Investors have been cornered by inflation, Fed tightening and a volatile stock market, but can take steps to potentially reduce their vulnerability and open up the field to opportunity.
If investors questioned the seriousness of the Federal Reserve in facing down inflation, they were able to put those concerns to rest in recent months as the central bank hiked rates significantly in three straight meetings and then promised more increases in the near future.
Like a runner caught between first and second base, investors faced palpable consequences as hopes for lessening inflation pressures and an opportunity for a pause by the Fed failed to come to fruition. After surging more than 17%, the S&P 500 fell backward to test previous lows and beyond, experiencing its worst first nine months of the year since 2002.1 Meanwhile, the 10-year U.S. Treasury yield rose to over 4% for the first time since 2007. Truly, economy and markets have entered new innings, but the extent and duration of this tough new environment remains subject to uncertainty.
Although one might take solace in the downward movement we’ve already seen, it’s possible that we could see more—periodic rallies notwithstanding. Indeed, the current weakness has closely followed patterns seen in past bear environments (see display). Multiweek rallies like those this past summer have been a feature in such markets, especially those associated with recessions. We would expect a few more before the ongoing bear market ends.
Current vs. Past Bear Markets
Source: Neuberger Berman and FactSet. Data as of September 30, 2022. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indices are unmanaged and not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
Weakening Economic Picture
Economic data has been weakening on the heels of inflationary pressures and central bank tightening. The U.S. Leading Economic Index has now declined six months in a row, and the OECD Global Leading Indicator has declined for over a year. Goldman Sachs’ Current Activity Index, a composite aggregate of all U.S. economic activity, was negative for three months in a row before turning positive in September.2
The OECD’s latest forecast for global growth in 2022 is now down to 3% and its 2023 forecast down to 2.2%, while it has cut a full percentage point from its U.S. growth forecast for this year at 1.5%, with just 0.5% expected next year. With gas supply strains, a cold winter could reduce European growth another 1.25 percentage points and global growth another 0.5 percentage points.
These developments are consistent with a global economy sliding toward recession. Indeed, recent weeks have seen a rise in the number of analysts putting the probability of U.S. and European recession at 90% or above. Those forecasting a recession generally suggest that it could be mild—more like 1980, 1990 or 2000 than 1973, 2008 or 2020, for example.
That’s because they anticipate a pullback in demand for goods that chiefly affects the manufacturing sectors, rather than a pullback in investment or leverage that would have the potential for broader economic impact. However, this remains a question, and we will be looking closely for signs of a broader slowdown in services. Overall, although we still think a soft landing is possible, the higher probability is for a U.S. recession within the next 12 months.
‘Sticky’ Inflation and the Fed
Part of the problem is the nature of current inflation, which is proving stickier than the Federal Reserve and many others anticipated. Some elements of inflation are more subject to short-term fluctuation, while others tend to remain in place. Currently, labor pressures show no sign of disappearing given pandemic-related retirements, while inflation more broadly is stickier due to de-globalization and the significance of shelter costs. Overall, we anticipate that inflation will recede from here, but the trend will likely be gradual, with some potential for upward shocks around energy and commodities.
Shelter and Services Are Key Inflation Drivers
While we expect goods prices to decelerate, we believe
1970s redux? A strong and simultaneous increases in major inflation drivers making it hard to ignore history
Source: Neuberger Berman. Actual data through September 2022. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
With the labor market continuing to show resilience, we believe the Fed will likely maintain its aggressive stance to tighten financial conditions and continue to increase interest rates. We believe the central bank would need to see labor demand weaken and labor supply increase, which implies slower economic growth to make room for pausing and allowing market interest rates to stabilize.
As such, a key factor that gives us pause is the market’s expectation of what the Fed will do going forward. For some time, the market has been looking for the Fed to stop raising rates—the “Fed pivot”—because economic growth is anticipated to slow. We believe the Fed is seeking to avoid the mistakes of the 1970s when it increased rates rapidly and then took its foot off the pedal, only to see inflation rise again. In the wake of discouraging inflation data, the market is now pricing in a more “hawkish” interest rate backdrop for the rest of the year and into 2023. During the summer rally, the market was expecting the terminal rate (the high point for rates before they recede) at between 3.3% to 3.7%, but that number has continued to drift higher, settling recently around 4.5%.3
Waiting for Earnings Cuts
Although the market has recently been volatile, to a large extent the action has not been consistent with on-the-ground results at companies, which have remained relatively resilient. However, we believe that higher interest rates, inflation and slower growth are likely to cause further deterioration in earnings moving forward.
In the second quarter, corporate earnings were generally mixed but, in aggregate at the index level, they were positive (6 – 7% year-over-year). However, if you dig deeper and strip out energy sector earnings, earnings were actually at -4%. Following commentary and forward guidance from company earnings announcements, concerns remain about companies’ ability to maintain profit margins. Currently, earnings per share for the S&P 500 are still about 18% above their average trend level since 1990, as shown in the display. Moreover, in a typical recession, earnings have tended to fall about 17%, which we have not yet seen.4
Could Earnings Be Overextended?
S&P 500 Earnings Per Share v. Trend (Log Scale)
Source: Bloomberg, as of October 10, 2022.. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed. Investing entails risks, including possible loss of principal. Indexes are unmanaged and are not available for direct investment. Past performance is no guarantee of future results.
Our equity research analysts report that, while they are not hearing a marked turn to pessimism from corporate management, a growing number of the companies they monitor have either cut their earnings projections or have signaled growing uncertainty. They anticipate deteriorating news as higher rates and energy prices begin to bite over the coming quarter. For 2023, consensus earnings are still expected to increase by nearly 8%—but our analysts think current U.S. earnings forecasts might be overstated by 20% or more in the event of recession. The downside could be exacerbated because the earnings reported by S&P 500 companies appear to exhibit the poorest quality, with overreliance on accounting accruals leading to the greatest gap between net income and cash flow seen in at least 30 years.
Unfortunately, in the wake of a rates-driven sell-off, we are likely gathering momentum for further declines related to recessionary earnings weakness. The good news is that this makes us closer to the end of a painful process, but that doesn’t mean we think the pain is yet over.
Tamping Down the Wealth Effect
In our view, the current overheated jobs market is a symptom of an overstimulated economy; wealth creation much in excess of GDP growth, especially in the upper-tier consumer, is an important cause of this overstimulated economy. Taming this variety of inflation could require engineering both job losses and dampening the wealth effect.
A great divide appears to exist today between the recessionary spending patterns of lower-income U.S. consumers and the strong spending patterns of wealthier consumers. The former largely depend on shrinking real incomes to spend and save, whereas wealthier consumers tend to take their spending cues from the value of their assets. Thanks largely to pandemic-era stimuli, stock market and housing booms have made those wealthier U.S. consumers some $15 trillion richer today than they would have been otherwise, with about $2 trillion of that in excess, readily spendable cash. They have been on a spending boom that started in goods, has moved to services and is still ongoing. So, moderating that boom may involve a hit to wealth, which likely means reducing housing and financial market valuations further.
—Raheel Siddiqui, Senior Research Analyst
Volatility Out of the U.K., Weakness in Europe
Worries about financial discipline in the U.K. have contributed to global market turbulence this fall, even as the Bank of England and other developed market central banks appear on course to continue raising interest rates.
Many were surprised by a plan for additional fiscal stimulus to support the U.K. economy while the U.K. continues to struggle with high inflation. This resulted in a rapid sell-off in the British pound and a significant increase in interest rates across the yield curve—the magnitude and speed of which is usually seen in developing markets’ currencies and bonds. The pound flirted with record lows against the U.S. dollar, and the 30-year U.K. government bond yields jumped 160 basis points within a week of the policy announcement, prompting the Bank of England to intervene in the bond markets and delay its quantitative tightening program. Remarkably, the U.K. reversed course on the bulk of its tax proposals, which met with some approval from markets. However, the country’s policies remain a source of concern for many investors.
Elsewhere, the Eurozone economies continued to face headwinds, with Germany seeing a hotter-than-expected initial inflation print of 10% year-over-year in September, skewing the risk toward a higher terminal rate from the European Central Bank. Disruptions to the European natural gas market due to the conflict in Ukraine (leaks in the Nord Stream pipelines were attributed by NATO to Russian sabotage) may continue to put pressure on European risk assets and raise the odds of a more severe downturn there.
—Investment Strategy Group
Developing a Game Plan
Our general investment principle is to stay the course, assuming that your asset allocation has been carefully constructed to match personal goals. Typically, the wheels of portfolio adjustment are relatively slow, so it’s important to be comfortable with what you have in place, all things equal. Good markets come and go, and that hasn’t changed. That said, it can be useful to have a certain degree of flexibility in your financial assets so that you can make minor changes—so-called tactical allocations—that can help your risk/reward profile during periods of market stress such as we find ourselves in today.
Along these lines, higher interest rates typically have a greater effect on more interest-rate-sensitive assets (for example, long-dated bonds or growth-oriented stocks). This is why, in our view, the stock market—currently dominated by “growthier” names—reacted to the news so negatively to recent inflation and interest rate news. As a result, we would favor a more defensive approach at this point. This would tend to favor U.S. stocks over non-U.S. given current turmoil in Europe (see “Volatility” above). We favor value shares over growth, and income-generating assets such as dividend stocks over non-income-producing assets. Quality is also likely to be important. In our experience, larger, more defensive companies with strong balance sheets and conservative accounting practices, as well as earnings visibility, have tended to outperform in difficult economic times.
Diversification should always be an elemental characteristic of portfolios. Within core holdings, we favor equities with less “beta” to the market, or sensitivity to broader market trends. Although fixed income has taken its lumps this year, we believe having a diversified bond exposure can help smooth the turbulence experienced by investors. Now that the 10-year Treasury yield is around 4%, there’s considerable opportunity to pick up yield and offset high inflation; this also helps limit the risk of negative total returns, which have been rampant thus far in 2022. In our view, municipals are attractively valued relative to government bonds, but other pockets of the fixed income market, including quality high yield and some emerging market debt, may be worth exploring. Broadly speaking, we favor shorter-maturity bonds with lower interest rate risk.
Importantly, alternative investments may be worth a look. Although private equity valuations may be vulnerable to reset, a key advantage has tended to be their timing of the deployment of capital. After recent public market declines, the purchase prices of many assets could be appealing in coming years as managers get to work on current fundings. Elsewhere, selective investment in private real estate may provide an opportunity to seek income generation and capital appreciation where focused on quality properties with strong fundamentals. Commodities also show appeal as a potential hedge against inflation (see “Thinking Strategically About Commodities”). Finally, a healthy cash position has its advantages as a source of dry powder despite its inherent depreciation of value tied to inflation.
‘Boring’ Stocks Have Outperformed This Year
Low-Beta Exchange-Traded Funds vs. Benchmarks
Source: Bloomberg. Data as of September 30, 2022. For illustrative purposes only. Nothing herein constitutes a prediction or projection of future events or future market behavior. Due to a variety of factors, actual events or market behavior may differ significantly from any views expressed or any historical results. Indices are unmanaged and not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.
We are currently in a period of transition between an “easy money” regime and one that prices risk more appropriately. The much-talked-about “new normal” is now reverting to the “old normal”: higher inflation, higher interest rates and less intervention from policymakers, both fiscal and monetary. During an inflection point such as this, it is critical to remain focused on long-term strategic investment goals. While short-term volatility can be unnerving, it is often a natural part of the shift from one regime to the next. In our view, being clear about your goals and working with advisors who have the potential to combine long-term focus, diversification and tactical flexibility can help in seeking to achieve successful outcomes.
1 Data through September 30, 2022.
2 Data through September 30, 2022.
3 Source: Bloomberg.
4 Source: FactSet.
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