Economic and Financial Market Outlook 1Q 2023

Summary

Heading into the new year, almost all major economies are enduring broad-based challenges. The major issues that disrupted financial markets in 2022 are still apparent: high inflation, restrictive monetary policy, continuing COVID outbreaks, and an energy crisis brought on by the Russian invasion of Ukraine. After the declines of 2022, financial markets reflect the rising risks that have beset the global economy. In the US and the EU, central bankers seek to curtail high inflation without hammering their economies into a severe recession. In China, the focus is on reopening from years of zero-COVID policy shutdowns and implementing stimulus measures. While the present obstacles look daunting, if the major policy initiatives show signs of progress in the first half of 2023, then this could be the beginning of a multi-year advance in global stock markets, anticipating a global economic recovery in 2024.

US Economy

In the US, the Federal Reserve continues to aggressively raise interest rates and thus far has attained some success in lowering inflation. November core PCE, the Fed’s preferred inflation measure, retreated to 4.7% from 5.0% in October and 5.2% in September. We expect the Fed to stop rate hikes in the first quarter after an additional 0.50% or 0.75% increase. This restrictive stance will push inflation down over the course of the year at the expense of economic growth. There is already weakness in the housing, auto, and manufacturing markets. On the other hand, unemployment has stayed historically low, and the economy has added jobs for 24 consecutive months. We project 2023 US GDP to grow less than 1.0%, but not dip into a deep recession, though a short and shallow recession is possible.

US Stock Market

US equities look to bounce back from a dismal 2022. The major indexes fell into bear territory and while there was a slight recovery in the fourth quarter, the S&P 500 closed the year down 19.4% and the NASDAQ 100 was off 33.1%. Despite these numbers, there is reason for cautious optimism. Most of the factors that contributed to the selloff are moderating: inflation is slowing, the Fed is nearing the end of its rate hikes, and excessive earnings multiples have declined, though they remain near long-term averages. As we stated, we are expecting low growth, possibly even slightly negative growth, but an economy that bends without breaking should support modest advances in equities this year. Corporate earnings are expected to grow 5.3% this year which is a slight acceleration from 2022. The financial media seems to believe that these expectations will decline but that was also the case in 2021 when corporate earnings were resilient. Lastly, even though our optimism exists despite last year’s returns, there is a case to be made that one can be optimistic because of last year’s returns. Since World War II, there have only been three times when the S&P 500 had consecutive negative annual returns. Historically, after a decline of 20% or more in the S&P 500, the index has increased an average of 14%, 33.6%, and 61.5% over the following 1-year, 3-year, and 5-year periods, respectively. As long as the economy holds up, US equity investments will have a positive year in 2023.

International Economies

We are upbeat on international markets in 2023 as China ends their zero-COVID policy, EU inflation data eases, a mild winter calms fears of gas shortages, and global economic resilience surpasses last year’s grim expectations. The shift in China occurred late last year, when mass civilian protests led to a drastic policy change focused on growth. Since then, Chinese authorities have:

We think many economic forecasters underestimate the ability of the Chinese government to stimulate growth and, like other reopening countries, experience a swift rebound. If we are correct that China will grow above expectations, it will have a profound effect on the global economy, improving the prospects for many international economies and companies. The EU will welcome a boost to offset the restrictive monetary policy enacted by the European Central Bank. The ECB is raising rates to fight high inflation, though their tightening policy thus far has been modest compared to the Fed (2.0% benchmark rate vs 4.5%). Recent data suggests that inflation in the key economies of Germany, France, and Spain is moderating, giving the ECB the possibility to achieve their target inflation goals with less economic fallout. A major tailwind has been the precipitous fall in the price of natural gas, alleviating concerns of an expensive, and deadly, winter.

International Stock Markets

We recommend that long-term investors consider adding more international stocks to their investment portfolios. International stock market indexes trade at considerable valuation discounts to their US counterparts. On December 31, the MSCI All-Country World Index ex-US benchmark traded at a 11.8x forward P/E ratio, compared to the 18.8x forward P/E ratio of the S&P 500, a 37% discount. There are companies exhibiting strong balance sheets, talented management, and earnings growth that will benefit from improving economic trends both abroad and in the US.

Bond Markets

Recession concerns for the US and the EU drove a dramatic selloff in bonds pushing yields to levels not seen in a decade. Although the interest rates appear attractive, with inflation still above 5%, real yields on bonds are negative for most investment grade issues. Our recommendation remains to focus on short-dated bonds. Investors with a mandate for fixed income could consider medium-term bonds but should still overweight short issues to protect against losses if rates continue to rise. Quality should be favored as well, while below investment-grade presents unappealing risk versus return potential.

Has US Inflation Peaked?

2022: The Year of Inflation

As we approach the end of the year, undoubtedly the top story for the economy is inflation, with the increase in consumer prices reaching levels not seen since the 1970s. Consumers are feeling the pain as they try to manage budgets in the face of increased costs in all expense categories. A broader concern is that the high prices will lead to reduced consumption, raising the risk of recession. How much longer will we contend with high inflation? First, this environment has no historical precedent to make comparison with so there will be considerable uncertainty. Second, assessing inflation can be uniquely challenging because of how personally the effects are felt. Therefore, we emphasize taking special care to rely on a wide range of data to support our forecast and maintain caution against negative surprises. Ultimately, our view is that inflation in the US has peaked and is starting a downward trend which will continue throughout 2023, falling below 4.0% by the end of next year.

Where is Inflation Now?

We think that it is more likely inflation is falling based on the most recent batch of data and Federal Reserve statements. October was the first evidence of Fed policy leading to lower inflation, with broad-based core goods prices declining. Headline CPI came in at 7.7% year-over-year, down from 8.2% in September and the 9.1% high point reached in June. Core CPI fell to 6.3% from 6.6% in September. Key housing readings (primary rents and owners’ equivalent rents) experienced a steep drop off, among the largest since the early 1990’s. Goods prices saw their prices fall month to month across the board, including furniture, apparel, medical services, used and rental cars, and electronics. To be sure, these CPI readings are far too high and decelerating price increases is not the same as prices coming down. It will be a long time until there is relief for the consumer in the form of lower interest rates or an increase in real wages (inflation-adjusted compensation).

Can this trend continue?

We have confidence in this peak-inflation view because many of the inflationary pressures of 2021-22 have abated and tighter monetary policy is in place to restrain price growth:

What are the major threats to our forecast?

While we predict inflation will continue to trend lower, it is unlikely to be a smooth transition to a low-inflation environment. Several key obstacles remain and could quickly change the outlook:

The focus on inflation will continue into 2023. As stated above, it will take time to return to normal and we will monitor developments closely to ensure the improvements stay on track. We welcome your thoughts and wish you and your families a safe and happy Thanksgiving.

Economic and Financial Market Outlook 4Q 2022

Speculation regarding the path of inflation and central bank policies will dominate global economic and investment forecasts for the foreseeable future. In the US, the Federal Reserve has unmistakably articulated its full determination to drive inflation down to 2.0%, accepting that there will be collateral economic pain. Consequently, we anticipate the US economy will weaken through the remainder of the year and into 2023, hindered by increased borrowing costs, further declines in key commodity prices, and sustained strength in the US dollar. Early indications suggest that the Fed’s aggressive policy has been somewhat successful so far in softening the spikes in prices and wages. While there remains a long path ahead to reach comfortable financial conditions, we think that a sufficient improvement will occur in the first half of 2023, warranting the Fed to pause and possibly end the interest rate hiking cycle. However, the path of inflation has so far defied most forecasts, so we caution against overconfidence in any prediction. The health and resilience of the global economy will be the key in the coming months. We think a soft landing is certainly possible, but not necessarily probable.

The increasing bite of rising interest rates on the US economy is becoming ubiquitous. Prices across various sectors are down from highs (energy, agricultural commodities, automobiles, housing), and, most important from the Fed’s perspective, the wage-price spiral has yet to develop. Spending on goods is waning, though services demand remains high as consumers shift toward pre-pandemic behaviors. Also normalizing are supply chains, with bottlenecks easing. In combination, these developments are encouraging signs of easing inflation. More worrisome is that historically, the impact of monetary policy is delayed before it is fully realized. To date, the labor market is holding up well and unemployment remains historically low. But with the Fed increasing benchmark rates faster than any time since the 1970s, there is a heightened threat of an overreaction, and similar policy errors have triggered steep recessions. We lean to the view that short-term rates will rise to about 4.5% by early 2023 and that the Fed will pause at this point to better gauge progress in reducing inflation to their 2.0% target. This would be the best hope for a soft landing. Our greatest concern is that inflation does not fall as expected, forcing the Fed to act more aggressively, thereby increasing the risk of a sharp downturn.

Stock markets continue to experience large swings as investors weigh the likelihood and severity of an imminent recession. The most widely held negative outlook is that the Fed will not be able to tame inflation with 4.5% benchmark interest rates and that additional larger hikes will be necessary. As we said above, we think the most likely outcome is a Fed pause in 2023. There will be near term pain but, in our opinion, that is already mostly reflected in this year’s lower equity prices. We think it is too late for investors to reduce risk by lowering equity ratios, but too early to be aggressively positioned for a sharp upturn. In other words, our recommendation is that patience will be rewarded at this time of heightened uncertainty. Our advice is to:

Stock market bottoms usually occur following capitulation at a time when risk is paramount and fear is rampant. Worth noting is the current bear market’s length (9+ months) is already equal to the historical average. Stock valuations will recover at some point. Those that are invested in the earliest days of the inevitable rally will benefit the most.

The major international economies and financial markets are also struggling. On October 4, the International Monetary Fund (IMF) issued its Annual Report titled “Crisis Upon Crisis.” Managing Director Kristalina Georgieva introduced the report with the alarmist statement, “the global economy is facing its biggest threat since World War II.” A sobering roster of multinational crises have combined with country-specific problems, such as the property sector turmoil in China, to reduce prospects for future global growth:

With so many obstacles, it is not surprising that GDP forecasts have retreated steadily throughout the year. On October 6, the IMF lowered its global growth prediction to 3.2% in 2022 and 2.7% in 2023, much lower than the robust 6.0% reached in 2021. This would be the weakest growth since 2001. Of the key economies, only China is expected to expand next year: the US is to slow from 1.6% in 2022 to 1.0% in 2023, the Euro Area from 3.1% to 0.5%, Japan from 1.7% to 1.6%, and China from 3.2% to 4.4%. The IMF inflation outlook calls for more short-term pain: 8.8% in 2022, a decline to 6.5% in 2023, finally returning to a more normal 4.1% in 2024.

The outlook may not be as ominous for international stock markets as it first seems. All the crises, listed above, are well known. Governments, business leaders, and central banks are increasingly adopting stronger and more effective measures to ameliorate the negative conditions. Further, investors have been dealing with these problems for the past year, and arguably their concerns are already apparent in stock market valuations. Our recommendation for international investors is similar to our advice for US investors: emphasize a diversified portfolio of high-quality companies able to maintain sales and earnings growth in highly volatile markets. We think this approach will be more successful and less stressful than trying to pick the winning country or industry sector ETFs, or to bottom fish stocks with cheap prices but troubled fundamentals.

Bond yields have soared (with bond prices falling precipitously) in response to Fed policy. US 2-year Treasuries ended the quarter at 4.2%, climbing from 2.9% reached on June 30, and far above the 0.7% at the beginning of 2022. For the first time in over a decade, investment grade bonds are offering something in the ballpark of a reasonable yield. However, we emphasize that interest rates are still lagging inflation. Further, we expect the value of longer-term bonds to continue to slump as the Fed Funds rate is projected to hike another 1.0% – 1.5% in the next three months. For investors who desire fixed-income exposure, we continue to focus on short-maturity bonds and to avoid increasing duration or lower quality to pick up yield.

Bear Market Rally or New Bull Market?

US stocks have rebounded sharply from the June lows, with the S&P 500 Index soaring over 15% the past eight weeks, continuing the extreme volatility that has persisted throughout 2022. The key question for investors following the recent upturn is whether the strong positive returns are sustainable and mark the beginning of a bull market, or if relief is temporary and will ultimately end up as a “bear market rally.” Our view is that based on the path of inflation, incoming economic data, and equity valuations, there is no obvious answer as to which of these two scenarios is most probable.

The positive case anticipates a decline in inflation sufficient to satisfy the Federal Reserve and consequently prompt an end to the current rate hiking cycle. Critically, this decline in inflation must occur while the US economy remains resilient enough to support a healthy consumer and maintain corporate earnings growth. Optimists cheered the most recent CPI report, which showed inflation peaked in June and fell slightly month over month in July. The July jobs report boasted a 528,000 rise in nonfarm payrolls and an unemployment rate of 3.5%, matching a 50-year low. Second quarter corporate earnings have been better than expected; on June 30 the aggregate estimate was for 4.0% year-over-year profit growth but has since been revised higher to 6.7%.

The negative case is predicated on inflation staying persistently high and the Fed continuing to raise rates in response. Pessimists point to weak or weakening economic indicators to show the economy is already under duress: consumer confidence has plummeted to all-time lows, housing market data have cooled, and the latest PMI services reading showed a contraction. With a slumping economy, higher interest rates will result in individual buying power evaporating, liquidity drying up, and business profits turning negative. Already, corporate earnings excluding the energy sector fell in the second quarter. In addition, some members of the Fed have stated categorically that a deteriorating economy is a tolerable side effect in the battle against the major adversary: high inflation.

In our opinion, current US stock market valuations appropriately reflect the uncertainties regarding these opposing scenarios. Even the Fed is broadcasting confusion; in its July meeting minutes, members stated concern for both being too hesitant about raising future rates (thereby permitting inflation to continue at an unacceptably high level) as well as being too aggressive in interest rate hikes (thus damaging the economy too much). We think the Fed is being pragmatic in adopting a data-dependent strategy rather than committing to a predetermined course. Similarly, investors should resist the temptation to make major portfolio changes until the picture becomes clearer.

Marietta Returns to “Money Life with Chuck Jaffe”

On Friday, May 27, Jonathan Smucker returned as a guest on the “Money Life with Chuck Jaffe” podcast. Almost one year since his last appearance on the show, Jonathan was featured on the Market Call segment, where Chuck speaks to experienced portfolio managers about their investing approach and current views.

Listen to the interview by clicking the play button below:

 

To listen to the full episode on the “Money Life with Chuck Jaffe” website, click here.

The Risk of Recession is Rising

Yesterday, the US Department of Labor reported that inflation in April remained very high at 8.3%. While the headline measure of rising consumer prices pulled back from March’s peak of 8.5%, it was both higher than forecasted and at a level that is unsustainable for continued growth. The core measure, which is favored by the Federal Reserve to guide policy, came in at 0.6%, also higher than expected and double the rate in March. This all but guarantees another 50 basis point rate hike or greater next month and a faster tightening path at subsequent Fed meetings than they have previously indicated for 2022.  

We wrote in April that we did not expect a recession in the US this year. The Federal Reserve planned to raise interest rates to cool off the heated economy but there was room for error to navigate a soft landing. However, the persistently high level of inflation will likely take a heavy toll. Economic conditions are already worse now than at the start of the quarter. The initial measure of the economy for the first quarter showed a declining GDP of –1.4%, the first contraction since the start of the pandemic. Still, the consensus expectation, which we agree with, is for a rebound in the second quarter to just under 3% growth. So while the risk of an imminent recession is rising, we think it is still more likely that the economy will be able to avoid recession this year. 

The market will continue to respond to the path of inflation, which is very difficult for investors to predict. The positive case for the economy and the market is that inflation has peaked. That’s not impossible, especially considering developments already at work in the economy. The Fed’s 50 basis point hike, which occurred at the beginning of the month, coupled with the expectation of more hikes coming, could already be dampening upward price pressures. Certainly, the declines in the stock market will slow consumer demand to some degree. The alternative is continuing high inflation that further harms the economy. In this case, the Fed is behind the curve and will have to catch up with faster rate hikes that threaten a prolonged recession and bear market.  

It will take time to see enough data to determine with confidence whether we have brought inflation under control and stabilized the economy.  We are unlikely to see an end to the volatility for some months. However, volatility includes sharp moves upward as well. In a market like this, positive indications will have a large reaction in stock prices. We caution against making short-term decisions that will miss out on the eventual recovery rally. That said, we don’t expect the market to start a consistent rise until we can see inflation come down significantly and remain at lower levels.  

In this market, investors should balance the current high levels of volatility and uncertainty against the opportunity brought by the recent market declines. The next few months will likely continue to see large swings in the market but, historically, following big declines stocks have generated better than average returns. Investors with a short-term investment horizon or who are more sensitive to high volatility should consider implementing a more defensive position. For a long-term horizon, equity investments appear attractive in this market and these investors should consider holding or even adding to equity positions.  

Economic and Financial Market Outlook 2022 Q2

Entering the second quarter, the outlook for the global economy is uncommonly uncertain. The result is above average volatility in financial markets and rapidly shifting investing trends. In the US, the key issue is rising inflation and the response of the Federal Reserve as it attempts to pilot a soft landing (raising interest rates without causing a recession). In our March 2 blog and January 13 Outlook, we expressed confidence that the Fed would be successful. We still adhere to this view but acknowledge that inflation has proved to be more intractable and economically disruptive, which makes the Fed’s task more difficult. In addition to rising inflation, international markets will need to cope with the negative economic consequences of the Russian invasion of Ukraine as well as potential hurdles impeding a pickup in China. Although our forecast carries less conviction than usual, the most probable scenario is that 2022 US GDP will remain positive in the coming quarters, inflation will gradually subside below 5.0% by year-end, corporate profits will rise around 10.0%, and the S&P 500 will be higher at year-end than it is now. 

The US economy currently faces persistently high inflation. Monthly readings of core CPI (ex-food and energy) have risen each month since last September, with the latest reading at 6.5%, the highest in 40 years. In response, the Fed has indicated that it is ready to push through faster rate hikes and balance sheet reductions, which will slow the economy in hopes of dampening upward price pressures. We are intensely focused on the success of this course of action. Achieving a soft landing will enable the economy to continue its growth trajectory and prolong the post-pandemic recovery. However, if inflation continues at a high pace without relief, consumers and businesses will have to curtail spending and the Fed will take even more aggressive measures, increasing the likelihood of recession. 

The exceptional strength of the US economy has thus far blunted the negative impacts of high inflation. The unemployment rate of 3.6% has only been lower once in the past 50 years (3.5%, Oct. 2019). GDP grew 5.7% in 2021, the fastest year since 1984. The US consumer, the backbone of the economy, is solid; balance sheets are healthy, credit utilization is low, and wages are rising. Household cash exceeds debt for the first time since the early 1990’s. Nevertheless, two recession indicators occurred in the first quarter: a spike in oil prices and the inversion of the yield curve (when short-term rates go above long-term rates). Of these two, we are less concerned about oil as it has already stabilized well below the peak. The yield curve inversion, on the other hand while a more reliable predictor, has in the past delivered false signals and on other occasions preceded recession by as long as three years. The robust US economy, in particular the consumer, provides some room for error to navigate a soft landing or, at worst, fend off recession for at least 12-18 months. We expect GDP growth to remain positive every quarter this year, measuring 3.5% for the year. 

US stock markets swooned in the first quarter in response to escalating threats to the burgeoning economic expansion. Major benchmark indices are still mired in a correction, with the S&P 500 producing the first negative quarterly returns in two years. The forward P/E ratio of the S&P 500 index has dropped to 19.0 from the 21.3 recorded at the end of last year, with growth stocks experiencing an especially large multiple contraction. This indicates that current equity valuations are not alarmingly high considering the expected double-digit rise in 2022 corporate profits. If investors gain confidence in the resilience of corporate earnings and/or a successful soft landing, stock markets should make a sharp advance. However, if the Fed makes a policy error and leads the US toward recession, additional negative returns can be assumed before equities begin a new bull market cycle. 

Investing in international equity markets carries additional uncertainties and risks. In the EU, in addition to a more acute impact on consumption from higher energy and food prices, Russia’s invasion of Ukraine has dragged down sentiment, even while economies enjoy a boost from the lifting of COVID-19 restrictions. Alternatively, China is still imposing a “zero COVID-19” policy, which is negatively impacting growth. Encouragingly, however, China policymakers have pivoted to stimulating the economy and committed to achieving a 5.5% GDP growth rate in 2022. This stimulus may serve as the bedrock for a continuation of a strong global economic expansion. China and the US, in combination, account for 42% of global GDP. Our projection is that global GDP will slow to 3.8% in 2022 from 5.9% last year. The concern is that some economies may experience hard landings though the consensus view remains optimistic. The most recent forecasts cited in The Economist (04/09/2022) are encouraging: 

Region           4Q2021 GDP         2022 GDP
China                    6.6                          5.5
Euro Area            1.0                          3.3
Japan                    4.6                          2.8
Canada                 6.7                          3.8

If the forecasts are correct, policymakers will have avoided a hard landing scenario and equity markets will rise.  

In the bond markets, the strong economy, surging inflation, and anticipation of aggressive Fed rate hikes has swiftly pushed yields higher. The benchmark 10-year Treasury rocketed from 1.52% at the beginning of the year to 2.77% on April 11. Many investors fear that high inflation will result in a further updraft in interest rates, which could result in negative real (inflation-adjusted) returns on bond investments. In our view, bonds still do not offer a competitive return profile compared to inflation and stocks, though if held to maturity they offer portfolios protection from volatility. We normally emphasize quality and short duration in bond selection, and we think this advice is especially relevant now in order to protect principal in these uncertain times.  

Jonathan Smucker Named 2022 40 Under 40 Recipient

We are enthusiastic to announce that Marietta partner and portfolio manager, Jonathan Smucker, is a Milwaukee Business Journal 2022 40 Under 40 Award winner. The winners were announced in late January. The 40 Under 40 Awards recognize Milwaukee-area leaders with a strong record of innovation in their fields, outstanding performance in their business, and a clear track record of meaningful community involvement.

Besides Jonathan’s contributions at Marietta, he serves on the board of directors and is the chair of the marketing and communications committee at SecureFutures, a non-profit organization that empowers teens with financial education, tools, and mentorship. He is also involved directly in his community as a Shorewood Public Library board member. In addition, he aids another non-profit organization focused on youth leadership and development, Teens Grow Greens, through its advisory committee.

We congratulate Jonathan on this major accomplishment. To learn more about the 40 Under 40 Nominees, click this link to the Milwaukee Business Journal.

Economic and Financial Market Outlook 1Q 2022

Uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets. Investors agree that the major issues include inflation, COVID-19, central bank activity, labor and supply chain disruptions, the potential for international upheaval, and developments leading up to the US midterm election. What is hotly debated is how these issues will interact to impact the investment results for the year. The three most prominent scenarios currently debated in the media are highly divergent and range from strong optimism to alarming pessimism: moderate growth, hyperdrive economy, and recession risk. As the year progresses, we expect incoming data to change the prevailing viewpoint, resulting in sudden and dramatic shifts in financial markets. At this point, we do not think any one of the three scenarios warrants a greater than 50% probability for the year, and we advise against excessive reliance on any one of these investment narratives occurring comprehensively. Rather, our recommendation is that investors focus on their long-term strategy, exercise patience and discipline, emphasize quality and diversification, and avoid the temptation of market-timing or chasing short-term trends.  

We assign a 50% probability to the moderate growth scenario, which most closely reflects our current US outlook of 3-4% GDP expansion, a 10-15% rise in corporate earnings, and an advance of 8-12% in the S&P 500 Index. The “Goldilocks” forecast, which we consider the most correct, anticipates meaningful progress in the COVID-19 battle in the first quarter; we do not expect the Omicron variant to significantly damage the economy for the rest of the year. This will permit a boost to employment, consumer and business spending, and corporate earnings. The most likely threat to the recovery will come from the potential emergence of a new virus variant. We also agree with the moderate growth scenario’s assertion that inflation will rise early in the year, but then stabilize. A modest decline in inflation could occur as supply chain disruptions are ironed out, pent-up consumer spending during the COVID-19 period is satisfied, demand shifts from products to services, the more restrictive policy of the Federal Reserve takes hold, extraordinary fiscal stimulus policies lapse, and a gradual decline in labor shortages reduces the risk of a wage/price spiral. A relaxation in the threat of runaway inflation will permit the Federal Reserve to initiate its highly awaited rate hike cycle in a gradual and non-threatening way to the stock and bond markets.  

The second scenario, which we accord a 35% probability, assumes that the economy becomes overheated, and inflation spirals out of control. As in the moderate growth scenario, the expectation here is that the virus situation ceases to impact negatively the economy. However, labor shortages and wage gains persist, and consumers and businesses adopt inflation as a major consideration in their decision making. Supporters of this scenario also point to the likelihood that a concurrent reopening of international economies will elevate commodity prices, including oil. The result will be a rise in both GDP and inflation, somewhat reminiscent of the 1970s. In the meantime, the Federal Reserve will confront a rising criticism that they have responded too slowly, too indecisively, and in short, that they are behind the curve. 

The most pessimistic scenario, which we designate a 15% probability, projects the likelihood of a surprise recession and bear market. Here the thinking is that inflation will rise dramatically and prompt the Federal Reserve into aggressive and repressive rate hikes. This is a development which has punctuated the US economy several times over the past 50 years. While we think this scenario is unlikely, we are carefully watching recession indicators including the Treasury yield curve, the unemployment rate and initial jobless claims, the price of oil, corporate profit margins, manufacturing and services PMIs, consumer confidence, and housing prices.  

Each of the three above scenarios is associated with distinctive investment style outperformance. If the moderate growth forecast is correct there will be a double-digit stock market gain and a modest rise in bond yields. Growth stocks in the technology and consumer discretion industry sectors will lead the market higher, much as they have over the past decade. The hyperdrive economy scenario will produce a surge in the economy and corporate profits. The tide will be strong enough to lift all equity boats, but the leaders will be value stocks in the financial, materials, and industrial sectors. In the recession risk scenario, the market could well drop 20% or more and the best place for investors to limit losses and avoid volatility will be in the consumer staples and utilities sectors. Our current view is that investors should stay diversified and emphasize stocks of industry leading companies with strong management, and attractive recent earnings momentum and future potential.  

Conditions in the international economies and financial markets resemble the US. The IMF projects 2022 GDP to increase about 5.0% in both the developed and emerging country groups. We predict, however, considerable divergence as countries battle COVID-19 with mixed success. China and Europe will be the keys to the general outcome. The situation in China is worrisome: the government is taking ever more severe steps to impose its control over significant sectors of the economy, and at the same time, adopt restrictive policies to combat the virus. Also looming is a potential real estate crisis which could threaten a national financial upheaval. These myriad challenges are expected to slow the recovery and further exacerbate supply chain disruptions. On the other hand, if the government is successful in its virus containment measures and simultaneously stimulates the economy, there could well be a large boost to global demand. The stocks of Chinese companies were severely damaged in 2021 and we think a period of improved credibility is necessary to restore long-term investment prospects.  

The economies and equity markets of Europe have been underperformers relative to the US for so long that it would be easy to dismiss the possibility of a renaissance. Yet, this may happen in 2022. European companies and economies are in the best position relative to the rest of their international competitors as they have been in years, sporting solid GDP growth, higher vaccination rates, strong corporate balance sheets, and healthy consumers ready to spend. The political authorities and the European Central Bank are determined to keep economies open and vibrant. European stocks, particularly in the financial, industrial, and consumer sectors, could well provide positive earnings and stock price surprises. 

A major factor influencing all financial markets, in particular the bond market, will be the response of investors to the new policies of the Federal Reserve. We think that a key component of a moderate growth scenario will be a rise in bond yields, with the yield on the benchmark 10-year US Treasury Note topping 2.0%. In the hyperdrive economy scenario with higher inflation, the 10-year US Treasury Note could even top 3.0%. We do not consider these yields to be competitive with the total return potential of common stocks, and bonds with maturities more than 10 years could well experience a negative total return. The major attractiveness of bonds will be to provide portfolio stabilization in the event of a surprise recession and bear stock market.