Chris Hyzy: This is Chris Hyzy, Chief Investment Officer, for the market update for December 5th. Some economic data out over the weekend as well as Friday. The employment report on Friday was a little bit better than expected in terms of jobs growth and the focus at the beginning of the stock market session on Friday and through midday was all on average hourly earnings which were above the consensus level in terms of the tick up on it. However, the market did balance itself out and was mixed to close trade on Friday, indicating that there’s still enough money on the sidelines to buy some of the dips in the markets. Now, following on this economic report data, particularly the employment report this morning, on Monday we received the important data point on the institute for supply management gauge of services. We talked a lot about the shift in spending from goods over to services, particularly this year in 2022 and the back half of ’21 but really the momentum in ‘22 has been all about the services part of the economy which is where we still see a good portion of the employment gap and in another words, why wage growth continues to run ahead of consensus - it’s this shift to services and the services gauge gave us positive data as it relates to economic growth this morning, which ultimately is not what the market is looking for. The market’s looking for weak economic data so the fed can pause. Now, the gauge rose to 56.5. Why is that important? Because that’s three points above consensus and more importantly, it’s 6.5 above what they call the expansion level, which is generally around 50. So, this is indicating that the services economy - again, it’s one month’s data point - but this has been a trend recently. The economic health and the services part of continues to show that it’s in expansion territory. This is very different than the manufacturing side of the economy. Bond yields climbed across the board, particularly the back end of the curve and the two-year also climbed as well off of a low level that it reached earlier on last week around 4.2 or 4.25. Now, looking at oil prices, that took a cue as well from this data. They rose and they also rose off of OPEC+ announcements and they looked away from the $60.00 cap on Russian oil. They’re looking more towards the health of the economy. West Texas Intermediate oil prices got back above $80.00 a barrel, also indicating a little bit of reprieve on the downswing that we saw for much of the past couple of weeks. So, if you roll this all up, the economy continues to showcase mixed numbers. This is typical of late cycle economic moves. We expect this to continue well into next year, not just the next one or two months. We believe the late year end rally that we’ve seen off of the lows particularly in November and the early part of December is still intact, but we don’t expect a significant one from here. The technical market factors in the market are still overhanging the overall push higher. The S&P 500 index, somewhere around 4,030, is having a hard time staying above 4.050 or its 200-day moving average. It’ll need a new catalyst to break above that and stay there. Now, we think two potential catalysts that that could entail could be coming in the mid part of December. So first and foremost, in just a few short days we get inflation gauges out on December 9th, that’s Friday and then on the 14th, obviously the fed, the FOMC, the Federal Open Market Committee meeting, needs to raise rates. We still expect a 50-basis point hike but the key will be the communication coming on the back of those inflation gauges that are out just five days prior to a decision by the FOMC. We remain neutral stocks at this point and still slightly overweight bonds heading into next year. We will look for opportunities to rebalance across the board and across asset classes and risk profiles the early part of the year as we see a seasonal trending pattern particularly in late cycle moves where stocks enter another exhale in anticipation of key events. What are those key events? First and foremost, a fed pause. We expect that sometime in first quarter, but with mixed economic data in the late cycle, we should continue to see positive data and negative data forcing the hands of the fed to continue to move forward on rate hikes. So, we think a pause is upon us sometime in the first quarter. Markets will look to that queue and then they’ll start to shift back in our opinion towards earnings. Earnings, unfortunately, generally bottom later in the cycle after the market bottom. So, we expect a bottom some time in the early part of next year and a better advance in the second half and we still believe that the call for next year. Overall, all things considered on a general basis, bonds outperforming in the first half and stocks in the second half. So that’ll do it for today. Thanks for listening.
Operator: Please see important disclosures provided on this page.
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Neel Mukherjee: Great. Well, thank you for tuning into this Chief Investment Office Street Talk Market Update for December 1, 2022. This is Neel Mukherjee, Head of Portfolio Strategy, with an update on the latest market developments, a preview of what will be the major drivers of financial assets in 2023, and some key knowns and unknowns out there.
First, on the latest market developments, we are in the midst of what feels like another low conviction bounce in equities. This one started in mid-October. It’s up roughly 14% since then and the rally has been led by cyclical sectors such as energy, industrials, materials, and financials and the equal weight indexes are doing better than the market cap based indexes, which suggests that we’re getting a broader participation in this rally with an average stock doing better while the mega caps have been lagging. So there’s a couple of reasons for this renewed risk sentiment. The third quarter earnings were okay and not as dire as many were expecting. Also, recent inflation data such as the Consumer Price Index and the producer prices surprised positively and lately the Fed has been indicating that after four consecutive 75 basis point hikes, they will down shift to 50 basis points for the December meeting. Interest rates have pulled back across the curve, leading to some valuation re-rating for equities and in some ways this rally was not a surprise to us because sentiment and positioning were very poor coming into the fourth quarter and seasonality is also favorable. So, November and December are typically good months for stocks and that’s typically true especially in the midterm election years. So historically in midterm election years, the market tends to sell off through the year and then tends to bottom in October and then rallies through year end and in the subsequent year. So this recent rally has now brought the year to date decline for the S&P 500 to about 14% from an earlier drawdown of about 25%. The bond market is getting a lift as well. The two-year treasury yield has declined by roughly 40 basis points since November 11th and the 10 year yield is almost down 60 basis points since October 25th. That’s a small relief for fixed income asset class in the context of a historical spike in interest rates this year. At their peak, the two year and the 10 year yields were higher by 400 basis points and 274 basis points respectively. Also notable in the bond market is that yield curves are inverted. The two-tens curve and the three month to the 10 year part of the curve, which economists actually pay a lot of attention to, are both inverted by a little over 70 basis points. So these are historically inverted yield curve. You have to go back decades to see these levels of inversions. Corporate bond deals are at attractive levels. The investment grade index is yielding roughly 5.5%. Credit spreads have widened this year but have recently come in given the risk on tone in the markets. IG spreads, after having reached 172 basis points in October, have fallen back to roughly 140 basis points at the moment. It’s a significant decline and to a level which is far below the 200 basis point level which in our mind would be signaling some recession concerns. So credit spreads are fairly well behaved. Similarly, when I look at the junk bond credit spreads, they reached a high of 605 basis points in July and have significantly tightened since then to about 475 basis points at the moment. All in all, the year to date losses for the US bond market stand at roughly 13% and for global bonds it’s roughly 17%. The dollar has been a focus for investors pretty much all year at the moment. The Bloomberg Dollar Index was up a strong 15% for the year til September, but has recently stabilized and moved lower and is up around only 8% for the year. This could be due to a variety of factors, but I think central banks outside the US becoming more aggressive - I think that has a lot to do with it and also we’re getting a little bit more of a relatively less hawkish Fed right now. So it’s a combination of more aggressive central banks outside the US and a relatively less hawkish Fed compared to where the Fed was let’s say two or three months ago. I think that’s leading to this recent pullback in the dollar. Another notable development recently has been a decline in oil prices. WTI oil prices reached a high of $107.00 a barrel. That was back in June. That was up 55% at that point for the year, but they have since pulled back to a level of roughly $80.00 a barrel or about 16% up for the year. Similarly when I look at natural gas prices, which at one point was higher by about 150% for the year, that has pulled back from those highs by about 25%. So it’s a little bit of a relief for consumers and businesses and for their energy bills going forward. The bottom line for these energy commodities is that supply constraints has been the big story all year, but now a weaker demand outlook is getting priced in with the global economy expected to slow further from these levels.
Now, pivoting to the second part of my commentary here, I’ll focus on what could be the main drivers for asset prices in 2023. These are some of the discussions we have been having in our internal committees and should be available to you in our year ahead report in short order. So, in looking forward to 2023, we look back and we acknowledge that the last three years have been eventful on many counts for investors. In 2020 we had an unprecedented global health crisis, we had self-imposed economic shutdowns, we had government backstops the likes of which we had not seen for a long time, and we had breakthrough vaccines that came into the picture and each of these individually were remarkable developments and impacted the markets in a pretty substantial way and the fact that all of them happened in just one year, it was a pretty, pretty giant set of circumstances and catalyst that came through. Now in 2021, not to be undone, we got another round of massive additional fiscal and monetary stimulus. We had the advent of new variants which really told us that the population may have to live with this virus and then you had historically strong nominal GDP growth as some of the main catalysts for 2021 and then in 2022 – well, 2022 has kept investors on the edge of their seats. We’ve had inflation spiking to 40 year highs, historically fast paced of monetary policy tightening, spiking interest rates globally plus the largest land war in Europe really since the Second World War, and the sheer speed and force of these unthinkable developments have proved to be toxic for financial assets.
So as we turn the page to 2023, our belief is that inflation, Fed policy, corporate earnings, and China will be the main driver for the market. So let me touch on them individually here and also mention what the implication for asset prices is likely to be. So first on inflation, and this broad category into the labor market dynamic and consumer fundamentals, inflation is expected to move lower given the lagged effects of policy tightening and we’re also seeing a slowdown in global growth. The recent moderation in CPI numbers and producer prices, average hourly earnings, industry rent data, lower commodity prices, not to mention a significant slowing in money growth all point in that direction, but the time frame to achieve the 2% inflation target that the Fed wants to get to could be longer than most markets would like to acknowledge especially if the labor market softening takes time to play out and wage pressures don’t dissipate easily in the red hot services sector for the most part. Another factor is that US consumers continue to spend. Real consumer spending is on track to be up roughly 4% in the fourth quarter according to some estimates, but with inflation still outrunning wage gains, many households are leading on savings, which is still roughly at the level of $1.1 trillion excess savings. Stimulus checks are coming in from some state government. That’s helping support income and then credit cards are also being tapped into by the consumer to spend. So the consumer could keep growth and inflation fairly well supported for longer than anticipated but clearly the momentum in consumer spending should win as we go through 2023 especially as the labor market cools. So inflation should keep moving lower and the implication of that should be one, the bond market returns are likely to be positive both from an attractive level of yield perspective and capital appreciation perspective. Second, the dollar stabilizes, as it seems to be showing signs of at the moment, and potentially weakens as the year progresses. Now, the second driver of asset prices is the Fed. The shock and awe of the Fed’s tightening efforts are mostly in the rearview mirror, but it is widely expected that the Fed will keep raising the Fed funds rate. After four consecutive 75 basis point hikes, they will slow down in December - that’s the most likely scenario - to about a 50 basis point hike, but then they will keep going til they get to a level of 5% and 5.25% in early 2023 and after that, they should pause to assess the inflation and growth dynamics. This would be a mini pivot by the Fed then they are likely to hold rates at those elevated levels for some time because they want to ensure that inflation is truly brought under control so they don’t make the stop and go mistake of the 1970s when inflation came roaring back. As such, rate cuts or a full pivot could be further out til the job of anchoring inflation is achieved from the Fed’s perspective. The market implication of the Fed’s actions are one, the back end of the yield curve should see rates move lower given the weakening growth environment and the moderation in the inflation backdrop. Number two, further inversion of the yield curve as the Fed holds the policy rates at elevated levels. Number three, higher duration is likely to benefit. Number four, cash returns remain attractive. Number five, positive real yields keep fixed income in favor versus equities. Number six - during the second half of 2023, equity valuation multiples should stop declining and eventually rise in anticipation of relatively easier monetary conditions in late 2023 and in 2024. The third major driver is going to be corporate earnings. The inflation and rate shock of 2022 could give way to the earnings shock of 2023. Companies will have to manage through the slowdown in nominal GDP while margin pressures remain high due to the persistent of input cost, higher input costs especially for labor. Eventually layoffs will pick up, which is likely to further contribute to slowing demand and moderating revenues. However, the earnings decline in this cycle could be shallower than average during recession due to the healthier household and company balance sheets as a starting point. The necessary adjustment to earnings estimates for next year is coming through. EPS estimates for the S&P 500 currently are at roughly $234.00 a share. It’s down from roughly $243.00 a share in early October. Now, Q4 earnings is likely to be the catalyst for broader declines, taking estimates for next year’s levels to about $200.00 a share in our opinion. The market implication for weaker earnings are one, the first half of 2023 likely proves to be volatile for equities and declining earnings estimates should render any meaningful equity market rallies quite fragile. Number two, credit spreads have a widening bias especially for lower quality credit. Number three, there is a dispersion in returns based on earnings quality, sustainable dividends, and balance sheet strength. Number four - during the second half, a stabilization in declining earnings estimate creates conditions for a choppy end to the bottoming process for stocks. Finally, China is likely to be a major driver of the global macro picture in 2023. In the last 18 months or so, the Chinese economy and markets have been held back by zero Covid policy, regulatory overhauls, and a property sector downturn. In recent weeks, rising Covid cases and spreading protests is adding to the near term uncertainty. However, post the Communist Party Congress, the government has begun to support growth through a series of policy actions. For example, they have released the comprehensive 16 point package to support the property sector including providing access to funding for property developers to finish projects. Easing of tensions with the US somewhat with the meeting between President Biden and Xi, and rate cuts and liquidity released by the central bank. These, along with the potential for the economy to reopen gradually in the first half but more broadly in the second half, could lead to a strong recovery in output and improving risk sentiment. The market implication here is that one, it is a positive for Chinese assets and broadly for other countries that depend on China for consumption especially that cheap valuations exist in many of these international markets. Number two, it’s a positive for energy and commodity prices as strong Chinese demand comes back online.
Now, to round out the investment picture for next year, there are two major known unknowns. Wildcards, if you will, with enormous implications. The first is the Russia-Ukraine situation and the second is the Fed’s resolve to see the job through. Let me quickly touch on these. Regional conflicts rarely create a fog for the entire global economy, but the Russia - Ukraine situation is a bit of an exception. That fog is only getting denser with both countries continuing to dig in and the bar for negotiating remaining pretty high. The range of outcomes is wide from a broader conflict which could directly involve the US to a proxy war between NATO and Russia that goes on for years to a surprise and everlasting ceasefire. The outcome and timeline would have a major impact on the Euro for example, oil and gas prices and inflation dynamics and monetary policy especially for the Eurozone. The good news is that most countries in Europe have filled their gas reserves and fears of energy rationing have receded for this winter but medium to long term energy security remains an issue not just for Europe, but for much of the global economy. The implication here is that themes such as defense spending and energy security, both traditional and clean, should continue to garner investor capital. Second, on the Fed’s resolve to see the job through. The Fed’s choices in 2023 continues to be between bad and worse. For inflation to move to their target of 2%, a significant slowdown may be a necessary condition. For now, this bad option is one they and most investors seem to have accepted but the acceptance is more palatable today because the economy is humming along and employment is near all time highs and politicians see no reason to get in the Fed’s way but as job losses rise, market and economic stress pick up, and as congress is unable to provide any fiscal backstop and it pushes the blame on the Fed, will the Fed have the resolve to stay the course or will they choose the worst option of pivoting early thereby increasing the risk of inflation expectations pushing meaningfully higher? The implication here is that equities, a much more sentimental asset class, if you will, will likely rally with an early Fed pivot but if bonds, which in my opinion is a much more astute asset class, should sniff out this worse outcome policy mistake by pushing rates higher, this could lead to an uncertain and volatile macro environment for some time, eventually ending with a much more aggressive Fed policy environment to break the back of inflationary forces. So in summary, the major drivers for 2023 are falling inflation. Fed tightening policy at first, and then doing a mini pivot. The major pivot that is cutting rates comes much later. Corporate earnings declining and then finding some stability in the second half and China reopening and stimulating their economy and add to that two known unknowns - the outcome and timeline of the conflict in Europe and the Fed having the resolve or not to crush inflation even as economic strains pick up.
So I’ll end now with our recommendation for what investors should do as we enter 2023 and as always, this depends on the kind of investor one is and what their risk tolerance and time horizon is but most investors should remain fairly diversified across both traditional and alternative asset classes in this environment, but given that relative valuations are better for fixed income versus equities and the slowing in global growth, bonds should be favored in multi-asset portfolios in our opinion. As bond yields on the front end top out and most of the earnings downgrades are in the rearview mirror, the bottoming process for equities in our view will move into an advanced phase in the second half of 2023 but since no one can really pinpoint this time frame with accuracy, an investment strategy should never be set in stone. Weaknesses along the way in equity land should be used to leg into equities in a dollar cost averaging fashion. In the near term, increasing cash flows through bonds and dividends can support the total return potential of portfolios. You can get quality dividends within utilities and energy. These two happen to be the sectors that we prefer at the moment. Investors can also seek non-correlated sources of returns through hedge fund strategies like equity, long-short and global macro and long term growth oriented investors should be putting together their buy list with high quality free cash flow oriented growth names and as we progress through 2023, add selectively to thematic areas such as semiconductors, cloud, factory automation, clean energy, and healthcare investments. That will do it for the upfront comments for this December 1st Street Talk Call. Thank you for listening.
Operator: Please see important disclosures provided on this page.
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Chris Hyzy: This is Chris Hyzy, Chief Investment Officer, for the market update for November 28th. One point of interest over the weekend has been the continued bearishness on the part of investors as it relates to the overall equity markets, but risk assets in general. What we’re noticing is that many investors are still looking past this recent relief rally and overall considering the recessionary backdrop potentially for all of 2023. We think it’s important for all of us to step back, take a look at the fundamentals, mirror that with what’s going on in the market today, and try to figure out what has been discounted already. From our perch, we believe that it’s important to explore what we call the contrarian bull case. Investors so far have not shied away from letting their pessimism be known. That’s pretty obvious again, according to most statistics. Bears or investors who feel the near-term future direction in the market is lower continue to far outweigh the bulls in sentiment readings. According to the American Association of Individual Investors, bear sentiment has sat well above its historical average every week so far this year. The survey even saw consecutive weeks of the percent of bear stay above 60% in September; the first time in the survey’s history and a level surpassed only four other times. When we look at positioning, it also reflects extreme bearishness in the markets. Institutional portfolio cash levels have reached their highest amount since April of 2001. This is according to B of A Global Research. Concern over inflation, possible economic downturn, and again, geopolitical crises among other factors have all weighed on equity market expectations. So, we asked the question, “Is it really still a bear market overall?” Equity markets have not yet recovered from their technical bear market drawdowns, but history has told us that the S&P 500 has gone on to realize above average returns in the six- and 12-month periods that followed unusually high bearish sentiment readings. The S&P 500 hit an interim bottom in October following off the June bottom with the index down about 25% from its January high and has since seen a near term price recovery attempt with the index up about 13% off of that low. Now to be fair, much of the recent equity volatility has been sentiment driven, not fundamental driven. Stability in equity markets will likely only be found once the fundamental backdrop improves and is visible. Now, that shift in macro factors has not yet happened in our opinion. We do see some bright spots in the first half of next year, but we continue to believe that bonds outperform between now and the end of the second quarter of 2023 beginning with the pricing of recession risk at the back end of the curve. In other words, rates coming down following the path of inflation thereby supporting bonds outperforming only to pass the baton over to equities for the second half of the year. We do expect opportunities to present themselves in the first half of the year. For equity investors and for the diversified investors, we still believe that a diversified equity and bond portfolio overall for 2023 has a much better year than obviously ‘22, but overall on an average basis it supports our view that a diversified portfolio should have a robust overall 2023. Inflation further surprises to the downside in ‘23 is our number one surprise at this point. So, let’s take a look at the quick contrarian bull case. Let’s start with inflation. In other words, for fundamentals to continue to improve, we need to see inflation further surprise to the downside. Number two - as a part of the contrarian bull case, a dollar peak, in our opinion, has happened. A dollar peak and continue to retreat is what’s needed. Earnings don’t decline as much as anticipated is number three. Our view continues to be about a 9% decline according to B of A Global Research for all of 2023. That is pretty much discounted at this point. Number four, household and corporate balance sheets position to handle economic weakness. That’s what we see right now. Household balance sheets are still healthy. Corporate balance sheets are still healthy even in the face of heading into what we believe is a mild recession. Labor force participation rate needs to improve. It’s still early. We’ll be watching this closely. Those are the top contrarian bull case items to watch as we head into the beginning part of 2023. For now, we believe the cyclical bear market ends early next year and we support the view overall that a new bull market begins at some point in 2023. That’ll do it for today. Thanks for listening.
Operator: Please see important disclosures provided on this page.
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