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Central Banks – In this article let’s see:
- The stock returns over the first two years of Fed tightening cycles
- The earnings yield despite higher interest rates
- Where we could expect inflation go in 2023
- How stocks tend to react removing the stimulus by Fed
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• Strength in the US economy expected to counter pressure from rising interest rates; recession unlikely before mid-2023.
• Increasingly concerned that risks have increased to our multiyear expansion thesis.
• The Fed’s aggressive rate hikes combined with the balance sheet reduction is unprecedented.
• Rising rates are intended to and will cause unemployment to rise. How much matters.
• Inflation staying higher for longer due to recent developments in the Ukraine crisis and China’s COVID-19 policy.
• Inflation pressure should begin to moderate in the second half of 2022, but remain elevated into 2023.
• In the near term the US economy will slow but positive GDP for all 2022 and into early 2023 forecasted.
• Some consumer segments will experience lower spending due to higher food and energy inflation.
• The outlook for job growth and wage gains remains solid, supported by solid corporate profit growth.
• Global economic activity is slowing, the US being much better positioned especially versus Europe/Asia.
• Unprecedented uncertainty is causing us to expand possible scenarios and decision framework.
• Depending on path of rates and consumer behavior may lead us to reduce overweight to equities.
• We like US quality companies and income equities selling at reasonable valuations and municipal fixed income.
• Quality companies expected to generate good earnings and dividend growth next 12 months.
• We remain underweight European equities for recession and stagnation risks.
• EM Asia exposure is under review as China’s Zero COVID-19 policy is reducing economic growth. Tax loss opportunity.
• Municipal fixed income yields: both investment and high yield are opportunistically attractive.
• Remain cautious in the near term; continue to expect modest returns with increased volatility across asset classes longer term.
Stocks Appear Fully Valued
• Valuations remain historically elevated despite recent market pullback.
• Rising interest rates expected to be increasing headwind for valuations.
• Higher valuations point to more limited stock gains going forward.
US Earnings Outlook Continues to Be Solid
• Lowering 2022 EPS forecast from $230 to $225 on Euro weakness and higher input costs reducing margins.
• Strong nominal US GDP growth supports sales growth and continued profit expansion.
• Overall EPS growth still expected to be above the long-term average of 7%.
Government Bonds May No Longer Diversify Growing economic risk generally leads to rising market volatility. That makes portfolio diversification a priority.
Traditionally, riskier asset exposures are balanced by allocations to “low-risk” investment grade government and corporate bonds. But can they continue to perform that function in the current environment?
When the European Central Bank (ECB) surprised markets by emphasizing its focus on inflation rather than growth in the face of the Ukraine crisis, and the Fed followed with its notably hawkish “dot plot,” long-dated U.S. Treasury yields rose, and real yields rose even faster. That kind of signal is now very difficult to interpret, particularly when closely watched points in the U.S. yield curve have been briefly inverting. Does it suggest that investors are gaining confidence that the Fed can bring inflation under control without inducing a recession? Or are investors selling long-duration, investment grade government bonds because they are no longer confident they would be an effective natural hedge for riskier assets in a slowdown? We could be entering a period of “heads, yields are up; tails, yields are up”—with bonds exhibiting much tighter correlation with riskier assets like equities.
Sure enough, since the last quarter of 2021, we have begun to see equity-bond correlations rise. The history of correlations through the different inflation regimes of the past 40 years gives an indication of how this might develop. During the 2000s, when inflation was low and anchored, equity-bond correlation was almost always negative; bonds were a natural hedge for riskier assets. But during the 1980s and 90s, when inflation was persistently above 3% and more volatile, correlation was almost always positive, and sometimes high.
Coming into 2022, we anticipated slower growth compared with the steep recovery levels of 2021, and inflation that was declining but persistent. We do perceive growing economic risks, and are focused on two things that have the potential to tip the economy into a steep slowdown or recession.
The first is a fundamental, cyclical stalling in the economy. We do not see that risk on the horizon today. For that to materialize, we would need to see signs of sales declining, industrial production contracts going unrenewed, wages stagnating or declining and, ultimately, jobs being lost. Instead, retail sales are strong, Purchasing Managers’ Indices remain robust, wage inflation is high and the employment market is tight. Millions of vacant jobs would have to be destroyed before filled jobs are lost. The spike in commodity prices looks alarming, but it is much less harmful in today’s less commodity-intensive economy than the shocks of 50 years ago.
A historically challenging market regime
Both stocks and bonds are down year-to-date as policy confusion and Russia’s invasion roil markets. We still see stocks up and bonds down for a second straight year – a first since data started in 1977.
War, energy shock and the Fed’s pivot – in a single quarter The tragic war in Ukraine, a global energy shock and the Fed’s surprisingly hawkish pivot – all in the space of a few months – have sparked reassessments of macro scenarios among market participants.
Energy supply shock on top of restart-driven inflation This year’s energy supply shock builds on the restart driven jump in energy prices in 2021. Higher energy costs – the main macro transmission channel from the Ukraine conflict – are stagflationary.
Markets starting to price in a more aggressive Fed The Fed struck a surprisingly hawkish tone in kicking off its hiking cycle. We see a higher risk of the Fed slamming the brakes on the economy as it may have talked itself into a corner.
Restart dynamics still fundamental driver of growth The strong restart momentum going into the Ukraine crisis should help cushion the stagflationary impact of supply shocks – particularly in energy prices.
My conclusions and considerations
The commodity index is unstoppable.
After Fed tightening cycle begins the still look positive both in recession cycles or no-recession cycles.
On average, stock returns have historically been positive over the first two years of Fed tightening cycles.
When the Fed is removing stimulus because the economy is on solid footing and there is no recession, stocks tend to do very well.
Earnings yield still attractive despite higher interest rates.
Earnings growth expectations remain healthy, bolstering attractiveness of earnings yield vs Treasuries.
- The Fed’s aggressive rate hikes combined with the balance sheet reduction is unprecedented.
- Inflation pressure should begin to moderate in the second half of 2022, but remain elevated into 2023.
- Some consumer segments will experience lower spending due to higher food and energy inflation.
- Valuations remain historically elevated despite recent market pullback.
- Higher valuations point to more limited stock gains going forward.
- Both stocks and bonds are down year-to-date as policy confusion and Russia’s invasion roil markets.
- Markets starting to price in a more aggressive Fed. The Fed struck a surprisingly hawkish tone in kicking off its hiking cycle.
Join the conversation with your own take on these topics in the comments below.
About the Author
Alessandro is a Financial Markets enthusiastic and he loves learning from articles/papers on many financial topics and in doing so he shares with you the most interesting charts and comments.
This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. This material has been prepared for informational purposes only. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.