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.

Economic and Financial Market Outlook 3Q 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.

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.  

Reflections on the Current US Stock Market Correction

Our January 13 Economic and Financial Market Outlook opened with the comment, “uncertainty and volatility dominate the 2022 outlook for global and US economic growth and financial markets.” Through the first two months, this has certainly been the case. Well before the Russian invasion of Ukraine, a barbaric and inhumane catastrophe that saddens us greatly, the S&P 500 Index had already approached a correction, which we define as a 10% or greater decline. By the 23rd of February, as Russian armies prepared to launch a full-scale invasion of Ukraine, the S&P 500 had retreated 11.2% and the technology-heavy NASDAQ had fallen 17.9%. Within the S&P 500, 40% of stocks had experienced a 20% or greater sell off. A discussion of the current correction, which places it in historical perspective, is useful to guide investors through the volatility. Though the stock market’s sudden retreat has been startling, it is worth keeping in mind that including this correction, the S&P 500 has provided strongly positive returns over the past 1-, 3-, and 5-year periods. We also think it is most probable that the current correction will resolve without a recession and corresponding bear market.

Corrections are not an uncommon occurrence, with 24 instances since 1974, or about one every two years. Only 5 of these 24 turned into a full-fledged bear market with at least a 20% decline. The remaining 19 recovered to reach new highs and continue a prior bull market. The average duration from peak to trough has been 177 days, with a median duration of 87 days. So far, the duration of this year’s peak on January 3 to trough on February 23 was 51 days. If this correction proves to be typical, we are already more than halfway through it and the worst may be behind us.

The consensus view is that there are two major developments behind the retreat in equities. One is the threat that rising inflation will prompt the Federal Reserve into excessive rate hikes, which has led to several recessions in the past. The optimistic view is that the Fed will be able to tame inflation, and restore its own credibility, without causing a recession. Many investors are skeptical. The recent surge in inflation increased fears that the Fed would need to adopt more restrictive policies more quickly than anticipated. There is a widespread view that the US economy is not strong enough to absorb higher interest rates. We do not think that the expected 4 or 5 rate increases in 2022 to 1-2% is high enough to meaningfully upset economic growth. The Fed is determined to avoid recession speculation and possible financial market dislocations and yet be strong enough to have a propitious impact on inflation. We also expect a gradual improvement in supply chain disruptions and reduced labor shortages to slow the rate of inflation. Our conclusion is that inflation will peak in the first half of 2022 and trend lower by year-end, so that a corresponding Fed-induced recession will be avoided.

The second threat is that the Russian invasion of Ukraine will create significant global economic upheaval with highly uncertain negative consequences. It has already caused a further jump in the cost of most commodities, which makes the Fed’s task of subduing inflation even more problematic. An area of special concern is Russia’s substantial oil and gas exports, which could result in significant shortages and price shocks if these exports are shut down. Currently, Europe relies on Russia for nearly 40% of its natural gas and 25% of its oil. However, apart from energy the Russian economy is too small, about 2% of global GDP, to have serious impact. Similarly, the ongoing plunges in the ruble and Russian banking system, while shocking, is of minimal influence outside Russia. We do not know Putin’s ultimate objectives, but we do not think he is willing to risk an expansion of warfare by attacking NATO member countries. Although the Russian invasion of Ukraine will have huge humanitarian and geopolitical consequences, we do not think that it will derail the global economic expansion.

The two threats to the US economy and stock market come at time when the economy is exhibiting impressive strength; this provides a major argument against the likelihood of US recession and bear market this year. Economic indicators remain very strong despite the lingering effects of the COVID-19 Omicron variant. The unemployment rate remains low at 4.0% and labor markets should be able to withstand rate increases of 1-2%. Real GDP expanded a massive 6.9% in the 4th quarter, and manufacturing and services purchasing manager reports indicate huge demand for and production of goods and services. US consumers are as healthy as they have been in decades. Consumer confidence has dropped below the all-time highs reached in 2019 but is still above the 10-year average. Corporate profits in the 4th quarter experienced their 4th consecutive rise of at least 30%. With mask mandates ending and local economies fully reopened from COVID restrictions, a 2022 recession seems extraordinarily unlikely.

It is never comfortable when stocks fall to this degree, but our advice in the January Outlook remains appropriate. Although we did not foresee the crisis in Ukraine, we expected heightened volatility this year. Despite the seriousness of world events, our long-term view of the global economic expansion is unchanged. As we wrote in January, we continue to recommend that “investors focus on their long-term strategy, exercise patience and discipline … and avoid chasing short-term trends.”

Economic and Financial Market Outlook 2021 Q3

Our 2021 forecast, which we have held since our first quarter Outlook, remains intact: a synchronized global economic expansion is underway, will extend into 2022, and will support another year of rising stock markets. The International Monetary Fund in April projected 2021 global GDP growth of 6.0% and The Economist projects this gain will be led by the US (6.0%) and China (8.5%). We acknowledge that the extent of economic progress for most countries, including the US, will be determined by their ability to secure and distribute COVID-19 vaccines, sustainably reopen their economies, and successfully implement fiscal and monetary policies. We observe significant divergence in the speed and magnitude of country recoveries, but overall growth should provide solid opportunities for equity investors.

The US economy is experiencing a stronger than expected vaccine-powered recovery, led by consumer spending. In response to recent indications of strength, on July 1 the IMF raised its 2021 US GDP estimate from 6.4% to 7.0%. Going forward, extremely accommodative monetary policies adopted by the Federal Reserve in combination with highly stimulative fiscal spending by the US Congress and Administration will be a major support. A bulge in household savings rates during the pandemic coupled with employment gains in the millions and rising wages will further boost consumer spending. Another development is a potential surge in home equity loans arising from the large increases in property prices at this time of very low interest rates. Additional positives include the pent-up demand in capital expenditures and a pickup in international economies.

The US stock market continues to be highly attractive. Corporate earnings have mushroomed far above analyst expectations so far this year: based on consensus analyst projections (FactSet, 6/17/21), we expect 2021 year-over-year S&P 500 profit growth of 61.9% for the second quarter and 34.8% for all of 2021. Public companies are eager to restore share buyback programs and raise dividends, both of which are positives for their stocks. There is still $4.5 trillion in money market funds on the sidelines (Investment Company Institute, 7/1/21) that could flow into equities as investors reallocate their portfolios. The S&P 500 Index currently trades at a forward P/E ratio of 21.7x, which is reasonable compared to the 5-year average of 18.0x. In other words, the forecasted rise in corporate profits will allow for stock price appreciation without stretching valuations.

Most international economies are not as far along in the recovery process as the US, with some faring better than others. This divergence is reflected in investment returns: Euro Area stock markets year-to-date are up 14.7% versus a more meager 5.4% gain for emerging markets. Another example is Japan, with expected GDP growth of only 2.2% this year and a corresponding equities gain of 5.2%; in contrast, France is anticipated to grow 5.5% and its stock market has soared 18.0% (The Economist, 6/26/21). Political developments are having a negative impact on equities in certain countries, including China, Hong Kong, and Brazil. Although some markets may prosper and others may falter, many individual companies will capitalize on the strong global expansion. Moreover, countries currently struggling with the virus will prevail eventually and subsequently experience an economic recovery. With billions of vaccines already manufactured, we think this will occur sooner than later.

Risks to a global stock market advance which we consider noteworthy include:

Each of these challenges already exist to some extent, with the possible exception of excessive inflation. However, their severity hasn’t reached the point to derail the current bull market. We do not expect these threats to fade completely, and as always, we will keep a close watch regarding their impact on the positive case.

Investors are highly sensitive to the yield on the US 10-Year Treasury Note because it is an indicator for the outlook for inflation, future Federal Reserve policy, prospects for the overall US stock market, and the relative return on industry sectors and growth versus value styles. We anticipate the Federal Reserve will resist pressures to taper or raise short-term rates at least through 2021, and thus we expect only a gradual rise in the 10-Year yield from the current 1.32% to 1.50-1.80% by the end of the year. As competitors to equities, money market and bond yields continue to be unattractive. Bonds remain important as portfolio stabilizers but are less appealing as a source of income.

We wish all our readers a safe and pleasant summer.

The Marietta Investment Team

Economic and Financial Market Outlook 2021 Q2

We continue to hold to our January 6th forecast that a synchronized global economic expansion in 2021 will support another year of rising stock markets. The International Monetary Fund recently (04.06.2021) projected 2021 global GDP growth of 6.0% led by the US (+6.4%) and China (+8.4%). Similarly, JPMorgan expects U.S. GDP growth of 6.4%. Both forecasts revised upward their growth targets from earlier in the year. We are more optimistic; U.S. GDP growth will be at least 7% if the pace of reopening continues. This acknowledges that the economic path forward for most countries, including the U.S., will be determined by their ability to secure and distribute COVID-19 vaccines, sustainably reopen their economies, and successfully implement effective fiscal and monetary policies. In 2020 there were investor fears of a severe and prolonged virus-related recession, global GDP shrank by -3.3%, and every major economy except for China suffered negative growth. Now, all major regions are expected to grow at above average rates, COVID-19 cases are well off their peaks (though concerningly rising in some parts), and staggering amounts of financial relief is breathing life to the economy. We are closely watching the progress to overcome the pandemic as well as any signs that recovery efforts trigger excessive inflation, but we believe we are in the early stages of a new bull market. At this time, we recommend investors take a disciplined approach and stay with their long-term strategy.

The US economy will enjoy a strong rebound this year as the COVID-19 threat subsides and economic restrictions lift, with monetary and fiscal stimulus providing additional support. The COVID-19 situation has clearly improved: over 3 million vaccine doses are administered on average each day, over 25% of the US adult population has now received two doses, and hospitalization rates continue to decline. As a result, states and cities have further eased emergency restrictions. As the entire country has begun its long-awaited “reopening,” the labor market has drastically improved. The unemployment rate has come down to 6.2% from a high of nearly 15.0% and the US added over 900,000 jobs in March. Besides benefiting from reopening, US households have been supported by monetary and fiscal policies. The $1.9 trillion stimulus passed in March and the Federal Reserve’s commitment to keep interest rates low have put the US economy on steadier footing. While many people have not felt the recovery yet, consumer confidence is on the rise and average household savings rates are at elevated levels (see chart).

The US is further along in its vaccination efforts than most, but as other countries undergo a similar process and reopen with increased immunity in the coming quarters, the US economy will further benefit from the virtues of a broad-based, synchronized global economic expansion. This optimistic outlook assumes that vaccines stay effective against the prevalent COVID-19 strains and new coronavirus variants do not spread to an extent that lockdowns are brought back.

At the other end of the spectrum, we must be watchful that the stimulus and easy monetary policy does not lead to an overheated economy with excessive inflation. At this juncture we do not think inflation will be a drag on the economy. We have already seen reports of short-term higher prices, but we think this is due to businesses trying to catch up to growing demand with pandemic-idled production capacity. The March Producer Price Index (PPI) showed 1.0% month over month price increases, the second highest on record. These are extraordinary numbers but we expect that once producers can increase hiring and production capacity, the inflation pressures will subside. Over the past decade, the greater threat has been disinflation rather than inflation and we should not lose sight of the fact that it is healthy for inflation to run at or slightly above the Federal Reserve’s 2.0% inflation target.

 

The fundamental backdrop is positive for US stock markets. The Federal Reserve has promised to continue accommodative policy and a faster-than-expected recovery should enable companies to report stronger earnings and give better guidance. FactSet estimates full-year corporate earnings will surge over 23% year-over-year, which we consider conservative. This large increase in profits will moderate what currently appear to be lofty P/E multiples. Moreover, alternative investments to equities, such as bonds and money market funds, provide low and unattractive potential returns, further justifying elevated stock market valuations. Coming off a deep but short-lived recession, the market is experiencing a period of transition. Historically stock market recoveries from recession have resulted in a change in leadership. Whereas growth and momentum stocks, led by information technology industries, are favored leading up to recession, value and economically sensitive stocks found mostly in the financial, consumer discretion, and energy/commodity sectors come to the forefront during recoveries. This has been the case since the positive vaccine news broke on November 6, 2020 with the Russell 1000 Value Index surging 23.1% while the Russell 1000 Growth Index improved a more modest 6.0%. Similarly, stocks of businesses that were depressed or even shut down during the pandemic have been catching up to the companies that were minimally affected over the past year. The worst stocks of 2020 performed the best in the 1st quarter of 2021. It is possible that this trend will continue near term, but we prefer companies that can demonstrate earnings and revenue growth from pre-pandemic levels. Certainly, investors should hold some investments with improving prospects due to the reopening (travel/leisure, entertainment, manufacturing), but we continue to emphasize companies with strong fundamental attractiveness that benefit from trends that will run long past the point of full recovery.  

 

The pace of recovery across regions is striking. Nevertheless, IMF forecasts that every major economy will recover from recession this year and continue growing in 2022. We think this will create numerous and significant investment opportunities across countries and industries. The Eurozone should bounce back to 4.5% growth in the second half and the UK will see full year output at 5.0-6.0%. In the near-term we favor developed economies as they will likely recover more quickly. These regions also have value-oriented sectors like financials and industrials. China and India are bright spots in the emerging world and are expected to grow at 8.4% and 12.5% this year and moderate in 2022. Mexico will likely experience above trend growth as well given its close relationship to the US.

There are always threats to an optimistic outlook and we closely monitor risks that could disrupt economic growth. Again, first and foremost, is the continued presence of COVID-19 which has begun to rise again in Europe, South America, and India. We are also cognizant of global supply chain shortages, particularly in semiconductors. Further, we think rising nationalism is a significant risk as people in various countries push for less globalization and it could negatively affect international trade. Lastly, as always, we want to keep watch on geopolitical tensions, especially with respect to China.

Across the world, but especially in the U.S., interest rates have turned higher in anticipation of stimulus-fueled spending and economic growth. While the move has been sudden, the 10-Year US Treasury yield jumped from 0.92% to 1.74% during the last quarter, rates are still exceedingly low. The 10-year rate is still lower than 2019 levels and near the lows for the entire 2009-2020 expansion. Rates will likely move higher as this expansion matures but bond investors should not expect a return to a pre-financial crisis yields. This may provide an opportunity to select some bonds at better prices for fixed-income portfolios but we still recommend underweighting this asset class.

 

One year ago, we wrote at the outset of the pandemic that one key question was “When will there be a return to near-normal activity, and will the mass amounts of unemployed workers be able to resume their jobs?” One year later we can finally see the light at the end of the tunnel as the reopening gets underway. Economic indicators are turning decidedly positive and global stock markets have advanced in anticipation. This process will take place over the next few quarters and it will not be a steady journey, but there are better days ahead.

As always, stay safe and healthy and be optimistic for the future.

The Marietta Investment Team 

Economic and Financial Market Outlook 2021 Q1

The tumultuous 2020 calendar year has finally ended. Despite enduring a global recession, most of the world’s stock markets recovered to finish the year with solid gains: the US benchmark S&P 500 Index returned 18.4% while the MSCI All-Country World ex-US Index rose 10.3%. When we issued our last Outlook on October 13, we noted that a heavy fog had obscured financial market forecasting. At that time, major questions regarding the future course of COVID-19, the response of policymakers, and the impact of US politics, were impossible to predict with conviction. We also anticipated this uncertainty to lift by year-end and improve visibility into 2021. This has happened and, on balance, the developments have been positive for financial markets. The consequence has been surging global equities propelled higher by a growing consensus view, which we share: a synchronized global economic expansion will gain steam in the second half of 2021, resulting in another year of rising stock markets.

The greatest factor affecting economic progress remains the battle against the coronavirus. The consensus forecast expects COVID-19 to become more severe in the US and Europe in the first few months of 2021, which has already led to increased restrictions in some countries. However, if vaccine distribution estimates are correct, by the end of the first quarter a hundred million or more people should be inoculated globally and the virus will commence a steady retreat. This positive outcome would lead to the beginning of a “return to normal” by the end of summer. In the US, the current record-high household savings rate indicates pent-up demand and should boost consumer spending in the medium-term. Corporate profits are poised to rebound faster than the economy, surging over 20% in 2021. All eleven S&P 500 sectors are projected to report year-over-year earnings growth. Huge corporate cash positions could spur a new wave of stock buybacks, dividend increases, and mergers and acquisitions activity. In short, the end of the COVID-19 pandemic would likely be accompanied by flourishing economies and stock markets.

S&P 500 Earnings Growth CY2021

The role of the world’s central banks in supporting economies and lifting equity markets should not be underestimated. For example, the Fed has promised to maintain historically low interest rates relative to other recoveries. In 2003, interest rates were between 4.0-5.0%. Following the Great Recession, the yield on 10-year Treasuries vacillated between 3.0-4.0%, whereas currently the yield is about 0.9%. The resulting boost to stocks is twofold: near-zero interest rates support economic growth, but also reduce bond yields to such a low level that the asset class ceases to be a substantial investment alternative for investors seeking capital appreciation. Sovereign wealth funds, pension plans, and retirement plans with balanced investment portfolios are already experiencing pressure to increase equity ratios as their only hope of achieving total return objectives. The power of the Fed is on full display. Generations of investors have learned wisdom in the phrase, “don’t fight the Fed.”

Despite strong tailwinds, our near-term enthusiasm is tempered because the strong equity gains in 2020 occurred in the absence of corporate profit growth, resulting in high valuations. While we think the overwhelmingly positive economic fundamentals will prevail, the road ahead is likely to sustain setbacks and challenges; expensive stock markets pricing in considerable optimism frequently lay the groundwork for corrections. Our view would be any pullback would likely be short and provide a buying opportunity. Our forecast for the year is that 20%+ growth in corporate profits will reduce current sky-high multiples, and US equities will provide a solid 8-10% annual return.

A key strategic question for both US and international investors is where to invest? Should investors favor the growth stocks that performed so well in the second and third quarter of 2020, led by technology and companies benefiting from the “stay at home” economy? Or should investors take the leap of faith that the positive forecast is correct and invest in downtrodden industries such as travel, transportation, banks, and commodity producers? We recommend a broadly diversified blend of the two strategies with a strong emphasis on high-quality, well-established companies which will almost certainly survive, if not thrive, if the bright outlook dims.

We emphasize that our positive case and strategy recommendation applies to both the US and international stock markets. In the fourth quarter, the 12.2% return of the S&P 500 Index was overshadowed by the 18.4% surge of the iShares Emerging Market ETF (EEM). This is not surprising, since emerging markets and highly volatile commodity stocks have been market leaders in the early stages of recovery following each of the last two recessions. Emerging markets are also benefiting from weakness in the US dollar, which is partially a consequence of Federal Reserve policy. Euro Area GDP is expected to grow at 5.2% with a hefty 30%+ increase in corporate profits, both at a faster pace than the US. With European stocks trading at lower valuations than their US counterparts, value-oriented investors may look to the region for opportunities.

The 2020 bear market and its ultimate resolution has reaffirmed our view that keeping a long-term perspective is highly beneficial to improving investment results. We find it especially gratifying to guide our clients through turbulent markets such as last year.

We wish our clients and readers a healthy and happy 2021.

The Marietta Investment Team