Economic news: investment outlook

July 1, 2022 | Market news

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

Global economy

Quick take: Our proprietary Health Check, which compiles more than 1,000 global economic indicators to determine the current economic state and trend, reflects slowing growth across the globe. The U.S. and developed economies are decelerating from above-average economic activity. Our emerging market Health Check fell to below-average activity with a negative trend, which indicates mixed growth among the diverse economies, with China the largest and most challenged for now.

Our view: Supply constraints likely keep global inflation pressures elevated into year end. Consumers, especially in the United States, may weather the storm, but global central bank interest rate increases and higher input costs for companies could drag down real economic activity.

  • Key points: hides details

    • Persistent inflation is a headwind for U.S. economic growth into next year. Limited inventories of energy and grains coupled with continuing rent increases mean inflation rates are likely above average through 2023. Inflation historically depresses consumer spending; however, wage gains, a tight labor market and high savings balances should support consumer spending into next year. Business spending is the economic growth swing factor as companies navigate inventory pressures and higher labor and input costs. In our base case, the economy weathers these storms to eke out modest levels of growth for 2022. Risks to our modestly positive outlook center on inflation, Fed policy and corporate earnings.
    • The Russia/Ukraine conflict and high prices have dampened economic activity in Europe and Japan. High global inflation and higher interest rates likely keep economic growth low and perhaps risk recession if companies are unable to pass along cost increases.
    • Coronavirus shutdowns and reopening are the primary determinant for China’s economic growth, with inflation pressures a challenge for other emerging economies. As the second-largest economy, China’s slowdown impacts growth across developed and emerging economies. A key event is this fall’s Central Committee meeting of the Chinese Communist Party, which is likely to elect President Xi Jinping to a third term. Episodic regional shutdowns to combat coronavirus are driving economic cycles, with the reopening of the Shanghai province bringing a near-term boost to activity. The government may provide further stimulus to the economy ahead of the Central Committee meeting. Meanwhile, other emerging market economies are struggling with inflation, and several are raising interest rates in response. Near-term growth prospects appear muted, but the stronger U.S. dollar could support export growth prospects late this year or early in 2023.

U.S. equity market

Quick take: The Fed’s determination to restore inflation to normal levels through raising interest rates and the Russia/Ukraine crisis are among key factors driving our cautious outlook for U.S. stocks, though investment opportunities exist in all market environments.

Our view: Elevated equity market price volatility is likely to continue while uncertainty surrounding inflation and the Fed’s interest rate hiking path and the potential impact on corporate earnings growth persists. We favor companies with solid balance sheets and strong growth, viewing cyclical sectors as likely to perform well as inflation remains elevated while secular growth companies can benefit over the long term.

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    • 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.

International equity markets

Quick take: Bearish investor sentiment toward foreign equities reflects challenging macroeconomic conditions, but current pessimism provides upside price potential if conditions improve.

Our view: Europe’s proximity to the Russia/Ukraine conflict, a surge in commodity price inflation, renewed China lockdowns and major central banks initiating or announcing plans to raise interest rates to combat elevation are headwinds for foreign equities’ growth prospects. Investor sentiment remains well below average relative to U.S. equities; however, if geopolitical conflicts de-escalate, supply chains constraints ease or central banks pause their interest rate hiking path, currently bearish sentiment could quickly reverse, providing upside potential.

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    • 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.

Bond markets

Quick take: Rising Treasury yields reflect investor expectations that the Fed hikes interest rates to around 3.5% by the end of the year. Rising yields dragged on performance across the bond market. Corporate and municipal bonds underperformed as investors’ appetite for credit risk waned over concerns of tightening financial conditions and slowing economic growth.

Our view: We favor high-quality bonds that offer meaningful income and can aid in portfolio diversification. Treasury yields near decade highs and above-average yields relative to Treasuries for corporate and municipal bonds means income on investment-grade bonds has improved significantly. Potential for ongoing market volatility from tighter Fed policy and decelerating economic growth may favor the defensive characteristics of investment-grade bonds.

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    • 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.

Real assets

Quick take: Fundamentals are currently positive across all real asset categories. Cash flow and earnings growth are above long-term averages, in some cases quite significantly, for real estate and infrastructure assets. Additionally, commodity markets appear undersupplied, and the Russia/Ukraine conflict is limiting supply further. However, monetary policy is causing a repricing of cash flows and negative returns for most asset classes so far this year. Commodities will not be immune to this price action. The primary risk facing the market is monetary policy and the associated deterioration of demand.

Our view: Rising interest rates have already damaged real asset markets and still higher rates are needed to inflict more serious downside price action. Public real estate investment trusts (REITs) have repriced compared to private real estate assets. Assets providing stable cash flows will outperform in 2022’s second half as economic growth slows.

  • Key points: hides details

    • 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.

Alternative investments

Quick take: Hedge fund managers remain focused on potential risks in the macroeconomic and capital market environments, digesting the significant policy and economic shifts that have occurred. Generally, hedge fund managers have positioned defensively in this volatile environment by actively trading and reducing risk through broad market hedges. Individual winning positions have not separated the top-performing hedge funds this year as much as managers’ decisions around overall net exposure to the markets.

Our view: Hedge funds are likely to remain defensively positioned into 2022’s second half but shift their focus to individual security selection, such as stock-specific short selling, which are investments that benefit when individual company prices fall. We expect additional market pullbacks may also encourage some managers to position portfolios for potential upside volatility. Nimbleness and agility continue to be critical for navigating the markets this year.

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    • 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.

Private markets

Quick take: Private markets performance is expected to soften given challenging macroeconomic conditions. Assessing this changed macroeconomic environment, investor preference has shifted toward businesses with more visible current cash flow streams as a “flight to safety.” Investor sentiment has dramatically shifted from “growth at any cost” to valuing capital discipline. Companies with sound business models, capital efficiency and a large market to grow into will continue to attract capital.

Our view: While past performance is not a guarantee for future performance, private markets may experience a less severe correction through this cycle as well. We maintain our conviction that private markets present persistent attributes that allow for opportunities to outperform public markets. Also, secular trends in technology are here to stay despite headlines claiming the bursting of a second technology “bubble”; digitization across industries and consumer preference for technology-enabled services remains intact.

  • Key points: hides details

    • 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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This commentary was prepared September 2021 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. The S&P 500 Total Return Index includes the same stocks but include the reinvestment of dividends. The MSCI EAFE Index includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East (EAFE). The MSCI Emerging Markets Index is designed to measure equity market performance in global emerging markets. The Cambridge U.S. Private Equity Index is based on returns data compiled for U.S. private equity funds (including buyout, growth equity and mezzanine funds) that represent the majority of institutional capital raised by private equity partnerships formed since 1986.

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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