The drivers of this turbulent market – Federal Reserve (Fed) tightening, inflation, recession worries and geopolitical fears – feel like they will never stop and seem to have more staying power than The Rolling Stones lead singer Mick Jagger (who turns 80 in July).
With equities struggling and interest rates moving higher, investors could be seeking some emotional rescue. However, we believe we are closing in on the end of the equity bear market, peak yields, Fed hawkishness and expect investors to be rewarded for enduring the current volatility as it should lead to robust performance for most asset classes in the long term.
The U.S. economy remains resilient, driven by the wild horses of consumer spending. While consumers are shifting spending from goods to services, overall spending continues at a healthy clip. But three factors – dwindling excess savings, higher interest rates and softening job creation – should curb growth soon. Despite the outsized job gains in January and February, economic undertones suggest employment gains are already slowing. Withholding taxes’ growth has slid lower on a year-over-year basis, companies have begun to lay off employees (particularly in tech-related businesses), and both online and professional recruiters have lamented slackened hiring. Indeed, the unemployment rate could climb near 5% from its current level of 3.6% by year end. Weakened consumer consumption is one reason our economist expects a mild recession in the second half of this year.
Another recession reason: The Fed kept raising interest rates because it can’t get no satisfaction with inflation until recently. Look for possibly another rate hike in the fed funds rate to 5.25% at the May Federal Open Market Committee (FOMC) meeting. The problem is this: Monetary policy acts with a lag of approximately one year. So, much of the economy is just starting to feel the impact of the first interest rate increases from about a year ago. As we progress further into the year, the accumulation of these rate boosts will crimp both capital spending and consumer spending. We’ve already seen a bit of this in the Silicon Valley Bank failure. While we believe the SVB fallout will be contained, it’s an example of the Fed squeezing... until things break. This year, there will be little, if any, help from Washington as lawmakers focus on the battle to avoid a government shutdown over the debt ceiling. We believe they’ll avert a shutdown at the eleventh hour – as usual.
In bonds, investors have complained for decades that you can’t always get what you want when it comes to higher interest rates and meaningful income. But wait... now you can… with interest rates soaring to levels not seen since 2008. The rate reset has flipped the script to focusing on attractive yields rather than stretching for yield in lower-quality bonds. In addition, improved yields afford investors the ability to balance their portfolios better. But the higher interest rate opportunity probably won’t last long.
Equities tend to rally when the Fed ends its tightening cycle, inflation decelerates, and interest rates fall. Assuming the Fed doesn’t overtighten and take the economy into a severe recession, S&P 500 earnings should remain solid around $215. If anything, the economy’s better-than-expected start this year gives us more confidence in the upside potential of those numbers. When we finally get to the recession, sentiment should turn more positive – as markets anticipate coming out of it. As these factors improve, the S&P 500 should move higher, ending the year at ~4,400. While selectivity remains paramount, given the transition of the economy, we continue to favor Technology, Health Care, and Financials, among others.
Internationally, we still favor the U.S. over other developed markets. Europe has been like Jumpin’ Jack Flash in a crossfire hurricane given its proximity to the Russia-Ukraine war. Europe has managed to navigate the effects of the war for now, thanks to the warm winter and unprecedented shift away from Russian natural gas. But the eurozone’s recovery must survive tighter monetary policy as European Central Bank hawks focus on stubborn inflation and a tight labor market. If oil reaches our $90/barrel year-end target, Latin American equity indices should benefit.
The last year or so has been challenging for investors, with many assets, from fixed income to equities, still in the red. If our assessment is correct, we are past the bottom in both the equity and fixed income markets, and we’ll probably see performance improve into this year and next. Short-term volatility may rattle markets, but a focus on diversification and asset allocation should help guide us through those threats. As always, your financial advisor is there to take the lead or serve as backup to help harmonize your portfolio. Remember: patience and a long-term focus are vital. After 60 years, the Rolling Stones are still touring and filling stadiums – with Mick Jagger singing and Keith Richards still going on the guitar. Like them, focus on continuing success over the long run.
To read the full article, see the Investment Strategy Quarterly publication linked below.
Read the full
Investment Strategy Quarterly
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