures remain high, putting pressure on market valuations. From a fundamental perspective, rising interest rates have accounted for the entire decline in the S&P 500. The real yield on the 10-year US Treasury rose by 60 bp (-1.1% to -0.5%) between the S&P 500's all-time high on January 3 and the day after last week's FOMC meeting. Over the same period, the S&P 500's forward P/E multiple fell from 21.8x to 19.5x, matching the market's decline.

Of course, a recurring question these days is whether the worst of this adjustment is already behind us or whether we may still face further losses until the markets stabilize. As a reference, all else being equal, the S&P 500 would fall approximately an additional 10% to 4,000 if real Treasury yields rose from the current -0.6% to 0%, and 15% to 3,800 if they rose another 50 basis points.

In this sense, an S&P 500 at 4,000 points would be consistent with a reversion to the mean in terms of valuation (around 18x) and surely a great buying opportunity. 

When the tide goes out, there will be many opportunities.

In a way, we had become somewhat "spoiled" by adjustments that did not exceed 5% in 2021 and that the market quickly rushed out to buy. In fact, we ourselves often promoted "buy the dip," but clearly things have changed. But the question remains: are corrections of 10% or more so rare? Without reaching a bear market (falls of more than 20%). The evidence shows that they are not.

There have been 33 corrections of 10% or more in the S&P 500 since 1950. The median episode lasted approximately 5 months and covered a decline from peak to trough of 18% (which in practice would be consistent with an S&P 500 around 4,000 points). An investor who buys the S&P 500 at 10% below its peak, regardless of whether it was the trough, would have earned an average return of 15% over the next 12 months (positive 76% of the time), and corrections rarely turn into bear markets unless the economy is heading into a recession (which is not our base case).

Source: Goldman Sachs

 

And what about fixed income?

Our recommendation has been to be very conservative in terms of duration due to the risks of higher interest rates. However, just as in equities we talk about "reversion to the mean" in terms of valuations, a similar approach can be applied to fixed income.

Corporate spreads for the IG US category have risen by around 25 bp, a relatively limited and orderly movement. This makes sense, as the economy is performing well and corporate balance sheets are robust. But with increased interest rate pressures, we should not be surprised to see further increases, converging to average levels of 130 bp (a movement very similar in practice to the tapering of 2013).

One positive outcome, which should be viewed as an opportunity, is that yields are starting to look more attractive. Today, the category offers a yield of 2.8% (which could approach 3%), which is more than 100 basis points higher than just six months ago. In a world with such low rates on offer, this is sure to be highly sought after.

 

Humberto Mora 

Strategy and Investments