Economic and Financial Market Outlook Q2 2024

Can We Anticipate More Good News?

Global investor focus is on the US economy and stock markets, which enjoyed a very strong gain in the first quarter. Can we anticipate more good news? Building on the Marietta Investment Team’s January 19 Outlook, we reaffirm its major points: there are two positive developments which suggest a further, sustainable market advance. First, inflation continues its slow decline, which will permit the Federal Reserve to introduce interest rate cuts this summer. Second, healthy economic growth, based on robust consumer spending, will continue for the duration of the year and fuel strong corporate earnings. Short-term, a market correction, limited in duration and severity, is possible and perhaps overdue, but long-term these two powerful stimulants point to further gains in the stock market and possibly a multi-year bull market.

US Economic Resilience Despite Inflation Above Target

The trajectory of inflation, which peaked at 9.1% in July 2022, has moderated to its current level of 3.2% (Bureau of Labor Statistics), representing a significant departure from the inflationary spikes experienced during the COVID period. Although inflation measures remain above the target, the Fed is evidently content with the progress made and forecasts three interest rate cuts this year. At the March 20 press conference, Fed Chair Jay Powell noted, “inflation has come way down, and that gives us the ability to approach this question carefully and feel more confident that inflation is moving down sustainably.” (AP News) This development is poised to support equity valuations as investors cheer lower interest rates.

At the heart of ongoing US economic stability is consumer spending, which constitutes nearly 70% of GDP. Despite challenges from elevated inflation and interest rates, consumer spending has remained robust, contributing to fourth quarter GDP growth of 3.4% and a 2.5% growth rate for 2023. The Atlanta Fed’s current estimate for the first quarter suggests a continuation of this trend, with a projected growth rate of 2.8%. Sentiment, while still below pre-COVID highs, has improved. The University of Michigan Survey of Consumers final March results indicate a +3.3% change month over month and a significant +28.1% surge year over year.

This enduring consumer strength, underscored by real wage growth and low unemployment rates, establishes a solid foundation for sustained future spending. Consumer debt is rising but is offset by real wage growth and is not yet alarming. Despite the hurdles posed by higher borrowing costs, this backdrop paints a cautiously optimistic picture for the US economy. A further decline in interest rates, prompted by potential future Fed rate cuts, would reinforce this positive trend.

US Equities: Balancing Growth and Valuation

US equity markets took off in the first quarter in response to declining inflation, robust economic growth, and ascending corporate earnings. With these underlying fundamentals expected to remain steady, the momentum of the current stock rally looks sustainable, with S&P 500 earnings expected to rise 11.0% in 2024 (FactSet Earnings Insight). We maintain our forecast that we are in the early stages of a new, multi-year bull market. Market internals, however, reveal a more nuanced environment for equities. The rally has notably been led by high growth sectors such as Artificial Intelligence, resulting in a concentrated market driven by a handful of companies. This phenomenon has been exacerbated by the ongoing disparity in performance between mega-cap stocks and smaller-cap companies. While market concentration is not inherently problematic, a broader rally across more industry sectors would be indicative of a more robust investment climate. Somewhat more concerning, valuations have risen to a cautionary level, though this could be justified if corporate earnings materialize as anticipated. Elevated valuations pose the risk of sharp negative market responses to adverse news. Considering that, on average, there is a 10%+ downturn every 14 months, a correction in the near future would not be surprising. If this does occur, we would anticipate it to be brief, mild, and perhaps even constructive for market health. While our outlook remains optimistic in the long term, we note that equity gains in the next six months will likely moderate after a notably strong first quarter.

International Recovery

Our forecast for the global economy is gradually improving and we now project a GDP advance of 3.2% in 2024 and 3.4% in 2025. The catalyst for our modest optimism is above-expectation growth in the US and China, supported by another year of healthy growth from India. Apart from the US, GDP gains in most developed countries will be sluggish and remain well below pre-pandemic levels. In particular, the Euro Area, which is recovering from a shallow recession in 2023, will need ECB interest rate cuts and a pickup in US and China trade to achieve 1.0% growth. A potential bright spot is Japan, where policymakers are promising corporate governance reforms, yet it is still difficult to anticipate a GDP growth rate above 1.0% in 2024.

We are keeping a close eye on China and emerging economies, where equity markets have been underperforming for years. The Conference Board estimates emerging and developing countries as a group to grow at a 4.0-4.5% rate in 2024. They emphasize that 70% of global GDP growth from 2025-2030 will be attributable to emerging economies, and they will “remain the key global growth engine.” China policymakers in March established a 5.0% GDP growth target for 2024, which will be a challenge unless the policymakers implement major stimulus. If China exceeds this target, emerging market equities will become increasingly attractive.

In past outlooks we have recommended investments in individual international-based equities rather than increasing international exposure through country ETFs. We confirm this view, as there are compelling international stocks with strong management teams, healthy balance sheets, and solid growth prospects trading at attractive valuations.

Bond Market Stabilization

The Fed is maintaining its 2.0% core inflation target, which we think may be achieved by the end of the year. In this event, short-term rates would fall substantially but we do not expect a similar decline in longer-term rates. For example, we think the benchmark 10-year US Treasury Note will stabilize around 4.0%, or about 2.0% above the inflation rate. It is likely that financial markets will celebrate the re-emergence of a normal yield curve (where short-term rates are below long-term rates) and a Fed policy that is considered neither stimulative nor restrictive. The major risk to our forecast is that stronger than anticipated inflation and growth will trigger a delay in rate cuts.

Economic and Financial Market Outlook Q1 2024

Summary

The global economy is approaching the end of a four-year period when financial markets were driven by concerns about the COVID pandemic, inflation, central bank policies, a spike in interest rates, and the omnipresent threat of a recession. We think these issues are largely behind us. In the final phase of this period, which will extend through the first half of 2024, a further decline in inflation will enable key central banks to reduce restrictive policies. In the second half of 2024, we expect the emergence of a new period of relatively stable economic growth and rising corporate profits that will create propitious conditions for global equities.

Soft Landing in Sight

The U.S. is poised to lead in this transition. In recent Outlooks we maintained the forecast of an economic soft-landing in which inflation would steadily recede and the economy would avoid recession. In 2023 we were correct: GDP rose 4.9% in the third quarter, and a preliminary estimate for the fourth quarter is 2.3% growth.  Resilient consumer confidence and spending supported by a strong labor market should continue into 2024. A decline in core inflation to approximately 2.5% and two 25 bps cuts in short-term rates by summer will also help GDP remain positive. The second half of the year holds even more promise for steady growth and lower, less volatile rates. Overall, we now estimate 2024 GDP growth will be 2.0% and inflation will near the 2.0% target of the Federal Reserve, allowing the Fed to further reduce rates in the second half. We expect to no longer see an inverted yield curve by year-end.

Is This the Beginning of a New Bull Market?

The US stock market has considerable momentum entering 2024 and the outlook remains bright.  In November and December, optimism spread that lower inflation and interest rates along with higher GDP and earnings lay down the road, and the result was double-digit rallies in the major US market benchmarks.  The question now is whether stocks are overvalued and vulnerable to another large setback, or whether the current rally is the beginning of more gains and possibly a multi-year bull market.  The answer will depend on the strength of corporate profits. Earnings for the S&P 500 Index grew 4.9% in the 3rd quarter of 2023 and the consensus forecast for the 4th quarter is 2.4%.  We think the recovering economy in 2024 will be strong enough for earnings to rise 10-12%. The market in our view is fully valued but not overvalued, and thus will rise at the same pace as earnings. This will be welcome news for stock investors who have experienced extraordinary volatility over the past 4 years: two declines of at least 25% separated by a dizzying rally that doubled many equity benchmarks. We think their patience for reduced volatility is about to be rewarded.

A Global Rebound

Major international economies, with the notable exception of China, will likely experience the same positive developments occurring in the US. Moderation of inflation will enable acceleration of GDP growth ex-China, though the Eurozone will be mired in a soft patch for much of the year before picking up going into 2025. We maintain a cautious view towards China. Stimulus was less than expected and insufficient to boost their economy. The OECD forecasts China’s GDP growth to slow to 4.7% in 2024, down from 5.2% in 2023. We questioned in our last Outlook whether China has the determination to take the necessary steps to restore growth. So far the answer appears to be that they do not. Overall, we are encouraged that global growth appears to be making a favorable turn but we note that international economies comparatively are not as well positioned as the US. Therefore, investors looking for international exposure should continue to focus on companies that are experiencing positive secular trends. There is still potential for attractive returns in these markets with an average multiple of 12.8x forward earnings for companies in the ACWI ex-US index.

There Are Still Reasons for Caution

Despite the many positives for equity markets, we must still caution against complacency. The greatest threats are less likely to come from any of the problems of the past 4 years (pandemic, inflation, interest rates, etc.), but rather from new issues emerging. Foremost, we are sensitive to the potential for international conflict to disrupt trade and supply chains. We are closely monitoring Ukraine, Israel and the broader Middle East, and Taiwan. Global business seems to be navigating these situations successfully so far but escalation, particularly in the Middle East and Taiwan, would have a major negative impact on the global economy as those areas contain the world’s most important shipping routes. Second, commercial real estate is still struggling with the post-covid trend of remote work and lower demand for office space. While we believe that this will be a drag on the real estate and finance sectors of the market we do not see this spilling over into a crisis for the whole economy. Nevertheless, there are many unknowns about the exposure to assets that will inevitably see their values decline. This warrants close monitoring as well.

Excitement Over Higher Yields May Be Short-lived

The stock market rally of last November and December coincided with a sharp decline in bond yields. The table below shows peak US Treasury yields (occurring in October) and the subsequent drop.

The yield on the benchmark 10-year T Note, for example, fell from 4.99% to 3.88%. In the near term, we forecast additional declines across the yield curve, with the largest declines occurring in the shortest maturities. We expect this will finally bring to an end the inverted yield curve, which has generated much of the recession speculation in recent years. With this outlook, fixed-income investors may wish to lock in these yields to protect against future drops in rates. In our view though, we think a stronger and more stable economy will eventually lead to a rise in longer-term yields. We are not yet ready to advise increasing longer duration holdings and as always we recommend staying with high-quality issues. Lastly, we note that if inflation does fall to the Fed’s 2% target, the days of money-market funds and Treasury bills yielding over 5% will be over. When this occurs, trillions of dollars will seek alternative investments, including stocks.

Economic and Financial Market Outlook Q4 2023

Cautious Optimism

Our outlook for the US economy and stock market remains constructive, albeit tempered by rising oil prices and long-term treasury yields surging to levels not seen since 2006. Another potential threat is that Federal Reserve policy will be too restrictive by maintaining high interest rates for too long. Despite these headwinds, our 2024 forecast is for US GDP to grow 2.0%, core PCE inflation to soften to 2.0%, and stock market indices to increase in tandem with a projected 10-12% expansion in corporate profits. It is more difficult to hold a positive outlook for the major international economies and markets, with China struggling to control a property crisis and Europe facing stagflation. Yet there are select companies with robust earnings growth which remain appealing. In the bond market, short-term interest rates offer appealing yield and stability, but long-term interest rates carry the risk of moving higher and lowering the value of longer maturity bonds.

Third Quarter Blues

At the writing of our last Outlook on July 14, we expressed an expectation for an economic soft landing in the US. This included slowing growth but avoiding recession due to low unemployment, further easing of inflationary pressures, and a resilient consumer. In August and September, data indicated the economy might actually be accelerating. Retail sales were strong, the unemployment rate remained near its five-decade low, job openings were plentiful, the Manufacturing Purchasing Manager’s Index rose to a ten-month high, and the construction industry was surprisingly healthy. Forecasters rushed to increase GDP expectations. The Atlanta Fed’s GDPNow reading for the third quarter, for example, jumped to 5.1%. Suddenly, the fear that the economy was slumping and headed for a recession was replaced by a fear that the too-hot economy would trigger long lasting inflation. The Fed fueled this view by hiking the benchmark interest rate by 25 basis points and suggesting that rates would remain at elevated levels well into 2024. Long-term bond yields swiftly adjusted higher, which if sustained could burden entities depending on revolving debt. In short, the prospect rose that the Fed would push the economy into recession by keeping rates too high for too long. In September, this dismal mood was exacerbated by the 30% jump in oil prices, labor strikes stoking fears of a wage-price spiral, a potential government shutdown, and further evidence that the Chinese economy had not improved.

A Solid Foundation

The two pillars of a positive forecast for 2024, which we think will gradually overcome the negative scenarios, are a constructive view of inflation and a continuing expectation of moderate economic growth. The reality is that the Fed’s preferred measure of inflation has been coming down steadily for over a year with a drop from 6.3% to 3.9%: the latest three-month annualized rate shows a near-target 2.2%.

Data: Bureau of Economic Analysis; Chart: Axios Visuals

Easing inflation makes sense considering its main causes. The surge since 2020 was a direct consequence of COVID-19 and the government’s response with unprecedented transfer payments and shutdowns. In contrast, today COVID-19 no longer has a significant economic impact and the stimulus spending has come to an end. We think it is highly likely that inflation will decline to pre-COVID levels by 2025. The case for moderate GDP growth next year is supported by this year’s impressive economy in the face of a Fed Funds rate rising to 5.5%. High borrowing costs will be a drag on the economy but not sufficient to result in a downturn. Among other positives, the labor market and consumer spending may well be slowed but not reversed.

Will Stocks Recover or Retreat?

If our forecasts on inflation and the economy prove accurate, it is likely that we are on the brink of a new bull market. With inflation subsiding in the fourth quarter, we anticipate at most one more quarter-point rate hike from the Fed later this year, followed by a prolonged pause. Less threatening inflation and Fed policy will provide a huge relief to equity markets. Also key will be a return to corporate earnings growth. After three consecutive quarters of contraction, S&P 500 profits are set to accelerate to a double-digit gain in 2024. A claim often used to support the negative forecast is that the market has risen to an unsustainable level and that valuations are excessive. We noted in our last Outlook that the performance of the S&P 500 Index was not representative of the overall stock market. This situation continued through the third quarter, with the S&P 500 +13.1% year to date, whereas the Dow Jones Industrial Average and the Russell 2000 reported modest gains of +1.1% and +2.5% respectively. The S&P Small Cap 600 Index was +0.8%. From this perspective, valuations are not currently excessive. The S&P 500 trades at 17.9x forward earnings, below the five-year average (FactSet Earnings Insight, 9/29/23). We conclude that many quality stocks have attractive valuations, and they will respond favorably to good earnings reports. We prefer companies with strong earnings prospects, especially those that thrive on improving economic conditions in the industrial, technology, and consumer discretion sectors.

International Obstacles

In its latest World Economic Outlook (10/10/23), the International Monetary Fund forecast global growth of 3.0% in 2023 and 2.9% in 2024, well below the 3.8% average over the 2000-2019 period. Numerous economic and geopolitical factors account for this discouraging outlook, but the principal factors are the continuing slump in China and the wide-reaching impact of EU and US central bank policies to reduce inflation. The IMF expects Chinese growth to rebound modestly to 5.0% next year from a below-target 3.0% in 2023 but anticipates a slower recovery in Europe, with the euro area narrowly avoiding recession this year followed by a modest 1.2% gain in 2024. Slightly less pessimistic is the IMF’s expectation of a future decline in global inflation from a high of 8.7% in 2022 to 6.9% in 2023 to a still lofty 5.8% in 2024. We accept the somewhat gloomy prognostications of the IMF but are hopeful that there will be an upside surprise if the policymakers in China and Europe are more successful.

Entering 2023, China’s economy was expected to rebound strongly following the restrictive “zero-COVID” shutdowns. Consumer spending flourished for a brief period, but then deteriorated into weak growth and deflation. During the summer, the policymakers responded with surprisingly weak and ineffective measures. The once prosperous property market is perhaps the greatest problem, but there is also a sharp downturn in exports and industrial production. Chinese consumers have evidently lost confidence: retail sales are slumping, employment is uncertain, and wages are stagnant. In the past, such as in 2008, the Chinese government responded quickly and decisively with successful stimulus policies. Why are policymakers so inactive this time? In a lengthy cover article, “Xi’s Failing Model: Why He Won’t Fix China’s Economy,” The Economist (8/26/23) rendered a verdict that, “Mr. Xi lacks the credibility or focus of previous leaders.” Our view is that the Chinese authorities have the ability to restore prosperity as in past crises, but we do not know whether they have the determination.

The euro area’s economic woes are more similar to the US than China. Inflation is a central problem, which is higher and descending more slowly than in the US. The ECB is determined to stamp out inflation with restrictive measures, but they run the serious risk of pushing the economy into a recession, convincing some observers that they would prefer a hard landing with economic pain rather than failing to reduce inflation. At this point, unemployment remains at a record low while the demand for goods and services is weak. The worst may well be behind us and baked into current forecasts, but there is little evidence of any imminent improvement. Investors should focus on companies that have been able to grow earnings and revenue in the current challenging environment, as we do not have good visibility on when the current headwinds will abate.

Relief for Bond Investors

The major surprise in the third quarter was long-term interest rates rising to decade highs, with the 10-year Treasury yield moving above 4.5%. This has increased the attractiveness of bonds as an investment. We expect long- and short-term rates to remain near these levels throughout 2024. However, we continue to favor bonds maturing within five years as longer bonds still carry excessive interest rate risk. We also recommend maintaining investments in high quality issues rather than junk bonds and view equity markets as a more appropriate asset to seek higher returns in a balanced portfolio.

Economic and Financial Market Outlook Q3 2023

Prepare for a Soft Landing

The global economy continues to slow, but the US and euro area should avoid recession, albeit narrowly.  We expect a positive global GDP growth surprise of 3.0% to 3.5% for 2023, based in part on the anticipated boost from coming stimulus in China.  In the second quarter the views of the most probable US scenario shifted from recession to “soft landing,” which reflected the capacity of the economy to withstand inflation and higher interest rates. We now estimate the likelihood of a recession to be below 20%. The improved environment raises prospects for the US stock market and reduces the probability of a renewed bear market. We are cautiously optimistic regarding a further advance of the S&P 500 Index, but we note that this Index over the last six months has featured extreme divergence in the performance of different industry sectors and market capitalizations. This is unhealthy, and a near-term correction is possible. The arrival of more favorable macro conditions should broaden participation and makes a future market advance more sustainable.

US Economy Refuses to Quit

So far this year, the US economy has exhibited surprising strength. In the first half of 2023 there was plenty of bad news: the Federal Reserve hiked rate above expectations, inflation declined at a disappointingly slow pace, major banks failed, the government tottered on the brink of default, international economies were weaker than anticipated, manufacturing indicators contracted, and recession predictions were ubiquitous. Yet the economy continued to grow. US GDP rose 2.0% in the first quarter, and we expect a similar result for the second quarter. The major support for the economy has been the labor market: the unemployment rate has settled near a 70-year low and job creation has been vibrant.  Home prices and sales have remained firm despite a sharp increase in mortgage rates, and consumer sentiment and spending data have been encouraging.  As the quarter drew to a close, there was a notable jump in optimism that the soft-landing scenario was the most probable.

What does a soft-landing look like?

Over the next two quarters, we expect GDP growth to approach 0.0% but remain positive, as the lagging impact of previous Fed rate hikes takes its toll. Annual CPI inflation will continue to decline gradually from its current 4.0% but remain above the Fed’s 2.0% target.  We estimate two more quarter point rate increases, the first in July and the second in September.  By the end of the third quarter, the Fed will be satisfied with the reduction of inflation from its peak of 8.3% in 2022 to below 3.0% and decide to pause rather than raise rates further but we do not expect any decisions to lower rates until well into 2024.   Despite higher rates, the labor market will stay strong with the unemployment rate below 4.0%. As was true in the first half, this positive scenario will be driven by the resilience of consumers and businesses spending and investing despite the headwinds of inflation and worries of an impending recession. The housing and auto markets should remain healthy. Recent, successful stress tests administered to banks have been encouraging and we think another banking crisis is unlikely. While all of this should be welcomed as good news, conditions are intended to remain tight to slow the economy and GDP will be on the cusp of contraction. There remains a lot of progress to be made before we are on a path of healthy, sustainable growth.

US Stock Market Resilient

The unexpected strength of the US economy drove equity markets to advance in the first half of the year. In the face of a slowing economy and a forecasted recession, high inflation and rising interest rates, and fear of government default, the market rally was certainly a surprise to investors. While the S&P 500 index had the strongest performance, most broad market indexes provided positive if unspectacular single digit returns:

12/31/2022 - 6/30/2023 Total Return
S&P 500 Equal Weighted Index 7.0%
S&P Mid Cap 400 8.8%
S&P Small Cap 600 6.0%
Russell 2000 8.1%
Dow Jones Industrial Average 3.8%
Source: FactSet


7 of the 10 Industry sectors of the S&P 500 Index returned less than 10%, and 5 were negative or flat: consumer staples (0.0%), financials (-1.5%), health care (-2.3%), utilities (-7.2%), and energy (-7.3%).

In sharp contrast is the truly remarkable performance of technology stocks and especially the largest stocks by market capitalization (see our 6/2/23 blog, “2023 US Stock Markets: The Year of the Giant.”). For the six-month period, the technology heavy NASDAQ Composite and the information technology sector of the S&P 500 Index rocketed 31.7% and 42.1% respectively, and the six largest companies measured by market capitalization rose an average of 85.3%: Alphabet 36.3%, Amazon 55.2%, Apple 49.7%, Meta 138.5%, Microsoft 42.7%, and Nvidia 189.5%. These giant companies have a combined market cap above $9.4 trillion, or about 26% of the total S&P 500 Index. This is the reason the S&P 500 Index (+15.9%) was such an outlier in the first half. As we pointed out in the blog, the S&P 500 Index was not representative of overall stock markets and well-diversified portfolios saw more modest single digit returns in line with most other indexes.

For the rest of the year, we expect the path of inflation and the response of the Fed to be the major focus of stock investors. Based on our forecast for a continued decline in inflation, we expect the market rally to extend through the end of the year. Although additional rate hikes are coming, investors expect this and the modest increases should not pose a significantly larger obstacle than the previous 500 bps.  We project corporate earnings will turn positive again in the third quarter and accelerate in the fourth quarter, justifying current higher price multiples. Our positive forecast includes a broadening of market participation away from a reliance on the largest stocks mentioned above.

International Green Shoots

In China, the financial market situation has turned ambiguous after a brief surge earlier this year. A short-lived rally in stocks faded as the economic headwinds arose. In response, the government has resorted to stimulus measures to invigorate the economy, and we anticipate more in the pipeline. Contrary to the rest of the world, China has faced deflationary pressures, underscored by June’s negative core CPI. While deflation has presented a challenge for the world’s most populous country, it has benefited the rest of the world where inflation is still an obstacle.

Turning to the European Union, the economic landscape more closely resembles the US, albeit on slightly weaker footing. Harmonized CPI inflation has cooled from 8.5% in February to 5.5% in June as growth stalled. Though consumption and manufacturing have been contracting, we may be seeing early indications that the worst is behind us. If this is indeed the case, the EU will emerge from this slowdown without a substantial rise in unemployment, which could lead to a rapid recovery. A noteworthy risk remains the ongoing conflict in Ukraine, with the potential to cause supply shocks and exacerbate geopolitical tension.

Recoveries in other international economies have added to our cautious optimism. India’s growth has accelerated even while inflation has retreated. Similarly, we are seeing robust momentum in Mexico and much of Latin and South America, despite some political turbulence. Japan, too, presents an encouraging picture with a 17-month high in consumer confidence and a low unemployment rate of 2.6%.

Fixed Income and Higher Rates

The recent bond selloff has brought rates back near the highs set late last year. The 10-year Treasury yield approached 4.0% at the end of the quarter and briefly exceeded that in the early days of July. As investors’ appetite for risk assets like stocks grew, coupled with their acceptance of higher fed fund rates through 2024, perceived safe assets like treasuries were out of favor. As a result, new fixed income investments are providing the most attractive real yields in over a decade. The yield curve remains inverted which means both that there is still an expectation for recession in the near future and the best yields are in short maturity bonds. In this environment, it is worthwhile for balanced portfolios to consider whether bond investments can now be a greater part of their strategy but we continue to recommend that investments focus on high-quality and short duration selections.

 

Economic and Financial Market Outlook Q2 2023

Summary

The rising risk of a US recession has diminished our cautious optimism for global equity markets, as stated in our January Outlook. The first quarter introduced new challenges to growth, including persistently high wage inflation, OPEC’s oil production cuts, and a banking crisis. These negative surprises are concerning and elevate the likelihood of a more severe downturn in the US. In fact, most countries are experiencing declining economic activity, though a soft landing is still possible. Investors with an elevated concern for preservation of capital may consider adopting defensive strategies until conditions improve.

Clouds over the US Economy

The US economy is mired in a difficult environment marked by slowing GDP growth, high inflation, and a Federal Reserve committed to raising interest rates further. The Economist April 8-14 consensus forecasts 2023 US GDP growth to slow to 0.8%, from 2.1% in 2022. The labor market remains a bright spot, with unemployment rates near all-time lows. This has sustained robust consumer spending, though consumers have progressively reduced their savings and relied more on credit for purchases. Though the strong labor market indicates that the US is not currently in a recession, it also has the effect of keeping wages stubbornly high. This creates sticky core inflation and puts pressure on the Federal Reserve to implement additional rate hikes, which impedes economic growth and can cause unintended consequences, like the banking crisis in the first quarter.

Bank Crisis Update

Almost a month has passed since a massive withdrawal of deposits at Silicon Valley Bank on March 9 led to its sudden collapse and triggered a bank crisis. Within a week, several other banks required a rescue. Fears spread that problems in the banking system were systemic and would endanger the entire global banking industry (see Marietta blog Bank Failures Increase Uncertainty 3/21/23). In recent weeks bank stocks have stabilized, although at a lower level, and fears of a prolonged crisis have subsided. The relative calm is due in part to autopsies of the failed banks, which indicates the bankruptcies were a consequence of mismanagement and not a systemic weakness. The stabilization was also in part a consequence of the rapid and effective action taken by the Fed and the Treasury Department.

At this point there is temptation to declare that the bank crisis is over. We think this view is premature, though the risk of a financial meltdown similar to 2008 is unlikely. The new emergency lending facility, the Bank Term Funding Program, is a very positive step forward, as is the government’s readiness to protect depositors. But there is still room for negative contagion to resurface, especially as the Fed funds rate goes even higher. One potential threat is that a huge flow of funds out of bank deposits into money market funds and US treasuries will diminish banks’ willingness and ability to loan, which will slow the economy. Worth noting is the April 4 warning by Jamie Dimon, chairman and CEO of JP Morgan, “the current crisis is not yet over, and even when it is behind us, there will be repercussions from it for years to come.”

Resilient US Stock Markets

US stock market indices have been resilient, continuing to advance from October lows. However, S&P 500 earnings have fallen for two successive quarters, with projections for the first quarter indicating a third consecutive decline. As companies factor in the negative surprises from the first quarter, it is probable that management teams will issue further downward guidance. This combination of lower earnings expectations and higher stock prices has stretched valuations, pushing up the S&P 500 forward price-to-earnings ratio to 18.0x, above the 10-year average of 17.3x (FactSet Earnings Insight 4/6/23). As equities have gotten more “expensive,” yields on money markets and short-term bonds have risen to a level where they are a legitimate competitive investment. This is a relatively recent phenomenon; it has yet to be seen whether this will significantly impact the price investors are willing to pay for stocks, though the massive movement out of low yield money market funds indicates that investors are paying attention. Though the near-term outlook is muddled, we remain confident in our view that equities will provide investors with solid long-term returns. Investors should focus on adding exposure to quality companies with talented management teams, strong balance sheets, manageable debt levels, and growing market share. Special attention should be given to those companies benefiting from China’s reopening and a weakening dollar.

The International Opportunity

Despite strong growth in India and China, over 90% of international advanced economies are expected to endure declining growth in 2023 (International Monetary Fund, April 11 World Economic Outlook). We expect global growth to decline from 3.4% in 2022 to 2.8% in 2023, in-line with the IMF projection. Although this still constitutes a soft landing, there is a greater risk to the downside. The major negative developments causing this decline are high inflation, synchronized tightening monetary policy, the banking crisis, and the consequences of Russia’s War in Ukraine. A notable gap has opened between GDP growth expectations of 5.2% in China, and, in contrast, 1.6% in the US and 0.8% in the Euro Area. Much of this difference may be attributed to an estimated 2023 inflation rate of only 2.0% in China versus 4.5% in the US and 5.3% in the Euro Area.

We reiterate our view from our last Outlook that long-term investors consider adding more international stocks to their investment portfolios. The US dollar peaked in October and international stocks have rallied over +23% since, measured by the MSCI All-Country World ex-US Index (ACWX). The anticipated economic weakness in the US could push down the dollar further, continuing this trend. Despite this quiet rally, valuations remain compelling at 13.0x 2023 earnings. Developed international company earnings are expected to rise in the first half of 2023, in contrast to the US where they are expected to fall. Not all opportunities are created equal, and our focus is on high quality companies benefiting from long-term trends, including the burgeoning Chinese consumer, the proliferation of semiconductors, and resilient global household spending.

Bonds a Practical Alternative

As concerns for the economy have increased and the inflation rate has slowly come down, yields have reflected this by declining from March highs. In this period where there is a rising risk of recession, quality remains a prime consideration. We reiterate that short-term treasuries offer the best risk reward over money markets and longer-term bonds.

Economic and Financial Market Outlook Q1 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.

Economic and Financial Market Outlook Q4 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.

Economic and Financial Market Outlook Q3 2022

Almost all the largest world economies, including the United States, are experiencing a growth slowdown and troubled financial markets. Consumers and businesses continue to grapple with soaring inflation, which in the US and Eurozone has topped 8.0%. The focus is now on the response of central banks to combat inflation and whether they can do so without excessively damaging their economies. While prices in the US likely will remain uncomfortably high throughout the summer, our view is that inflation is peaking and will ease to below 5.0% by year-end. This would permit the Federal Reserve to stop raising the Fed funds rate, which will pave the way for an economic rebound and a turnaround in slumping stock markets. The major risk is that the Fed will raise rates too high for too long and trigger a recession of increased severity. Even if this scenario occurs, we think that in its severity it will be typical of the average recession in the past 70 years. Similar to previous recoveries, we expect large equity gains in the first months, or even weeks, of the rally.

US first quarter GDP came in at –1.4% and forecasts for the second quarter show an increased likelihood of consecutive quarters of negative growth. There will be a debate over whether this constitutes a recession (we note that NBER is the official judge of the beginning and end of recessions, and typically give their opinion long after the fact). Rather than laboring over semantics, it is most useful to acknowledge that the economy is weakening: the high rate of inflation is taking a toll on the economy and Fed rate hikes are intensifying pressures on growth. We pointed this out in our May 12 blog, “The Risk of Recession is Rising.” Since then, several leading economic indicators soured, including new orders in purchasing manager surveys, the Conference Board Leading Economic Index, job openings, auto sales, and home sales. A turnaround will require substantial moderation in inflation to restore confidence and spending. Recent developments have been constructive on this front: a sharp decline in industrial commodity prices and even gasoline have contributed to a recent easing of input costs. An improvement in supply chain bottlenecks would provide further relief. But the key to decreasing inflation in the coming months will be the cooling economy.

The major US stock indices are officially in a bear market: the NASDAQ composite plummeted 22.4% in the second quarter alone and 29.5% for the half year, while the S&P 500 dropped 16.1% in the second quarter and produced the worst first half returns since 1970. Many of the leading US corporations have suffered major first half stock price plunges:

Stock Ticker 1H22 Performance
AAPL -23.0%
AMZN -36.3%
BAC -30.0%
BA -32.1%
DD -31.2%
DIS -39.1%
GM -45.8%
GOOGL -24.8%
HD -33.9%
JPM -28.9%
MSFT -23.6%
NKE -38.7%
SBUX -34.7%
TGT -39.0%

 

Our view is that for equities to reverse this downward trend, there needs to be a sign that the Fed will end its anti-growth policy of monetary tightening. As we mentioned above, this will only happen once inflation is deemed to have been sufficiently subdued. If our forecast that inflation will moderate over the next several months is correct, and, in response, the Fed indicates an end to their rate hike cycle in a timely manner, then there is a strong probability that the stock market will bottom in the second half of the year and commence a new bull market. There is solid historical evidence to expect the eventual market recovery will be fast and strong. The past three bear market lows in 2020, 2009, and 2002 were followed by 3-month advances of +35.1%, +40.2%, and +20.0%, respectively.

We acknowledge that there is a rising risk that the US economy will suffer something deeper than a modest recession. The major threat is a policy error from the Fed. Historically, the full impact of higher interest rates has not become evident until six to nine months later. This means that the Fed will be raising the benchmark interest rate based on an assumption of future conditions, which will make it easy to overshoot. On the other hand, if the Fed wavers too soon and does not sufficiently tackle the inflation problem, a prolonged period of stagflation and market turmoil could result. We are monitoring closely the US labor market for evidence of a wage-price spiral, which inflamed the inflation problem in the 1970s but has yet to occur this year. Another risk is the geopolitical threat of Russia further upending the global energy trade. Russia is one of the top three oil producing nations and provides most of the natural gas the EU consumes. A disruption in the flow of these natural resources could cause another massive spike in oil and natural gas to record highs.

Most developed international economies are experiencing the same threat of inflation and economic deterioration as the US. From The latest inflation data in the EU is 8.1% year-over-year, Britain is 9.1% and Spain has reached double-digits. The only exceptions are China and Japan, at 2.1% and 2.4% respectively (The Economist 7/2/2022). Like in the US, the European Central Bank, as well as the central banks of Britain, Canada, and Australia, have telegraphed their intention to tighten monetary policy. The consequence has been a growth slowdown in these countries with the additional threat of an energy shortage in the Euro Area, which may make consumer hardship worse than in the US. Indeed, the euro has declined to a 20-year low and reached parity with the US dollar. In contrast, Chinese policymakers, spared from high inflation, are taking steps to stimulate their economy and growth has recently accelerated back above 5.0% despite rolling COVID-19 lockdowns. We recommend investors focus on individual companies benefiting from long-term secular trends with strong fundamental growth opportunities in the Euro Area, Canada, and Australia. While Chinese equities are attractive from a valuation and earnings perspective, the regulatory risks remain elevated.

The benchmark US Treasury bond has continued its march higher, reaching above 3.0%. This has by some measures resulted in the worst first half ever on record for US Treasuries (index inception 1973). While higher yields appear tempting to bond investors, real returns (inflation adjusted) are worse now than when interest rates were near zero. We reiterate our view that bonds do not offer a competitive medium- or long-term return profile compared to inflation and stocks. We think the principal benefit of bonds is their role in portfolios as a volatility stabilizer and continue to emphasize quality and short duration in bond selection.

Economic and Financial Market Outlook Q2 2022

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.  

Economic and Financial Market Outlook Q1 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.