Rising rates continue to rock stocks

The last week’s market highlights:

  • Financial markets continue to be hobbled by plans for more aggressive tightening by central banks in 2022. Last week, Federal Reserve Chair Jerome Powell seemed to confirm that a 50 basis point increase is likely at the Fed’s next meeting on May 4.
  • Despite a good start to the first-quarter earnings season, U.S. stocks have struggled to find a foothold amid persistent uncertainty about the path of interest rates. The S&P 500 Index fell 2.8% for the week ended April 22, with only defensive sectors like real estate and consumer staples posting gains. The index has now declined 5.7% in April and 10.4% for the year to date.1
  • The market’s attention is beginning to shift away from higher inflation risks and toward the possibility of lower growth. Central banks have a huge role to play here, most believing that steady growth can be achieved only when prices have stabilized. The path of least resistance remains for interest rates to keep rising until inflation shows signs of slowing.
  • This week’s data calendar is full, with the advance (initial) estimate of first-quarter U.S. GDP growth likely to show a marked deceleration from the 6.9% pace in the fourth quarter of 2021. Personal income and spending data for March will be a bit more timely and perhaps more telling than the broad GDP number. Of particular interest will be whether income growth failed to keep up with price inflation for an eighth straight month.2

Each week, we present our featured topics in the context of the major themes listed below from Nuveen's 2022 Outlook:Nuveen's 2022 Outlook

  • U.S. economy: Slower growth and inflation compared to 2021, but still pretty fast.
  • Global economy: Showing signs of heating up thanks to accelerating vaccination rates.
  • Policy watch: No more stimulus, but the Fed isn’t likely to raise rates too quickly.
  • Fixed income: Expect further challenges for rate-sensitive assets; consider assuming more credit risk.
  • Equities: Our cyclical tilt includes U.S. small caps and non-U.S. developed market shares.
  • Asset allocation: Although valuations appear relatively full across many segments, we’re leaning toward risk-on positioning.

Quote of the week:

"There must be some kind of way outta here,” said the joker to the thief. “There's too much confusion, I can't get no relief.”  –  Bob Dylan, All Along the Watchtower

The IMF’s downgrade of the global economy sheds intriguing light on China

Last week, the International Monetary Fund (IMF) published its quarterly World Economic Outlook, considered a benchmark for consensus thinking on the global economy’s near-term path. Unsurprisingly, given sharply higher interest rates and energy prices, as well as the depression-level hit to growth in Russia delivered by worldwide sanctions, most of the revisions from the previous IMF report, issued in January, were downward.

Let’s start with the good, or at least “less bad,” news. U.S. GDP growth is still projected to hit 3.7% in 2022 and 2.3% the year after.3 We think the 2022 number is overly optimistic, reflecting only a 0.3% decline from the IMF’s prior forecast despite the likelihood of considerably tighter monetary policy beginning in May and the impact of higher energy prices.

The cost of energy may be even more damaging in Europe, which, compared to the U.S., imports a higher percentage of its energy (about 60%, much of it in the form of Russian oil and natural gas).4 Accordingly, Europe’s GDP growth for the year is expected to slow to a greater degree, by 1.1%. For advanced economies overall, the IMF anticipates 3.3% expansion this year, down from 5.2% in 2021 but still — to borrow a phrase from our 2022 outlook — “pretty fast.”5

Perhaps the most surprising aspect of the IMF’s latest forecasts is that its downgrade of China – from 4.8% GDP growth in the January outlook to 4.4% today, wasn’t more severe.6 Given that country’s well-publicized struggles to contain COVID-19 outbreaks, a less sanguine view might have been in order. Indeed, the IMF warned that “China’s economy could slow more than currently projected” given the “possibility of more widespread lockdowns.”

China’s economy expanded by 1.3% in the first quarter of 2022, raising annual GDP growth to 4.8%. While below Beijing’s ambitious 5.5% target for the calendar year, it nonetheless marked an improvement over 2021’s pace of 4%.7 So on the surface, all seemed well.

But looking at monthly data is the key to gauging the health of the Chinese economy since the government began locking down cities in March. This latest “zero-COVID” containment strategy, although stringent, does not seem to be having the same damaging economic impact compared to those implemented at the onset of the pandemic in 2020. For example, industrial production rose 0.4% last month, versus a 22% plunge in February 2020. Similarly, exports grew at a 14.7% annual pace, versus a year of -40% growth ending in February 2020. The same benign outcomes have not shown up in China’s domestic economy. Retail sales shrank nearly 2% in March, likely just a hint of what’s to come in April. Imports have fallen over the past year, mainly as a result of March’s sharp decline.8

In our view, Chinese policymakers seem to be taking a two-pronged approach to controlling this highly contagious variant of the virus: They’ve prioritized keeping the country’s manufacturing and export sectors running, while allowing service-sector activity to plummet. The consequences of this decision were evident in March’s purchasing managers’ indexes (PMIs), with the services PMI reaching its lowest level since February 2020 and the manufacturing PMI declining only modestly.9

Overall, the silver lining for global growth is that parts of China’s economy — exports in particular — remain in relatively good shape. That’s vital, given China’s position as a global export powerhouse. But if the deceleration in China continues, we would expect the IMF’s next report (to be published in July) to include another downgrade of the country’s GDP outlook. If that occurs, it would almost inevitably translate to slower growth for economies worldwide.

Better news ahead for bonds?

In a year full of headline-grabbing events, one that stands out for investors is the sharp rise in interest rates. The yield on the bellwether 10-year U.S. Treasury note, which reflects the market’s outlook for long-term growth and inflation, has jumped 138 basis points (bps) for the year to date, closing at 2.90% on April 22. Meanwhile, the 2-year yield, which is especially sensitive to potential changes in Federal Reserve policy, has popped 199 bps, to 2.72%.10

Against that backdrop, major segments of the bond market have posted negative returns thus far in 2022, roughly in proportion to their sensitivity to changes in interest rates. (Bond yields and prices move in opposite directions.) Among the worst performers: investment grade corporate debt, U.S. Treasuries, high-quality municipals and emerging markets (EM debt). In contrast, bonds with lower credit quality and higher yields, which tend to make them less susceptible to the impact of rising rates, have lost a bit less.11

Investors have responded by pulling money out of bonds. Through last week, outflows from fixed income mutual funds and exchange-traded funds (ETFs) totaled $35.5 billion. That’s a massive reversal from the $105 billion in inflows during 2021, when interest rates were also rising but at a somewhat gentler clip. The pattern of redemptions has been similar over the past 10 years. For example, in periods when interest rates have risen quickly – most notably in 2013 and 2018 – investors shifted their assets away from high-quality bonds, and in doing so missed out on subsequent periods of strong performance.12

This behavior ignores a time-tested principle, namely, “buy low and sell high.” When the price of any asset – a stock, bond or piece of land – falls without a change in the asset’s intrinsic value, the asset’s expected (future) return rises. In today’s world, a burst of inflation and expectations that central banks will have to raise policy rates to contain it have pushed bond prices down. But once interest rates plateau – in all likelihood at a significantly higher level than they’ve averaged over the past several years – investors may be able to purchase those bonds at higher yields than they could have at any time in the past 15 years.

  1. Bloomberg, FactSet
  2. Bloomberg
  3. IMF
  4. Clean Energy Wire
  5. IMF
  6. IMF
  7. Bloomberg
  8. Bloomberg, Trading Economics
  9. Bloomberg
  10. Federal Reserve via Haver
  11. Bloomberg
  12. Bloomberg

This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.

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