Market Commentary - Q4 2022

Equity markets retreated into bear market territory in the third quarter as recession seemed ever more likely and consumers began to retrench. Meanwhile, fixed income assets appeared increasingly attractive when structured into a portfolio aligned with investors’ tax-status and risk tolerance.

Stock investors continued to flee the market—the S&P 500 and tech-heavy Nasdaq have now recorded three straight down quarters for the first time since 2009.  After an overly-enthusiastic June rally that reflected misplaced optimism the Federal Reserve (Fed) could engineer a soft landing and avoid recession, investors reversed direction to reprice in the Fed’s aggressive normalization away from rock bottom rates. Markets continued to absorb the impacts—reduced consumer savings and spending being one—of the end of fiscal stimulus. It appears that Goldilocks has left the building and the Fed, shifting from engineering economic growth, now must manage recessionary conditions.

It is not surprising that equity markets have retreated—the S&P 500’s 28.7 percent return in 2021 represented unsustainable conditions resulting from low rates and the inescapable laws of mean reversion are finally taking hold. But markets are late to the game at repricing a recession and are still holding at long-term averages. We anticipate future volatility as prices reset below long-term averages in acknowledgement of weakening corporate demand and cost fundamentals.

• Purchasing Manager Index service sector activity fell to 44 in August, a 27-month low and down from 47.3 the prior month. Excluding the decline between March and May 2020 during the height of the pandemic, this reading signaled the sharpest decline in output in 13 years.

• Many strategists have cut their corporate earnings forecasts: earnings growth expectations for the S&P 500 stand at an increase of 3.7 percent for the third quarter, down sharply from expectations of 9.8 percent growth at the end of June.

• Of S&P 500 companies that held earnings calls from June 15 through September 8, 240 used the term “recession”. This is the highest number citing the term since at least 2010, and well above the five-year average of 52.

• Sales of existing homes declined for the seventh straight month in August as mortgage rates over 6 percent hampered demand.

Consumer savings and spending are two areas where the punch bowl of stimulus-driven and atypical economic conditions is giving way to a morning-after hangover and an increasing likelihood of recession.

Savings Feast to Famine

The outlook for corporate profits and share appreciation is also dampened by recent consumer retrenchment in the face of soaring inflation. With consumer spending accounting for between 60 and 70 percent of U.S. Gross Domestic Product (GDP),  shifts in consumer habits are an important bellwether of economic conditions. Whether the result of COVID-era fiscal stimulus or COVID-era rainy day concerns, consumers enjoyed high levels of savings, both in absolute terms as shown below, or as a percent of income, and spending soared as the 2020 mini-recession ended.

Some of the increased spending was due to stay-at-home COVID protocols, government stimulus checks, and near negative interest rates that prompted many households to add credit card debt. But it appears consumer savings and spending are reverting back to long-term trends.

Rising inflation is also dampening consumer spending along a wide range of industries from cruises to autos. Particularly impacted are companies reliant on items that are typically financed through bank or credit card borrowing.

Disposable personal income, after peaking last year, is also reverting back towards long-term trends. While reduced spending may help drive down inflation, consumer retrenchment is a worrying development for corporate profits and share prices.

Not Always a Good Thing

At first glance, recent dollar strength might seem a source of pride. But global investors are casting a wary eye on the greenback’s recent peak. Demand for U.S. dollars does not reflect a particular attraction for the currency in itself but, rather, an indication of heightening global tensions arising from geopolitical tensions, uncertain economic prospects globally and rising recession risks around the world.

The unusual strength of the dollar has prompted the Bank of England, the UK’s central bank, to intervene in currency markets to prop up the Pound—an indication of the seriousness of the situation. And strong U.S. dollar conditions are particularly damaging to companies with significant foreign earnings such as many of the large firms in the S&P 500. Emerging market countries are particularly vulnerable to strong dollar conditions as they are frequently reliant on dollar-denominated debt as well as food and energy imports priced in U.S. dollars.

While it may seem that emerging market economies and stock markets are not particularly germane to U.S. investors, the world is increasingly interconnected from domestic to developed to emerging markets. Many investors already hold emerging market stocks in their funds and many global companies have significant investments in countries that could face significant challenges from continuing dollar strength.

So far, the Fed leads the world in aggressively raising rates. We might see continuing dollar strength as long as U.S. interest rates remain above those of other countries, providing a magnet for global capital flows to the U.S.

Shifting Tides

A new global paradigm appears to be shaping up that is not hospitable to risk assets—higher inflation, trade barriers, reduced globalization and dwindling open markets, and a shift from “just in time” manufacturing to “just in case” inventories. The impacts of the Ukraine war and rising tensions between China and Taiwan, coming on top of the COVID pandemic, have altered global financial markets in fundamental ways not seen since the last cold war. Corporate profits are likely to suffer in this new world order.

If there is any good news in today’s situation, we believe the recession will fall into the category of a cyclical recession rather than an event-driven recession, like the COVID recession or the structural recession of 2008. Cyclical recessions are painful, but necessary, to reset the economy onto a new path of growth. Like a controlled forest burn, a cyclical recession clears out the undergrowth and leaves behind conditions conducive for green shoots of recovery.

And there may be good news on the inflation front as it appears consumers are reducing spending and companies are finding it more difficult to pass along price increases. Consumers themselves appear to believe inflation may be tempering  and clogged supply chains appear to be opening up as well with a 90 percent decline in ships waiting to unload at Long Beach, California.  Lastly, we may be seeing an easing of COVID concerns.

While equity market declines are understandably wrenching, we believe that, over time, the inherent strength of the U.S. economy -- propped up by companies agile enough to remain highly profitable -- will ultimately manage the downturn successfully.  Investors with patience and a long-term horizon should benefit from not overreacting to bad news in the short run to take advantage of good values likely to emerge from unwarranted market dislocations.

Multi-decade inflation highs, aggressive tightening of monetary policy globally, a strengthening dollar, and slowing economic growth have helped cause the largest year-to-date increase in U.S. interest rates in over four decades. Unpacking the drivers of higher rates, and the effects of slowing economic growth, are key factors in forecasting the future path of fixed income markets.

By most measures, we have reached peak U.S. inflation and pricing pressures are decelerating but inflation remains high--recent measures of headline and core PCE inflation are 6.2 percent and 4.9 percent respectively on a year-over-year basis.   With core PCE inflation well above the Fed’s long-term target of 2 percent and unemployment at only 3.5 percent,  the Fed will remain aggressive in increasing the Fed Funds rate until substantial and sustained progress is made to lower inflation irrespective of slowing economic growth or rising unemployment.

Short maturity government bond yields are heavily influenced by both Fed Funds policy and market expectations of what the Fed Funds rate will be over the next 3, 6, 12, 24 months, etc.  Given unrelentingly hawkish messages from the Fed, markets are now pricing the average terminal lower-bound Fed Funds rate of 4.5 percent as cited by the Fed.   This rate is almost 200 basis points higher than the Fed’s estimated long-term neutral rate and we believe additional substantial increases in short maturity government bond yields are unlikely unless inflation proves stickier and longer lasting, resulting in even more aggressive Fed actions.

Intermediate and long maturity government bond yields, while also influenced by the path of the Fed Funds rate, are also highly influenced by fundamental factors including forward economic growth estimates and inflation expectations. Technical influences include bond supply influences from the budget deficit and quantitative tightening and demand influences such as absolute yield attractiveness to domestic and foreign buyers, as well as relative yields versus domestic bonds on a fully currency-hedged basis for foreign buyers.  These supply and demand factors will often push and pull yields in opposite directions.

With the interplay of various factors, we believe intermediate and longer maturity interest rates are near 2022 highs and should modestly decline in 2023.

• Factors pushing rates lower:
  • Slowing economic growth estimates with markets anticipating a Fed policy pivot occurring in the middle of 2023 towards easing rates over the following year or two thereafter.
  • Anticipated declining inflation and inflation expectations given an aggressive Fed policy and slower economic growth.
  • Smaller budget deficits resulting in reduced Treasury supply.
  • Higher yields attracting domestic retail, insurance, and pension fund buyers.

• Factors pushing rates higher:
  • Weak foreign demand given the strong U.S. dollar, extremely high currency hedging costs, and increased yields for similar maturity bonds in the home country currency.
  • Fed balance sheet reduction through quantitative tightening.
  • Higher path of near-term Fed Funds policy rates.

Although we believe U.S. Treasury yields are near the highs for the year, short maturity yields could trend modestly higher if the Fed needs to raise short rates above what is already priced into the market.  Conversely, we expect longer maturity Treasury yields will be weighed down by declining economic growth prospects as Fed actions percolate through the economy.  Therefore, we expect the U.S. Treasury yield curve to remain inverted near term and potentially invert even more.

As monetary policy tightens globally, economic growth prospects may deteriorate which, in turn, should reduce corporate earnings and cause corporate bond credit fundamentals to deteriorate.  With investment grade corporate bond credit spreads (as of 9/30) modestly higher than their 25-year average,  we expect credit spreads to widen as the situation plays out.  Similarly, spreads on below investment grade bonds, such as high yield and leveraged loans, are only modestly higher than their 25-year average (as of 9/30) and should also widen in this environment.

We believe high credit quality issuers and more defensive industries should experience less credit spread widening than lower quality offerings.  However, we don’t believe credit spreads will widen back to the levels experienced during the last several recessions—the current corporate bond downturn, unlike those of the past, is not driven by corporate balance sheet concerns or corporate malfeasance.  Further, the attractiveness of fixed income yields should boost investor demand and dampen some, but not all, of anticipated credit spread widening.

Within the securitized fixed income markets, we believe U.S. government agency mortgage-backed securities (MBS) should perform well once interest rate volatility diminishes.  As investors shift their risk concerns from interest rate risk to credit risk, agency mortgages may garner increased demand due to their government guarantee as well as minimal refinance incentive at current interest rate levels. Partially offsetting this potential demand will be continuing Fed MBS balance sheet reductions of $30 billion per month. Spreads on high quality short duration asset backed securities (ABS) will likely remain contained given robust bond structures and strong consumer balance sheets. However, cracks are beginning to emerge in lower credit quality ABS borrowers and we believe the highest credit quality segments of the ABS bond structure will provide the most spread stability.

Last, but certainly not least, within the tax-exempt municipal bond market we expect yields as a percentage of similar maturity U.S. Treasuries to remain volatile, although less volatile than taxable corporate bonds. Slowing economic growth and higher interest rates will likely strain some lower credit quality municipalities as well as tax-exempt issuers tied to real estate and cyclical industries. As with corporate bonds, high credit quality issuers and more defensive industries should outperform given our economic outlook.

Outlooks, however, are not without risks and there are several notable ones on the horizon including the following:

• Persistent inflation and more aggressive central bank policy.
• Hard economic landing.
• Geopolitical tensions.
• Central bank policy error.
• Pandemic re-emergence.
• Market liquidity seizing.
• A systemic issue arising from the interplay of dollar strength, rising global rates, slowing global growth, and shrinking central bank balance sheets.

There is an Alternative - Getting Paid to Wait in Fixed Income

Tighter monetary policy by many global central banks has moved the investment universe from the acronym TINA, “There is No Alternative”, to TIAA, “There is An Alternative.”  With yields on most investment grade fixed income assets at their highest levels since 2009 and the flat/inverted yield curve making short maturity fixed income assets look attractive strictly from a yield perspective, investors are finally getting paid a reasonable yield to invest in fixed income.  Furthermore, the prospects of slowing economic growth, combined with elevated financial market volatility, supports an increasing portfolio exposure to high quality fixed income assets as a place to hide while also getting paid to wait.

Given our fixed income outlook, we recommend the following fixed income strategies.

• Increase allocation to investment grade fixed income assets relative to equities in a balanced portfolio:
  • An up-in-capital structure place to hide during market volatility and slowing economic growth.
  • Take advantage of yields greater than the dividend yield of many U.S. equity indices.

• Focus on higher credit quality fixed income assets and issuers, minimize below investment grade fixed income exposure.

• Consider short maturity investment grade fixed income as a place to earn a 4-5 percent yield with compelling total return prospects over a one-year horizon including:
  • U.S. Treasuries, corporate bonds, asset-backed securities, money market securities and tax-exempt municipal bonds.
  • Yield carry can offset a significant move higher in yields/spreads over a one-year horizon given the minimal duration of the asset. 

• Barbell bond positioning:
  • Capture significant yields by holding short maturity bonds while also investing some of your bond allocation in long maturity investment grade bonds.
  • A barbell strategy offers a yield enhancement relative to an equal duration intermediate bond strategy.
  • Long maturity high quality bond returns should benefit as inflation and economic growth slow. 
  • A barbell strategy will benefit from a flat or inverted yield curve relative to a bullet maturity strategy.

• Non-U.S. dollar-denominated investment grade bonds from developed markets with currency exposure fully hedged back to the U.S. dollar:
  • Significant yield enhancement over similar U.S. dollar-denominated bonds given a significant hedging cost benefit for U.S. dollar investors as well as some credit spread dislocation between markets.
  • Slowing economic growth in many non-U.S. developed markets could lead to reduced monetary policy tightening.

• Keep a keen eye on tax-exempt bond valuations relative to taxable bond alternatives:
  • Ensure a proper after-tax yield comparison (dependent upon your individual tax bracket) between taxable and tax-exempt fixed income products as part of structuring a fixed income portfolio.

Summary

As investor attention turns from acronyms such as FOMO (“Fear of Missing Out”) and TINA (“There is No Alternative”) which led to soaring stock market rallies over the last several years and a subsequent bear market, the near record move higher in interest rates this year has made fixed income assets an attractive place to ride out stock market volatility while earning attractive yields.  There are various investment strategies investors can employ in bond investing, depending on risk preferences, investment horizon, liquidity needs, etc.  Given our fixed income outlook we would advocate for a high credit quality strategy, take advantage of the flat yield curve by investing in short maturity bonds, and for those with longer duration or a higher risk tolerance, a barbell maturity strategy and an allocation to non-U.S. dollar denominated investment grade bonds from developed market countries with fully hedged currency exposure may be attractive.

Find out more about our goal-based investment solutions for wealth clients—from managed accounts to individual equity and fixed income products, liquidity management and more. Contact a relationship manager at The Private Bank to discuss the strategy that is best for you.