Rates & markets

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   By Guest Blogger Ryan Lewenza

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Are you having fun yet? When I said in our outlook blog post that the equity markets would be more volatile this year, I didn’t expect it to come in the first few weeks of January. Year-to-date the S&P 500 is down 9% and the hard-hit Nasdaq is down 15%, while the TSX is down a gentler 3%. What gives?

Well as I predicted, higher interest rates and tighter monetary policies from key central banks would likely trigger these short-term bouts of volatility as the equity markets recalibrate to these tighter policies. The days of easy money from central banks are over and markets are adjusting accordingly.

Indeed, since December the US 10-year treasury yield has surged from 1.4% to 1.8%. And this week we saw the Federal Reserve (Fed) and Bank of Canada (BoC) set the stage to start hiking rates at the next meetings in March.

Bond Yields Surge Higher

Source: Stockcharts, Turner Investments

I actually think the BoC made a mistake by not hiking this week as they clearly have to with inflation at a 30-year high. Additionally, the markets had largely priced in a hike so when markets give you a pass or ‘green light’ you take it. But nonetheless, rates are going up, which has led to this recent market volatility and pullback. And based on decades of market history, this is exactly what we should expect.

Below is a chart that shows the average performance of the S&P 500 around past Fed tightening cycles. I calculated the average 1, 3, 6 and 12 month performance following the start of these cycles going back to 1980.

Note how the S&P 500 typically declines in the first month and quarter following the beginning of the rate tightening. But critically, the S&P 500 then recovers and is up on average 2.5% six months following and up 5.9% one year later. In fact, in only one of the seven tightening cycles was the S&P 500 down 12 months following the start of the Fed hiking and it was down just 1.3% (1984 cycle).

So, equity markets quickly re-align to the higher interest rates and tighter monetary policies but then rally as the economy keeps growing and corporate profits keep rising. That’s the key point. This is normal, and remember that the central banks are hiking rates because the economy is doing better, which is supportive of corporate profits and stock prices.

S&P 500 Average Performance Following Fed Rate Hikes

Source: Bloomberg, Turner Investments

Moreover, market volatility is normal! Nothing goes straight up. The markets need to pullback from time to time to digest gains, ensure markets don’t overheat too quickly, and to recharge ‘internal energy’ to steel a phrase from my old pal and colleague Jeff Saut.

Let’s review some important market facts:

• First, on average the S&P 500 experiences three 5% pullbacks and one 10% correction per year. Currently, the S&P 500 is in official correction mode (down more than 10% from the peak) but this is nothing out of the ordinary.
• Second, take a look at the chart below. While it’s a busy chart it provides a lot of info and insight. The chart shows the annual return for the S&P 500 (in blue) and the largest intra-year decline (red diamonds) for each year going back to 1980. For example, in 2020 the S&P 500 had an intra-year or peak-to-trough decline of 35% (that was one for the books) yet managed to return 16% on the year. So this shows that it’s common to see large declines but then still experience positive returns on the year. The other key takeaway from this chart is the average selloff for the S&P 500 in any given year is 15%, yet with an average annual return of over 10%.
• Finally, bear markets, defined as a greater than 20% market drop, are mainly (70%) driven by economic recessions, which we do not see in the cards for 2022. So while this correction has been unpleasant we don’t see it spiraling into a bear market.

I subscribe to Winston Churchill’s belief that “Those that fail to learn from history are doomed to repeat it”, which is why I’ve always studied and leaned on market history in making my calls and recommendations over the years. It’s not infallible of course, but based on market history, combined with our views that the global economy will continue to recover and grow this year, we remain optimistic that markets will grind higher throughout year. But as we’ve stated clearly in recent posts here, it’s going to be a bumpier ride so buckle up.

S&P 500 Annual Returns with Intra-Year Selloffs

Source: Bloomberg, Turner Investments

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

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