At a glance
To call 2022’s start to the year challenging for investors would be an understatement. Pervasive selling gripped stocks, bonds, currencies and real estate interests; only select commodities were spared during the year’s first six months. A core tenet of investment theory hinges on prevailing interest rates or bond yields; as interest rates on safe assets rise, all other asset prices should fall, and vice versa. Driven by the United States Federal Reserve’s (the “Fed”) attempts to combat persistent inflation, interest rates jumped and outside of the energy market, assets repriced sharply lower.
Our outlook remains cautious, yet we are seeing compelling opportunities emerge. In client communications throughout this year, we have shared the concept of two potential “repricings”: the first being the Fed’s interest rate increases, which could provide some price volatility, and the second representing the risk higher interest rates and elevated prices could impact consumer and business activity with a commensurate decline in riskier asset classes like stocks. As the year’s second half begins, we are seeing evidence that consumers and businesses are scaling back demand, but the extent of that slowdown remains an open question. Businesses and consumers came into 2022 with strong savings and liquidity relative to prior periods, but that liquidity is being tested by higher borrowing, energy, food and shelter costs. While we continue to weigh issues with a global perspective, we do favor a more defensive and cautious outlook but recognize that the pessimistic pendulum can swing too far during uncertain periods.
― Eric Freedman, Chief Investment Officer, U.S. Bank
- Equity market declines have been broad based across geography, company size and economic sector year-to-date. This highlights the disparate impact of a resolute Fed combating high food and energy inflation across economic sectors, in addition to a slowing earnings growth pace, the ongoing Russia/Ukraine crisis and supply chain challenges.
- Earnings remain a bright spot and a wildcard. Analysts’ earnings estimates remain elevated, but the potential that profit margin pressures associated with higher input costs, wage pressures, supply chain shortages and shifts in consumer preferences may lead analysts to lower anticipated corporate profit growth expectations remains a key consideration in our more cautious outlook. Earnings visibility for the remainder of the year will become clearer following the release of second quarter results and management guidance beginning in mid-July.
- Consumers are paying for “experiences” more than durable goods. An emerging trend from first-half company results, as reported by airlines, hotel companies, credit card companies, big box retailers and others, is that consumers are paying for experiences, such as travel and leisure, beauty items, office apparel and household essentials. The dynamic shift in consumers’ spending patterns is contributing to overall market volatility due to divergent company performances in managing inventories and navigating supply chain challenges. Another focal area for the second half is assessing the extent to which high energy prices meaningfully impact the all-important back-to-school and holiday selling seasons.
- Opportunities exist in all market environments. In the current inflationary and rising interest rate environment, dividend-paying and traditionally defensive growth sectors are well-positioned, providing steady streams of dividend income with upside potential should inflation remain sustained. For investors with longer time horizons and a tolerance for shorter-term volatility, secular-growth companies’ prospects remain compelling. Importantly, the interaction of artificial intelligence, machine learning, cloud computing and e-commerce have tentacles that extend well beyond the duration of the current economic cycle, which favorably positions select Information Technology, Consumer Discretionary and Communication Services companies for longer-term performance. In both instances, we favor companies with consistent revenue growth, minimal debt, a history of profitability, strong free cash flow and competitive advantages.
- Falling prices relative to expected earnings reflect investors’ demand for higher compensation to take on foreign equity price risk. The price foreign equity investors are willing to pay for anticipated earnings, or price/earnings ratio, has declined 22% since the start of the year. A lower valuation reflects investors’ demand for higher compensation for taking on equity price risk considering Europe’s disproportionate impact from elevated hydrocarbon prices and sluggish economic growth prospects. However, valuation is well below the 20-year average, and investors’ pessimistic growth assessment could quickly reverse upon an improvement in macroeconomic conditions or resolution to the Russia/Ukraine conflict.
- Italian and Spanish bond yields are key gauges for foreign developed equities’ second half prospects. Foreign developed equity price movements have historically been sensitive to investors’ confidence toward peripheral European countries such as Italy and Spain as measured by those countries’ sovereign bond yields relative to core European yields, with a lower spread coinciding with positive equity price movements and vice versa. As the European Central Bank tightens monetary policy to combat inflation, peripheral European bond yields will be a key focal area to gauge investors’ risk sentiment and foreign developed equities’ second half prospects.
- Equity performance differences across emerging markets reflect the ongoing Russia/Ukraine conflict’s disparate impacts. Emerging markets encompass a heterogenous set of global economies: Manufacturing powerhouses such as China, Taiwan, and South Korea; high population, service sector economies such as India; and commodity exporters such as Brazil, Saudi Arabia and South Africa. The Russia/Ukraine conflict’s onset accelerated crude oil price gains, rising 40% since the start of the year, leading to sharp declines in energy importers’ equity markets while commodity exporters have experienced notable price gains.
- China’s policy responses leading up to this year’s Communist Party Congress are keys to emerging market equities’ 2022 fortunes. China’s strict virus containment policies have materially impaired the world’s second-largest economy’s activities and disrupted global supply chains. In contrast to other major central banks’ pivot to tightening policies, China’s policymakers have announced accommodative monetary and fiscal policy measures intended to cushion the economic blow from COVID-related lockdowns and re-accelerate economic growth in the lead-up to the 20th Party Congress later this year, providing a much-needed boost for the region’s fortunes.
- High-quality bonds may help manage portfolio risk during times of volatility, despite the potential for higher interest rates. Investors expect the Fed to raise interest rates another 1.0%-1.5% in the third quarter to combat high inflation. Although Treasury yields already reflect these aggressive Fed policy expectations, inflation that continues to run hot could push yields higher and bond prices lower. Short-term Treasury bonds can help mitigate this interest rate sensitivity due to lower price sensitivity to changing interest rates. We believe high-quality core bond exposure remains a critical component of diversified portfolios, particularly during times of heightened stock market volatility.
- Slowing growth, tightening financial conditions and deteriorating investor sentiment could challenge riskier bond prices despite reasonable yields on corporate and municipal bonds. Corporations and municipalities issued debt at low yields in 2020 and 2021 to strengthen their balance sheets and build up cash reserves. Higher borrowing costs reduced refinancing activity and lower-quality issuers are instead drawing down their large cash reserves. The average high yield corporate bond issuer retains ample ability to service their debt, but bond prices could continue coming under pressure if earnings weaken alongside slower economic growth. Weak investor sentiment could also fuel ongoing market volatility.
- Reinsurance and bank loans offer opportunities to earn favorable income. Also referred to as insurance-linked securities, reinsurance offers attractive yield and can aid in portfolio diversification given its limited relationship with the broader economic cycle for sophisticated investors. Substituting some high yield corporate bond allocations with bank loans can improve credit quality while reducing interest rate sensitivity.
- Rising interest rates pressured real estate valuations and assets now trade below pre-pandemic highs. Vacancy rates are low, though income growth is slowing. Commercial mortgage interest rates are higher, but they remain below earnings yields on average properties, supporting investor returns. However, still higher rates could pressure property prices as inventors demand higher yields.
- Economic uncertainty benefits infrastructure stocks, which offer long-term assets paying consistent dividends. Energy, infrastructure and utilities led asset class performance. Investor demand for quality assets paying large and stable dividends will remain high as the Fed hikes interest rates. Given the Russia/Ukraine conflict and associated global economic uncertainty, we remain positive on infrastructure.
- Commodity prices have risen on tight supplies, but slowing economic growth could limit further gains. A high degree of uncertainty remains. The Russia/Ukraine conflict reduced output of several commodities, including oil, natural gas and wheat. A resolution of the conflict or much slower global economic growth could mean more downside to prices. Prices could remain elevated, since we are seeing little near-term investment to support supplies.
- Lower net exposure funds, where the portfolios have a similar number of long and short positions, have held up relatively well. Many hedge fund managers position their portfolios for when markets once again reward profitability and strong fundamentals. They have relied on sectors traditionally sensitive to the economic cycle, as well as utilities, and have reduced exposure to growth-oriented Technology and Consumer Discretionary stocks.
- Hedge fund managers continue to look through current market volatility for opportunities. Hedge funds that continue to stay agile and appropriately size the risks are well-positioned. Macro strategies, where managers allocate across currencies, equities, fixed income and real assets, are particularly well-suited for this environment.
- It is still early to assess the full impact of recent public market volatility and assertive central banks on private investments. Private markets can take six to nine months to reflect the impact on valuations and overall funding activity levels. Looking back on two prior market downturns, the technology-led crash of 2000-2002 and the global financial crisis of 2007-2009, our research shows muted private equity losses compared to the public markets. For example, during the technology crash, the S&P 500 Total Return Index, a proxy for large, publicly traded domestic companies, fell 44% from peak to trough while the Cambridge Associates Private Equity Index, a proxy for private equity investments, declined by 21%. Similarly, during the financial crisis, the S&P 500 Total Return Index fell 46% and Cambridge Associates Private Equity Index declined 32%.
- Growth investing requires investors to predict future cash flows for valuing a business. The further in the future one must go to predict cash flows, the greater the impact of higher interest rates and economic headwinds on the valuations. This dynamic and shifting investor preference for predictable cash flow businesses is causing markdowns in growth businesses.
- We expect differentiated outcomes for private market businesses depending on the quality and stage of growth of the business. The most immediate valuation contraction will be felt in late-stage private companies with plans to list in public markets over 12 to 18 months. Earlier stage growth companies are relatively insulated at this point from public market volatility. Finally, we think companies with sound business models, capital efficiency and large market to grow into will continue to perform better than companies lacking those characteristics.
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