Navigating the Course Ahead
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.
The third quarter of the year was characterized by moderated inflation levels, a resilient consumer, a healthy labor market and abated recession concerns. However, there remain many crosscurrents within the market and economic landscape, including a deeply inverted yield curve, and still-heightened geopolitical risk.
Amid this uncertain backdrop, we believe it is important to stick to a diversified and long-term investing strategy, maintaining the ability to make tactical asset allocation decisions as the year progresses. In this edition of The Horizon, we identify factors that may support the Equity market, recap the corporate earnings season and highlight the importance of the private credit space.
“We believe Equities still warrant a neutral view relative to our strategic benchmarks, but remain cognizant of developments that may support a sustainable, broad-based recovery.”
In “Watch List: 7 Bullish Catalysts for Equities”1 from our weekly Capital Market Outlook report, we recap various signals that could indicate the recently established technical bull market has more room to run. Firstly, this year’s equity market rally has been driven almost entirely by multiple expansion. With the S&P 500 trading at a forward price-to-earnings ratio well above its long-term average, additional momentum could be limited. However, Equities could have more potential for upside once earnings make a meaningful bottom and begin to reaccelerate. Secondly, investors are increasingly concerned that monetary policy will be tighter for longer. Looking back at the third quarter, we saw a 25 basis point interest rate hike in July, followed by the decision to keep rates steady in September. Commentary from the Federal Reserve’s Jackson Hole Economic Symposium highlighted the central bank’s data-dependent and ‘higher-for-longer’ stance moving forward. Equities could find their footing once investors are more convinced the Federal Reserve will stay on hold.
Thirdly, a potential recession (although not our current view), could emerge more as a ‘reset’ than a deeper downturn given labor market and consumer strength. This development would further boost our appetite for risk assets. Additionally, several secular forces, such as automation, an increased focus on reshoring and fiscal stimulus boosts, could form a solid CapEx cycle as we move deeper into the next macroeconomic regime. This could provide a tailwind to earnings and offer Equities additional momentum. Furthermore, if the U.S. dollar were to weaken, it could prove beneficial for large multinational corporations as their international earnings would become more valuable at home. This could also lead to more constructive relative performance for International Developed and Emerging Market Equities. Lastly, improvements in the economic backdrop that help ease the disconnect between the economy and the markets would be a reassuring signal. Bank lending standards have increased, for example, while consumer savings rates have diminished and manufacturing remains weak. A recovery in these areas, amongst others, could ease concerns around the economy and suggest business conditions are more favorable, which would be positive for risk assets. Given the current environment, we believe Equities still warrant a neutral view relative to our strategic benchmarks, but remain cognizant of developments that may support a sustainable, broad-based recovery.
In our Equity Spotlight report “Don’t Fear the Earnings,”2 we take a deep dive into second-quarter earnings and address both positive and less favorable aspects of the Equity market. This year, second-quarter earnings have generally been better-than-expected, mainly due to a resilient consumer and solid consumer services spending sustained by a still-tight labor market. While margin pressures are a concern, companies have applied cost-cutting measures to support profits and help offset slowing revenue growth. On the other hand, similar to first-quarter results, aggregate earnings are declining on a year-over-year (YoY) basis for a third consecutive quarter. Revenues and margins are also still decreasing YoY, while nominal growth in the economy is slowing. Additionally, even though there was an above-average number of companies whose earnings performed positively, the unsatisfactory stock price reactions for many of them could be interpreted as a cautious signal. This response could be due to various reasons, including investors who hoped to see larger beats against lowered consensus estimates and the notion that these results were already discounted into current stock valuations.
From a sector perspective, Consumer Discretionary, Communication Services, Industrials and Consumer Staples experienced positive earnings growth, while Energy, Materials and Healthcare delivered negative earnings growth. Honing in on geographic regions, we maintain our preference for U.S. Equities over the International Developed and Emerging Market regions as global companies with significant international exposure saw more earnings misses compared to domestic-oriented companies. While it is not clear that we reached a bottom in earnings for this cycle yet, and with muddled signals across both sectors and industries, investors will be looking for signs of a bottom and a turn in the profit cycle in Q3 and Q4 results. Equity markets could start to discount the bottom of the profit cycle and transition to the next cycle before earnings and estimates begin to shift higher. Because of this, we would use any market corrections to put excess cash to work, rebalance back to strategic Equity portfolio weights and stay invested for the next Equity bull market.
“In light of this grind-it-out market background, we continue to highlight the need to maintain a long-term investing mindset with an emphasis on diversification and balance and a focus on high-quality investments in the near term.”
Given both tailwinds and headwinds facing the macroeconomic landscape, we think investors should stay diversified within their portfolio. In our Investment Insights report “Private Credit on the March,”3 we highlight Alternative Investments as a potential beneficial factor, in addition to Equities and Fixed Income, for qualified investors to enhance their portfolios. Recently, Private Credit has garnered significant attention as providers have been able to step into a void left by the retreat of lenders from public leveraged credit markets. We believe Private Credit is poised to continue its absolute and relative growth as a major player in leveraged finance. Historically, Private Credit has performed well, outperforming high-yield and leveraged loan indexes on both 10- and 20-year bases. While these strategies typically have wider ranges of reported performance compared to investment strategies in public or traditional asset classes, there are many benefits to utilizing Private Credit. For example, many borrowers today prefer private markets because pricing is locked in once terms are set and does not alter due to market conditions, and because there is generally faster execution and a greater certainty of closing. Additionally, given Private Credit’s lower duration, it has been attractive in the current environment and can be a useful complement to traditional Fixed Income as it has lower volatility and lower interest rate sensitivity. However, credit risk, specifically related to defaults and loss rates, is a potential concern. Overall, qualified investors could consider increasing Private Credit exposure as another tool within their portfolio toolkit.
The next phase of the market cycle may be characterized as an ‘overcast’ environment, with potential choppy market activity ahead as we close out the year. In light of this grind-it-out market background, we continue to highlight the need to maintain a long-term investing mindset with an emphasis on diversification and balance and a focus on high-quality investments in the near term.