On what should investors focus?
The upcoming earnings season is of major importance. With the bulk of tightening and inflation fears behind us, the valuation excesses which resulted from the pandemic stimulus bazooka have been entirely erased. The S&P 500 trades at a price/earnings ratio similar to that of late 2019, while the big pandemic winners have made a complete round trip. At the same time, we have most likely seen the peak in Treasury rates this year.
The remaining hurdle is corporate profitability. While market sentiment is on the bearish side, analysts have hardly revised their earnings expectations downwards. At the same time, we expect company management to take advantage of the current climate to issue more cautious forward guidance. The key would be to watch the market reaction to both good and bad earnings surprises.
Soft landing remains our base case
Today, US equities are pricing in a meaningful slowdown in economic activity, but not a recession. Markets expect inflation to cool off and the Fed to pause its tightening early next year with the federal funds rate at just below 3.5%.
What about fixed income?
Since the Fed embarked on its renewed attempt at quantitative tightening earlier last month, US Treasury yields have been falling. With market-implied longer-term inflation expectations well anchored, the Fed managed to uphold its hard-earned credibility in fighting inflation. Counterintuitively, at a time when liquidity conditions deteriorate, as the reserves floating around in the financial system are drained by the Fed’s actions, US bank lending accelerates.
What at first appears as a conundrum might in fact be a temporary phenomenon. With capital market financing either closed or too costly, the private sector might have temporarily turned to commercial banks to receive bridge financing. It goes without saying that it remains important to monitor future developments to verify this thesis.
As the economy slows, there is a window of opportunity for bonds to perform. There is finally income in fixed income again.
Time to search for opportunities
Taking even a bearish stance, reducing risk at this stage is a matter of trading, not investing. Increasing recession fears and geopolitical uncertainty promise volatile months ahead.
Market timing requires two decisions: when to go out, and most crucially, when to re-enter. The war in Ukraine has done nothing to make this endeavour any easier or the risk-return pay-off any more attractive. For investors, however, the second half of 2022 would be the time to search for opportunities to position portfolios for the next cycle, as we believe the market will find its bottom in the next six months and the bear market will not carry into 2023.
Large market declines are rare, and it is on these occasions that investors have the chance to truly secure future returns. Equities remain our preferred asset class in the new inflation regime of somewhat above 3%.