United States
Heightened market volatility, weak retail earnings guidance and elevated inflation continue to pressure markets
Equity markets were volatile during the month as domestic large-cap equities fell into an intraday bear market on May 20 and then reversed course with a late-month rally. The S&P 500® ended the month up 18 basis points (bps), just the second monthly positive return of the year.
In our view, much of the ongoing volatility is being driven by the Federal Reserve’s (Fed’s) resolve to tame inflation, as investors speculate whether this goal can be achieved without harming the U.S. economy.
We believe market volatility will remain elevated until markets gain more clarity on the Fed’s policy measures and as macro headwinds fade.
Despite the S&P 500’s two positive monthly returns, this has been the worst start to the year for the index over the past 50 years as equities adjust to the Fed’s removal of unprecedented monetary policy accommodation. Easy financial conditions and excess liquidity fueled the rally in asset prices since the pandemic, yet the abrupt move higher in interest rates and impending withdrawal of the Fed’s liquidity has swiftly reset valuations.
Growth stocks across the market-cap spectrum have been the most challenged by higher interest rates and the dramatic compression of earnings multiples. The S&P 500 Growth and Russell 2000® Growth indices sunk deeper into bear market territory during May, while value indices remained relative outperformers. The Energy sector, traditionally a value-oriented sector, is benefiting from higher prices of crude oil and natural gas. Higher interest rates are aiding the Financials sector; however, they are hindering Real Estate sector performance. Earnings reports during the month from several consumer-related companies indicated price increases may be starting to impact corporate profitability as they are trying to balance raising prices against lower consumer spending.
The April reading for the Consumer Price Index (CPI) declined modestly to an annualized rate of 8.3%, increasing at the lowest monthly rate since August 2021. The headline number remains elevated as the ongoing Russia-Ukraine war continues to negatively impact food and energy prices globally. Notably, durable goods inflation continues to ease as service inflation has been steadily increasing back to pre-pandemic levels. 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.
Lower consumer demand is showing up in the housing market as the April report of new home sales declined 16.6%, the inventory of new homes increased by almost 30% to a nine-month supply and construction costs grew 20%. Higher interest rates have stifled refinancing, while elevated home prices and 30-year mortgage rates above 5% are having a large impact on affordability, especially for first-time homebuyers. More broadly, consumer demand continues to be strong as seen in the recent ISM report, and the labor market continues to tighten. These dynamics should support positive, albeit moderating, economic activity.
Markets experienced heightened volatility in May as the CBOE Volatility Index (VIX), which measures near-term volatility of the S&P 500, surged above 36 to start the month, but ended at 26, just above the post pandemic average of 24. More notably, the index that measures the volatility of the VIX (the CBOE VVIX Index) fell significantly during the month and is now at levels not seen since early February 2020 (Figure 1)! While major headwinds continue to roil markets, we believe monetary policy guidance from the Fed will continue to drive markets and the path of yields.
Figure 1. CBOE VVIX Index
Market volatility declined significantly by month end
As of 5/31/2022 | Source: Bloomberg, L.P.
View accessible version of this chart.
Fixed income volatility, as measured by the MOVE Index, also showed signs that tightening financial conditions may have reached a peak, as it fell below 100 for the first time in more than 60 days. Yields declined throughout the month, with the 2-year U.S. Treasury (UST) yield ending at 2.56% after reaching 2.78% in early May. We believe the sudden change in course of short-term yields signals the market may have fully priced in expectations for Fed tightening. Despite intra-month fluctuations, the spread between 2- and 10-year USTs ended the month modestly higher at 28 bps, while the spread between the 3-month and 10-year USTs declined to 177 bps. We believe this reflects rising ultra-short yields due to the Fed’s actions.
While both investment grade (IG) and high yield (HY) spreads widened during May, they narrowed significantly from intra-month highs, with IG and HY spreads falling 19 bps and 79 bps, respectively. Even the lowest-rated junk bond spreads (Ba to Caa) eased in May as they ended the month on a seven-day rally, the longest since September 2021. Much of the mid-month jump in spreads occurred the week of notable earnings misses from Walmart Inc. and Target Corporation. However, when other retailers alleviated concerns of consumer spending contagion, spreads dramatically narrowed.
We believe a lack of new issue supply could be keeping fixed income index spreads tight, with May being the first month since 2014 that new IG bond volume has failed to surpass $100 billion. Many HY issuers remain on the sidelines as financing has become increasingly more expensive. Though spreads have widened as financial conditions tighten, they generally remain at healthy levels, with HY spreads below the 10-year average of 433 bps. An area worth monitoring is the amount of distressed debt trading in the market (defined as any bond trading over 1,000 bps to similar-maturity Treasuries). Volumes reached peak levels in December 2020 and had been steadily declining but surged back to peak levels in May.
First-quarter earnings season is largely complete with almost 99% of S&P 500 constituents having reported. The blended earnings growth rate (actual growth rate combined with consensus estimates) improved to 9.25%, compared to the 4.6% estimated growth rate at the start of earnings season. However, upside surprise moderated to 4.8%, the lowest level since the first quarter of 2020, but results were heavily influenced by Amazon.com, Inc.’s earnings miss. By excluding just this one company, the upside surprise would have increased by 265 bps and improved the earnings growth rate to 12%.
Moderating earnings growth rates in 2022 are largely a function of fading base effects from the pandemic downturn; however, we continue to monitor how higher interest rates and commodity prices are impacting consumer spending and thus corporate profitability.
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. The growth outlook remains positive for the year with 10% estimated earnings-per-share (EPS) growth for 2022.
Valuations continued to compress across the market-cap spectrum in May, although they improved off mid-month lows. The S&P 500 forward price-to-earnings ratio (P/E) of 17.4 times (x) is back to pre-pandemic levels. While large-cap valuations are trading above their 10-year averages, both the S&P 400 MidCap® and Russell 2000 continue to experience valuation compression below their long-term averages. This may be due in part to the composition of those indices as they lean toward lower-valuation, lower-growth sectors. Going forward, we do not expect meaningful multiple expansion without a material decline in inflation rates from 40-year highs.
Developed International Markets
Positive market performance masking persistent headwinds
International developed markets delivered their second positive monthly return for the year, but it masked the volatile macro and geopolitical risks during the month. The MSCI World ex USA Index rose 95 bps in May, with most of the contribution to performance coming from the Energy sector.
Value outperformed growth for the sixth consecutive month by 390 bps. Since the beginning of the year, value has outperformed by more than 1,800 bps, supported not only by Energy sector returns but also expectations for potential interest rate increases. The European Central Bank (ECB) may begin to raise its policy rate later in the year, which prompted long-term interest rates in many countries to reach multi-year highs. While rising interest rates have been a significant headwind to U.S. equities, the more interest-rate-sensitive sectors in developed markets benefit from rising rates since regions such as Japan and Europe have experienced negative interest rate policies for years.
Geographically, Europe was the return leader, rising 4.1%, supported by the Energy sector and a strengthening euro. In contrast, sales and margins among the Consumer Discretionary, Information Technology and Industrials sectors continue to be negatively impacted by high inflation and supply chain disruptions.
Headline inflation continues to break records with the European Union’s May CPI print of 8.1%, the highest since 1982. In our view, high inflation is putting further pressure on the ECB to join the Fed and the Bank of England in their crusade to tame inflation. As a result of rising inflation and the Russia-Ukraine war, value outperformed growth for the sixth consecutive month in May by 372 basis points, led by cyclical sectors such as Energy and Materials.
It remains to be seen how the ECB’s hawkish pivot might impact economic activity and consumer demand in the near term. Sanctions against Russia are adding more uncertainty to inflationary and supply chain issues.
Credit impulse — the flow of new credit issued from the private sector as a percentage of GDP — in the region is already collapsing (Figure 2). Given the cyclical tilt of the region’s index, we expect the contribution to return from Energy and Materials to abate. However, if Russia’s actions exacerbate high commodity prices, we believe the “deep cyclicals” rally could still have legs. On the other hand, with the European economy facing strong headwinds to economic growth, we believe Financials, the largest sector in the regional index, will need more than a hawkish ECB to sustain outperformance.
Figure 2. Eurozone Credit Impulse Index (% Growth YoY) vs. MSCI Eurozone Index
Macro pressures are weighing on private credit issuance
As of 5/31/2022 | Source: Bloomberg, L.P.
View accessible version of this chart.
On the earnings front, with 91% of index constituents having reported, the overall picture in the developed international region is showing signs of slowing growth. The MSCI World ex USA Index reported a blended earnings growth rate of 10.6%, driven almost entirely by the Energy sector. In fact, the ex-Energy growth rate would fall to -7.1%, with an earnings miss instead of a beat. While that might sound alarming, context is key as comparisons with last year were incredibly difficult when earnings growth was almost 200%. Earnings estimates for 2022 have been improving in recent weeks despite challenges from first-quarter reports.
Emerging Markets
China’s policy easing remains a catalyst, but lockdown uncertainty is an overhang
The MSCI Emerging Markets Index managed to deliver its first month of positive returns for the year, up 46 bps. Notably, returns were supported by Chinese equities, which have not had a positive month since last October, as stimulus measures appeared to be gaining support among policymakers. However, the ongoing war in Ukraine and prospects for substantially tighter U.S. monetary policy remained headwinds.
Bottoming economic data in China is reflecting renewed Covid lockdowns and concerns around slowing consumption and manufacturing. After falling sharply in March and April, China’s Purchasing Managers’ Indices (PMIs) showed a clear rebound in May, outpacing consensus expectations. While the sharp improvement in PMIs indicates the worst of the pandemic-driven slump may be behind us, the fact that all PMIs remain below the 50-mark, which separates economic expansion from contraction, indicates the economy is still facing serious headwinds.
On the policy front, we believe recent actions illustrate the government’s growing sense of urgency to offset the impact of the pandemic disturbances in the run-up to the National Party Congress in November. China lowered the mortgage lending rate in May from 4.60% to 4.45%. At the same time, the country presented a comprehensive support plan with a total of 33 measures, ranging from loan extensions and tax relief for companies and households to additional support for infrastructure investment in areas such as transportation and power projects.
This urgency is also illustrated by Chinese Premier Li Keqiang, who met with thousands of local-government officials, and by meetings between the People’s Bank of China, financial regulators and major banks to urge banks to boost lending. China’s credit impulse index, a leading indicator of equity performance, continues to recover. We expect this to be a strong tailwind for Chinese equities, which are currently at undemanding valuation levels (Figure 3).
Figure 3. China Credit Impulse Index (% Growth YoY) vs. MSCI China Index
China’s credit impulse continues to recover
As of 5/31/2022 | Source: Bloomberg, L.P.
View accessible version of this chart.
On the earnings front, the first-quarter 2022 earnings season is wrapping up with a reported blended EPS growth rate of 18.5%. Earnings exhibited a balanced contribution across sectors, in contrast to developed international markets that relied extensively on Energy earnings. Despite numerous headwinds in China and eastern Europe, consensus earnings estimates for the calendar year still indicate growth of more than 5%.
Cryptocurrencies have been under pressure this year, with the Bloomberg Galaxy Crypto Index down 29% in May and nearly 50% year to date.
A crash in value of an algorithmic stablecoin called Terra was the primary driver. Despite its touted link with the U.S. dollar, it effectively “broke the buck” and spiraled below its $1.00 net asset value, losing nearly $20 billion in market capitalization in less than a week. As crypto markets have increasingly become correlated to equities — growth stocks in particular — the stablecoin crash may have compounded the mid-month selloff in public equities.
For more information, please contact your PNC advisor.
TEXT VERSION OF CHARTS
Figure 1: CBOE VVIX Index
Market volatility declined significantly by month end (view image)
Figure 2: Eurozone Credit Impulse index (% Growth YoY) vs. MSCI Eurozone Index
Macro pressures are weighing on private credit issuance (view image)
Figure 3: Figure 3. China Credit Impulse index (% Growth YoY) vs. MSCI China Index
China’s credit impulse continues to recover (view image)
| Date | China Credit Impulse Index, RHS | MSCI China Index, LHS |
|---|---|---|
| 5/31/2012 | -7.0865 | 53.43 |
| 5/31/2013 | 10.7121 | 60.04 |
| 5/31/2014 | -6.6771 | 60.46 |
| 5/31/2015 | -4.8018 | 80.16 |
| 5/31/2016 | 8.9659 | 56.06 |
| 5/31/2017 | -1.54 | 71.8 |
| 5/31/2018 | -4.93 | 92.56 |
| 5/31/2019 | -1.23 | 74.15 |
| 5/31/2020 | 5.3737 | 80.68 |
| 5/31/2021 | -3.4181 | 110.25 |
