Breaking insights on the economy, market volatility, policy changes and geopolitical events
PRELIMINARY MIDTERM ELECTION RESULTS SURPRISED MARKETS that had already priced in a decisive Republican sweep. “Leading up to the elections, we had seen the equity markets advance, particularly in the last couple of weeks,” says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank.
Instead, with votes still being tallied, Republicans now appear likely to take control of the House of Representatives by a slim margin, and Democrats have retained control of the Senate. Below, Dan Clifton, head of Washington Research for Strategas Research Partners, provides insights on the midterms and the likely impact on markets and the economy moving forward.
Why gridlock can be good for the markets
While gridlock can be a negative for the economy, markets respond favorably to the idea that a president or Congress may have a harder time enacting new spending, tax increases and regulation. A slimmer-than-expected Republican majority in the House, with Democrats holding on to the Senate, would still bring a degree of gridlock, Clifton notes. New tax increases or energy regulation would be unlikely over the next two years, for example, he says. But Republicans may be unable to slow the progress of existing bills such as the Inflation Reduction Act, promising billions of dollars in spending on green energy. “Historically, the combination of a Democratic president, Republican House and Democratic Senate has produced a 13.6% increase in the S&P 500 over the next year,”1 he adds.
The remainder of 2022 could be a key time to accomplish goals that benefit both parties, Clifton notes. For example, “Both parties have an incentive to hammer out a budget.” Washington may also find bipartisan agreement to raise the debt ceiling before the new Congress takes office, he adds. These actions would help avoid headaches for both parties next year, and they also could mollify markets, since pitched battles over budgets and debt ceilings are a type of gridlock that markets don’t like, Clifton says. Despite partisan tensions, lawmakers may also find common ground on the National Defense Authorization Act, funding the military, and on corporate tax credits, established during the previous administration, that are set to expire, he adds.
In anticipation of a larger Republican victory, markets had priced in a potential reduction in green energy spending. Now, “there may be a bit of a rally in clean energy stocks,” Clifton says. Infrastructure-related companies, too, may prosper as they begin to see a bump in spending related to 2021’s Infrastructure Investment and Jobs Act. In other sectors, the impact of the midterm elections may be overshadowed by the economic and market volatility that 2022 has already experienced, thanks to inflation, rising interest rates, geopolitical instability and other factors, Clifton notes. Biotechnology and pharmaceuticals, meanwhile, will likely continue to perform well in a time of inflation.
Heads are already turning to the election two years from now, which will include a presidential race. “The market will start anticipating outcomes almost immediately,” Clifton notes. With the potential for races focusing less on partisan hostility and more on policy matters, he says, “I think the 2024 election is going to be one of the great elections of our lifetime.”
To hear the complete conversation between Hyzy and Clifton, recorded on November 9, listen to the “Special CIO Post-election Market Update Call.” For regular insights on the markets and the economy, tune in to the CIO Market Update audiocast series.
1 Strategas Research Partners, based on FactSet S&P 500 data.
AT A TIME OF SHARP INFLATION, rapidly rising interest rates, uncertainty around the midterms and other pressures, the approaching Nov. 8 elections have already seen the fourth-largest midterm drawdown since 1950, says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank. But, historically, midterm market volatility has been followed by market growth lasting through the first half of the following year. In fact, “the average gain from the midterm market low point, one year after the election, is about 32%,”1Hyzy notes.
However, because this time around any potential market rally might be delayed by a mild recession, Hyzy encourages investors to look to the future. “With great resets come great opportunities,” he says. The outcome of the midterms could determine where some of those potential investment opportunities lie.
With inflation and the economy at the forefront of voters’ minds in 2022, “Republicans appear in pretty good shape to win back control of the House of Representatives,” says Jim Carlisle, head of Federal Government Relations at Bank of America. The Senate remains too close to predict, he says, adding that a split Congress would result in gridlock.
With no new legislation getting through, Democrats would likely shift to implementing infrastructure and green energy projects paid for under bills that have already passed. “Republicans would likely focus on crime, energy independence and border security,” notes Carlisle. Areas of common ground might include regulating crypto assets and enhancing digital privacy.
With so many unknowns, investors should stay diversified and avoid trying to time the markets based on short-term predictions, Hyzy notes. “Now is a good time to step back and take a deep breath,” he says. “Between the midterms and year-end, we should get a better view of corporate profits and momentum for next year.” In the meantime, investors can consider the following three strategies.
For more midterm market perspectives, listen to “Midterm Market Effect: What to Look for After the Election,” and read “Midterm Elections 2022: Potential Outcomes and Investment Implications.”
1 Strategas Research Partners, Chief Investment Office. Data as of October 14, 2022.
AMID INFLATION, RISING INTEREST RATES, MARKET VOLATILITY and geopolitical conflict, the November 8 midterm elections may be drawing less attention than usual from financial observers, says Marci McGregor, senior investment strategist for the Chief Investment Office, Merrill and Bank of America Private Bank. “In a typical midterm year, this would be the dominant subject,” she says. Yet while the elections may be competing for headline space, investors should not discount their potential impact on policy, the economy and markets, she adds.
For perspectives on the elections, what a shift in Congressional power could mean, and likely next moves from the Federal Reserve (the Fed), McGregor turned to Libby Cantrill, head of public policy for the global bond firm PIMCO.
While there’s no sure way to predict outcomes, midterm elections historically tend to work against whichever party currently holds the White House, especially during a president’s first term, Cantrill says. “Since World War II, the party in power has lost an average of 26 seats in the House of Representatives and four in the Senate.” As in previous midterms, a party turnover may be likeliest in the House, where all 435 seats are up for election, versus 34 of 100 Senate seats, she adds.
Over the past two years, new laws such as the Inflation Reduction Act have passed with slim margins along party lines. A change in control in one or both houses of Congress would likely bring “gridlock, meaning that the administration’s legislative agenda is completely frozen,” Cantrill says. For the next two years at least, that would likely mean no new changes to the tax code. Additionally, “a shift in Congress would throw sand in the gears of regulatory efforts — and investment markets may favor the prospect of fewer business regulations,” she adds.
“The downside, if Congress flips, is that we should expect more policy volatility around things that are relatively routine. So funding the government becomes much more difficult,” Cantrill says. Gridlock could lead to potential government shutdowns, as well as protracted battles over everything from the debt ceiling to the administration’s new student loan forgiveness policy and fiscal support for the economy in the event of a recession. “I liken it to the fiscal punchbowl being taken away,” Cantrill says.
Regardless of the election results, the Fed is likely to continue raising interest rates until inflation comes under control, Cantrill believes. That’s because the Fed is worried that inflation is becoming more entrenched. Further rate hikes could lead to a “hard landing” for the economy, she adds. “The degree of recession, though, if we have one, is an open question. Our base case is that it would be a shallow but persistent recession, but there is more downside to that growth prediction, meaning we could see a deeper recession.”
Tune in to Merrill’s CIO Market Update audiocast series, for regular insights on the markets and economy.
THE LATEST INTEREST RATE HIKE by the Federal Reserve (the Fed) sent the Dow Jones Industrial Average to a new low for the year on Friday.1 Though Wednesday’s .75% rate increase (the third in a row) was widely anticipated, the markets’ downturn has gathered speed as the Fed and central banks globally struggle to contain stubbornly high inflation.
“We believe markets are in a ‘reset phase,’ trying to simultaneously price in higher rates, a stronger dollar, lower economic growth and earnings, and heightened geopolitical risk. This takes time,” says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank. “Investors should expect markets to remain choppy through the end of the year.”
Stocks aren’t the only asset class that has struggled, Hyzy notes. “Bonds have been selling off, and gold and oil prices have declined, signaling that investors are moving toward an ultra-defensive tone.”
As with the markets generally, individual investors should be thinking defensively, Hyzy suggests. That could mean reducing your exposure to stocks, for conservative investors, or increasing your proportion of utilities, healthcare and other “defensive stocks” that tend to outperform other stocks during volatile times. Bond investors, meanwhile, may want to increase their exposure to long-term government bonds.
Another key point is diversification, across and within asset classes, to help mitigate volatility, Hyzy adds. And while a defensive posture is warranted, investors with a long-term view should look for attractively priced stocks over the next three to six months that could benefit as the economy and markets stabilize.
For weekly insights on market volatility, tune in to the “CIO Market Update” audiocast series.
1 The Wall Street Journal, “Dow Drops to Lowest Level of 2022 as Growth Fears Roil Markets,” Sept. 23, 2022.
THE QUEST FOR A SUSTAINABLE FUTURE — a key theme of this week’s global Climate Week NYC 20221— has spawned a growing movement away from the long-time global economic model based on consumption and disposal. Instead, businesses, governments and environmental leaders are taking steps to foster what economists call a “circular economy,” which shrinks waste and pollution by keeping products and materials in circulation longer, and by regenerating natural resources rather than simply extracting them.2
Based on current consumption trends, experts estimate that by 2030, the world will need two times the Earth’s resources just to keep up with demand.3 “That path, which we’ve been on for centuries, is no longer viable,” believes Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. “Fundamental change, while complex and difficult, has the potential to benefit businesses, consumers and countries both environmentally and economically,” he adds. “Circular Economy,” a recent report from the Chief Investment Office (CIO), explains what’s involved and how investors can take part.
A circular economy is based not just on recycling, but also on designing waste and pollution out of the system wherever possible. To cite just one example, some clothing manufacturers are now using innovative processes to break down fabric from old garments to make new products.4 Such developments are poised to capture consumers’ growing interest in sustainability, Hyzy notes—according to one estimate, the clothing resale market will exceed the fast fashion market by 2030.5
Another key element of the circular economy involves better managing biodegradable waste. Instead of material simply being dumped, usable byproducts are recycled, remanufactured and redistributed for use, while unusable byproducts are carefully maintained so that they can be safely absorbed back into the earth.
While the circular economy represents a broad concept rather than specific investments, says Hyzy, “Investors who potentially incorporate environmental risk factors into their portfolios may support the transition, while at the same time positioning themselves for potential financial returns.” For example, you might consider supporting industries working towards net-zero carbon emissions. For more ideas, read “The World Is Changing — Should Your Investments?” and “What Could Climate Change Mean for Your Investments?”
“But keep in mind that ESG, however vital, is just one factor to consider when building an investment portfolio,” Hyzy cautions. Before making decisions, make sure any investments fit comfortably with your long-term goals.
2 Ellen MacArthur Foundation.
3 Overshootday.org and Global Footprint Network, July 2021.
4 Ellen MacArthur Foundation.
5 Absolute Strategy Research, “Investment Themes for an Uncertain Transition,” January 2022.
THE DOW JONES INDUSTRIAL AVERAGE DROPPED nearly 1,300 points Tuesday on news that the Consumer Price Index (CPI) rose by 8.3% for August, compared with August 2021. While that number actually represents a slight dip from July’s 8.5% year-over-year number, economists and investors had hoped to see inflation ebbing faster. Disappointment set off the steepest one-day market sell-off in more than two years.1
“Unfortunately, the recent drop in gas prices was offset by higher prices in areas such as shelter and food,” says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank. Core inflation, which does not include gas and food, also rose more than expected. As a result, markets expect the Federal Reserve (the Fed) to raise interest rates by at least another .75% when it meets next week, he adds.
“Inflation may have peaked over the summer, but it remains well above the Fed’s target of 2%,” Hyzy says. “Therefore, we expect to see continued choppy markets over the near term.” Tuesday’s drop, ending an extended rally through much of July and August, should be seen in the context of a post-pandemic “reset period” of uncertainty and mixed signals, he adds. “We expect the reset to last six to nine months, after which we should see a return to more normal market valuations.”
Given the likelihood of volatility for months to come, investors may want to consider defensive steps for their portfolios, Hyzy suggests. Depending on your situation, that may mean adding so-called defensive stocks, such as utilities and healthcare, which tend to offer stability and consistent returns even when the economy and markets struggle. For more conservative investors, that could mean reducing your exposure to equities. Still, long-term investors may find strategic opportunities to buy equities that could perform well as the economy and markets stabilize. “We continue to suggest maximizing diversification across asset classes and positioning yourself for the long term,” he says.
1 The Wall Street Journal, “Stocks Suffer Worst Day Since June 2020,” Sept. 13, 2022.
STRONG INFLATION-FIGHTING WORDS from the Federal Reserve (the Fed) spurred a 1,000-point drop in the Dow Jones Industrial Average last Friday.1 And that may be a prelude to a September marked by intermittent volatility as the Fed continues to raise interest rates and tighten the money supply, says Chris Hyzy, Chief Investment Officer, Merrill and Bank of America Private Bank.
“Markets were prepared for Fed chair Jerome Powell to signal ongoing tightening, but they were not prepared to hear terms such as ‘purposely,’ ‘forceful’ and ‘some pain,’” as he discussed the prospects for future rate hikes to tame inflation at last week’s Jackson Hole Economic Symposium,2 Hyzy says. “These words indicate that interest rates will likely stay higher and the money supply will be tighter for longer than markets had anticipated.” And that, in turn, signals a higher cost of capital, which eventually means slower growth, he adds.
“The combination of monetary tightening and weaker growth likely creates a formidable headwind for stocks and other risk assets,” says Jonathan Kozy, Senior Macro Strategy Analyst for the Chief Investment Office (CIO), Merrill and Bank of America Private Bank. And the Fed has few options but to stay the course. “It will be difficult to pivot away from its current policy of rate hikes and monetary tightening, since inflation is still running hot,” adds Kozy, author of a recent CIO Capital Market Outlook report.
In terms of the economy and markets, “It’s no longer a question of whether we are aiming for a soft landing; it’s now more about how to avert something much harder,” Kozy adds. “For now, we expect to see consolidation in equity markets and see-saw trading as more data is released. There are still plenty of unknowns.” Among them, how high the next rate hike, scheduled to be announced at the Fed’s September 20-21 meeting, will be.
The current situation is grounds for caution and adhering to a long-term strategy and goals, rather than taking abrupt or drastic action, Hyzy says. “As we carefully follow each development, we recommend staying on guard, balanced and diversified. We maintain a neutral view on equities, as risks to economic growth and corporate profits remain.” Further in the Fed hiking cycle, long-term equity investors may find buying opportunities at attractive prices, he adds, and high-quality bonds continue to be an important way to diversify and protect a portfolio.
For more insights from the CIO, read “Your Frequently Asked Questions on Volatility Answered” and tune in regularly to the CIO Market Update audiocast.
AFTER WEEKS OF NEGOTIATING, last Friday the House of Representatives passed the Senate version of the Inflation Reduction Act of 2022, and this Tuesday the President signed it into law.1 Despite its name, the bill may be more remarkable as “the single biggest climate investment in U.S. history,” says Mitchell Drossman, head of National Wealth Strategies in the Chief Investment Office for Merrill and Bank of America Private Bank.
The bill’s $369 billion in spending on energy security and combating climate change will cut domestic carbon emissions by about 40% by 2030, its Senate backers say.2 Meanwhile, the bill promises to generate approximately $762 billion by raising revenue and controlling costs via a combination of new corporate taxes, price controls on Medicare prescription drugs and enhanced IRS enforcement. A new Chief Investment Office Tax Alert, “Inflation Reduction Act of 2022: From December Shocker to July Surprise!” details the bill’s provisions.
“The bill provides an assortment of credits, ranging from consumer home-energy rebate programs to consumer tax credits for those making their homes more energy-efficient and manufacturing incentives for corporations investing in on-shore clean-energy initiatives. It also pays for a $64 billion, three-year extension of subsidies for people who buy health coverage under the Affordable Care Act, designed to limit the impact of potential premium hikes. In addition, it places an annual limit of $4,000 in 2024 and $2,000 starting in 2025 on out-of-pocket drug spending for Medicare beneficiaries and caps their out-of-pocket insulin expenses at $35 a month. The remaining $300-plus billion is slated to go towards deficit reduction.
Among the key provisions is a 15% minimum tax on large corporations’ “book income,” aimed at closing the gap between the income they report to shareholders and the income that appears on their tax returns. Beginning in 2023, the tax, which would affect more than 100 major companies and raise an estimated $222 billion over a 10-year period, could change the way those companies expense equipment and capital improvements, Drossman says.
Another $74 billion would come from an excise tax of 1% on stock buy-backs (or repurchases) by publicly traded companies, starting in 2023. “A number of exclusions apply,” Drossman notes. “For example, no excise tax would be due on repurchases that are contributed to an employee pension plan or employee stock ownership plan.” Still, companies subject to the tax might accelerate planned repurchases to make sure they take place before the tax goes into effect, he adds. Stock buy-backs tend to boost share prices and earnings per share to investors in the short term, notes Drossman.
The bill would also reduce government spending by $265 billion by allowing Medicare to negotiate for prescription drug prices, starting in 2026. “Another $80 billion in investments in IRS modernization, compliance and enforcement measures are expected to yield $204 billion in additional tax collections over 10 years, for a net revenue increase of $124 billion,” Drossman says.
“Just because you call it the Inflation Reduction Act doesn’t mean it’s so — at least in the near term,” Drossman says. It’s unlikely to bring immediate relief to consumers stretched by higher costs for food, gas and other goods. “While drug price controls will bring down costs and, likely, some inflation, those controls don’t kick in until 2026 and therefore won’t have short-term benefits.”
IN ITS ONGOING FIGHT AGAINST INFLATION, the Federal Reserve (the Fed) on Wednesday hiked interest rates by .75% for the second month in a row — the largest two-month increase since the 1980s.1 This marked the fourth time the Fed has raised rates in 2022, after years of near-zero interest rates and low inflation.
In his remarks explaining the rate hike, “Chair Jerome Powell clearly stated the Fed will do what is necessary to break the back of inflation, and the markets applauded that commentary,” says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank. The S&P 500 rose by 1.8% on Wednesday. The Dow Jones Industrial Average rose .8% and the tech-heavy Nasdaq Composite index jumped 3.2%, boosted also by better-than-anticipated earnings reports from some tech companies.2
Following Wednesday’s Fed announcement, the Bureau of Economic Analysis on Thursday reported that U.S. GDP dropped by .9% in the second quarter, the second quarterly decrease in a row, surprising economists who had expected a slight increase.3 While two significant consecutive declines in GDP often signal a recession, “technically, we’re not there yet,” believes Hyzy. “But the probability is rising for a mild recession later this year or early next year,” he says.
At least initially, markets shrugged off the GDP news and talk of a potential recession, with the S&P 500 gaining another 1.2% on Thursday, and the Dow and the Nasdaq posting similar gains.4 In part, this could reflect that markets are concerned mainly with inflation and are already pricing in the impact the Fed’s higher rates and tighter money supply would have on GDP, Hyzy believes.
In his announcement, Powell signaled the possibility of another large increase at the Fed’s next meeting in September, saying that the decision will depend on the data we get between now and then. “We foresee rate hikes continuing to the end of the year and most likely into the beginning of next year,” Hyzy says. “If the Fed pauses these increases, it will be because its preferred measure of inflation, the core PCE price index, is coming down aggressively,” he adds. The core PCE (for “personal consumption expenditures”) excludes two items, food and energy, where rising prices have hit consumers hardest. The Consumer Price Index (CPI), which includes food and energy, will need to drop before markets — and consumers — believe inflation has turned a corner, Hyzy believes.
Until a clearer picture emerges on inflation and the economy, investors should think defensively for the second half of the year, Hyzy suggests. That could mean lowering your exposure to high-growth stocks such as technology, and increasing proportionally to high-quality, dividend-producing companies in areas such as utilities and healthcare.
While rising rates may lower the value of bonds you own, their higher yields are making bond income attractive for the first time in years, he adds. An approach known as bond laddering, investing in bonds that mature at different times, could help you capture rates as they rise, to maximize your income.
For more ideas for the balance of the year, watch “Midyear outlook: Turning volatility into opportunity.” And tune in weekly to the CIO Market Update audiocast series.
THE LATEST INFLATION NUMBERS, announced this week, came in much higher than expected. The Consumer Price Index (CPI) rose 9.1% from June 2021, according to the Bureau of Labor Statistics (BLS). That’s the largest such increase in more than 40 years.1 A 41.6% surge in energy prices helped drive the increase, followed by a 10.4% increase in food prices. Coming on the heels of May’s 8.6% year-over-year rise, the June news dampened hopes that the economy might be ready to turn the corner on inflation.
But the inflation news hasn’t been all bad. The BLS report showed core inflation (not counting energy and food) increasing by only 5.9% over June 2021, a slightly lower rate of growth than May’s 6%.2 And despite the June energy numbers, gas prices nationally have declined somewhat in recent weeks. Yet volatile energy prices could easily go higher again, and the sharp jump in the CPI virtually guarantees that the Federal Reserve (the Fed) will continue raising interest rates and tightening the money supply in hopes of bringing inflation under control.
“The most important question right now,” says Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank, “is how much corporate earnings could contract as the Fed continues its tightening policies.”
The Fed is likely to raise rates by another .75% at the end of July, with some analysts weighing the possibility of a full 1% hike — a move the Bank of Canada just made.3 What that might mean for the economy is uncertain. Consumer spending, while declining in the face of higher prices, is not as yet signaling a recession, believes Hyzy.
“We are in a ‘reset’ period, moving from maximum liquidity and low rates to minimum liquidity and higher rates,” Hyzy says. If inflation turns the corner soon, “we believe that corporate earnings will decline at most by 10%, after which a new cycle of economic growth could begin.” But if the Fed is forced to continue raising rates and tightening the money supply, the economy could tip towards recession, with a much steeper drop in earnings. “Markets are likely to remain volatile until the inflation, interest rate and liquidity picture becomes clearer through the second half of 2022,” Hyzy adds.
For the time being, we suggest a more defensive approach to investing, says Hyzy. “In our multi-asset portfolios we have lowered equities to neutral from slightly overweight by lowering exposure to small-cap stocks,” he notes. Investors may want to consider defensive stocks such as consumer staples and utilities and less emphasis on areas such as materials and consumer discretionary stock. Bonds remain important for diversification, and amid rising rates, “bond yields will become attractive again.”
Hyzy adds, “We believe that in the next six to nine months, long-term investors may see a very important buying opportunity,” with the ability to add securities at attractive prices at the onset of a new growth period.
For more CIO insights and strategies to consider, read “From the Great Separation to the Reset Period,” and “Fine-tune Your Investments for Rising Inflation — and Slower Growth.”
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You have choices about what to do with your 401(k) or other type of plan-sponsored accounts. Depending on your financial circumstances, needs and goals, you may choose to roll over to an IRA or convert to a Roth IRA, roll over a 401(k) from a prior employer to a 401(k) at your new employer, take a distribution, or leave the account where it is. Each choice may off er different investments and services, fees and expenses, withdrawal options, required minimum distributions, tax treatment (particularly with reference to employer stock), and provide different protection from creditors and legal judgments. These are complex choices and should be considered with care.
Diversification does not ensure a profit or protect against loss in declining markets.
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