Extreme Market Volatility Demands Engagement

Helping retirement plan participants navigate big market swings is a key part of ensuring long-term success—as is sticking to strategic and diversified asset allocations.

As noted in new market commentary by Brad McMillan, chief investment officer for Commonwealth Financial Network, April was a hard month for the markets, and things have only gotten worse in May.

On May 5 alone, all three major U.S. market indices dropped precipitously, with the Nasdaq dropping 5% of its value in a single trading session and the Dow Jones Industrial Average and S&P 500 indices giving up about 3% each. These drops came on top of April’s 5% drop for the Dow and whopping 14% retreat for the Nasdaq, while international markets fell between 5% and 7%.

Fixed income was also down for the month of April, McMillan notes, meaning there was nowhere to hide for individual and institutional investors alike. Such dramatic market swings—or negative ones, at least— always raise big questions in the minds of investors, so it is only natural that individuals and institutions are seeking explanations and reassurances about what may come next.

“Overall, rising interest rates drove the poor performance,” McMillan argues. “With inflation holding at a 40-year high, the Fed signaled that it intended to keep tightening monetary policy. This drove interest rates higher around the world, shaking financial markets.”

The basic market reality currently at play, McMillan says, is that higher interest rates imply lower present values for future earnings. As such, growth stocks have been hit the hardest, as shown in the Nasdaq.

“The question is whether or not that trend will continue in May,” McMillan says.

McMillan’s base case is that May is likely to be better than April for several reasons. First, the economic news remains positive: Hiring is strong, supporting consumer confidence and spending growth, and business confidence and investment remain healthy as well.

“While the economy contracted in the first quarter, that contraction had more to do with imports and exports and less with the fundamentals of jobs and wages, which remain solid,” he says. “This should be a one-time hit, as the economic fundamentals continued moving forward last month.”

McMillan says there is good news for May in the fact that inflation is showing signs of peaking, and rate increases now appear to be fully priced in. Much of the bad market news in April is already priced in, he adds, leaving room for better performance in May.

“As those increases are priced in, the valuation drop will start to be offset by expected earnings growth,” McMillan argues. “As we enter May, analysts are indeed raising their earnings growth estimates. Higher interest rates meant lower stock prices in April, but as painful as this was, it set the stage for growth to resume in May and beyond. That’s not to say we won’t see more turbulence this month. Market valuations are still high, and interest rates could rise further … We started April with a fear that a lot of bad things could happen—but what hurt most was actually a good thing: the overdue normalization of interest rates. Normalization is now largely priced in and no longer a pending risk. While we’ve seen substantial volatility, and may see more, this provides a good foundation going forward.”

Context for McMillan’s viewpoint can be found in the newly released federal jobs report, which shows the U.S. economy added 428,000 jobs in April, including notable gains in leisure and hospitality, manufacturing, and transportation and warehousing. According to the Labor Department, the unemployment rate remained unchanged at 3.6%, or just 0.1 percentage point above its pre-pandemic level. 

Yash Chauhan, a global capital markets analyst for Validus Risk Management, says this “modest” jobs report shows that jobs growth may be slowing compared to previous months, and notes the lack of another “blockbuster surprise” should provide some respite to markets. He feels the report will help give the Federal Reserve confidence to continue on its current tightening trajectory.

“The unemployment rate was unchanged at 3.6% and a moderation in wage growth should give some comfort to the Fed, as this is exactly how they would like the economy to evolve, i.e., with a gradual cooling that will allow for a soft landing,” Chauhan says. “[Federal Reserve Chair Jerome Powell] clearly mentioned that monetary policy tools are more effective on the demand side, and they would probably like jobs growth to be concentrated in services.”

Ultimately, given the lack of surprises today, the inflation numbers coming out in the next several weeks have becomes even more significant, Chauhan suggests.

“We could see a sharp correction in rate hike expectations in the next few months if data continues to moderate,” he says. “The risks are more asymmetric than ever.”

Nigel Green, the CEO and founder of deVere Group, is somewhat less optimistic about what may happen with markets in May and June.

“The central banks are close to running out of tools to try and tackle persistent inflation and falling GDP growth,” he warns. “We should prepare to once again see the ghost of ‘stagflation,’ something policymakers were hoping we would never return to after the 1970s.”

Stagflation—a combination of the concepts of inflation and economic stagnation—occurs when higher consumer prices feed into wages as workers demanded higher wages to match price increases. In short, the stagflation dynamic makes economic policymakers’ jobs extremely difficult.

“As central bankers continue their efforts, we can expect stock markets to remain highly volatile as headwinds continue, including lockdowns in China disrupting global supply chains further, with major sell-offs still in the cards, as we saw on Thursday,” Green suggests. “However, working with a good adviser, many investors will be seeking out the potentially hugely rewarding buying opportunities that are being presented by this turbulence. They are moving to pick up some high-quality stocks that have a solid future at what they will see as ‘discounted prices.’ They will not want to miss out. After all, there are always winners and losers in bouts of volatility—and this is where a good fund manager comes in.”

Green says savvy investors are indeed staying invested. In fact, they may even be increasing investments, and are not spooked by short-term fluctuations and headlines.

“As always, a considered mix of asset classes, sectors, regions and currencies offers protection from market shocks,” he says.