During the weeks following this year’s summer solstice (occurring in 2022 on June 21st, at 5:14 AM Eastern Daylight Time), financial market participants began to entertain the notion that the Federal Reserve might be seriously considering a late-2022 or early-2023 rotation (often described as a “pivot”) toward reducing or ending its restrictive monetary policy. As a result, from its June 16 closing low of 3666.77, the S&P 500 rallied +16.8% to close at 4283.74 on August 18th.
Yet following: (i) Fed Chairman Jerome Powell’s August 26th speech at the Central Bankers Symposium in Jackson Hole, Wyoming, and then (ii) Chair Powell’s news conference commentary after the FOMC’s September 21 FOMC policy meeting, stock and bond prices have tended to trace a generally declining path as the Fed has: (1) decisively underscored its commitment to restoring price stability; (2) reiterated the fact that a considerable amount of monetary tightening likely remains in the pipeline; and (3) indicated that the interval of elevated policy interest rates could very well pertain for a lengthier-than-anticipated duration, perhaps extending through 2023 or even longer. In response, through Tuesday, September 27, the S&P had declined -6.5% over six consecutive trading sessions — representing the first time the S&P 500 had recorded a decline extending that many days since February 2020, when financial market participants initially began to be unnerved by the beginning of the coronavirus pandemic.
Against a backdrop of tightening monetary policy, heightened geopolitical tensions, weakening economic data (including six consecutive months of contraction for the Leading Economic Indicators index — which has not occurred since the beginning of the Global Financial Crisis 15 years ago), enervated business and consumer confidence, unusual currency movements, a preponderantly risk-off atmosphere over the past three quarters for equities, and U.S. midterm elections on Tuesday, November 8th, investors should prepare for volatility in October and the remaining months of this year.
The nearby chart depicts the essentially sideways movement of the Dow Jones Industrial Index in the midterm year of the four-year election cycle in the U.S. over the past 120 years. And covering the past 71 years, from 1950 through late 2021) the adjacent chart shows that the average annual price return of the S&P 500 index during midterm election years (+5.9%) is materially below all non-election years (+12.1%), and even presidential election years (+7.2%).
Emphasizing all of the caveats associated with averages calculated over a 60-year time frame, from a seasonal standpoint, the nearby chart shows that on average, almost all of the S&P 500’s returns are generated in the six months from November 1st through the following year’s April 30th (perhaps one of the ancestral origins of the age-old stock market adage “Sell in May and go away”.) From an economic cycle standpoint, the adjacent chart shows that during the Late Cycle and Recession/Downturn phases of an economic regime — which in our opinion characterizes current conditions — portfolio emphasis should be placed on risk management, high-quality securities, and stable income generation.
We recognize that a hawkish Federal Reserve, high rates of inflation, and high interest rates, plus the likelihood of potentially disappointing corporate revenue growth and unfavorable earnings outcomes, may already be well reflected in the year-to-date return through September of -24.8% for the S&P 500. In the post-1970 era, as shown in the nearby chart, when September’s S&P 500 price performance has been negative -7.0% or worse, October’s price performance has averaged +4.3% (with a median price return of +7.1%) and has been positive 83.3% of the time, with the sole exception of September 2008, when the S&P declined -16.9% during the onset of the 2008-2009 Global Financial Crisis.
With the 2022 year-to-date drawdown of -23.3% through September 26th (as shown in the nearby chart) ranking among the S&P 500 price declines of 1974 (-29.7%), 2002 (-23.4%), and 2008 (-38.5%), we hasten to point out that: (i) corporate balance sheets and the capital position of America’s commercial banking industry appear to be in decent shape; (ii) aggregate household savings levels, liquidity, and money market balances — although drawn down somewhat from peak levels — remain substantial; and (iii) a significant degree of pessimism and variation already prevails (often a short-term contrarian indicator, and thus moderately bullish), as reflected in the nearby charts showing (1) the quite elevated percentage bearish readings in the weekly American Association of Individual Investors Survey (the first time on record that the AAII Bearish Sentiment reading has exceeded 60% for two weeks in a row), and (2) the extreme bearishness of the Bank of America Bull and Bear Indicator, reflecting “investor sentiment unquestionably worse since the Global Financial Crisis of 2008-2009.”
What Direction Do All Members Feel The Stock Market Will Be In The Next 6 Months?
As investors enter the tenth month of 2022, it can be seen in the nearby chart that on average over the 94 years from 1928 through 2021 inclusive, the month of October – with its historical +0.5% price gain for the S&P 500 – ranks tied for eighth among months in more than nine decades of monthly performance ranking. It is worth repeating that these nine-decade results are averages, with a given month’s outcome having the potential to vary above or below the long-term average. According to Investors Business Daily, October has generated an average +2.7% price increase in midterm election years.
And as highlighted in the nearby price performance table, after falling -4.8%, -4.7%, and -2.9%, respectively, in the last three weeks of September, the S&P 500 declined -9.3% (closing at 3585.62 on September 30th versus 4955.00 on August 31st). The technology-heavy Nasdaq Composite fell -10.5% in September, closing at 10575.62, and the Russell 2000 index of small- and mid-cap companies declined -9.7% over the month, to close at 1664.72.
Over the course of September, West Texas Intermediate crude oil prices declined -11.2%, from $89.55 per barrel on August 31st to $79.49 per barrel on September 30th. The global oil demand side continues to reflect signs of China’s Covid-19 lockdown measures; slowing momentum in the global economy; fuel shortages; currently low levels of inventories; and precautionary buying, while on the supply side: (i) the seven-month Russia-Ukraine conflict continues to create significant demand and supply disruptions; (ii) several nations, especially the U.S. and including certain allies, have launched the release of crude oil from their respective Strategic Petroleum Reserves; (iii) Iran continues with the nuclear talks begun on November 29th, which could in theory increase the supply of Iranian oil officially entering global oil markets if economic sanctions on Iran are relaxed; (iv) facing pressure from investors to moderate growth and address their emissions amid concerns about increasing regulations and climate change, large U.S. and European oil companies have continued to spend sparingly to boost production, even as certain major oil companies have halted and/or completely exited their Russian activity; (v) consolidating U.S. shale producers have exercised financial probity; have not excessively increased output; have followed production discipline and exerted capital spending restraint; and (vi) at the 32nd OPEC+ Ministerial Meeting on Monday, September 5th, the organization (which includes Saudi Arabia, Russia, the United Arab Emirates, Kuwait, Iraq, and other countries) decided to cut production targets by 100,000 barrels per day for October, and scheduled its 33rd meeting (in Vienna on Wednesday, October 5th, the first in-person meeting since the Covid-19 pandemic began in 2020).
During September, the U.S. dollar rose +3.1% versus the DXY index, comprised of six major currencies (the Euro, Japanese yen, British pound, Canadian dollar, Swiss franc, and Swedish krona). On September 30th, the DXY index closed at 112.12, +16.8% versus its level of 95.97 on December 31st, 2021.
Reflecting a significant degree of competition from higher short-term interest rates and a stronger U.S. dollar over the course of the past month, the daily spot gold price (as logged by USA Gold) closed at $1,660.60 per troy ounce on September 30th, down -2.8% during September and down -9.2% from its close of $1,829.05 per troy ounce on December 31, 2021.
In the accompanying table, September month-end closing yield levels are shown for 2-year, 10-year, and 30-year U.S. Treasury securities, and these monthly data are used to compute the year-to-date 2022 yield level changes (expressed in basis points), also highlighted nearby.
For 2-year U.S. Treasury securities, yields rose 77 basis points in September to 4.22% at month-end, where they are up 349 basis points (3.49%) since their closing level of 0.73% on December 31st, 2021.
For 10-year U.S. Treasury securities, yields climbed 68 basis points in September and closed at 3.83% at the end of the month, where they are up 204 basis points (2.04%) since their closing level of 1.52% on December 31st, 2021.
For 30-year U.S. Treasury securities, yields increased 52 basis points in September and reached 3.79% at the end of the month, where they are up 189 basis points (1.89%) since their closing level of 1.90% on December 31st, 2021.
The Way Ahead
The following discussion reviews several of the key factors that we consider at this time to be likely to exert meaningful influence on financial asset prices in the interval ahead.
Slowing Economic Growth: Representing the governments of 37 market-based countries which collaborate to promote sustainable economic growth, the Organization for Economic Cooperation and Development (OECD) on September 26th published its latest Interim Economic Outlook, containing analysis and projections for the world economy and all G20 countries. The nearby chart displays the OECD’s updated GDP growth projections for 2022 and 2023. It can be seen that global real GDP growth is projected by the OECD to slow from +3.0% in 2022 to +2.2% in 2023, well below the pace which had been projected prior to Russia’s February 24th invasion of Ukraine. For the United States, which experienced +5.7% real GDP growth in 2021, annual real GDP growth is projected by the OECD to slow sharply, to +1.5% in 2022 and + 0.5% in 2023. For the 19-country Euro Area, real GDP growth is projected by the OECD to decline from +3.1% in 2022 to +0.3% in 2023 (with risks of actual GDP declines in several European economies during the winter months). Amidst Covid-19 shutdowns and property market weakness, real GDP in China is projected by the OECD to advance by +3.2% in 2022, with policy support currently projected to help achieve +4.7% GDP growth in 2023.
The OECD’s Interim Economic Outlook also forecasts headline and core (ex food and energy) inflation projections for the G20 countries. The nearby chart displays the OECD’s updated headline inflation projections for 2022 and 2023.
It can be seen that inflation has become broad-based in numerous economies, with easing supply bottlenecks and tighter monetary policy projected to moderate inflation pressures in 2023 even as elevated shelter prices and higher labor costs appear likely to impede the pace of decline. Most major economies are likely to pursue further monetary policy tightening through interest rate increases and other measures in order to anchor inflation expectations and establish that inflation pressures are durably reduced. For the United States, headline inflation is projected by the OECD to be +6.2% for 2022 before declining to +3.4% in 2023. For the Euro Area, headline inflation is projected by the OECD to reach +8.1% in 2022 and ease off somewhat to +6.2% in 2023. For China, inflation is projected by the OECD to rise from +2.2% in 2022 to +3.1% in 2023.
Additional perspective on the outlook for U.S. real GDP growth, employment levels, and inflation for each year from 2022 to 2024 — and over the longer run — is contained in the quarterly Summary of Economic Projections (SEP) released in conjunction with the Federal Open Market Committee meeting held on September 20-21. The nearby bar chart and the accompanying table set forth the economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy. The term “FOMC participants” encompasses the members of the Board of Governors and all presidents of the 12 Regional Federal Reserve Banks. The term “FOMC members” includes the voting members of the FOMC — namely, the members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and 4 of the remaining 11 Reserve Bank presidents who serve one-year terms on a rotating basis.
It can be seen in the chart and in the table that FOMC participants’ median projections of U.S. real GDP growth is +0.2% for 2022, +1.2% for 2023, and +1.7% in 2024; the average civilian unemployment rate in 4Q2022 is estimated to be 3.8%, in 4Q2023 4.4%, and in 4Q2024, 4.4%; Headline Personal Consumption Expenditures (PCE) inflation is estimated to be +5.4% in 2022, +2.8% in 2023, and +2.3% in 2024; and Core (ex food and energy) PCE inflation is estimated to be +4.5% in 2022, +3.1% in 2023, and +2.3% in 2024. Given these assumptions and projections, FOMC participants’ policy interest rate projections represent the value of the midpoint of the projected appropriate target range for the fed funds rate at the end of the specified calendar year — 4.4% at year-end 2022, 4.6% at year-end 2023, and 3.9% at year-end 2024.
With consumer and corporate demand experiencing downward momentum and profit margins being squeezed by upward pressure on labor, interest, and selected input costs, according to the FactSet Earnings Insight report of September 30th, for 3Q22, S&P 500 companies are expected to report earnings growth of +2.9% (which would represent the lowest growth rate since the -5.7% earnings decline experienced in 3Q2020) and revenue growth of +8.7%. For 4Q22, analysts are projecting earnings growth of +4.0% and revenue growth of +6.2%. For the full year 2022, analysts are projecting earnings growth of +7.4% and revenue growth of +10.7%. For 1Q23, analysts are projecting earnings growth of +6.5% and revenue growth of +5.9%. For 2Q23, analysts are projecting earnings growth of +5.5% and revenue growth of +3.9%.
For calendar year 2023, analysts are projecting earnings growth of +7.9% and revenue growth of +4.4%. These FactSet projections are essentially corroborated by the nearby chart, showing the Yardeni Research and Analysts’ Consensus 2009-2017 year-by-year (and over the 2018-2022 time frame, quarter-by-quarter) earnings and forecasts for the S&P 500 companies. In our estimation, incorporating our assessment of recession-risk odds at 20%-30% for 2022 and 60%-70% for 2023, S&P 500 profitability is likely to be buffeted by the twin forces of weakening demand and rising input costs (including interest costs). Barring exogenous shocks, aggregate 2023 S&P 500 earnings appear likely at this point to end up calendar 2023 somewhere in the range of $215-$230.
Among the significant determinants of whether these earnings estimates can be achieved — or whether they will be subject to further meaningful downward revisions — are those set forth in the discussion below.
Decelerating U.S. Corporate Profit Growth: In real terms after inflation, U.S. GDP decreased at an annual rate of -1.6% in 1Q22 and -0.6% in 2Q22, with the GDPNow forecasting model of the Federal Reserve Bank of Atlanta projecting (as of Monday, October 3rd) an annual rate of growth of +2.3% for 3Q22. Anemic revenue and output growth tend to exert downward pressure on corporate profit margins and aggregate earnings.
Vitiated Overseas Earnings Generation: Foreign earnings represent an important component of the profits of the U.S. multinational companies which populate the S&P 500 index. These earnings are projected to be subpar, due not only to: (i) the lackluster prevailing economic and business conditions in Europe, Asia, and numerous other overseas economies (as highlighted above in the OECD Interim Economic Outlook discussion); but also owing to (ii) the strong U.S. dollar, which hinders U.S. companies’ exports and exerts downward pressure on the repatriated dollar value of earnings generated in countries whose foreign exchange values have depreciated meaningfully versus the U.S. currency.
Higher Interest Costs for Households and the Corporate Sector: As shown in the nearby chart, the FOMC has been hiking rates further and faster than any time in modern history, raising borrowing costs for consumers and businesses.
Labor Market Tightness: Upward pressure on labor costs has been a persistent characteristic of this year —represented by the weekly lows in initial jobless claims for unemployment insurance, as shown in the nearby chart — with a lack of available labor and unbalanced labor market conditions reflecting robust economic conditions, keeping pressure on inflation-fighting actions by the Fed while at the same time exerting downward pressure on corporate profit margins.
Household Wealth Drawdowns: Perceived and actual declines in the aggregate net worth of the household sector can lead to weakening effects on consumer psychology and spending. Some meaningful portion of the decelerating hit to personal consumption derives from the first six months of 2022’s -$13 trillion retreat in equities market capitalization as well as a -$3 trillion decline in the market value of U.S. high-grade bonds.
Housing Sector Fragility: Hindering the economic contribution of the housing sector have been: (i) sharply escalating mortgage financing costs (a depicted in the nearby chart); (ii) constrained demand; and (3) increased supply. Housing represents a key driver of investment, employment, and consumption (especially of appliances and home furnishings), and according to Barron’s, economic theory holds that a -$1.00 decline in housing values translates to a $0.40 reduction in spending (almost 4 times the effect of a $1.00 dollar decline in equity prices).
As of early September, having declined for seven consecutive months and having reached their lowest level since May 2020, existing home sales are down -27% from their peak and -25% thus far in 2022; new home sales are down -50% from their peak and -40% year-to-date; and the 1.7 million in aggregate new homes under construction exceeds the total experienced in the pre-2008 housing bubble.
According to mortgage data provider Black Knight Inc., marking the largest monthly declines since January 2009, median home prices fell -0.98% in August month-over-month, following a -1.1% decline month-over-month in July. And the downward-turning S&P CoreLogic Case-Shiller 20-City Composite Home Price Indexes on a month-over-month basis and a year-over-year basis are shown in the two nearby charts.
Inflation Vectors: The forces of inflation affect asset valuations through their influence on: (i) prices paid and prices received (and thus on corporate profitability); (ii) nominal and real interest rates (which in turn influence the capitalization rate applied to income streams of equities’ dividends, bonds’ coupon interest payments, real estate rent flows, and the capitalization rate applied to assets’ terminal values; (iii) currency levels; and perhaps of paramount importance, (iv) monetary policy through central banks’ mandates to pursue price stability and full employment, plus fiscal policy through the expense of government spending and debt service financing.
Elevated housing-related and labor costs tend to not be as susceptible to downward-trending supply/demand forces as grains, gasoline, industrial metals, and a considerable number of other goods. As highlighted with red circles in the nearby Inflation Data table — helped by declining gasoline prices for gasoline, freight rates, and several other index components — on a year-over-year basis in August, Headline CPI had declined to +8.3% versus +8.5% in July (and +9.1% in June), Headline PPI had decreased to + 8.7% in August versus +9.8% in July (and +11.3% in June), and Headline Personal Consumption Expenditures prices had declined to +6.2% in August versus +6.4% in July (and +6.8% in June). After excluding food and energy prices, on a year-over-year basis in August, Core CPI (at +6.3% versus +5.9% in July) and Core Personal Consumption Expenditures prices (at +4.9% versus +4.7% in July) were continuing to trace out a rising path even as Core PPI at +7.3% for August was rising at lower a slower rate than July’s +7.6% rate of advance.
To be sure, as highlighted in the nearby table of release dates, in the near-term, the FOMC will be carefully parsing the September PPI data (to be released on Wednesday, October 12th), the September CPI data (to be released on Thursday, October 13th), and (especially since the August Core PCE month-over-month and year-over-year readings surprised to the upside versus expectations), the September Personal Consumption Expenditures inflation report (to be released on Friday, October 30th). In quite a few sectors of the economy, the rate of inflation has slightly declined, even as price level changes remain at an uncomfortably high level.
Reported inflation data affect: (i) wage and compensation bargaining; (ii) price escalation clauses in rental agreements and many other contracts; and crucially, (iii) consumers’, workers’, and businesses’ inflation expectations. The Federal Reserve and numerous other central bankers thus carefully monitor inflation expectations to determine whether higher prices are begetting higher wages on a recurrent basis, creating a difficult-to-tame wage-price spiral.
Showing inflation beliefs drawn from the monthly New York Federal Reserve Survey of Consumer Expectations, respondents’ one-year ahead inflation expectations had declined to +5.7% in August versus +6.2% in July, and hearteningly, respondents’ three-year ahead inflation expectations had declined to +2.8% in August versus +3.2% in July. A similar trend can be discerned from the results of the Inflation Expectations portion of the University of Michigan Consumer Sentiment Survey. Respondents’ one-year ahead inflation expectations had marginally declined to +4.7% in September versus +4.8% in August, and on an encouraging note, respondents’ 5-to-10 year-ahead inflation expectations remained below the one-year ahead expectations and had declined to +2.7% in September versus +2.9% in August.
Approaching the upcoming holiday season and the turn of the year, and in the absence of any large-scale financial shocks arising from: (i) political, regulatory, judicial, global trade, or geopolitical developments; (ii) monetary, fiscal, and currency policies; (iii) energy (and semiconductor) supply and demand levels; and (iv) public health and/or climatological conditions; we are of the opinion that inflation is likely to continue trending downward, albeit at a gradual pace, to what could represent an elevated plane measurably above the widely-mentioned +2.0% circumstances of the pre-Covid years, perhaps to the +3.5-4.5% range in 2023 and on into 2024.
As of now, we believe that financial asset prices are likely to be driven by the degree of the Federal Reserve’s inflation-fighting resolve, which in turn should exert influence on the course of the economy and corporate financial results. As mentioned above, we expect S&P 500 earnings estimates to be guided downward by corporate managements and revised downward further by analysts in the waning months of 2022, which is likely to present somewhat of a headwind on equity prices. In the Portfolio Positioning section which follows, we therefore emphasize patience, discernment, caution, discipline, deliberation, and time-spacing unhurriedness in increasing exposure to risk assets, with emphasis on quality and an unyielding insistence on a favorable risk-reward calculus for existing asset allocations and new capital commitments.
Portfolio Positioning
Portfolio Positioning Strategies:
Following the S&P 500’s well above-average total return performance of +31.5% in 2019, +18.4% in 2020, and +28.7% in 2021, and in the current environment of: (i) significant monetary policy restraint via multiple policy interest rate increases and Quantitative Tightening; (ii) a slowing economic trajectory; and (iii) still-elevated inflation, we believe that careful thought, planning, and attention need to be devoted to the investor’s most appropriate forms and vehicles for implementing the fundamental elements of Asset Allocation and Investment Strategy, which include:
Diversification: while it does not by any means guarantee a profit or ensure against a loss, diversification means including low- and negatively-correlated investment exposures that truly counterbalance price movements in other assets, particularly during times of significant financial stress and/or rising financial asset volatility as well as during intervals of trendless asset price movements;
Rebalancing: which encompasses consideration of when to use concepts of reversion to the mean and market price dislocations to trim exposures to assets that have grown to represent too large a portion of the overall portfolio, while at the same time, adding exposures to high-quality assets that have fallen out of investor favor and suffered significant, though deemed not permanent, price declines versus intrinsic value;
Risk Management: which involves recognizing when markets have become consumed by unrealistic expectations, meme securities, excessive speculation, momentum plays, “story stocks,” and information overload — a situation that has pertained at various times last year and earlier this year to a number of companies in certain parts of the cryptocurrency realm and the technology spectrum — and understanding the degree of liquidity, the true pricing realism, and the appropriate roles of short-term liquid securities, real assets, financial assets, and alternative assets during intervals of geopolitical disturbance and especially, in years-long or even in decades-long regimes of inflation, stagflation, deflation, monetary disruptions, and currency resets;
Reinvestment: which encompasses knowing when to emphasize and trade off income return versus capital growth return, all the while keeping in mind the critical importance of discipline, equanimity, patience, perspective, cost consciousness, tax awareness, and longevity in capturing and compounding dividend, coupon, rental, maturing securities, and other forms of incoming capital flows; and
Asset Protection and Husbandry: which encompass considerations of current and likely future income, wealth, and capital gains taxation at the state, local, federal, and possibly international level; estate planning; relevant insurance design and structuring; cybersecurity shielding; portfolio monitoring and reporting; administrative expenses; forms, frequency, and means of asset access; and asset custody.
Portfolio Positioning Principles:
We continue to allocate a meaningful exposure to equities, with prudent shifts between styles, sectors, geographies, and — where appropriate from a cost, timing, tax, liquidity, and size standpoint — public versus private markets.
Given the equity and fixed-income price swings of the past three years, expressed below are a number of themes that we believe should be taken into consideration over the next few quarters and years in selecting asset categories, asset classes, asset managers, sectors, companies, and security types:
Paying Attention to the Value of Money: Taking advantage of (rather than being taken advantage by) the consequences of money printing, internal and external currency debasement, government debt monetization, and the ‘Modern Monetary Theory’ approach that to some degree in the pandemic-response era has at times been pursued by the Authorities — within shifting money and credit cycles — to service America’s massive explicit government and corporate indebtedness and the enormous implicit obligations of pension and healthcare benefit promises;
Concentrating on “All-Weather” Sectors and Companies: Seeking investments with balance and flexibility, that are able to thrive regardless of: which political persuasion informs the thinking and policies of the White House, Congress, the judiciary, the state legislatures, and relevant domestic and international regulatory authorities; evolving Environmental, Social, and Governance (ESG) priorities and values; wealth distribution initiatives and public health conditions; social unrest; episodes of geopolitical tension (such as have especially pertained since February of this year), entente, and detente; and wider socioeconomic trends;
Distinguishing Between Temporary and Permanent Change: Focusing on the commercial, financial, and labor cost implications of new social and political power structures, alliances, and global associations; new energy sources and resources; new trade channels; new on- and offshoring structures; new cost, logistical, supply-chain, and transportation modalities, hybrid “WFH” and “WFA” (Work From Home and Work From Anywhere) employment patterns; and new business models, pathways, digitalizations, and forms of person-to-person and business-to-business work, leisure, learning, and wellness activity;
Taking Advantage of Demographic Tailwinds: Through select U.S. and non-U.S. companies, recognizing current economic, currency, public health, and financial challenges facing several emerging markets and using significant asset price and valuation discontinuities, shifts in exchange rates, and changes in consumer and business preferences to gain exposure to, and benefit from the rising needs, aspirations, and appropriate spending power of, the expanding global middle class (Please see the nearby chart for data on the past and projected growth of the middle class as a percent of the total inhabitants in five large population countries – India, Indonesia, China, Brazil, and Mexico);
Comprehending and Verifying Past Success: Emphasizing companies and sectors that have demonstrated successful track records and past experience in: competitive preeminence; abundant free cash flow generation; capital allocation skill; balance sheet strength; risk management; sustainably defendable supply chain structures and business models; and the ability to maintain high multiyear returns on equity (derived from revenue growth and favorable margin preservation, rather than through disproportionately high levels of leverage) meaningfully above the companies’ and sectors’ weighted average cost of capital; and
Identifying Innovative and Disruptive Technology Hegemons: Recognizing when, at various points in economic and financial market cycles, to focus on (and when to reduce exposure to) technology enablers, disrupters, and dominators in such fields as diagnostics, biotechnology, and therapeutics based on CRISPR (Clustered Regularly Interspaced Short Palindromic Repeats), weight management and wellbeing, public health, medical nutrition, regenerative medicine, artificial intelligence, data analytics, machine learning, 5G cellular network technology, the Internet of Things, infrastructure, robotics, retraining, quantum computing, battery inventions, alternative energy, virtual reality and augmented reality devices, hypersonic aviation, rare earths, electric vehicles, and cybersecurity, while not least, also taking account of the Environmental, Social, and Governance (ESG) risks, aspirations, and initiatives of companies in these and other fields.
Portfolio Positioning Tactics:
Keeping Things in Perspective: Many of the overarching themes and conditions that influence our intermediate- and long-term asset allocation and investment strategy emphasize the need to recognize that the concepts and implementation methods intended to achieve safety, balance, purchasing power protection, diversification, and liquidity are likely to face evolving (and sometimes, rapidly shifting) internal financial market dynamics, legal frameworks, taxation regimes, regulatory emphases, social priorities, geopolitical power relationships, price level changes, demographic trends, indebtedness levels, technological penetration and usages, financial structures, currency systems, and importantly, perceptions of the definition, role, degree of physicality, embodiment, and value of money itself.
Flexibility versus Conviction in Formulating Investment Thinking: In seeking to determine when to adhere to, and when to lean against, prevailing consensus views (such views have sometimes been pejoratively referred to as “groupthink”), it is important to critically question the soundness and durability of the reasoning and assumptions underlying a given investment framework and positioning at any point in time. While it at intervals may not make sense to hold out-of-consensus views — often expressed as “fighting the tape,” — at other times — especially at major cyclical or secular turning points (at a significant asset top, when reality is finally found to fall short of prevailing overly optimistic expectations, or a major asset bottom, when reality is authenticated to be worth considerably more than prevailing overly pessimistic expectations), the rewards of implementing a contrarian stance can be quite meaningful.
Enhancing and Preserving: Even with some of the speculative fervor having materially diminished thus far this year in more than a few areas of the financial realm, we still confess to a degree of unease over several lingering manifestations of erroneous asset valuation, and the popularity of certain securities and sectors considered to be “forever holdings” — our preference at this juncture remains to take note of the Federal Reserve’s reiteration of its explicit policy measures to rein in inflation, while taking advantage of episodes of asset price strength to continue the regimen of upgrading positions — offloading lower-quality, higher-risk assets and with timing and price discipline, gradually adding to attractively-priced, higher-quality assets on equity market pullbacks.With monetary policy interest rate increases and intensified Quantitative Tightening (Federal Reserve balance sheet reduction) under way; slow growth in China and conspicuously slowing growth in Europe; and in view of our expectation of continued asset price volatility in the months ahead, prudence counsels formulating specific game plans to take advantage of financial asset price retrenchments as a key component affecting the timing and amount of new capital commitments.
Equity Emphases and De-emphases: In the current conditions of higher U.S. Treasury interest rates across the maturity spectrum, to us it appears likely that cash-generating, financially-stable companies with robust growth prospects, which are able to operate and thrive within a distinctly unsettled geopolitical backdrop and in the digital sphere as they continue to enhance their business models, deserve to retain some degree of a valuation affirmation. Within equities: (i) we advocate continuing to gradually shift emphasis toward high-quality, dislocated Growth sectors, companies, and managers using proceeds from any reduced Growth exposure to select Value and Defensive sectors, companies, and managers (while retaining a focus in these two sectors on energy, select financials, and consumer staples, and a concomitant de-emphasis on companies and sectors dependent on access to low-cost energy); (ii) we continue to counsel very selectively adding small- and mid-cap companies (or investment managers specializing in and with good track records in this space) to our primary emphasis on large-capitalization enterprises; and (iii) for the time being, while we continue to prefer a tactical overweighting to U.S. domestic equities — with pullbacks such as those encountered in January, April, June, August and September viewed as an opportunity to only carefully and highly selectively add attractively valued equities, particularly those sectors and companies that are resilient within a multiplicity of economic and financial scenarios — we also espouse holding (or gradually building) relatively defined allocations to global leaders listed in international markets.
Focus on Strength and Quality: Our long-term equity portfolio weightings continue to emphasize asset managers, sectors, and specific companies that can benefit from the major identifiably sustained trends of the 2020-2030 decade, including: (i) incremental growth in a wide range of economic circumstances; (ii) a focus on economic and infrastructure repair, digitalization, e-commerce, personal wellness, safety, domesticity, home improvement, and sustainable consumer demand; and (iii) advantageous capture of benefits from onshoring, supply chain redesign, and deglobalization as important drivers of capital spending and disruptive innovation. At the company level in equities, as mentioned above in “Comprehending and Verifying Past Success,” we emphasize identifying and building long-term exposure to firms possessing fortress-like, cash-rich balance sheets, prudence in balance sheet utilization, limited debt, consistency and growth of positive free cash flow generation, secure supply chains, capital expenditure flexibility, and customer bases that are less exposed to recurrent shocks originating from abroad, dividend strength, and competitive business models with abiding competitive advantages (high barriers to entry, low threat of substitute products, and enduring pricing power vis-à-vis suppliers and/or customers) that over a long time frame can produce high returns on equity through revenue generation and sustainable profit margins, rather than through unhealthily high levels of leverage. At the current time, we recommend that consideration be given to top-quality companies in the healthcare and consumer staples sectors, as well as firms exceptionally-positioned to benefit from inflationary forces in the real assets sectors that have demonstrated an ability to opportunistically take advantage of shifting price level changes.
Balancing Growth and Value Sectors: At its closing level of 2117.70 on Friday, September 30th, the price return of the Russell 1000 Growth index[6] (symbol RLG, and including companies in sectors such as technology, healthcare, and communication services) was (according to The Wall Street Journal) down -31.1% from its December 31, 2021 closing level of 3074.99, while the price return of the Russell 1000 Value index[7] (symbol RLV, and including companies in sectors such as financial, real estate, energy, utility, and industrial businesses) was, at its closing level of 1339.62 on Friday, September 30th, (according to The Wall Street Journal), down -19.1% from its December 31, 2021 closing level of 1655.73. This +12.0 percentage point (+12.0) difference in returns appears to argue for continuing a degree of balanced exposure in selected Value sectors, companies, and managers as well as in selected Growth sectors, companies, and managers. As this process continues, it is worth keeping in mind that true value investing represents identifying and owning assets that are trading for less than they are actually worth, not assets that are merely inexpensive. Many superficially inexpensive assets may be inexpensive for a reason, and can very well remain so or deteriorate further.
Fixed Income Securities: Reflecting some of their largest year-to-date price declines in more than three decades, U.S. Treasury bond prices year-to-date through September 30th have declined -5.1% in the 1-3 year maturity range, -16.5% in the 7-10 year maturity range, and -30.9% in the above 20-year maturity range. Even though yields have moved upward in the past month, to us they appear likely to be subject to conflicting forces, with higher yields coming from monetary tightening, perhaps counterbalanced by lower yields coming from the economic retrenchment brought about in the monetary tightening. We continue a preference for issuers at the high-quality end of the rating spectrum, both in taxable investment grade and high-yield bonds and in tax-exempt bonds (where we see some pockets of value on a taxable equivalent basis). To preserve value and generate income in the crosscurrent-laden environment we foresee in the last three months of 2022 and on into 2023, for now, we prefer maturities and durations along the short-to-intermediate portion of the yield curve spectrum, while preparing to build (or gradually building) exposure to longer maturities and durations as recessionary forces continue to exert influence on the economy and eventually bend yields in a downward direction.
U.S. Dollar Outlook: After declining -9.9% in 2017, appreciating +4.4% in 2018, marginally gaining +0.4% in 2019, and declining -3.4% in 2020, the DXY U.S. dollar index measured versus a basket of six major currencies — the euro, Japanese yen, Swedish krona, British pound, Canadian dollar, and Swiss franc — had as of its market close of 95.97 on December 31st, appreciated +6.7% in 2021. On Friday, September 30th, the DXY U.S. dollar index had appreciated +16.8% year-to-date, closing at 112.12. Over the next few quarters, even given our expectations of the Federal Reserve: (i) continuing its policy interest rate increases; and (ii) commencing the process of reducing the size of its portfolio of U.S. Treasury and mortgage-backed securities, we believe the U.S. dollar may slow the pace of its rise relative to major currencies including the euro and Japanese yen. In an environment of higher currency volatility and the anti-inflation response of the monetary authorities in the Eurozone and in the United Kingdom, we expect: (i) a slower rate of increase in the U.S. dollar; (ii) intervals of U.S. dollar weakness alternating with episodes of U.S. dollar strength; as currency exchange rates produce and/or exaggerate price level, economic, financial, trade patterns, and capital flow imbalances; and (iii) the possibility of coordinated accords to rectify egregiously over- or under-valued currency quotations.
Alternative Investments and Real Assets: In alternative investments, we continue our multi-quarter focus that has for some time emphasized exposure to: (i) commodities and real-asset sectors of the economy including industrial metals, agriculture, and materials, (ii) (even though this sector has for a good part of this year had very few financial market advocates) some degree of investor-appropriate exposure to gold and/or gold mining ETFs/shares, particularly those miners with reserves in stable geographic locations, capital discipline, and cash flow growth; (iii) high-quality master limited partnerships with strong business models and sustainable dividend-paying capacity; (iv) select investments in private credit and private real estate; (v) and opportunistic strategies that are positioned to selectively derive meaningful value from dislocations created by geopolitical developments and/or any potentially injurious additional mutations of the coronavirus, as well as the economic and profits recuperation therefrom.
— David Martin Darst, CFA, Dynasty Financial Partners
Investment Strategy Themes for 2022
To continue our Investment Strategy Themes as we enter the final quarter of 2022, we are including them below, surrounded by the 27 flags flown by the United States of America in the 246 years since the nation’s founding. In preparing Portfolio Positioning Strategies, Portfolio Positioning Principles, and Portfolio Positioning Tactics for 2022 and 2023, we again pay tribute to the oft-quoted observation of the 34th U.S. President (and Five-Star General) Dwight David Eisenhower (1890-1969) that “plans are useless, but planning is indispensable.” With this wisdom in mind, our late 2022 and early 2023 Investment Planning approach reflects and encompasses the following themes:
Growing but Slowing GDP as forecast by the September FOMC median projection ( +0.2% in 2022 and +1.2% in 2023) and 2022 S&P 500 profits as estimated by FactSet (approximately +7.4%), with downside risk to both projections
Implementing restrictive monetary policies by central banks
Fluctuating financial asset prices in conditions featuring shifting performance leadership and increased equity volatility (VIX), bond volatility (MOVE), and currency volatility (VXY)
Differentiating with emphasis on greater discernment and selectivity in asset classes, managers, sectors, and companies
Challenging — even in an environment of reduced valuations, asset protection remains paramount, with the ongoing considerable upward and downward swings in individual securities prices not a constructive characteristic of financial asset markets
In addition, we have included content from some of our asset management and research partners:
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Where We Are
During the weeks following this year’s summer solstice (occurring in 2022 on June 21st, at 5:14 AM Eastern Daylight Time), financial market participants began to entertain the notion that the Federal Reserve might be seriously considering a late-2022 or early-2023 rotation (often described as a “pivot”) toward reducing or ending its restrictive monetary policy. As a result, from its June 16 closing low of 3666.77, the S&P 500 rallied +16.8% to close at 4283.74 on August 18th.
Yet following: (i) Fed Chairman Jerome Powell’s August 26th speech at the Central Bankers Symposium in Jackson Hole, Wyoming, and then (ii) Chair Powell’s news conference commentary after the FOMC’s September 21 FOMC policy meeting, stock and bond prices have tended to trace a generally declining path as the Fed has: (1) decisively underscored its commitment to restoring price stability; (2) reiterated the fact that a considerable amount of monetary tightening likely remains in the pipeline; and (3) indicated that the interval of elevated policy interest rates could very well pertain for a lengthier-than-anticipated duration, perhaps extending through 2023 or even longer. In response, through Tuesday, September 27, the S&P had declined -6.5% over six consecutive trading sessions — representing the first time the S&P 500 had recorded a decline extending that many days since February 2020, when financial market participants initially began to be unnerved by the beginning of the coronavirus pandemic.
Against a backdrop of tightening monetary policy, heightened geopolitical tensions, weakening economic data (including six consecutive months of contraction for the Leading Economic Indicators index — which has not occurred since the beginning of the Global Financial Crisis 15 years ago), enervated business and consumer confidence, unusual currency movements, a preponderantly risk-off atmosphere over the past three quarters for equities, and U.S. midterm elections on Tuesday, November 8th, investors should prepare for volatility in October and the remaining months of this year.
The nearby chart depicts the essentially sideways movement of the Dow Jones Industrial Index in the midterm year of the four-year election cycle in the U.S. over the past 120 years. And covering the past 71 years, from 1950 through late 2021) the adjacent chart shows that the average annual price return of the S&P 500 index during midterm election years (+5.9%) is materially below all non-election years (+12.1%), and even presidential election years (+7.2%).
Emphasizing all of the caveats associated with averages calculated over a 60-year time frame, from a seasonal standpoint, the nearby chart shows that on average, almost all of the S&P 500’s returns are generated in the six months from November 1st through the following year’s April 30th (perhaps one of the ancestral origins of the age-old stock market adage “Sell in May and go away”.) From an economic cycle standpoint, the adjacent chart shows that during the Late Cycle and Recession/Downturn phases of an economic regime — which in our opinion characterizes current conditions — portfolio emphasis should be placed on risk management, high-quality securities, and stable income generation.
We recognize that a hawkish Federal Reserve, high rates of inflation, and high interest rates, plus the likelihood of potentially disappointing corporate revenue growth and unfavorable earnings outcomes, may already be well reflected in the year-to-date return through September of -24.8% for the S&P 500. In the post-1970 era, as shown in the nearby chart, when September’s S&P 500 price performance has been negative -7.0% or worse, October’s price performance has averaged +4.3% (with a median price return of +7.1%) and has been positive 83.3% of the time, with the sole exception of September 2008, when the S&P declined -16.9% during the onset of the 2008-2009 Global Financial Crisis.
With the 2022 year-to-date drawdown of -23.3% through September 26th (as shown in the nearby chart) ranking among the S&P 500 price declines of 1974 (-29.7%), 2002 (-23.4%), and 2008 (-38.5%), we hasten to point out that: (i) corporate balance sheets and the capital position of America’s commercial banking industry appear to be in decent shape; (ii) aggregate household savings levels, liquidity, and money market balances — although drawn down somewhat from peak levels — remain substantial; and (iii) a significant degree of pessimism and variation already prevails (often a short-term contrarian indicator, and thus moderately bullish), as reflected in the nearby charts showing (1) the quite elevated percentage bearish readings in the weekly American Association of Individual Investors Survey (the first time on record that the AAII Bearish Sentiment reading has exceeded 60% for two weeks in a row), and (2) the extreme bearishness of the Bank of America Bull and Bear Indicator, reflecting “investor sentiment unquestionably worse since the Global Financial Crisis of 2008-2009.”
What Direction Do All Members Feel The Stock Market Will Be In The Next 6 Months?
As investors enter the tenth month of 2022, it can be seen in the nearby chart that on average over the 94 years from 1928 through 2021 inclusive, the month of October – with its historical +0.5% price gain for the S&P 500 – ranks tied for eighth among months in more than nine decades of monthly performance ranking. It is worth repeating that these nine-decade results are averages, with a given month’s outcome having the potential to vary above or below the long-term average. According to Investors Business Daily, October has generated an average +2.7% price increase in midterm election years.
And as highlighted in the nearby price performance table, after falling -4.8%, -4.7%, and -2.9%, respectively, in the last three weeks of September, the S&P 500 declined -9.3% (closing at 3585.62 on September 30th versus 4955.00 on August 31st). The technology-heavy Nasdaq Composite fell -10.5% in September, closing at 10575.62, and the Russell 2000 index of small- and mid-cap companies declined -9.7% over the month, to close at 1664.72.
Over the course of September, West Texas Intermediate crude oil prices declined -11.2%, from $89.55 per barrel on August 31st to $79.49 per barrel on September 30th. The global oil demand side continues to reflect signs of China’s Covid-19 lockdown measures; slowing momentum in the global economy; fuel shortages; currently low levels of inventories; and precautionary buying, while on the supply side: (i) the seven-month Russia-Ukraine conflict continues to create significant demand and supply disruptions; (ii) several nations, especially the U.S. and including certain allies, have launched the release of crude oil from their respective Strategic Petroleum Reserves; (iii) Iran continues with the nuclear talks begun on November 29th, which could in theory increase the supply of Iranian oil officially entering global oil markets if economic sanctions on Iran are relaxed; (iv) facing pressure from investors to moderate growth and address their emissions amid concerns about increasing regulations and climate change, large U.S. and European oil companies have continued to spend sparingly to boost production, even as certain major oil companies have halted and/or completely exited their Russian activity; (v) consolidating U.S. shale producers have exercised financial probity; have not excessively increased output; have followed production discipline and exerted capital spending restraint; and (vi) at the 32nd OPEC+ Ministerial Meeting on Monday, September 5th, the organization (which includes Saudi Arabia, Russia, the United Arab Emirates, Kuwait, Iraq, and other countries) decided to cut production targets by 100,000 barrels per day for October, and scheduled its 33rd meeting (in Vienna on Wednesday, October 5th, the first in-person meeting since the Covid-19 pandemic began in 2020).
During September, the U.S. dollar rose +3.1% versus the DXY index, comprised of six major currencies (the Euro, Japanese yen, British pound, Canadian dollar, Swiss franc, and Swedish krona). On September 30th, the DXY index closed at 112.12, +16.8% versus its level of 95.97 on December 31st, 2021.
Reflecting a significant degree of competition from higher short-term interest rates and a stronger U.S. dollar over the course of the past month, the daily spot gold price (as logged by USA Gold) closed at $1,660.60 per troy ounce on September 30th, down -2.8% during September and down -9.2% from its close of $1,829.05 per troy ounce on December 31, 2021.
In the accompanying table, September month-end closing yield levels are shown for 2-year, 10-year, and 30-year U.S. Treasury securities, and these monthly data are used to compute the year-to-date 2022 yield level changes (expressed in basis points), also highlighted nearby.
For 2-year U.S. Treasury securities, yields rose 77 basis points in September to 4.22% at month-end, where they are up 349 basis points (3.49%) since their closing level of 0.73% on December 31st, 2021.
For 10-year U.S. Treasury securities, yields climbed 68 basis points in September and closed at 3.83% at the end of the month, where they are up 204 basis points (2.04%) since their closing level of 1.52% on December 31st, 2021.
For 30-year U.S. Treasury securities, yields increased 52 basis points in September and reached 3.79% at the end of the month, where they are up 189 basis points (1.89%) since their closing level of 1.90% on December 31st, 2021.
The Way Ahead
The following discussion reviews several of the key factors that we consider at this time to be likely to exert meaningful influence on financial asset prices in the interval ahead.
Slowing Economic Growth: Representing the governments of 37 market-based countries which collaborate to promote sustainable economic growth, the Organization for Economic Cooperation and Development (OECD) on September 26th published its latest Interim Economic Outlook, containing analysis and projections for the world economy and all G20 countries. The nearby chart displays the OECD’s updated GDP growth projections for 2022 and 2023. It can be seen that global real GDP growth is projected by the OECD to slow from +3.0% in 2022 to +2.2% in 2023, well below the pace which had been projected prior to Russia’s February 24th invasion of Ukraine. For the United States, which experienced +5.7% real GDP growth in 2021, annual real GDP growth is projected by the OECD to slow sharply, to +1.5% in 2022 and + 0.5% in 2023. For the 19-country Euro Area, real GDP growth is projected by the OECD to decline from +3.1% in 2022 to +0.3% in 2023 (with risks of actual GDP declines in several European economies during the winter months). Amidst Covid-19 shutdowns and property market weakness, real GDP in China is projected by the OECD to advance by +3.2% in 2022, with policy support currently projected to help achieve +4.7% GDP growth in 2023.
The OECD’s Interim Economic Outlook also forecasts headline and core (ex food and energy) inflation projections for the G20 countries. The nearby chart displays the OECD’s updated headline inflation projections for 2022 and 2023.
It can be seen that inflation has become broad-based in numerous economies, with easing supply bottlenecks and tighter monetary policy projected to moderate inflation pressures in 2023 even as elevated shelter prices and higher labor costs appear likely to impede the pace of decline. Most major economies are likely to pursue further monetary policy tightening through interest rate increases and other measures in order to anchor inflation expectations and establish that inflation pressures are durably reduced. For the United States, headline inflation is projected by the OECD to be +6.2% for 2022 before declining to +3.4% in 2023. For the Euro Area, headline inflation is projected by the OECD to reach +8.1% in 2022 and ease off somewhat to +6.2% in 2023. For China, inflation is projected by the OECD to rise from +2.2% in 2022 to +3.1% in 2023.
Additional perspective on the outlook for U.S. real GDP growth, employment levels, and inflation for each year from 2022 to 2024 — and over the longer run — is contained in the quarterly Summary of Economic Projections (SEP) released in conjunction with the Federal Open Market Committee meeting held on September 20-21. The nearby bar chart and the accompanying table set forth the economic projections of Federal Reserve Board members and Federal Reserve Bank presidents, under their individual assumptions of projected appropriate monetary policy. The term “FOMC participants” encompasses the members of the Board of Governors and all presidents of the 12 Regional Federal Reserve Banks. The term “FOMC members” includes the voting members of the FOMC — namely, the members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and 4 of the remaining 11 Reserve Bank presidents who serve one-year terms on a rotating basis.
It can be seen in the chart and in the table that FOMC participants’ median projections of U.S. real GDP growth is +0.2% for 2022, +1.2% for 2023, and +1.7% in 2024; the average civilian unemployment rate in 4Q2022 is estimated to be 3.8%, in 4Q2023 4.4%, and in 4Q2024, 4.4%; Headline Personal Consumption Expenditures (PCE) inflation is estimated to be +5.4% in 2022, +2.8% in 2023, and +2.3% in 2024; and Core (ex food and energy) PCE inflation is estimated to be +4.5% in 2022, +3.1% in 2023, and +2.3% in 2024. Given these assumptions and projections, FOMC participants’ policy interest rate projections represent the value of the midpoint of the projected appropriate target range for the fed funds rate at the end of the specified calendar year — 4.4% at year-end 2022, 4.6% at year-end 2023, and 3.9% at year-end 2024.
With consumer and corporate demand experiencing downward momentum and profit margins being squeezed by upward pressure on labor, interest, and selected input costs, according to the FactSet Earnings Insight report of September 30th, for 3Q22, S&P 500 companies are expected to report earnings growth of +2.9% (which would represent the lowest growth rate since the -5.7% earnings decline experienced in 3Q2020) and revenue growth of +8.7%. For 4Q22, analysts are projecting earnings growth of +4.0% and revenue growth of +6.2%. For the full year 2022, analysts are projecting earnings growth of +7.4% and revenue growth of +10.7%. For 1Q23, analysts are projecting earnings growth of +6.5% and revenue growth of +5.9%. For 2Q23, analysts are projecting earnings growth of +5.5% and revenue growth of +3.9%.
For calendar year 2023, analysts are projecting earnings growth of +7.9% and revenue growth of +4.4%. These FactSet projections are essentially corroborated by the nearby chart, showing the Yardeni Research and Analysts’ Consensus 2009-2017 year-by-year (and over the 2018-2022 time frame, quarter-by-quarter) earnings and forecasts for the S&P 500 companies. In our estimation, incorporating our assessment of recession-risk odds at 20%-30% for 2022 and 60%-70% for 2023, S&P 500 profitability is likely to be buffeted by the twin forces of weakening demand and rising input costs (including interest costs). Barring exogenous shocks, aggregate 2023 S&P 500 earnings appear likely at this point to end up calendar 2023 somewhere in the range of $215-$230.
Among the significant determinants of whether these earnings estimates can be achieved — or whether they will be subject to further meaningful downward revisions — are those set forth in the discussion below.
Decelerating U.S. Corporate Profit Growth: In real terms after inflation, U.S. GDP decreased at an annual rate of -1.6% in 1Q22 and -0.6% in 2Q22, with the GDPNow forecasting model of the Federal Reserve Bank of Atlanta projecting (as of Monday, October 3rd) an annual rate of growth of +2.3% for 3Q22. Anemic revenue and output growth tend to exert downward pressure on corporate profit margins and aggregate earnings.
Vitiated Overseas Earnings Generation: Foreign earnings represent an important component of the profits of the U.S. multinational companies which populate the S&P 500 index. These earnings are projected to be subpar, due not only to: (i) the lackluster prevailing economic and business conditions in Europe, Asia, and numerous other overseas economies (as highlighted above in the OECD Interim Economic Outlook discussion); but also owing to (ii) the strong U.S. dollar, which hinders U.S. companies’ exports and exerts downward pressure on the repatriated dollar value of earnings generated in countries whose foreign exchange values have depreciated meaningfully versus the U.S. currency.
Higher Interest Costs for Households and the Corporate Sector: As shown in the nearby chart, the FOMC has been hiking rates further and faster than any time in modern history, raising borrowing costs for consumers and businesses.
Labor Market Tightness: Upward pressure on labor costs has been a persistent characteristic of this year —represented by the weekly lows in initial jobless claims for unemployment insurance, as shown in the nearby chart — with a lack of available labor and unbalanced labor market conditions reflecting robust economic conditions, keeping pressure on inflation-fighting actions by the Fed while at the same time exerting downward pressure on corporate profit margins.
Household Wealth Drawdowns: Perceived and actual declines in the aggregate net worth of the household sector can lead to weakening effects on consumer psychology and spending. Some meaningful portion of the decelerating hit to personal consumption derives from the first six months of 2022’s -$13 trillion retreat in equities market capitalization as well as a -$3 trillion decline in the market value of U.S. high-grade bonds.
Housing Sector Fragility: Hindering the economic contribution of the housing sector have been: (i) sharply escalating mortgage financing costs (a depicted in the nearby chart); (ii) constrained demand; and (3) increased supply. Housing represents a key driver of investment, employment, and consumption (especially of appliances and home furnishings), and according to Barron’s, economic theory holds that a -$1.00 decline in housing values translates to a $0.40 reduction in spending (almost 4 times the effect of a $1.00 dollar decline in equity prices).
As of early September, having declined for seven consecutive months and having reached their lowest level since May 2020, existing home sales are down -27% from their peak and -25% thus far in 2022; new home sales are down -50% from their peak and -40% year-to-date; and the 1.7 million in aggregate new homes under construction exceeds the total experienced in the pre-2008 housing bubble.
According to mortgage data provider Black Knight Inc., marking the largest monthly declines since January 2009, median home prices fell -0.98% in August month-over-month, following a -1.1% decline month-over-month in July. And the downward-turning S&P CoreLogic Case-Shiller 20-City Composite Home Price Indexes on a month-over-month basis and a year-over-year basis are shown in the two nearby charts.
Inflation Vectors: The forces of inflation affect asset valuations through their influence on: (i) prices paid and prices received (and thus on corporate profitability); (ii) nominal and real interest rates (which in turn influence the capitalization rate applied to income streams of equities’ dividends, bonds’ coupon interest payments, real estate rent flows, and the capitalization rate applied to assets’ terminal values; (iii) currency levels; and perhaps of paramount importance, (iv) monetary policy through central banks’ mandates to pursue price stability and full employment, plus fiscal policy through the expense of government spending and debt service financing.
Elevated housing-related and labor costs tend to not be as susceptible to downward-trending supply/demand forces as grains, gasoline, industrial metals, and a considerable number of other goods. As highlighted with red circles in the nearby Inflation Data table — helped by declining gasoline prices for gasoline, freight rates, and several other index components — on a year-over-year basis in August, Headline CPI had declined to +8.3% versus +8.5% in July (and +9.1% in June), Headline PPI had decreased to + 8.7% in August versus +9.8% in July (and +11.3% in June), and Headline Personal Consumption Expenditures prices had declined to +6.2% in August versus +6.4% in July (and +6.8% in June). After excluding food and energy prices, on a year-over-year basis in August, Core CPI (at +6.3% versus +5.9% in July) and Core Personal Consumption Expenditures prices (at +4.9% versus +4.7% in July) were continuing to trace out a rising path even as Core PPI at +7.3% for August was rising at lower a slower rate than July’s +7.6% rate of advance.
To be sure, as highlighted in the nearby table of release dates, in the near-term, the FOMC will be carefully parsing the September PPI data (to be released on Wednesday, October 12th), the September CPI data (to be released on Thursday, October 13th), and (especially since the August Core PCE month-over-month and year-over-year readings surprised to the upside versus expectations), the September Personal Consumption Expenditures inflation report (to be released on Friday, October 30th). In quite a few sectors of the economy, the rate of inflation has slightly declined, even as price level changes remain at an uncomfortably high level.
Reported inflation data affect: (i) wage and compensation bargaining; (ii) price escalation clauses in rental agreements and many other contracts; and crucially, (iii) consumers’, workers’, and businesses’ inflation expectations. The Federal Reserve and numerous other central bankers thus carefully monitor inflation expectations to determine whether higher prices are begetting higher wages on a recurrent basis, creating a difficult-to-tame wage-price spiral.
Showing inflation beliefs drawn from the monthly New York Federal Reserve Survey of Consumer Expectations, respondents’ one-year ahead inflation expectations had declined to +5.7% in August versus +6.2% in July, and hearteningly, respondents’ three-year ahead inflation expectations had declined to +2.8% in August versus +3.2% in July. A similar trend can be discerned from the results of the Inflation Expectations portion of the University of Michigan Consumer Sentiment Survey. Respondents’ one-year ahead inflation expectations had marginally declined to +4.7% in September versus +4.8% in August, and on an encouraging note, respondents’ 5-to-10 year-ahead inflation expectations remained below the one-year ahead expectations and had declined to +2.7% in September versus +2.9% in August.
Approaching the upcoming holiday season and the turn of the year, and in the absence of any large-scale financial shocks arising from: (i) political, regulatory, judicial, global trade, or geopolitical developments; (ii) monetary, fiscal, and currency policies; (iii) energy (and semiconductor) supply and demand levels; and (iv) public health and/or climatological conditions; we are of the opinion that inflation is likely to continue trending downward, albeit at a gradual pace, to what could represent an elevated plane measurably above the widely-mentioned +2.0% circumstances of the pre-Covid years, perhaps to the +3.5-4.5% range in 2023 and on into 2024.
As of now, we believe that financial asset prices are likely to be driven by the degree of the Federal Reserve’s inflation-fighting resolve, which in turn should exert influence on the course of the economy and corporate financial results. As mentioned above, we expect S&P 500 earnings estimates to be guided downward by corporate managements and revised downward further by analysts in the waning months of 2022, which is likely to present somewhat of a headwind on equity prices. In the Portfolio Positioning section which follows, we therefore emphasize patience, discernment, caution, discipline, deliberation, and time-spacing unhurriedness in increasing exposure to risk assets, with emphasis on quality and an unyielding insistence on a favorable risk-reward calculus for existing asset allocations and new capital commitments.
Portfolio Positioning
Portfolio Positioning Strategies:
Following the S&P 500’s well above-average total return performance of +31.5% in 2019, +18.4% in 2020, and +28.7% in 2021, and in the current environment of: (i) significant monetary policy restraint via multiple policy interest rate increases and Quantitative Tightening; (ii) a slowing economic trajectory; and (iii) still-elevated inflation, we believe that careful thought, planning, and attention need to be devoted to the investor’s most appropriate forms and vehicles for implementing the fundamental elements of Asset Allocation and Investment Strategy, which include:
Portfolio Positioning Principles:
We continue to allocate a meaningful exposure to equities, with prudent shifts between styles, sectors, geographies, and — where appropriate from a cost, timing, tax, liquidity, and size standpoint — public versus private markets.
Given the equity and fixed-income price swings of the past three years, expressed below are a number of themes that we believe should be taken into consideration over the next few quarters and years in selecting asset categories, asset classes, asset managers, sectors, companies, and security types:
Portfolio Positioning Tactics:
— David Martin Darst, CFA, Dynasty Financial Partners
Investment Strategy Themes for 2022
To continue our Investment Strategy Themes as we enter the final quarter of 2022, we are including them below, surrounded by the 27 flags flown by the United States of America in the 246 years since the nation’s founding. In preparing Portfolio Positioning Strategies, Portfolio Positioning Principles, and Portfolio Positioning Tactics for 2022 and 2023, we again pay tribute to the oft-quoted observation of the 34th U.S. President (and Five-Star General) Dwight David Eisenhower (1890-1969) that “plans are useless, but planning is indispensable.” With this wisdom in mind, our late 2022 and early 2023 Investment Planning approach reflects and encompasses the following themes:
In addition, we have included content from some of our asset management and research partners:
Important disclaimers and disclosures
If you are interested in any other market commentaries, or have further questions, please contact us.
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Michael has been providing strategic investment advice and wealth management services for over 24 years.
View Full BioAs a Financial Advisor, Ashley works closely with high net worth individuals and families with a niche focus on female executives and entrepreneurs.
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