Equity markets face geopolitical crisis, inflation and the Fed

Global equity market returns were broadly negative in the first quarter. The period was marked by heightened geopolitical volatility, surging energy prices and persistently high inflation, especially in the U.S. and eurozone. In the U.S., fears of a slowing economy and uncertainty over the U.S. Federal Reserve’s increasingly hawkish monetary policy weighed on equities. Non-U.S. stock markets also fell in aggregate, similar to most major U.S. indexes. On a regional basis, returns in Latin America and emerging markets ex-China were substantially more resilient than in Europe.

Key takeaways

• We maintain a modestly constructive view on global equity markets despite the first quarter’s tumultuous conditions and risk-off tone.
• Neither a recession nor stagflation appears imminent in the U.S., where economic data still supports healthy, albeit modestly slower, growth.
• How the global economy contends with persistent inflation and central bank tightening, as well as ongoing geopolitical issues, remains a key focus.
• While U.S. earnings revisions have lost some momentum, consensus estimates for 2022 should still support stocks.
• We slightly favor U.S. over non-U.S. developed markets in the near term, preferring high-quality growth and defensive areas, such as select opportunities in tech. Companies with strong balance sheets, free cash flow and pricing power could outperform.
• Outside of the U.S., emerging markets appear oversold and may present attractive entry points, especially among commodity exporters.
• Valuations and a potentially weaker dollar over time argue for increased allocations to non-U.S. equities over the intermediate term.

A dramatically changing backdrop

Optimism was the watchword for investors as 2022 began, but the tone deteriorated quickly as inflation remained much hotter than expected, energy prices spiked and most central banks accelerated plans to tighten monetary policy. Exacerbating these tensions was Russia’s invasion of Ukraine, which unleashed a humanitarian crisis and injected a heavy dose of geopolitical risk into global markets.

The Fed makes its first move

A rapidly improving U.S. labor market and persistent inflationary pressures prompted the Federal Reserve to adopt a much more hawkish policy stance. The Fed initiated rate “lift-off” at its March meeting, raising the fed funds target rate by 25 basis points (bps), to a range of 0.25% - 0.50%, and signaling the intention to hike at each of its remaining six meetings in 2022, possibly including several 50-basis-point hikes. Chair Jerome Powell and his colleagues also telegraphed plans to begin shrinking the Fed’s massive balance sheet, beginning in May.

One consequence of market expectations for inflation and Fed policy was the flattening and, shortly after quarter end, partial inversion of the U.S. Treasury curve — with the Fed-sensitive 2-year yield moving higher than the bellwether 10-year yield. Such inversions have preceded every U.S. recession of the past 50 years, but it is not a cause-and-effect relationship, and not every inversion has been followed by a recession. In our view, the U.S. growth cycle remains alive and reasonably well. And even if we were to see a more lasting inversion, history suggests that global equity markets would still be able to deliver positive returns for many months afterward (see Figure 1).

The pandemic refuses to let go

The global battle against Covid, which governments thought they were winning as the year began, experienced a number of setbacks. Notable outbreaks occurred in China and some other Asian economies, as well as in Europe. A subvariant of the Omicron strain known as BA.2 began to dominate new case counts. The vast majority of Americans have either been vaccinated/boosted, previously infected, or both, creating a level of immunity that helped U.S. fatalities fell below 1,000 per day as the first quarter came to a close. How the trajectory of the virus proceeds from here remains to be seen, however.

Bears bully the indexes

U.S. equity valuations fell sharply in early 2022 as market indexes tumbled into correction territory due to the Fed’s amped-up tightening plans and the impact of Russian hostilities in Ukraine. The S&P 500 suffered its first negative quarter since the initial U.S. Covid outbreak in the first quarter of 2020./p>

Heightened uncertainty about the path forward for equities caused global markets to falter as well. Positive outliers were few and far between, concentrated in the energy sector and commodity exporters, as prices for oil, agricultural commodities and precious metals surged. Beginning in mid-March, equities more broadly retraced a portion of their January and February losses, demonstrating a degree of resilience in spite of the geopolitical and inflation headwinds.

First quarter market performance and drivers

U.S. equity markets start the year with losses

Measured by the S&P 500 Index, U.S. equities recorded their worst January (-5.2%) since 2009 and officially hit correction territory (a decline of 10% or more off their most recent peak) in February. The index managed a gain in March to climb near its early January all-time high, but it pulled back at the end of the month and finished with a loss (-4.6%) for the quarter.

With U.S. Treasuries enduring one of their worst quarters on record and the 10-year yield spiking 80 bps, to 2.32%, concerns about rising interest rates became an outsized headwind for large cap growth stocks and risk sentiment in general. The Russell 1000 Growth Index posted a substantial decline (-9.0%) that badly trailed the -0.7% return of its value index counterpart.

Communication services fared the worst among U.S. sectors, reflecting missed earnings and competitive struggles for certain major names, while information technology underperformed on weakness in semiconductors and cloud-based software. Consumer discretionary came under pressure as well, with homebuilders, retail, apparel and accessories, and autos declining significantly.

On the positive side, energy soared 39%, its gains augmented by surging oil prices amid concerns about Russian supply. Utilities (+4.8%), often resilient during risk-off quarters, was the only other sector to rise during the period. Consumer staples (-1.0%) was a relative outperformer, aided by big box retailers, grocers, and select food and beverage stocks.

U.S. earnings momentum slowed throughout the quarter, even as Q4 2021 earnings season marked a fourth consecutive quarter of 20% earnings growth. In aggregate, earnings beat expectations by 8.3%, below the 15.7% one-year average.

Figure 2 shows first-quarter returns for the S&P 500 and other broad U.S. equity indexes, as well as results by market capitalization size and style, and the best- and worst-performing sectors.

Non-U.S. equities take a tumble, too

Overseas equity markets were hurt as badly or in some cases worse than their U.S. peers in the first quarter. In U.S. dollar terms, developed markets as a whole (-5.9%) outperformed emerging markets (-6.9%). The dollar appreciated against non-U.S. currencies, bolstered by its safe-haven status amid the Russia/Ukraine conflict and by Fed hawkishness.

The geopolitical crisis took a particularly hard toll on European equities, given the region’s dependency on Russian natural gas and oil. Eurozone stocks fell nearly 11%. U.K. shares, however, largely withstood concerns over higher energy prices and monetary tightening by the Bank of England, with the FTSE 100 Index essentially flat (0%). In Japan, which imports the majority of its energy and food and is thus exposed to higher prices from the conflict, the equity market (-7.7%) continued to disappoint.

Chinese equities (-14.2%) were severely hampered by a range of factors, including a decelerating economy and the government’s zero-Covid policy in the face of another outbreak. Moreover, Chinese technology stocks remained on a downward trend, having come under pressure from Beijing’s regulatory crackdown last year and delisting fears in the first quarter of 2022.

Outlook and best investment ideas

We maintain a modestly constructive view on global equity markets despite the first quarter’s tumultuous conditions and risk-off tone. In the aftermath of the Russian invasion, the key areas to monitor are slower global growth (with Europe bearing the largest burden), persistently higher inflation and central bank tightening.

If hostilities ease and energy prices stabilize, the global economy could expand at a rate above its long-term trend, but the geopolitical conflict has created enough new uncertainties or added to existing ones to make sustained volatility likely.

U.S. equities: The Fed and earnings growth in focus

• Neither a recession nor stagflation appears imminent in the U.S., where economic data still support healthy, albeit modestly slower, growth.
• We expect the repricing of the Fed’s rate hike path and expectations for an earlier, more aggressive balance sheet runoff to heavily influence U.S. equity markets.
• While consumer balance sheets remain strong and job creation continues to gather steam, inflation and geopolitical risks have made investing more complicated. Active stock selection will help separate companies that are better positioned to weather inflation from those that are more vulnerable to increasing costs.
• Earnings growth, which ultimately drives stock prices, decelerated in the first quarter, although the 2022 consensus EPS estimate for the S&P 500 still increased by about 2%. U.S. earnings may continue to move beyond consensus, but that is less likely if economic data begin to disappoint.
• We slightly favor U.S. over non-U.S. developed markets in the near term, with a preference for high-quality growth and defensive areas, such as select opportunities in tech. Companies with strong balance sheets, free cash flow and pricing power could outperform.

Non-U.S. equities: Near- and longer-term investment ideas

Valuations outside the U.S. remain compelling, with both developed and emerging markets stocks trading at some of their cheapest levels in the past 20 years.

• Emerging markets in particular appear oversold due to the fraught geopolitical climate and may offer attractive entry points, especially in commodity-exporting countries. Additionally, EM central banks are ahead of their developed market counterparts in terms of tightening policy to help combat inflation.
• Not all EM valuations are equally promising, however. At current levels, Latin America has more upside potential than Asian, European, Middle Eastern and African markets (Figure 5). The region looks more favorable because of relative interest rates and currency valuations in Brazil and Mexico, which together make up 90% of Latin American markets.
• In the non-U.S. developed arena, European economies might recover more quickly in the second half of 2022 if the current shock to energy prices proves to be short-lived.
• The U.K. market is intriguing given its high exposure to commodity prices and financial companies (which tend to benefit from rising interest rates) and its negligible weighting in high-valuation technology stocks.
• In general, lower valuations and a potentially weaker U.S. dollar over time argue for increased portfolio allocations to non-U.S. equities in the intermediate term.

Risks to outlook

The war in Ukraine is not only a human tragedy, but also a threat to global growth that will likely continue to stoke volatility as it evolves.

European economies are heavily exposed to surging energy prices and inflation because of their reliance on Russian oil and natural gas imports. If geopolitical risks and growth prospects worsen, Europe’s equity markets may be weighed down by their compositional bias toward financials and other cyclical sectors (energy, industrials and materials), which tend to lose ground in recessionary environments.

In addition to the risk of higher-for-longer energy prices, inflation may be driven by escalating food prices, as both Russia and Ukraine are leading exporters of wheat. At the same time, global supply chain disruptions, especially for automobile parts and semiconductors, continue to exert inflationary pressure.

China’s economic health remains tied in part to the less-than-stellar state of the country’s property sector, with sales volumes weak and real estate developers showing signs of credit stress.

Central banks around the world are being forced to respond to inflation with higher interest rates and may need to tighten faster than equity markets anticipate, making a potential monetary policy error a key risk for global equity markets.

An increase in inflation and nominal interest rates to the point where real rates are no longer negative would threaten the risk/reward advantage that equities currently enjoy.