Dealing with a painful sell-off

2022 has proceeded on an unusual, and particularly painful, note for financial market investors – and that’s probably an understatement. The equity sell-off has been sharp, and this has been matched by equally significant weakness in bonds and other asset classes as investors priced in the impact of high inflation and more hawkish central bank policies.

It is important not to throw the baby out with the bathwater.

However, at times like these, it is important not to throw the baby out with the bathwater. It is tempting to run to cash or cash-like assets after having endured mark-to-market losses for several months. Unless the US economy is headed for a recession, now may be a particularly bad time to make such moves.

What exactly has happened since January?

Since equity markets peaked in early January, the S&P500 is down about 17% (global equities are down by about 15%). This is a sizeable pullback, of course, but it is relatively small by historical standards. To put this number in context, there have been six 10-19% pullbacks over the 2008-2020 equity bull market, while recessionary sell-offs – such as the ones ahead of the 2000 or 2008 recession, or even the short-lived pandemic recession in 2020 - were considerably larger.

For well-diversified investors, this is only part of the story. In most periods, when equities fall this significantly, high quality bonds tend to provide an offset, rising in value and helping cushion portfolios. However, this year, that has not been the case.

The chart illustrates total returns across asset classes this year. This picture offers some insights into what has made the sell-off particularly painful, making it clear there was almost nowhere to hide:

1. The benchmark global bond index has fallen about 12%, slightly less than equities. This is unusual, because usually bonds tend to rise in value when equities fall.
2. Gold offered some offset in Q1, rising in value as both equities and bonds fell. However, gold also began to lose value in April and is now back to levels similar to the start of the year. Only broader commodities are still up year-to-date, but these are not always easily investible.
3. Alternative strategies fell by less than equities and bonds, but total returns are still negative relative to the start of the year.
4. These moves can largely be attributed to a repricing of Fed rate expectations. Rising rate expectations pushed short-term bond yields higher (the US 2-year government bond yield rose about 175bps), which in turn pushed rate-sensitive equities lower.

Did I hear you say cash?

After such dismal performance across asset classes, it is tempting to retreat to the safety of cash. However, such a move, besides being a classic manifestation of recency bias, could prove to be quite an unattractive strategy:

1. Cash yields are still very low, below 1% in USD terms. This offers investors almost no chance of beating inflation on a long horizon, even if inflation retreats from today’s multi-decade high levels.
2. History would not be on your side. Cash has underperformed almost every other financial asset class dramatically over time. Even in shorter periods, it is exceedingly rare for cash to outperform. 2018 was one exception, but many investors will recall this was largely due to a sharp move lower in equities and bonds in the last few months of the year, a move that was largely reversed in the early part of 2019.
3. In an ideal world, investors would want to offload investments and move to cash and re-enter markets once they bottomed. However, this means getting two separate market timing decisions right, which further raises risks.

Such a move, besides being a classic manifestation of recency bias, could prove to be quite an unattractive strategy

Back to the basics – growth and inflation

So, how should long term investors position themselves? The inflation and growth outlook, particularly in the US, remains the key factor in deciding whether to use current market conditions to add to risky assets or to move to more defensive ones.

The inflation outlook will be key here – it will determine whether the Fed simply delivers rate hikes that are already priced by markets, or whether the Fed will need to turn more hawkish in order to subdue price rises. Our view is that the Fed may largely deliver what is priced, or slightly below that, as inflation recedes to more moderate levels in the second half of the year.

Nevertheless, a tightening Fed does raise the question of whether a recession is looming on the horizon. This is key for risky assets such as equities because we know stock markets tend to peak 6-9 months before the start of an economic recession. Timing is key here because stocks also tend to perform very strongly in the period before they peak. Our own recession checklist is thus far not flashing warning signs, outside of indicating some softness in US consumer sentiment. Also, it is important to note that the spread between the US 10-year and 3-month government bond yields, which tends to be a more timely predictor of US recessions, remains steep – far from an inversion which would signal the coming of recession.

Rebalance allocations, but sensibly

The above backdrop leads us to believe that it is attractive to use the latest sell-off in assets to rebalance allocations. We retain a preference towards equities and parts of the corporate/Emerging Market bonds universe, balanced with a preference for gold. We expect these assets to outperform government bonds and cash in the second half of the year. Of course, this does not mean we should turn complacent – we would continue to maintain a well-diversified portfolio to ensure all investments are not positioned for this one scenario alone, while keeping a close watch on incoming economic growth and inflation data.