Repricing Risk
Stocks continued their sour start to 2022, marking their worst weekly return of the year as the S&P 500 sank -5.7%. Returns were most challenged for the technology heavy NASDAQ Composite, which dropped -7.6%. Bonds, which have been negatively impacted by rising interest rates were able to stabilize as interest rates were generally flat on the week. The market concluded the week at an interesting technical level with the S&P 500 finishing below its 200-day moving average, a key technical point of support.
Thus far in 2022, investors have been taking action to reprice risk in advance of tighter monetary policy, electing to adjust positions as we’ve flipped to a new tax year, and enacting scheduled rebalances of portfolios back to targets after a diverse range of asset returns in 2021. Recall the S&P 500 was up 11% in the fourth quarter of 2021. This came during a period when the Fed indicated they would be accelerating their timeline for winding down their asset purchase program, raising rates quicker than expected, and even considering reducing the size of their balance sheet. Despite these significant shifts in policy, the market didn’t seem to bat an eye, pushing these concerns into a new tax year.
While the pace of the downdraft has been a bit unexpected, we view it to be a rationale reaction for the market. Stock that are more sensitive to rising rates, such as higher multiple/high growth stocks are seeing their prices cut the most. The yield curve is now reacting and has begun to price in expectations of future fed actions. While not pleasant to go through, this is how markets should behave and these short-term movements should set up for more stable conditions over the long-term.
What 2022 has shown thus far is the power of diversification. Yes, stocks and bonds are both down. However, within each asset class there is a fairly wide bifurcation of returns. Among equities, the S&P 500 is down -7.7% year-to-date. However, if you dissect returns across growth and value styles, growth is down -12.3% versus a much more modest decline of -3.6% for valuei. Outside the U.S. declines have not been as severe with developed international markets retreating by only -2.2%. The standout has been emerging market stocks, which was the laggard last year posting a negative return. Thus far in 2022, emerging market returns are up a positive +1%.
For the past eighteen months market volatility has largely only occurred on the upside. As such, risk tolerances have grown, and some investors have been willing to accept more risk in their portfolios. As markets face the prospect of a rising rate cycle out of the Fed, we are beginning to see a repricing of risk. By repricing of risk we mean that valuation multiples reprice lower to reflect the underlying risk in stocks. This often leads to the highest multiple stocks being hit the hardest. This repricing will likely take some time to work through as higher multiple, negative earners arguably having more room to fall. Economic indicators and what we are seeing out of corporate earnings reports indicate sound fundamental conditions. Given that high yield spreads remain near record lows adds support to the fact that what is occurring in equities is a repricing of risk and not a function of deterioration in the economy or business conditions.
We see this year as being tricky as a hawkish Fed is becoming less predictable having to react to heightened inflation. It’s only natural to expect more up and down movements ahead for the market. Having diversification across and within asset classes, and not relying on what worked in 2021, is the right approach as conditions are changing.
i Growth stocks are referred by the Russell 1000 Growth index and value by the Russell 1000 Value.
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