• The Federal Reserve is aggressively raising rates (1.5 – 1.75%), but continues to lag the market with 2-year Treasuries at (2.8% on July 5).

• The economy is likely to go into a recession, if not already in one (based on the Atlanta Fed GDPNow forecast). I expect the recession to be shallow.

• US Earnings estimates continue to be good, but there is a risk that they will be cut in the second half.

• Relative to the end of 2019 (pre- pandemic), yields on fixed income funds are higher while the S&P 500 PE ratio on a forward basis is lower (more attractive).

• Given valuations for both fixed-income and stocks and a view of a shallow recession, maintaining a balanced exposure to risk allocation would be prudent (subject to personal circumstances).

The market had the toughest first half since the early 1960’s.  Stocks are down 20% (S&P 500 TR) and bonds are down 10.3% (US Agg Bond).  There are many factors driving interest rates up and the market down.  I’ll focus on the main issues and provide some perspective and outlook for the second half.

Inflation

The US government applied massive fiscal spending and went to a 0% interest rate for far too long.  Pandemic supply shocks and the Russian invasion of Ukraine added pressure (especially to energy and agriculture prices).  Inflation was heating up last year (before the Russian invasion) and the Federal Reserve policy of ‘inflation averaging’ was a big mistake.  They finally raised a larger then normal .75% in June.  However, much of the damage is done because the bond market took matters into its own hands, raising rates well before the Fed.

Interest Rates

At the start of 2022, the 10-year rate was 1.5%.  It steadily rose the first half, peaking at 3.5%.  Today, the 10-year is trading at 2.8%.  Interest rates are the price of money, all assets are priced based relative to government bond rates (with premiums).  We don’t know for sure if rates have peaked for good. Inflation continues to run hot.  The Fed cannot control inflation on certain goods that are supply constrained such as energy and food.  The market break-even for inflation over ten years has fallen from a peak of 3% to 2.34%, so for now investors are saying they don’t see long term sustained inflation.

Fixed Income

As noted, bond fund yields have increased sharply since the start of the year.  The yield to maturity on the US Aggregate Bond funds is 3.35% today.  Bond funds that take on additional credit risk have even higher yields.  So, relative to last year, fixed income looks pretty attractive.

Stocks

The S&P 500 earnings for the trailing 12 months is roughly $201.  So, with the index at $3,767 (July 5), the trailing PE multiple is 18.75.  The forward expectation for earnings is $227 (source: S&P500).  So, the forward PE is 16.6x.  The forward PE in December last year was close to 22x.  PE multiples have pricing in higher rates and lower growth, at least in part.

Earnings outlook. I do think that the earnings will be revised down some.  I am expecting earnings over the next 4 quarters to be flat with prior 4 quarters.  Why?  I do believe that consumer confidence has been shaken and people start to cut back on spending.  Retailers have a problem with inventory mix and higher labor and transportation costs.  At the same time, companies will pull back on hiring and spending and do what they need to do to deliver earnings.

Market Timing

Forecasting how long it takes for the market to normalize is more art then science.  I expect we will continue to see very high volatility in rates and the stock market until three things happen:  1) we see the Fed funds rate and the 2-year treasury rate converge, 2) we see some signs that inflation is starting to come down, and 3) we get increased visibility on earnings.  These things will take 2-3 quarters to work out.

Which leaves us to the final question, how should we position?

Given relatively attractive fixed-income rates, maintaining a healthy exposure over cash looks good.  Credit spreads are widening, but if we go into a prolonged recession spreads could widen further.  Therefore, I like high quality, intermediate term bonds at this point. 

For stocks, the valuations are fair assuming we get no more than a mild recession.  I think the US economy is very resilient and likely to come through this normalization period in good shape.  High quality US companies with good valuation should outperform in any deeper recession.  International stocks are relatively cheaper on a valuation basis, but growth and currency risk need to be considered.

Overall, maintaining exposure at a neutral risk level (consistent with one’s personal circumstances) is the recommended path.  For clients, I will provide additional details on specific investment changes on a case by case basis.