In July, equity markets delivered their best monthly return in nearly two years, with the S&P 500,® up 9.2%. However, year-to-date returns remain firmly in negative territory. Given the market has experienced three other rallies of 5% or more this year only to quickly fizzle out and mark new lows for 2022, investors are wondering whether the most recent rally is just another false start. Based on the guideposts we monitor, we believe the probability for continued positive market momentum has increased.

What's changed?

While there has been no shortage of negative headlines for investors this year, we believe the primary catalyst driving markets downward has been rapidly tightening monetary policy by the Federal Reserve (Fed). As the Fed played catch-up in its battle against high inflation, the anticipated pace and degree of interest rate increases put markets on edge as investors braced for the possibility of recession, leading to increased market volatility and negative returns.

During each of the three bear market rallies this year, our guideposts — summarized in Figure 1 — were mixed, indicating to us that investors anticipated further monetary policy tightening, thereby leaving heightened recession risk on the table. However, since global markets bottomed in mid-June, our forward-looking guideposts have all improved simultaneously and are aligned for the first time this year. In our view, this shift signals investors are adjusting once again to anticipated Fed policy changes, but this time to an increasingly likely pause in further rate hikes.

Figure 1. Our Guideposts for Market Expectations of a Fed Pause
All of our guideposts are aligned for the first time this year


 

As of 7/29/2022. Source: Bloomberg, L.P., PNC

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Guidepost details

Rate hike expectations: In the past month, rate hike expectations have decreased dramatically for the second half of the year, a sign the market is not waiting for a formal announcement from the Fed but is adjusting in anticipation of monetary policy changes.

  • Volatility: The CBOE Volatility Index reached its lowest level since April, the CBOE VVIX Index (i.e., the volatility of volatility) reached its lowest level since 2019, and the MOVE Index reached its lowest level since the bear market began.
  • Credit spreads: The Bloomberg Corporate High Yield Index spread reached its lowest level since the bear market began.
  • Initial jobless claims: In the “bad news is good news for the markets” category, the tight labor market has proved elusive to Fed tightening until recently.
  • Inflation breakeven yields: A reliable indicator of future inflation expectations, every breakeven yield we monitor is near its year-to-date low, signaling investors have moved beyond “peak inflation” despite the 9.1% Consumer Price Index reading last month.
  • Commodity prices: The biggest drivers of inflation this year have been oil, gasoline and agriculture prices. While prices are still at elevated levels, their year-over-year growth rates should begin to decelerate rapidly in the months ahead.
  • Risk market indicators: Metrics that have not moved in tandem until this current period:
    • Rising cryptocurrency markets – After more than $2 trillion in market capitalization got “nuked” by several idiosyncratic events unrelated to Fed monetary policy, the Bloomberg Galaxy Crypto Index had its best month since November 2020.
    • Defensive stocks lagging – One of the key giveaways that earlier rallies might be short-lived was the leadership from defensive sectors such as Utilities. While the sector has outperformed year to date, it has begun to lag the broader index more recently.
    •  Increasing market breadth – Market breadth measures the percentage of companies above a certain moving average. While market breadth generally improves during an up-market, the speed at which breadth is improving caught our attention (Figure 2). The percentage of companies above their respective 50-day moving average within the S&P 500 is 77%, the highest level this year. Additionally, the spread between short- and long-term market breadth is at its eighth-widest level since 2011 at 41%.

Figure 2 . S&P 500 Momentum Indicators
Momentum turns positive as market breadth improves

As of 7/29/2022. Source: Bloomberg, L.P.

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The path forward 

Amid this year’s significant market volatility, we remain firm in our asset allocation views for two key reasons. First, the business cycle is unchanged from earlier in the year as we believe it is firmly in a slowing expansion phase. Second, while valuations across the multi asset-class universe have compressed this year, since it has impacted both equities and fixed income, the benefit from reallocating between asset classes is less compelling. As a result, we continue to have conviction in our current asset allocation positioning:

  • Growth tilt: Growth stock valuations across the market capitalization spectrum have become attractive relative to their value counterparts. We believe the earnings outlook for value stocks in 2022 is being skewed by the Energy sector. Longer term, the current earnings imbalance is expected to shift back toward favoring growth companies.
  • U.S. small- and mid-cap overweight: As global growth slows, small- and mid-cap (SMID-cap) companies have more exposure to the U.S. economy compared to their more multinational large-cap counterparts. Therefore, as global growth slows, we expect large cap to be more susceptible to that slowdown. Furthermore, SMID-cap valuations have seen meaningful compression and are now lower than large cap, with small-cap valuations even dipping below their 20-year average.
  • Emerging markets overweight: We continue to see a stronger path forward for emerging markets relative to developed markets due to a stronger earnings outlook and stronger economic growth expectations. We believe China is in a unique position coming out of the pandemic and is just beginning its monetary policy easing cycle, whereas developed markets such as the U.S. and Europe are in tightening mode. Therefore, as global growth slows, we expect China to begin providing support on a lagged basis.
  • Credit overweight: In addition to flexible strategies such as unconstrained fixed income that can be nimble in a high-volatility regime, we continue to have conviction in credit allocations such as high yield, leveraged loans and emerging market debt. We believe as extreme levels of fixed income volatility recede, credit spreads should continue to decline as corporate balance sheets generally remain healthy despite the macroeconomic uncertainties still confronting investors.

The long, strange trip that has been 2022 is far from over, and there are still meaningful hurdles for investors to surmount; however, given the indications from our guideposts, we believe a positive shift is underfoot. While inflation appears to have peaked, growth remains positive and labor markets are still tight, markets tend not to wait for perfect clarity, even for an important catalyst such as a change in monetary policy. We continue to be mindful of macroeconomic headwinds; however, from a market perspective, the largest headwind of all has been monetary policy, and we are seeing early signals that its pressure on markets is coming to a pause.

 

Accessible Version of Charts

 Figure 1: Our Guideposts for Market Expectations of a Fed Pause

All of our guideposts are aligned for the first time this year

As of 7/29/2022. Source: Bloomberg, L.P., PNC

Figure 2: Average S&P 500 Momentum Indicators
Momentum turns positive as market breadth improves

Date

Percentage of Members Above 200-Day Moving Average

Percentage of Members Above 50-Day Moving Average

7/29/2011

52.11

29.66

7/27/2012

65.71

75.25

7/26/2013

90.87

79.68

7/25/2014

82.49

64.87

7/31/2015

56.57

50.91

7/29/2016

77.31

75.6

7/28/2017

75.3

64.16

7/27/2018

65.47

67.72

7/26/2019

76.26

78.73

7/31/2020

54.6

65.48

7/30/2021

88.05

56.04

7/29/2022

36.8

77.34

As of 7/29/2022. Source: Bloomberg, L.P.