Wall St Week Ahead-Investors expect no peace in U.S. stocks until bond gyrations subside

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NEW YORK – Investors believe the feedback loop between U.S. stocks and bonds will likely be a key factor in determining whether the moves that have shaken markets this year continue into the final months of 2022.

With the third quarter now over, both assets have seen painful sales: the S&P 500 is down nearly 25% year-to-date and the BofA ICE Treasury Index is down about 13%. The twin declines are the worst since 1938, according to BoFA Global Research.

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However, many investors say bonds have led the way, with rising yields hitting stock valuations as market participants recalibrated their portfolios to account for further monetary tightening. stronger than expected from the Fed.

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The forward S&P 500 price-to-earnings ratio fell from 20 in April to its current level of 16.1, a move that accompanied a 140 basis point rise in the benchmark 10-year US Treasury yield , which moves inversely to prices.

“Interest rates are at the core of every asset in the universe, and we won’t have a positive revaluation in stocks until the uncertainty of where the terminal rate will settle is clear,” said Charlie McElligott, CEO of cross-asset strategy. at Nomura.

US bond volatility has exploded in 2022, with this week’s Treasury yield swings pushing the ICE BofAML US Bond Market Option Estimated Volatility Index to its highest level since of March 2020. On the contrary, the Cboe volatility index, the so-called Wall Street gauge” – has not managed to scale its maximum since the beginning of the year.

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“We have emphasized … that interest rate volatility has been (and continues to be) the main driver of cross-asset volatility. However, even we continue to view the rate volatility complex with disbelief,” wrote Soc Gen analysts.

Many investors believe the wild moves will continue until there is evidence that the Fed is winning its battle against inflation, allowing policymakers to end monetary tightening. For now, more falconry is on the menu.

As of Friday afternoon, investors were estimating a 57% chance the U.S. central bank would raise rates by 75 basis points at its Nov. 2 meeting, up from a 0% chance a month ago, according to the CME’s FedWatch tool. Markets see rates peaking at 4.5% in July 2023, up from 4% a month ago.

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Next week’s US employment data will give investors a snapshot of whether the Fed’s rate hikes are starting to weigh on growth. Investors are also eyeing the earnings season, which begins in October, as they assess how much a strong dollar and supply chain turmoil will hurt corporate profits.

For now, investor sentiment is largely negative, with cash levels among fund managers near record highs as many increasingly choose to sit out market swings. Retail investors sold a net $2.9 billion in stocks last week, the second-biggest outflow since March 2020, JPMorgan data showed on Wednesday.

Still, some investors believe a turnaround in stocks and bonds may soon be on the way.

Deep declines in both asset classes make it an attractive investment given the likelihood of long-term returns, said Adam Hetts, global head of construction and portfolio strategy at Janus Henderson Investors.

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“We have been in a world where nothing worked. Most of that agony is over, we think,” he said.

Meanwhile, JPMorgan analysts said high cash allocations may provide support for both stocks and bonds, likely limiting future downside.

At the same time, the fourth quarter is historically the best period for returns for major US stock indexes, with the S&P 500 averaging a 4.2% gain since 1949, according to the Stock Trader’s Almanac.

Of course, dip buying has gone bad this year. The S&P 500 has made four gains of 6% or more this year, with each breakout rally followed by new bear market lows.

Wei Li, chief investment strategist at BlackRock Investment Institute, believes more jumbo rate hikes by the Fed could hurt growth, while a slower pace of tightening could hurt bonds by making inflation more entrenched .

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It is underweight developed market stocks and fixed income, and believes the “difficult choices” facing central banks will spur further market rout.

Stocks may have to fall more than bonds given the high probability of a recession in 2023, said Keith Lerner, co-chief investment officer and chief market strategist at Truist Advisory Services.

“We think the upside in stocks will be limited because there will be more pain in earnings and more central bank tightening,” he said.

(Reporting by David Randall; Additional reporting by Saqib Iqbal Ahmed; Editing by Ira Iosebashvili, Jonathan Oatis and David Gregorio)