Navigating Near-Term Headwinds
The Horizon is a quarterly report from our Chief Investment Office, exclusive to Merrill Private Wealth Management, intended to help high net-worth clients pursue their personal goals by addressing timely topics in areas such as macroeconomic trends, long-term investment themes, market dynamics, asset allocation and portfolio strategy as well as wealth structuring, planning and transfer.
Heading into the final quarter of 2022, financial markets continue to face a number of headwinds, including inflation that remains well above the Federal Reserve’s (Fed) target, tightening financial conditions, and weakening economic activity. In our view, a “grind-it-out” environment is likely to continue over the next several months before the cyclical bear market eventually gives way to the secular bull market trend. Here, we highlight key insights that may help investors navigate through this period of uncertainty.
A common question that often comes up at this stage is What the Markets May Not be Pricing in?1 We know that soaring inflation levels, aggressive monetary policy tightening by global central banks and the ongoing slowdown in economic activity all contributed to the bear market in equities that began earlier this year. The S&P 500 saw a late-summer rally after its June low, but cracks in the rebound have since emerged. We think that a slowdown in corporate profits, higher long-term inflation, and weaker economic activity could lead to further downside. It is also possible that investors may not be fully appreciating the effect of quantitative tightening (QT) — the Fed’s doubling of the monthly limit on its balance sheet reduction that was instituted in September could lead to more volatility ahead. On a positive note, we also see a few possible developments that could lead to further upside, such as positive developments on the international front or a weaker dollar.
“In our view, a “grind-it-out” environment is likely to continue over the next several months before the cyclical bear market period eventually converges back into the secular bull market trend.”
Moving forward, The Changing Paradigm for Corporate Earnings2 could also impact asset prices. U.S. corporate earnings rose at a high average annual growth rate of 10.7% throughout the previous decade and have remained strong this year, with the S&P 500 reporting over 6% year-over-year (yoy) growth in Q2, but a moderation has begun amid changing macro dynamics.3 Analysts have begun to trim estimates for the second half of 2022 and 2023, and BofA Global Research expects an approximate 8% decline for earnings next year once restrictive monetary policy fully filters through into the broad economy. These weakening earnings dynamics could add to the uncertain environment for risk assets like equities and corporate bonds in the near-term.
The shifting macroeconomic backdrop is also impacting the consumer. In The State of the Consumer—Firm but Fraying,4 we review factors that are currently in favor of the consumer, versus factors that call for getting cautious. The consumer has thus far remained resilient in the face of rising rates and steep price increases, supported by a historically tight labor market, strong wage growth, high levels of excess savings, and healthy levels of debt. However, multi-decade high inflation and a deteriorating wealth effect are beginning to pressure households, contributing to record-low levels of consumer sentiment. Reviewing these factors in aggregate, our consumer scorecard is still tilting positive but showing signs of transitioning lower (Exhibit 1).
Exhibit 1: A Consumer Scorecard
|(+) Jobs →||(-) Inflation|
|(+) Wages →||(-) Wealth Effect|
|(+) Spending →||(-) Consumer Confidence|
|(+) Debt →|
|(+) Savings →|
Source: Chief Investment Office. August 10, 2022.
Note: Transitioning arrows indicate the direction the factor
may be moving toward.
“Investors should consider maintaining a high level of diversification across and within asset classes, especially in this new era that is characterized by elevated uncertainty.”
While headwinds remain in the short term, the outlook for equities over the next several years could improve. In Short, Medium and Long Term Factors for Equities,5 we recount some of the factors that shape our view of equity markets and implications for portfolio strategy. Looking beyond the next few quarters, equities could get a tailwind if the Fed manages to rein in inflation and balance out its policy mandate. Over the longer term, we believe that trends like accelerated innovation, productivity-boosting digitization, and a budding equity culture lay a strong foundation for the secular bull market to continue forward.
Viewing these developments from an investment perspective, we maintain our view that A New Cycle Requires New Positioning.6 Going forward, portfolio positioning may need to be more micro than macro as the effect of rising rates and inflation will be specific to sectors, industries and companies, leading to a higher dispersion in earnings. We believe that dividend growth, high-quality, free cash flow and pricing power are characteristics that are likely to be rewarded in the marketplace. Investors should consider maintaining a high level of diversification across and within asset classes, especially in this new era that is characterized by elevated uncertainty and lower central bank liquidity.
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1 Chief Investment Office, “What the Markets May Not Be Pricing In?” Capital Market Outlook, July 11, 2022.
2 Chief Investment Office, “The Changing Paradigm for Corporate Earnings.” Capital Market Outlook, June 27, 2022.
3 Source: FactSet. August 30, 2022. Past decade refers to the average of annual earnings per share growth rates from 2010 to 2019.
4 Chief Investment Office, “The State of the Consumer—Firm but Fraying.” Capital Market Outlook, August 15, 2022.
5 Chief Investment Office, “Short, Medium and Long Term Factors for Equities.” Capital Market Outlook, September 6, 2022.
6 Chief Investment Office. “A New Cycle Requires New Positioning.” June 2022.
All data, projections and opinions are as of September 22, 2022, and subject to change.
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