Market volatility surges amid interest rate uncertainty

04/22/2024 — Key takeaways:

• Equity markets declined for the fifth time in seven weeks, driven by geopolitical tensions, inflation concerns, and interest rate uncertainty.
• Fed officials continued to shift to an incrementally hawkish tone as doubts crept in about rate cuts in 2024.
• This week saw heightened tensions between Israel and Iran, alongside renewed trade tensions with China.

Drivers of market movement

Equity markets continue their weak start to the second quarter, with the S&P 500® Index delivering the fifth weekly loss in seven, bringing the index to 5% below the record high from late March. Geopolitical and election year uncertainty join inflation, rates, and the Fed in pressuring markets, driving a rapid and dramatic shift in the attitude of investors. This week saw the worst weekly loss since last October and the first three-week losing streak since last September. This was the first week with five down sessions in more than four years. Volatility continues to reverse from the calm conditions for the previous six months, with the VIX breaking above 19, though we remain well below the average of 25 between 2020 and 2022. Interest rates continue to march higher as hopes for Fed rate cuts fade, with the 10-year Treasury yield up 0.08% to 4.60%, the highest since October.

The shift in market complexion is causing a reaction from investors, with global equity funds showing $29 billion of outflows over the past two weeks. This is in contrast to the latest Bank of America Fund Manager Survey that showed the greatest level of bullishness in more than two years and bond holdings experiencing the largest sequential drop in more than 20 years. Most strategists are convinced the pullback is due to simple repositioning following a tremendous run since October; UBS is concerned that the stubborn inflation picture could cause the Fed to reverse course and raise rates, while Morgan Stanley worries that higher interest rates will drive concerns over valuations.

The hawkish shift of Fed officials continued this week, with Fed Chair Powell saying that inflation data has introduced uncertainty over whether the Fed can cut rates this year. NY Fed President Williams said that he doesn’t feel any urgency to cut rates and that while it isn’t the base case, he is willing to raise rates if the data warrants. Atlanta President Bostic reiterated that a cut may not come until later in the year, particularly if the labor market remains strong. Cleveland President Mester advocated a wait-and-see approach before cutting rates, a shift from her previous guidance that three cuts this year is reasonable. The PCE deflator release next Friday is critical, as the core PCE deflator is the metric closely followed by the Fed. The headline number is forecast to rise 2.6% from a year ago (an acceleration from 2.5% last month), with core PCE expected to increase by 2.7%, a slight improvement from 2.8% last month. The Fed Futures curve currently embeds 1.6 cuts this year, down from 6.3 priced in at the beginning of the year.

Geopolitics continues to be a risk for markets, with news of an Israeli strike in Iran Friday morning in retaliation to the attack from last weekend. US officials confirmed the strike by Israel, though Iran said the explosions were the result of its air defenses destroying several drones. The attack was viewed as limited, and there have been no calls for retaliation, calming equity, bond, and oil investors. In other global news, President Biden called for tariffs on Chinese steel and aluminum to more than triple from the current 7.5% to 25% to stem the surge in Chinese exports, where volumes jumped 14% in the first quarter. Biden also announced an inquiry into China’s shipbuilding industry.

Earnings season is still in the early stages, with less than 15% of the S&P 500 having reported. Results have been disappointing, with growth currently tracking at less than 1%, down from the 6% expected at the beginning of the year and 3% at the end of March. In management commentary, there were anecdotal signs of sluggishness in March from JB Hunt, Proctor & Gamble, FedEx, and Walgreens. The consensus estimate for the full year has ticked down modestly, below $243 for the first time, implying 10% from 2023. Additionally, earnings growth for 2024 is heavily reliant on a surge in the second half, with 8% in the third quarter, and 18% in the fourth quarter despite headwinds from wage pressure, commodity prices, and supply chain disruptions.

Details on performance

Investors continued to move to the sidelines, as the strong market momentum stalled, with the S&P 500® Index down 3%, the Dow down fractionally, and the NASDAQ down 5%. Value indexes solidly outperformed growth, while small caps performed roughly in line with large caps. Leading sectors for the week included utilities, consumer staples, and financials, while technology, consumer discretionary, and real estate lagged. Volatility was elevated, with the VIX closing at 19, while trading volume was light.

Global markets fell, though the MSCI EAFE® Index and MSCI Emerging Markets® Index both outperformed the S&P 500. Asian markets were mostly lower in reaction to the conflict between Israel and Iran, with Japan losing 4% and South Korea falling 2%, though China was able to manage a modest gain. European markets were mixed, with some support coming from dovish comments from the European Central Banks, with Italy, Spain, and France gaining 1%, while the UK and Germany lost 1%. Latin America was weak on the tepid market, with Mexico down 4% and Brazil down 2%. The trade-weighted dollar index was fractionally higher for the week and has gained 5% since the start of the year.

Interest rates persist as a mounting concern of investors, with the 10-year Treasury yield rising 0.08% to 4.60%. The 2-year yield added 0.06% to 4.96%, marginally narrowing the spread between the two yields. Credit spreads are widening in the risk-off environment, with high yield spreads at the widest level in over two months. Global rates rose in sympathy for the domestic move. Commodity prices eased slightly despite the tension in the Middle East, with the S&P Goldman Sachs Commodity Index down 1%, though it remains up 10% for the year. Crude prices fell 4% after briefly surging Friday morning, while metals prices jumped in a safe haven trade. Agricultural commodities were mixed.

As mentioned, investors are aggressively adopting a risk-off posture, with $9 billion in outflows for equities in the latest week and $29 billion in two weeks, per EPFR data. The $21 billion of outflows from US funds in the last two weeks is the most since December 2022. Bond funds were the primary beneficiary, gaining $6 billion for the week. Money markets lost an incredible $160 billion due to tax-related outflows. Bank of America’s Bull/Bear indicator is neutral at 5.0, down from 5.2 last week. The CNN Fear & Greed Index hit the lowest level since October at 32, down from 46 a week ago. The AAII Sentiment Survey showed bulls fell back to the long-term average at 38%, marginally above the number of bears at 34%.

What to watch

Earnings season will be the driver of news next week, with nearly one-third of the S&P 500 set to report. Notable macro data include PMI and new home sales data on Tuesday, durable goods on Wednesday, first quarter GDP on Thursday, and personal income and spending and the PCE deflator on Friday.