Economic news: Q4 investment outlook

October 3, 2022 | Market news

At a glance

With capital markets experiencing year-to-date losses across most major asset classes, investors are wondering how much more downside risk exists in both economic trajectory and asset prices. Our team has incorporated a framework we call the “two repricings,” which centers on the two biggest investment drivers we are watching: Interest rates and economic growth. The first repricing represents how asset classes respond to central bank policy changes, which have moved from ultra-accommodative to restrictive. As the U.S. Federal Reserve (Fed), the European Central Bank, the Bank of England and other central banks have raised interest rates to thwart inflation, lower-risk and shorter maturity government bonds that carry higher compensation become more attractive to investors. The investment implication is riskier asset classes like equities and real estate sell off and reprice lower as investors demand more compensation for those categories relative to higher-yielding, safer alternatives.

The second repricing reflects how assets react should the global economy weaken. We anticipate slowing consumer activity due to higher prices, waning savings and still-underwhelming labor market participation. Governments have shifted from fiscal support to restraint, dollar strength and weak international demand may stifle exports, and businesses anticipating less consumer activity may withhold aggressive budgeting plans. These aggregate dynamics suggest lower economic growth and weakening corporate revenue and earnings. Lower corporate sales and earnings typically translate into price pressure for both stocks and bonds.

While we must respect a wide range of outcomes, we anticipate a bias toward lower prices for stocks and bonds. Central banks raising interest rates into an economic downturn has traditionally posed challenges for riskier asset classes. If inflation remains sticky, central banks may need to continue raising interest rates and the first repricing may continue. Should the economic downturn gain steam, corporate cash flows may diminish and impact how much investors are willing to pay for those cash flows. In the sections that follow, our most senior investment professionals share our forward views. While we anticipate risks outweighing opportunities in the very near term, the investment pendulum can shift too far and present benefits to patient investors. As always, please do not hesitate if we can answer any questions pertinent to your unique situation.

― Eric Freedman, Chief Investment Officer, U.S. Bank

Global economy

Quick take: Our proprietary Health Check, which compiles more than 1,000 global economic indicators to determine our view of the current economic state and trend, reflects slowing growth across the globe. Our U.S. Health Check highlights positive but below-trend economic activity and decelerating momentum as the Fed tightens monetary policy to combat elevated inflation. Outside the U.S., our foreign Health Check scores are mixed but slowing, with a stronger Japan moderated by weakness in Europe and China.

Our view: Global central banks’ focus on inflation comes at the expense of real economic growth. Global inflation rates are unlikely to meet central bank targets until well into 2023. Higher interest rates mean forecasters, such as the International Monetary Fund, are reducing growth projections and highlighting risks of recession.

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    • A strong U.S. labor market is balancing inflationary headwinds. Real economic growth (with “real” defined as a statistic net of inflation) probably remains slow into 2023 but seems unlikely to repeat the economic contraction starting this year. The strong U.S. labor market, rising wages and robust consumer balance sheets should support domestic consumer spending into year end. Inflation is likely to remain above long-term average levels as the economy repairs supply constraints and home price and rental increases work through the system. The path of Fed interest rate increases, inflation surprises and corporate margin pressures are key risks to the future economic story.
    • High energy costs are shifting developed economies into low gear. Consumer budgets, under duress due to a spike in energy costs from Russian sanctions and European Central Bank (ECB) interest rate increases, should further dampen economic prospects. The Bank of Japan (BoJ) appears likely to hold fast to its easy monetary policy, willing to tolerate inflation, to keep economic growth in positive territory. A resolution to the Russia/Ukraine crisis is a key swing factor in the economic narrative for developed global economies.
    • High food and energy prices are hurting emerging market economies, while China also suffers from rolling coronavirus lockdowns. Ongoing COVID lockdowns in China, the Russia/Ukraine conflict and inflation pressures are dampening economic growth across emerging market economies. Higher food and energy prices are hurting fragile emerging market consumers. Inflation is more modest in China, with its regional lockdown practice around coronavirus infections dampening economic growth. Ongoing challenges in the housing sector continue. For now, slower growth appears to be the primary trend if stimulus measures remain modest and coronavirus lockdowns continue.

U.S. equity market

Quick take: Inflation’s persistence, the path forward for interest rates and the pace of earnings growth are key to equities’ return potential as 2022 concludes and we look forward to 2023.

Our view: Inflation levels and interest rates influence equity valuations, or the price investors are willing to pay for anticipated earnings. Together, elevated inflation and rising interest rates cause investors to demand higher compensation for bearing additional interest rate and inflation risks. Investors’ higher compensation demand causes the price-to-anticipated earnings ratio to compress, resulting in increased volatility and more subdued returns. Importantly, opportunities exist in all market environments.

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    • Analysts continue to project positive earnings growth in 2022 and 2023, but they have modestly adjusted forecasts lower recently. Corporate earnings remain both a bright spot and a wild card. Consensus analysts’ S&P 500 earnings estimates for 2022 and 2023 are roughly $223 and $240 per share, respectively, according to Bloomberg, FactSet Research Systems and S&P Capital IQ, representing year-over-year growth of approximately 7.5%. To be determined is whether consensus earnings projections are reset lower following third quarter results.
    • Valuation remains in a “zone of okay.” The current price-earnings ratio for the S&P 500 on trailing 12-month estimates is roughly 16.4. This compares to the historical average of approximately 19.0 times during periods when both the 10-year Treasury yield and core Consumer Price Index were between 2% and 4%, based on data that extends back to the 1950s. To us, this implies current valuations are fair, neither at high nor low extremes.
    • Cyclical and defensive sectors have near-term appeal while inflation runs hot. The Energy, Materials and Industrials sectors tend to benefit from positive inflationary trends. Energy is a standout, benefiting from economic recovery and supply/demand disruptions, partially attributed to the Russia/Ukraine conflict’s impact on hydrocarbon supplies. Healthcare and Utilities have defensive characteristics, offering stable growth profiles throughout varying economic environments, with many companies offering compelling dividend yields.
    • Secular growth sectors remain well-positioned for longer-term growth. These sectors, where technological advancements and demographic trends drive longer-term demand, have largely underperformed in 2022 due to higher interest rates increasing borrowing costs and concerns associated with reduced demand, supply chain challenges and a slowing revenue and earnings growth pace. While the near-term outlook remains unclear, we continue to like the longer-term prospects for companies in several growth sectors, particularly for investors looking toward 2023 and beyond, taking advantage of year-to-date price declines. Information Technology is a longer-term favorite; fast is getting faster, and speed, scale and efficiencies do not occur without technology. We like consumer companies that have an internet presence, require or encourage in-store traffic and rank high on experiential metrics. And we favor growth-oriented media companies that are moving to online platforms where customer analytics improve prospects for better returns.

International equity markets

Quick take: Surging energy prices and rising interest rates present a challenging backdrop for Europe’s near-term growth prospects, supporting our cautious overall outlook for foreign equities, but return opportunities still exist considering disparate inflationary experiences across the region.

Our view: While the Russia/Ukraine conflict remains ongoing, foreign developed corporate profits remained resilient in 2022’s first two quarters, with companies proving generally successful in passing on rising costs to consumers. However, analysts’ earnings estimates for the remainder of 2022 and into 2023 remain at risk for downward revisions amid higher interest rates, higher energy prices and more restrained consumer confidence.

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    • Non-U.S. equities’ underperformance relative to domestic markets reflects investors’ demand for higher compensation (paying lower prices for anticipated earnings) to take on European equity price risk. High energy prices due to Europe’s tenuous hydrocarbon supply along with elevated food prices continue to erode European consumers’ confidence and discretionary spending ability, evidenced by declining retail sales volumes compared to a year ago. The combination of higher interest rates, higher energy prices and more constrained consumers may ultimately impair companies’ sales growth and profit margins, potentially leading to downgraded earnings growth expectations and further weakness in asset prices.
    • Return opportunities exist despite the challenges facing foreign developed markets. These markets encompass a geographically diverse country set, including 21 economies across three continents (Asia, Europe and Australia). While continental Europe faces material headwinds noted above, the outlook and investment opportunities across the full region are more mixed. Norway and Australia, for example, benefit from high commodity prices such as oil, natural gas, coal, industrial metals and foods. Most notably, Japan is much less dependent on Russian oil and gas imports than Europe. Due to relatively contained inflation, the Bank of Japan remains highly supportive of the economy via negative interest rates and ongoing asset purchases, sharply contrasting with aggressive monetary policy tightening by the Fed and other major central banks.
    • China’s Party Congress may unlock major policy catalysts for emerging markets. Policy analysts expect the Congress will ensure leadership continuity by re-nominating President Xi to a third term. Following that, a key investor consideration is whether Chinese authorities make any changes to the strict virus containment policies, known colloquially as “zero-COVID,” that continue to constrain domestic activity and disrupt global supply chain linkages. An easing of zero-COVID restrictions or a successful rollout of a new, domestically developed COVID vaccine represent potential positive post-Party Congress catalysts that would improve Chinese as well as global demand and supply prospects.

Bond markets

Quick take: Ten-year Treasury yields have risen 2.25% this year, to 3.81%. Investors expect the Fed will increase its short-term funding rate to around 4.25% by year-end and to 4.5% in the first half of 2023 to combat high inflation. We see opportunities in high-quality bonds sporting their highest yields in more than a decade, though ongoing volatility should be expected as the Fed attempts to slow inflation without significantly damaging economic growth.

Our view: High-quality bonds may bolster portfolios during volatile capital market periods. Rising Treasury yields (which move in the opposite direction of bond prices) and higher yields for corporate and municipal bonds compared to Treasuries mean improving high-quality fixed income return opportunities. Decelerating economic growth, elevated but decelerating inflation and restrictive monetary policy support the defensive characteristics of investment-grade bonds.

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    • Treasuries offer favorable yields, but interest rate sensitivity remains a risk. Ten-year Treasury bonds yielding over 3.5%, their highest levels in more than a decade, compensate for aggressive Fed policy expectations. However, inflation that continues to run hot could push yields higher and bond prices lower. Furthermore, the Fed is shrinking its bond holdings by up to $95 billion per month, which may eventually strain market liquidity conditions, because investors must absorb the additional bond supply. Short-term Treasury bonds can help investors mitigate interest rate sensitivity, since their prices fluctuate less when Treasury yields change.
    • High-quality bonds may help manage portfolio risk while slowing economic growth, tightening financial conditions and weak investor sentiment challenge riskier bond prices. Improving earnings growth and tax revenues increased corporate and municipal cash balances used for operations and debt payments. Institutions were also able to issue new debt at low yields in recent years, which locked in cheap borrowing costs and should help limit defaults in coming quarters. However, riskier bond prices remain vulnerable to marginal deterioration in credit fundamentals if earnings and tax revenues weaken in a slower growth environment. A tilt toward higher-quality bonds, which typically generate stable cash flow from healthier issuers, offers opportunities to collect meaningful income while defensively positioning portfolios.
    • Mortgage bonds not backed by the government and reinsurance can supplement portfolio income with less sensitivity to investor sentiment and typical business cycle risk. Despite higher mortgage rates slowing the housing market, recent home price increases bolstered collateral values backing mortgages. Low debt servicing costs from cheap fixed rate refinancing in 2020 and 2021 paired with a strong labor market have also limited mortgage delinquencies. The reinsurance category, also referred to as insurance-linked securities, offers attractive yield and can aid in portfolio diversification given their limited relationship with the broader economic cycle.

Real assets

Quick take: Fundamental metrics are positive across all real asset categories. Cash flow and earnings growth are above long-term averages for real estate and infrastructure assets. Commodity markets appear undersupplied, and the war in Ukraine deepens supply imbalances. However, higher interest rates mean investors are re-pricing cash flows, downgrading returns for most asset classes this year, including commodities. Downgrades in demand due to higher borrowing costs likely lead further repricing of cash flows.

Our view: Rising interest rates have already impaired real asset markets, and higher rates could generate further downside price action. We think publicly traded real estate investment trusts (REITs) look attractive compared to private real estate assets. Our investment thesis is that assets providing stable cash flows will outperform for the rest of 2022 as we see further deceleration in economic growth. Meanwhile, commodity prices are at risk as the deceleration occurs.

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    • Rising interest rates have negatively affected valuation metrics across the public markets, and REITs now trade at levels considerably below pre-pandemic highs. Direct real estate prices have yet to reset lower, and higher borrowing costs relative to incomes hamper direct real estate values in the near term.
    • Infrastructure assets have performed well on a relative basis so far in 2022. However, rising rates have taken a toll on some assets, especially communication infrastructure such as cell towers and data centers. While higher interest rates are a risk, stable incomes and the more defensive nature of Utilities and midstream energy stocks as economic growth decelerates are positives.
    • Decelerating global economic growth should provoke downside pressure to commodity prices. Commodity supplies are limited with Russian sanctions taking hold. However, slowing economic growth and a resolution to the Russia/Ukraine crisis could pressure prices from oil to industrial metals and grains.

Alternative investments

Quick take: Hedge funds are navigating the markets better this year than in recent market corrections, though it has not been easy. Hedge fund managers face challenging macroeconomic conditions relative to inflation, interest rates and potential for recession. As a group, they reacted to volatility this summer by further reducing leverage and net exposure to the markets (the difference between long and short positions) compared to the start of the year.

Our view: Hedge funds with lower net exposures comprised some of the best-performing strategies this year and we anticipate this defensive posturing will continue if the Fed remains committed to raising interest rates to fight inflation. The current environment remains conducive for certain hedge fund strategies with stock prices moving significantly and not always in the same direction. Hedge fund managers’ nimbleness and agility will continue to be critical for navigating the markets the remainder of the year.

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    • Hedge fund managers may keep their overall market exposure low, but that does not mean they will avoid risk. We anticipate more hedge funds will pursue targeted opportunities such as stock-specific short selling or increasing their portfolio concentration in individual long positions.
    • Hedge fund managers are revisiting underperforming sectors, such as Technology, with a discerning eye. For example, hedge funds have recently eschewed semiconductor stocks in favor of payment and software companies within the Technology sector. Many have also increased their exposure to stocks of Chinese companies, which we see as a sign that risk appetites are increasing.

Private markets

Quick take: Private markets are diverse and divergent outcomes thus far in 2022 are similar to other capital market asset classes. Private market business fundamentals across our portfolios remained resilient during the initial rapid rise in interest rates and public stock market volatility. However, as market sentiment has worsened, investors have increasingly shied away from riskier and more growth-oriented businesses, most impacting consumer internet and late-stage software companies with near-term plans to list on public market exchanges via an initial public offering (IPO) or through a merger with a special purpose acquisition vehicle (SPAC).

Our view: Performance ultimately reflects how efficiently a company converts investors’ capital into sales and cash flow. With the Fed and other central banks raising interest rates to combat inflation, business executives have shifted priorities from generating growth at any cost to investing in fewer opportunities, leading to slowing sales and cash flow growth. While this more constrained investment environment leads to our cautious outlook for the upcoming quarters, we take comfort in our investment process and expertise that in a diverse private market, the quality and execution capabilities of our investment partners can help our clients.

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    • Startup founders are taking several measures to adapt to the new environment. According to Wiss, an accounting and growth advisory firm, company founders are actively responding to continued monetary policy tightening, defined as central banks raising target interest rates. Most common changes have included raising prices (40%), freezing hiring (38%), reducing marketing (34%), scaling back product development (33%), lowering headcounts (25%) and paring salaries (21%).
    • Private equity firms are also taking steps to prepare portfolio companies for the anticipated economic slowdown. These measures include hiring specialized consulting firms to design product pricing strategies to keep up with inflation, recruiting specialists to help with sourcing of goods to bring down input costs and engaging other professionals to make operations more efficient.

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This commentary was prepared September 2022 and represents the opinion of U.S. Bank Wealth Management. The views are subject to change at any time based on market or other conditions and are not intended to be a forecast of future events or guarantee of future results and is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Any organizations mentioned in this commentary are not affiliated or associated with U.S. Bank or U.S. Bancorp Investments in any way.

U.S. Bank and its representatives do not provide tax or legal advice. Your tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation.

Diversification and asset allocation do not guarantee returns or protect against losses. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer-term debt securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Investments in high yield bonds offer the potential for high current income and attractive total return but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer’s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with investments in real assets such as commodities and real estate securities. For commodities, risks may include market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults). Hedge funds are speculative and involve a high degree of risk. An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks or bonds, including the risks of using derivatives, leverage and short sales, which can magnify potential losses or gains. Restrictions exist on the ability to redeem or transfer interests in a fund. Private capital investment funds are speculative and involve a higher degree of risk. These investments usually involve a substantially more complicated set of investment strategies than traditional investments in stocks or bonds, including the risks of using derivatives, leverage, and short sales, which can magnify potential losses or gains. Always refer to a Fund’s most current offering documents for a more thorough discussion of risks and other specific characteristics associated with investing in private capital and impact investment funds. Reinsurance allocations made to insurance-linked securities (ILS) are financial instruments whose performance is determined by insurance loss events primarily driven by weather-related and other natural catastrophes (such as hurricanes and earthquakes). These events are typically low-frequency but high-severity occurrences. Private equity investments provide investors and funds the potential to invest directly into private companies or participate in buyouts of public companies that result in a delisting of the public equity. Investors considering an investment in private equity must be fully aware that these investments are illiquid by nature, typically represent a long-term binding commitment and are not readily marketable. The valuation procedures for these holdings are often subjective in nature. Private debt investments may be either direct or indirect and are subject to significant risks, including the possibility of default, limited liquidity and the infrequent availability of independent credit ratings for private companies.

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