Investors believe the feedback loop between US stocks and bonds will likely be a key factor in determining whether the swings that have rattled markets this year continue into the final months of 2022.
With the third quarter over, both assets have seen painful selling – the S&P 500 is down almost 25% year-to-date and the ICE BofA Treasury index is down around 13%. The twin declines are the worst since 1938, according to BoFA Global Research.
Still, many investors say bonds led the way, as soaring yields sent stock valuations plummeting as market participants recalibrated their portfolios to account for stronger-than-expected monetary tightening from the Fed.
The S&P 500’s forward price-to-earnings ratio rose from 20 in April to its current level of 16.1, a move that was accompanied by a 140 basis point rise in the benchmark US Treasury yield to 10 years, which moves inversely to prices.
“Interest rates are at the heart of every asset in the universe, and we won’t have a positive revaluation of equities until the uncertainty of where the terminal rate will settle is clear.” , said Charlie McElligott, managing director of multi-asset strategy. at Nomura.
US bond volatility erupted in 2022, with this week’s swings in Treasury yields taking the ICE BofAML US Bond Market Option Volatility Estimate Index to its highest level since March 2020. gauge” – failed to peak from the beginning of this year.
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“We have highlighted… that interest rate volatility has been (and continues to be) the primary driver of multi-asset volatility. Nevertheless, even we continue to watch the rate volatility complex in disbelief,” Soc Gen analysts wrote.
Many investors believe the wild moves will continue until the Fed is proven to be winning its battle against inflation, allowing policymakers to end monetary tightening. For now, more hawkishness is on the menu.
As of Friday afternoon, investors were pricing in a 57% chance of the U.S. central bank raising rates by 75 basis points at its Nov. 2 meeting, up from 0% a month ago, according to the FedWatch tool. CME. Markets see rates peaking at 4.5% in July 2023, from 4% a month ago.
Next week’s US jobs data will give investors some insight into whether Fed rate hikes are starting to dampen growth. Investors are also looking to earnings season, which begins in October, as they assess how a strong dollar and supply chain failure will affect corporate earnings.
For now, investor sentiment is largely negative, with cash levels among fund managers near all-time highs, as many increasingly opt to stay away from market swings. Retail investors sold $2.9 billion net worth of stocks over the past week, the second largest outflow since March 2020, JPMorgan data showed Wednesday.
Still, some investors think a rally in stocks and bonds could soon be on the horizon.
Sharp declines in both asset classes make them an attractive investment given the likelihood of longer-term returns, said Adam Hetts, global head of portfolio construction and strategy at Janus Henderson Investors.
“We were in a world where nothing worked. We think most of that agony is over,” he said.
JPMorgan analysts, meanwhile, said high cash allocations could provide a safety net for stocks and bonds, likely limiting future declines.
At the same time, the fourth quarter is historically the best time for returns for major U.S. stock indices, with the S&P 500 posting an average gain of 4.2% since 1949, according to the Stock Trader’s Almanac.
Of course, bottom buying has done poorly this year. The S&P 500 has mounted four rallies of 6% or more this year, with each rebound followed by new bear market lows.
Wei Li, chief investment strategist at the BlackRock Investment Institute, believes that larger rate hikes from the Fed could hurt growth, while a slower pace of tightening could hurt bonds by making the more entrenched inflation.
It is underweight developed market equities and fixed income securities, believing that the “tough choices” facing central banks will cause further market turbulence.
Stocks may have fallen more than bonds given the high likelihood of a recession in 2023, said Keith Lerner, co-chief investment officer and chief market strategist at Truist Advisory Services.
“We think the upside in equities will be capped as there will be more headwinds in earnings and more central bank tightening,” he said.