Portfolio Intelligence podcast: unpacking spring's surge in volatility

John Bryson:
Hello, and welcome to the Portfolio Intelligence podcast. I'm your host, John Bryson, head of investment consulting at John Hancock Investment Management. Today is May 12, 2022, and we've got a lot going on in the markets. So I've invited back Emily Roland and Matt Miskin, our co-chief investment strategists here at John Hancock Investment Management. As you probably all know, Matt and Emily are the architects behind our quarterly capital markets outlook piece titled Market Intelligence. And they are very busy right now. Matt, I'm going to start with you. There's a lot of questions coming in from advisors around all the volatility we're seeing in the markets. Key questions like, “Is it time to panic? Is it time to go to cash? What other options do I have?” Matt, how are your conversations going?

Matt Miskin:
Yeah, it is. It's one of the most challenging market environments we've had in modern history. You think about a 60/40 portfolio, over the last four months, it's down just over 10%. In any four-month window since 1970, that's only happened two other times. That was 1987, and that was just a very quick but pretty significant flash crash liquidity event, market dropping very quickly. But recall, it actually snapped back pretty quickly after that. And then the other period was 2008. And we all remember 2008, but it was more in November of 2008, getting closer to that bottom. And then actually, 60/40 portfolio actually rebounded after that. So my point there being twofold; one this is one of the most challenging environments that we've had in history.

Matt Miskin:
But two is that when there is challenging market environments and it feels like there's nowhere to hide, but everything is down, it often means that's a good opportunity to put money to work in a broader portfolio context; so we still believe in diversification. We still see a lot of opportunities in traditional asset classes like stocks, bonds. And as the cycle matures, we'll be looking at alternatives. We'll look at defensive equities, all weather equities, things like that. But at the end of the day, I know it's tempting to kind of say my stocks are down, my bonds are down, I want to go all to cash. In times like this, we've seen cash rise and that's usually actually the low point for financial assets. You don't want to be caught offside right during the recovery after valuations just got more attractive in a lot of asset classes.

John Bryson:
Yeah. We preach over and over again, buy low and sell high. We don't want to get caught in that panic pattern. So, Emily, let me dig into equities. You know, a lot of people are keeping an eye on that market because it's where a bulk of a lot of people's assets. Are we starting to see a bottoming process or what would it take to see a bottoming process, to see that as an opportunity to buy back in?

Emily Roland:
Yeah, John, we're getting a lot of questions on this right now as we're approaching that psychologically important potential bear market here, a decline of 20% or more. And in our view, we probably need to see some more signs of capitulation before a bottom can really be formed. In other words, more signs of investors willing to get out at any price or a more significant evaporation of liquidity beyond what we've seen so far. And one thing we're watching really closely on that front is high-yield bond spread. So that's historically been a really good gauge of liquidity, a gauge of financial conditions. We're at about 440 basis points over Treasuries right now. But in other times where we've seen liquidity events, we've seen an exhaustion and the distress that's priced into the market. Like 2011, you look at 2016, 2020, in those times we've seen spreads widen to more like six or 800 basis points.

Emily Roland:
So there could be some more pain here to be felt within the high-yield bond market. And on a related note, we're also watching Treasury yield. So as everyone I'm sure understands, really the key factor here that's contributed to the downturn or the multiple compression that we've seen this year has really been this increasingly aggressive and hawkish Fed. In fact, the number of rate hikes that have been priced into the market has gone nowhere but up over the course of 2022. The market now expects to get to right around 3% on the fed funds rate by year end, that's a total of 10 quarter point rate hikes throughout the year. So I think we've thought a lot about how investors would react if potentially the bond market started to price in fewer rate hikes.

Emily Roland:
I think there would be a good sort of sigh of relief there if we saw the 10-year Treasury yield falling more meaningfully, really yields across the curve. The 2-year starting to fall, reflecting fewer rate hikes being priced into the market. Maybe again, a reflection of global growth slowing down here. And markets would certainly sniff that out in our view. So one final thought here: So there could be some further downside volatility, maybe even a bear market here. But it's pretty unusual to see a really severe bear market without a recession.

Emily Roland:
So we've done some work on this and we've looked at the last 10 bear markets since World War II in the U.S. and only three of them have not been associated with a recession. Two of them in the sixties, one in '87, which Matt was just talking about, and the ones that have not been associated with the recession have been much milder. We've seen a decline there of around 27% versus a bear market with a recession that's closer to 37%. So right now, we don't see a recession on our doorstep. The U.S. economy remains decent right now; it's decelerating but still solid. And so, we could be getting closer to that sort of average downturn in a non-recessionary bear market. So a little bit of silver lining here in terms of the volatility that's been playing out.

John Bryson:
Okay. That makes sense. And we can talk about the Fed and navigating a soft landing versus a hard landing in a moment, I do want to ask, because Matt you brought up the 60/40 portfolio. And one of the challenges is you're often expecting, when the 60s doing well, the 40 might not be and vice versa. We have this challenge right now where bonds, the 40 and many portfolios are down year to date, but they're holding up better than stocks. Emily started to talk about it. But digging a little bit more around the outlook for bonds in what role you should be looking at them to play in a portfolio.

Matt Miskin:
Yeah, I mean, at the end of the day, bonds are going to, total return wise, they're going to likely track their starting yields. And income wise what we're seeing is demographics didn't change during the pandemic. If anything actually, they got a little bit worse. Meaning that there's still a lot of baby boomers that need income. There's still a lot of investors that need income. And yields were really low before the last three to six months, but yields have exploded higher. And I know it's tough because current bond valuations have gone down, prices have gone down to make those yields go up. But what we're looking at now in terms of the Aggregate Bond Index, about 3 ½% yield. Investment-grade corporates are about 4.4%. High yield is 7 ½%.

Matt Miskin:
And these yields are almost double where they were just to start 2022. And in our view, the forward-looking return potential is going up. And you also want to think about the cycle. So as the Fed raises rates and raises rates, and like Emily said, I mean, we're looking at potentially 50 basis point rate hikes. It's like it's a shotgun and it's like a machine gun in that it's quick and it's a lot. And I don't mean to talk about guns that much. But it's just this, the Fed hiking this fast means it's likely later cycle. And what we would say is that as we get late cycle, as the Fed gets to the peak of that rate hiking cycle, that's when bonds usually turn and start to actually appreciate. You see prices come up, yields come down.

Matt Miskin:
And we think that we're setting up actually a good environment as growth slows, to see bonds come back into favor. You know, it's been a challenging environment and I think sometimes it's hard to make that pivot. But in our view, you're going to want to actually lean into kind of core, core-plus bonds here as the growth rate of the economy slows, as the Fed puts more tightening into the system. And in our view also, the diversification benefits will increase as equity volatility increases as economic growth slows, and not to overextrapolate the last four months, because it is such an outlier. Again, this is over a three standard deviation event in history of data, of looking at markets. This is so unusual. So don't plan your portfolio positioning based on the outlier. Plan it based on what happens more often than not. And more often than not, bonds typically do add to diversification benefits, the higher yields result in better income and total return potential. And that's what we would position for from here.

John Bryson:
And to build on that, Matt, do you feel like the market has priced in most of the hikes now and maybe much of the worst situation is behind us? Is that what I'm hearing from you?

Matt Miskin:
Yeah, exactly. I mean Emily was just saying, 11 rate hikes this year. So they've done three, the market's saying another eight, and I'm saying 25 basis point rate hikes. So if you think bonds are going to go down more based just on the Fed raising rates, the Fed has to do more than 11 rate hikes for the bond market to go down more. Because it's already priced in 11. Now if they do less, say they only do, instead of 8 more they do 4 more, then bonds are going to rally. And also, as soon as the Fed stops, that's usually a sign that they're done for the cycle. And that's when bonds usually really rally. So absolutely, John, in our view the bond markets over extrapolated the Fed policy guidance, and we think actually bonds represent an opportunity at the time.

John Bryson:
Okay, great. So, Emily, I want to pivot back to you some of the stuff that you started to talk about and really focus a little bit more on the economy, what we're dealing with right now and going forward. Thoughts that crossed my mind. We saw inflation drop recently. How long, like what numbers do we need to see before inflation's not the primary concern? Where are we in the cycle? What type of opportunities does this set us up for in the future?

Emily Roland:
Yeah, lots of good questions in there, John. And I would start by saying that the key dynamic that we're really watching right now is the fact that global growth is diverging. The U.S. economy is holding up relatively well, but the Eurozone is slowing significantly. We've seen sentiment data that's really plummeting there. PMI data, which is our key gauge of the health of the economy holding up, okay right now in Europe, it's really starting to show signs of slowing. And China potentially even in a recession at this point. So the U.S., again, the U.S. economy, we have a solid labor market. Our manufacturing data is holding in okay. But of course, we're not immune to global growth slowing. We look at things like the leading indicators showing that the U.S. is likely set to slow over the course of the year. Certainly tighter financial conditions, higher mortgage rates, higher lending rates, demand cooling, are really starting to set in here.

Emily Roland:
And so what this means in terms of our positioning is that we’re favoring U.S. equities right now on a global basis. Again, better economic data, better earnings data here in the U.S. But we also want to think about this potential slow down ahead. So we're still emphasizing the quality factor is a really important complement to value as the year progresses. Matt already highlighted the views across fixed income as economic growth slows, really leaning more into core and core plus bonds here. So, there is a consideration here in terms of where we are in this cycle. We're getting ever closer here to late cycle. This cycle is moving extremely fast. And again, you really want to start to look for areas like investment-grade bonds. You want to look for areas that are going to have better credit quality, lower default risks, steadier income, as we get closer to late cycle here.

Emily Roland:
All-weather equities, which Matt mentioned earlier, lower beta alternative type strategies. So, we're moving ever closer to that late-cycle environment. We want to also think about things like infrastructure. As we get closer to a late-cycle period, it's going to become, and as inflationary pressures really remain here and they start to crimp spending, it's going to become about what people need versus what people want. And infrastructure, which tends to be a mix of utility-type businesses, toll roads, things like that, can be a really attractive alternative investment to turn to as economic growth starts to cool and it, again, becomes more about what people need versus what they want. On the inflation front, I heard another strategist the other day saying they burned their team transitory T-shirt, which we've also done, along with other strategists.

Emily Roland:
It's been really tough to call. Inflations remained more sticky than we anticipated. The Russia-Ukraine crisis contributing to that via higher oil prices, which are inflationary. The zero-COVID policies in China bringing economic activity to a halt there, contributing to supply chain issues being exacerbated. But we are starting to see evidence that inflation is coming off the boil. We saw that in the year-over-year CPI data this week. We look at things like used car price data that showed a decline over the last few months. Lumber prices have been falling. Again, demands starting to come off the boil. So we do anticipate that inflationary pressures will cool over the course of the year, taking a little bit more time than anticipated. But frankly, that being another reason that we think that the Fed can pump the brakes a little bit and not move forward with those 10 or 11 rate hikes that the market's now pricing in.

John Bryson:
Excellent. Now, excuse me, I think what I would summarize with in talking to you two over the years is now is not a good time to panic. It's been volatile. We've gone through this in the past. We will get through this. Not a bad idea to reassess your portfolios, make sure you're taking advantage of high-quality options, maybe diversifying a little bit. And if you have some cash to put into work, think about where you want to go next. I know you two are super busy. There's a lot going on in the markets.

John Bryson:
I'm going to let you go now. But folks, to our listeners, I want to say you should definitely be following Matt and Emily on LinkedIn and on Twitter. They're always sharing great insight as to what's going on in the markets. They just released their mid-quarter release of Market Intelligence, came out last week. You can find that on our website, jhinvestments.com. And you can find a lot of the other research that our organization is doing to help you navigate these challenging markets. As always, Matt, Emily, thanks for joining me today. To my audience, thanks for listening. We'll talk to you next time.

Emily Roland:
Thank you.

This podcast is being brought to you by John Hancock Investment Management Distributors, LLC, member FINRA, SIPC. The views and opinions expressed in this podcast are those of the speaker, are subject to change as market and other conditions warrant, and do not constitute investment advice or a recommendation regarding any specific product or security. There is no guarantee that any investment strategy discussed will be successful or achieve any particular level of results. Any economic or market performance information is historical and is not indicative of future results, and no forecasts are guaranteed. Investing involves risks, including the potential loss of principal. Diversification does not guarantee a profit or eliminate the risk of a loss.