United States

Markets suffer pullback on rising expectations of aggressive monetary policy tightening

In April, domestic equities had their worst month since the start of the pandemic. Investors contended with an increase in hawkish Federal Reserve (Fed) rhetoric as inflation remained at 40-year highs. 

Fed policymakers communicated throughout the month they would consider moving more aggressively if needed to stabilize prices. 

However, conventional monetary policy tools may prove less effective against inflation as the ongoing war in Ukraine and the COVID-19 outbreak in China are exacerbating inflationary pressures. We believe market volatility will remain elevated until the Fed provides more clarity on its forward guidance and macro headwinds fade.

The S&P 500® fell back into correction territory in April, declining 8.7% in the month and widening to a 12.9% loss year to date. This has been the worst start to the year for the index in 50 years as equities have been challenged by the abrupt move higher in interest rates. Growth stocks with high valuations have seen their earnings multiples compress swiftly, with both the S&P 500 Growth and Russell 2000® Growth indices crossing into bear market territory. Value indices have been relative outperformers given their lower valuations and higher exposure to the Energy sector, but there was little room for positive returns given the volatile macro landscape.

The initial first-quarter GDP reading showed the U.S. economy declined 1.4%. The report is subject to two more revisions, but if it holds, it would be the first negative growth rate since 2020. The decline was the result of reduced exports, lower inventories and lower government spending rather than any material economic weakness. Notably, consumer demand continues to be supportive, even as durable goods orders and ISM® new orders soften. This indicates that while economic activity appears to be moderating, it remains firmly positive.

While several sentiment indicators trended lower during the month, the University of Michigan Consumer Sentiment Index surged in April — the highest one-month increase in more than a year. Consumers were positive on incomes despite rising prices due to the continued strength of the labor market, which has also helped support robust consumer spending. However, consumer sentiment readings have posed headwinds to equity markets since the start of the pandemic and remain below March 2020 levels. We believe as expectations for future inflation remained steady at 5.4%, indicating we may be nearing peak inflation, consumer sentiment may start to improve and become a tailwind for equity markets.

The March reading for the Consumer Price Index (CPI) reached another 40-year high of 8.5%. The headline number has been negatively impacted by rising food and energy costs due to the ongoing Russia-Ukraine conflict; however, goods inflation has begun to soften. Personal consumption expenditures also reflected this trend as spending on durables rose only 1.2% after two months of modest declines. Conversely, spending on non-durables and services continues to accelerate. Although we may have reached peak inflation, we believe the Fed will need to see more significant declines in inflation to change course with monetary policy.

Yields across the curve rose in April, but unlike previous months, the increase in interest rates was more concentrated in longer-term maturities. For example, 10-year U.S. Treasury (UST) yields ended the month at 2.93%, the highest level since December 2018. This rise in long-term yields has caused the yield curve (as measured by the spread between 2- and 10-year USTs) to steepen during the month, reversing the inversion seen in March. Markets continue to price in rate hikes at every Federal Open Market Committee meeting in 2022. We believe the path of yields is dependent on Fed forward guidance.

Increased volatility and market uncertainty contributed to widening credit spreads in both investment grade and high yield. Investment grade increased by 19 basis points (bps), while high yield widened by 54 bps, reversing much of the tightening that occurred in March. Although spreads have risen off record lows, they remain near late-2021 levels. As such, spreads are not pointing to deterioration in credit markets. Typically, the first signs of market weakness appear in the lowest-rated junk bond spreads (Ba to Caa), yet even those spreads remain at mid-2019 levels.

First-quarter earnings season is well underway with 56% of S&P 500 constituents having reported through month end. The blended earnings growth rate (actual growth rate combined with consensus estimates) of 7.1% is better than the 4.6% estimated growth rate at the start of earnings season. This growth rate was heavily influenced by Amazon.com’s earnings miss. If Amazon.com were removed from the calculation, the growth rate would improve to 10.0%. Furthermore, the earnings upside would nearly double from 343 bps to 607 bps, which is above the long-term range of 450-500. Second-quarter and calendar-year revisions moved lower for the first time in over a month, reflecting the impact from lockdowns in China and lingering supply chain bottlenecks. However, the growth outlook remains positive for the year, with 2022 estimates still pointing to 10% earnings-per-share (EPS) growth.

Valuations across the market cap spectrum contracted during the month, with growth indices experiencing the greatest multiple compression. The S&P 500 forward price-to-earnings ratio (P/E) declined nearly two multiple points in April, ending at 17.5 times (x), while its growth index ended almost three turns lower at 21.4x. The index’s value component declined one turn to 15.0x. While large-cap valuations remain above their 10-year averages, the S&P 400 MidCap® and Russell 2000 saw valuations fall further below their long-term averages. Current high levels of inflation and higher interest rates are expected to have an outsized impact on smaller companies. Given recent multiple compression has been driven by changes in the Fed’s forward guidance, we believe multiples could expand rapidly with more clarity on forward monetary policy like we saw in March (Figure 1).

Figure 1. S&P 500 Forward P/E
Three key moments in year-to-date market performance

As of 4/29/2022 | Source: FactSet®. FactSet® is a registered trademark of FactSet Research Systems Inc. and its affiliates.

View accessible version of this chart.

While there were several positives from the annual bitcoin conference held in Miami Beach, such as announcements from Strike to partner with Shopify and payment processors to allow easier access to bitcoin payments, in our view the bigger news involved the Ethereum network. Ethereum core developers announced a long-awaited shift in mining validation has been delayed from June to later in the year. This shift was expected to increase transaction and mining speeds, which we believe could dramatically reduce mining energy costs and allow the Ethereum network to scale faster. In our view, a faster Ethereum network could speed up the technological innovation supporting the development of the metaverse. Please see our second quarter 2022 Strategy Insights publication for more information about our views on the metaverse.

Developed International Markets

Hard data now reflecting Russia-Ukraine conflict, while survey data continues to worsen

Facing several macroeconomic headwinds, developed international equities, as measured by the MSCI World ex USA Index, declined 6.5%, the lowest monthly return in two years.

Concerns about rising inflation, supply chain bottlenecks and uncertainty regarding economic sanctions on Russia fueled market volatility.

Spillover effects from the Russia-Ukraine war are taking a toll on the European economy, which had a positive outlook at the start of the year. Escalating sanctions by various European countries and countersanctions have put further upward pressure on commodity prices and inflation expectations in Europe due to the region’s reliance on Russian oil and gas (Figure 2). As a result of these various factors, the consensus 2022 GDP estimate for the European Union has fallen from 4.2% at the start of the year to 2.8% at month end.

Figure 2. Developed International Country Exposure to Russian Natural Gas
Russian gas importers are not prepared for more sanctions

As of 12/31/2021 | Source: Bloomberg, L.P.

View accessible version of this chart.

Economic data for the month was mostly negative, but a few bright spots such as retail sales across Europe and Japan beat consensus estimates. While industrial production in Europe showed the strongest year-over-year growth rate since September at 2%, the data is from February, so it is not yet reflecting the impact from the Russia-Ukraine war. However, survey data capturing more current sentiment continues to weaken, with the monthly ZEW Eurozone Expectations of Economic Growth report falling to its nearly lowest level since March 2020. Furthermore, the Eurozone Manufacturing PMI has also declined to 55.5, the lowest level since February 2021. While it is firmly above 50, which signals activity is expanding, the cumulative backdrop highlights the macroeconomic challenges facing developed international markets.

Declining economic growth expectations have led to falling earnings revisions for 2022, with consensus expecting EPS growth of 4.7% for the index, the lowest level since estimates began. Even more troubling, by removing the Energy sector from earnings estimates, the growth rate declines to -0.3%. Should economic data remain challenged across Europe and Japan, we expect earnings revisions for 2022 could decline further. However, from a longer-term perspective, 2023 revisions continue to maintain a positive outlook with accelerating earnings growth expectations.

During April, the European Central Bank confirmed plans to wind down quantitative easing by July, as inflation readings reached a new high of 7.5%. In contrast, the Bank of Japan (BOJ) continues to hold off on monetary policy changes. Rising food and energy costs were offset by deflation in the core measure to produce a 1.1% headline number. The BOJ also kept its yield curve control policy unchanged in April, confirming the status quo. However, as the yen continues to weaken below a number of technical support levels, Japan’s finance ministry has acknowledged it would act “appropriately” should there be a need to support its currency.

Fixed income yields across the globe climbed higher amid rising inflation and compounding supply chain disruption concerns. The yield on the German 10-year bond ended April at 94 bps, the highest since June 2015 and a swift reversal from years-long negative rates. The noticeable divergence in central bank monetary policy across developed international regions persists, with the Bank of England looking to raise rates yet again in May, while the European Central Bank has yet to conclude its tapering of asset purchases and the BOJ remains steadfastly in accommodative territory. As a result of easy financial conditions across Europe and Japan, both the euro and the yen have weakened substantially relative to the dollar, with the euro/U.S. dollar exchange rate now at its lowest level since December 2016.

The Eurozone producer price index report reached a new record, jumping 30.6% year over year. The primary growth driver was energy inflation, up 86%.

Emerging Markets

Pandemic risk returns to China, but the earnings outlook remains firm

Despite outpacing U.S. equities year to date, the MSCI Emerging Markets Index suffered its worst month since last July as concerns regarding the Russia-Ukraine conflict, elevated global inflation and rising COVID-19 cases in China remain headwinds. The path forward for emerging markets (EM) continues to be dependent on the pandemic and normalization of supply chain bottlenecks.

Expectations of an accelerating Chinese economy were abruptly interrupted in April by the lockdown of Shanghai and many other major cities as China attempts to stamp out rising cases of COVID-19. Continued adherence to the “dynamic COVID zero” policy could lead to further supply chain delays and lower economic activity from the second-largest economy in the world.

China’s April manufacturing PMI contracted below 50 for the second consecutive month, and at a reading of 47.4, is at its lowest level since March 2020. 

In our view, this reflects the impact of broadening of lockdowns since the second half of March, rather than a fundamental deterioration in demand. 

In addition to the upside surprise from GDP growing 4.8% compared to consensus estimates of 4.2%, industrial production reached its highest year-over-year growth rate since last August.

Earnings season is ramping up with nearly 40% of the index having reported. The blended growth rate (combined actual and consensus estimates) of 15.2% is the highest growth rate of the three major global large cap indices. Even after removing the Energy and Materials sectors from the calculation, the estimated earnings growth rate of 4.8% is far stronger than the S&P 500 or MSCI World ex USA Index. EM 2022 earnings revisions have started to come down as the confluence of the Russia-Ukraine conflict, lockdowns in China and the slow recovery of global supply chains weigh on the earnings outlook.

Figure 3. EM Debt Spread Comparisons (bps)
Elevated idiosyncratic risks in EM debt

As of 4/29/2022 | Source: Bloomberg, L.P.

View accessible version of this chart.

The Markit EM Credit Default Swap (CDS) Index, a market-based proxy for risk concerns, rose throughout April; however, it was not due to concerns in China or the potential for a Russian debt default. Instead, the two biggest drivers are linked indirectly to the Russia-Ukraine conflict — Turkey and Egypt. Both countries are net importers of energy and grains, and rising inflation costs on top of impacts from the conflict are having a negative effect on economic activity. As such, CDS pricing for Turkish bonds is higher than during the peak of the 2018 debt crisis and at the same levels during the 2013 coup in which President Morsi was ousted from office (Figure 3). These two countries make up 5% of the Bloomberg Emerging Markets Aggregate Index; thus, from the index-level perspective, spreads are only 20 bps above their 10-year average, which is a reminder of why we recommend actively managed strategies in an asset class like EM debt where the risks are highly idiosyncratic.

For more information, please contact your PNC advisor.

 

TEXT VERSION OF CHARTS

Figure 1: S&P 500 Forward P/E
Three key moments in year-to-date market performance (view image)

Date S&P 500 Forward P/E Key Moment
4/30/2021 21.65 -
5/31/2021 21.23 -
6/30/2021 21.35 -
7/30/2021 20.12 -
8/31/2021 21.17 -
9/30/2021 20.69 -
10/29/2021 21.33 -
11/30/2021 21.41 1. Powel Pivot sends multiples lower
12/31/2021 19.95 -
1/4/2022 19.1 -
1/31/2022 18.04 2. Two weeks of clarity leads to 2x multiple expansion
3/29/2022 19.91 -
4/29/2022 17.54 3. Rate hike confusion resumes


Figure 2: 
Developed International Country Exposure to Russian Natural Gas
Russian gas importers are not prepared for more sanctions (view image)

Country % of Natural Gas Imports from Russia % of Natural Gas in Energy Usage
UK 7% 40.12%
Spain 9% 23.47%
Japan 9% 32.10%
China 10.0% 3.16%
France 20% 16.82%
Netherlands 27% 39.02%
Italy 46% 41.55%
Poland 55% 19.34%
Germany 56% 25.73%
Hungary 95% 37.85%


Figure 3: 
EM Debt Spread Comparisons (bps):
Elevated idiosyncratic risks in EM debt (view image)

Date Bloomberg EM Aggregate Index OAS (bps) Turkey 5Y CDS (bps) Egypt 1Y CDS (bps)
5/31/2012 441.051147 231.8 463.65
1/31/2013 286.182159 127.026 322.405
9/30/2013 349.108459 239.945 646.3
5/30/2014 281.050323 199.196 292.625
1/30/2015 429.32428 184.383 192.265
9/30/2015 435.804993 262.207 248.24
1/31/2017 283.372009 273.165 235.3
9/29/2017 245.101257 161.689 158.385
5/31/2018 280.817963 197.027 166.56
1/31/2019 297.833801 361.566 294.715
5/29/2020 571.846313 592.287 398.56
1/29/2021 280.466003 310.799 159.06
9/30/2021 300.398987 434.104 244.29