September 23, 2022
It’s been a long, tough year, and unfortunately there is little reprieve in sight as we head into the fourth quarter.
In our last update, we noted that expectations for a Fed pivot were premature and likely to lead to downside risk. Subsequent price action in bonds and equities validated that observation, with the S&P 500 down over 20% year-to-date and testing June lows, and the 10-year bond yield hovering around 3.7%.1
While the Federal Reserve’s third 75 basis point rate hike was in-line with estimates, its economic projections and Fed Chair Jerome Powell’s press conference were more hawkish than expected. The move followed an unexpected jump in August’s core inflation, driven by services such as housing and wages.
The Fed now expects the federal funds rate to end 2022 at 4.4%, implying another 125 basis points of tightening at its next two meetings. Policymakers also forecast the terminal rate to reach 4.6% in 2023, much higher than the 3.8% it estimated in June. The Federal Open Market Committee (FOMC) also projected rate cuts to begin in 2024 rather than 2023, meaning the Fed intends to hike rates higher and keep them there longer than projected in June.
Exhibit 1: Expect Higher for Longer Rates
In our view, the higher rates go and the longer the central bank remains restrictive, the narrower the runway for a soft landing. Powell warned of a “sustained period of below-trend growth,” with the Committee lowering its GDP outlook for this year and next. Forecasts also called for a rise in the level of unemployment and Powell asserted that a housing market correction was inevitable.
Changes in housing and employment foreshadowed by the Fed’s forecasts are often associated with recessions. The pain has already begun, with soaring mortgage rates pushing down existing home sales for seven months in a row. However, the labor market remains tight, with a better balance of supply and demand needed before we see wage pressures ease.
For investors, the next shoe to drop will be earnings.
S&P 500 earnings growth estimates have been trending lower, falling 2-3% since June to 7.9% and 7.7% for 2022 and 2023, respectively. Nevertheless, earnings estimates are not yet reflecting the impact of the fastest tightening cycle in decades. As consumer demand softens under the weight of higher rates, it will be more challenging for companies to maintain profit margins by passing on inflation to customers.
Exhibit 2: U.S. Earnings Expectations Likely to Fall Further
Global growth is slowing rapidly and the U.S. dollar is at 20-year highs. A stronger dollar negatively impacts earnings abroad, with 40% of S&P 500 revenue coming from outside the U.S. And Europe, likely already in a recession and expected to worsen, accounts for 15% of S&P 500 revenue.
We are projecting a 60% probability of a U.S. recession, but we believe that it will be mild. The labor market is exceptionally strong and corporate and household balance sheets remain healthy. Although higher rates will increase default risk, we don’t see the leverage levels that made previous recessions so painful. Financial stability and a better capitalized banking system should also limit contagion, keeping any downturn modest. Even a mild recession, though, can produce a downward revision cycle in earnings estimates of 20%.
Weakening earnings will be a challenge to markets, and with the S&P 500’s price-to-earnings multiple still close to historical averages at 15.9x, market risk is biased to the downside.
There are certain sectors that will suffer more from a material economic downturn and multiple contraction, namely consumer discretionary, materials and non-profitable technology sectors. Consumer staples, healthcare, utilities – things people need no matter what the economy is doing – are expected to fare better. Energy, given the supply challenges, stands to do well.
We see re-shoring and re-stocking as important themes moving forward, implying increased capital expenditure in both infrastructure and technology. We are drawn to sectors that will benefit from this fundamental shift through select industrials, utilities, and tech.
Of note, the major fiscal bills out of Washington, including the CHIPs Act and the Inflation Reduction Act, funnel money into these sectors and sub-sectors and we advise clients to invest alongside the government, so to speak.
Record low yields have kept fixed income in the shadow of equities for decades, giving stocks the long running “There Is No Alternative” (TINA) advantage. An aggressive shift in Fed policy is beginning to change that. Two- and 10-year Treasury yields have soared above 4.2% and 3.7% respectively, compared with a 1.9% yield on the S&P 500.
While our underweight to fixed income has served us well over the years, investment opportunities in the asset class are growing. The short-end of the Treasury curve now offers more competitive yields for those more risk-averse investors not able to stomach the gyrations of the equity markets. Municipal bonds also look particularly compelling for tax-sensitive investors, as they offer extra spread over comparable Treasuries, at a time when states are flush with revenues.
Exhibit 3: U.S. 10-year Treasury Breaks Multi-Decade Downward Trend as Fed Policy Shifts
Keep to the Investment Plan
This has been a challenging year for investors accustomed to V-shaped recoveries and a Fed pumping liquidity into the financial system. A historical perspective suggests that we have turned a page on the monetary excesses. Years of easy money have created buoyancy throughout financial markets and asset pricing. These conditions take time to heal, and we advise our clients to follow BNY Mellon Wealth Management’s investment guidance and stick to their plans.
Inflation is proving to be as difficult to model on its way down as it was on its way up. We do not expect a sustainable rally in stocks until the Fed sees clear and multiple months of evidence that services inflation is trending down. Earnings risk is the next hurdle for the market and a reset in expectations would prompt us to be more constructive.
That said, it is critical to remain forward-looking and invested. The fourth quarter is historically the strongest quarter of the year, particularly in more volatile years, and investor sentiment remains at historically low levels. Additionally, midterm election years are often difficult leading up to election day, with average drawdowns of 19% heading into November. However, since 1950, the S&P 500 has produced average 12-month returns of 15% after the midterms.
We will be focused on using volatility to position for an eventual economic and earnings recovery in late 2023 and 2024. Our neutral equity posture, our lowering of equity exposure, our early underweight to fixed income, our expanded allocation to alternatives and our building of dry powder means we are well-placed to do that. We remind our clients that markets anticipate inflections in the real economy and stabilize before the real economy does.
Beyond our portfolio positioning, alternative investment strategies less correlated to traditional assets, such as long/short equity hedge, absolute return and private equity, can help provide a buffer to volatility. We’ve also been taking advantage of volatility by harvesting losses in equity and fixed income, which can help improve portfolio returns this year and beyond.
We urge our clients to be in touch with their wealth managers in volatile times. Weeks and months of pounding asset prices are discouraging, but financial plans are constructed for the difficult times and not just the easy times. The history of markets suggests that sticking to an investment plan is a crucial pillar to achieving investing objectives.
We are here for any questions you may have.