Inflation holds the spotlight now, and all eyes will remain on the Fed for the foreseeable future. Some investors have questioned the possibility of a recession in the US—especially with the flattened yield curve that has briefly inverted. But while all recessions have been preceded by an inverted yield curve, not all yield curve inversions have presaged a recession. And currently, there are indicators below the surface that paint a healthier picture, such as the Institute for Supply Management’s survey, which remains in expansionary territory.
During this difficult quarter, nine S&P sectors turned in negative performances. Only two sectors—energy and utilities—were positive. Energy’s nearly 40% return for the quarter appears unsustainable. Utilities rose roughly 5%, as investors took a more defensive approach to market volatility and geopolitical unrest.
But in such a difficult environment, an exposure to high-quality stocks will likely prove rewarding. When the economy slows, active investors can find quality businesses among both growth and value stocks that have favorable attributes such as high profits, strong free cash flow, positive earnings revisions and pricing power. Also, quality opportunities can be found among growth companies on the cutting edge of innovation and those aligned with sustainable themes.
For bond investors, the meaningful change in the rate landscape has had an outsize impact on the bond market versus stocks. Emerging-market central banks started hiking rates last year. Now, developed-market banks are taking action: paring down or ending their quantitative-easing programs and hiking rates or some combination. That means yields are meaningfully higher today and so are credit spreads. Overall, that may create some compelling opportunities, especially in developed-market high yield. The high-yield sector’s yield to worst has historically been a reliable predictor of the sector’s return over the following five years. US high yield is further bolstered by the fact that corporate profits remain strong and default rates are very low—lower than they’ve been in 15 years.
Munis have also faced a grueling quarter—their worst since 1981. But while munis were down more than 6%, this was not a fundamental sell-off because balance sheets are generally strong today for states and municipalities. For both munis and taxable bonds, the pain of the sharp rise in yields may be difficult in the short term, but income investors should welcome rising rates: they pave the way for higher income.
As with all parts of the capital markets, it’s important to be selective. In these volatile and uncertain markets, it’s important to be active as you position your portfolio to participate and defend.