Monthly Investment Letter: Picking the bottom

Many of you have been asking when the stock market will bottom. Before my morning coffee, I might answer, “Trying to pick a bottom is a good way to lose a finger.” All-or-nothing market timing is not a successful long-term approach to investing. But now that I’ve had my morning coffee, in this letter I will set out how to think about market turning points and, in particular, this market turning point.

We believe that the conditions will be in place for a sustainable rally once investors can see Federal Reserve rate cuts or a trough for economic activity on the horizon, or when valuations are so low that they already price in a “bear case” scenario. Today, none of these conditions are in place.

• The latest US inflation and labor market data suggest that interest rate cuts remain far off, even if the Fed is likely to stop hiking rates in the first quarter of next year. Core consumer price inflation is at its highest since 1982, the Fed has consistently conveyed that it is more willing to “overtighten” policy than risk not doing enough, and the labor market is tight.
• Consensus earnings forecasts, which look for 5% growth globally in 2023, do not appear to factor in the potential negative consequences of a period of tight monetary policy. Numerous leading indicators are pointing down. And China remains a source of near-term risk as it attempts to resolve issues related to COVID-19 and the property market.
• The continued rise in interest rates also means that valuations, despite falling in absolute terms, do not yet fully discount a bear case, especially in the US. The selloff in equities can be almost entirely explained by higher interest rates, while lower growth expectations are not yet priced into stocks, in our view.

The more encouraging news is that we do expect economic growth to trough sometime in the middle of 2023. And once the Fed has stopped hiking in the first quarter as we expect, markets will start to consider the timing of future rate cuts.

Meanwhile, the decline in absolute valuations and rise in bond yields have improved the longer-term return outlook for diversified investors, and volatile market conditions such as today’s can present a good opportunity for long-term investors to build exposure.

For several months now, our asset allocation views have centered around the themes of defense, diversification, income, and value, as we have navigated an environment of tighter monetary policy and slowing growth expectations.

Today, we focus on mitigating near-term downside risks while retaining upside exposure for the medium and long term.

Today, we focus on mitigating near-term downside risks while retaining upside exposure for the medium and long term.

Within equities, we prefer capital protection strategies, value, and quality income. We like global healthcare and consumer staples. Globally, we hold a least preferred stance on growth, technology, and industrials. By region, we like the UK relative to the US. Within fixed income, we prefer high-quality and investment grade bonds relative to US high yield. And in currencies, we prefer the safe-haven US dollar and Swiss franc relative to the British pound and euro.

When will the Fed turn?

We think that high inflation and still-rising interest rates pose a headwind for risky assets in the near term. History tells us that markets usually need to be anticipating interest rate cuts, rather than a mere end to hikes, before reaching the bottom. A look at market turning points since 1960 shows that, on average, the 2-year US Treasury yield had fallen by 100 basis points from its peak in the six months prior to the market bottom, indicating that investors were starting to price a Fed rate cut cycle. So, when might such a turning point arrive?

The latest inflation data didn’t bring encouraging news. After a slight dip in the summer, US core CPI reached a four-decade peak of 6.6% in September. The data suggests that the shift in consumer spending away from goods and toward services has bumped up prices of items such as housing and transportation. Core services prices jumped 0.8% compared to August, while core goods prices were flat month-over-month.

Some items, like shelter, appear to be lagging a decline in rents evident in other sources of data. The Fed is aware of the data’s deficiencies, but we don’t think it sees itself as being able to argue over the numbers. Inflation remains far too high, the Fed sees its own credibility at stake, and we think it will keep hiking aggressively until official measures of inflation take a breather.

We expect the Fed to raise rates by 75bps in November and either 50 or 75bps in December contingent on the data. With inflation still elevated, it is likely that rate hikes will continue at the start of 2023. Federal funds futures markets are currently pricing a peak in rates at 5% in 2Q23.

Eventually, higher rates will have an effect on inflation and the Fed will be in a position to stop hiking. Higher rates increase borrowing costs and discourage consumer and business spending, particularly for debt-financed big-ticket items like housing, cars, and capital equipment. Mortgage rates have more than doubled since the start of the year, driving a slowdown in the housing market. Slowing demand will also reduce demand for labor, helping to moderate wage growth. As a result, real-time indicators of future inflation are almost all pointing down, including new rents, wage growth, import prices, and prices-paid indexes.

The announcement of a pause in rate hikes would likely prompt a relief rally for equities, and the market may also front-run such a decision if the economic data points toward a likely pivot in Fed policy. But the lesson from history is that the market needs to be anticipating rate cuts—rather than a mere end to hikes—to support a sustained rally in stocks. This could take a few months longer as investors demand clearer evidence that the Fed has done enough to bring inflation sustainably back to target, and that the direction of the next rate move is down, rather than up.

When will the growth data turn?

If the anticipation of Fed rate cuts tends to be important for market bottoms, history tells us that sustained turning points also require a trough for economic activity to be in sight.

Looking at US economic downturns since the 1970s, the trough in the ISM manufacturing index and its new-orders component have preceded a bottom in the S&P 500 by, on average, 1.4 and 1.7 months, respectively. Of course, it’s only possible to see the trough in hindsight. But a rise in both indicators for two consecutive months from levels below 50—which is considered contraction territory—would suggest a trough that historically has coincided with a turn in the equity market.

The six-month change in the headline ISM has also been well correlated (after a two-month lag) with changes in forward earnings growth estimates for the MSCI All Country World Index (ACWI), considering data since 1995. Our analysis suggests that the ISM tends to trough ahead of the equity market, and a turn in earnings momentum follows shortly after.

How does that relate to the situation today?

• Looking at the latest data, the ISM manufacturing index peaked in March 2021 but remains in expansion territory at 50.9. By our calculations, the extent of the change in 10-year US Treasury yields is consistent with an ISM in the mid-40s. Meanwhile, given that the effect of tight monetary policy on the economy is likely to grow in the months ahead, we think further downward earnings revisions can be expected.
• Our estimates for S&P 500 earnings per share (EPS) are USD 225 for 2022 (7.4% growth vs. 2021) and USD 215 for 2023 (4.4% decline vs. 2022). Our 2023 estimate incorporates 3.5% revenue growth (excluding energy and financials) and a contraction in profit margins back to pre-pandemic levels in 2019. Our estimate is roughly 10% lower than the bottom-up 2023 consensus estimate of USD 238.
• In our view, a trough for economic activity will come around the middle of next year. A deep and prolonged recession is unlikely given the strength of consumer and corporate balance sheets. Excess savings are still robust at over USD 1 trillion and should provide some cushion.
• But for the next three to six months, we think it is likely that leading indicators will continue to fall and earnings estimates will be revised lower—a mix that makes us less confident about equity market gains in the near term.

Are valuations low enough yet?

Of course, there is a price at which equities might look sufficiently cheap to buy, even in the absence of encouraging central bank or economic data. But today, we find that while equities have gone some way to price this year’s change in interest rates and bond yields, they have yet to factor in a slowdown in growth expectations.

While equity multiples have compressed this year, earnings estimates have increased, suggesting that the decline in stocks can be explained by higher discount rates rather than an earnings contraction.

At the start of 2022, 10-year US Treasury yields were at 1.5%, the S&P 500 forward price-to-earnings (P/E) multiple was 21.3x, and the equity risk premium (ERP) was 320bps. The consensus 12-month-forward EPS estimate was at USD 223, with the S&P 500 trading around 4,750.

Yields are now around 4%, the P/E has fallen to 15.6x, and the ERP has fallen to 240bps. The consensus forward EPS forecast is currently USD 236, with an S&P 500 level of 3,680. Despite a 23% fall in the index year-to-date, the S&P 500 is only pricing in the impact of higher rates rather than an earnings contraction.

In our downside scenario, our trough estimate for S&P 500 EPS is USD 193, which represents a 15% earnings contraction—the average fall in earnings during US recessions historically. In this environment, we would expect some softening in 10-year yields, allowing a modest rerating of equity multiples, and our downside target of 3,300 is equivalent to 17.1x trough earnings of USD 193.

How to invest?

As we consider investment positioning, we need to balance what looks like a still-solid 3Q22 for US earnings, an unfavorable risk-reward outlook in the near term, and a more encouraging picture over the medium-to-longer term.

...we think global economic growth and earnings will continue to decelerate into the start of the new year...

We don’t expect major central banks to end their hiking cycles until 1Q23; we think global economic growth and earnings will continue to decelerate into the start of the new year; and valuations are not yet fully factoring in a bear case scenario. Yet we expect economic growth to trough sometime in the middle of 2023 and markets to start to consider future rate cuts once the Fed stops hiking. Meanwhile, the decline in absolute valuations and rise in bond yields this year have improved the longer-term return outlook for diversified investors.

Investors therefore need to balance mitigating near-term downside risks with retaining upside exposure for the medium and long term.

• For investors whose exposure to equities is already close to long-term target levels, we recommend considering options or structured strategies that can allow them to participate in gains if the market rallies, while offering a degree of capital protection in case markets fall further. Adding exposure to sectors like global healthcare and consumer staples, which are likely to be less exposed to a deterioration in economic growth, can also help reduce downside risks while retaining upside exposure.
• For investors whose exposure to equities is above long-term targets, we advise trimming that overexposure in favor of fixed income opportunities including high quality bonds and resilient credit. The recent increase in yields offers a more attractive entry point for high quality bonds—USD high grade currently yields 4.8%—and we would expect the asset class to perform well in the event of a sharp slowdown in growth in 2023. Investment grade issuers in the AA or A category with tenors of around 5–7 years, operating in businesses that are relatively immune to the economic cycle, also look attractive in our view.
• For investors who are currently underexposed to equities, lower valuations suggest this could be a good time to start to commit capital. Based on historical data, today’s S&P 500 P/E is consistent with annualized returns of 8–10% over the next decade. One approach to building up exposure over time is through put-writing strategies, which can help generate yield and enable investors to potentially buy on dips if markets fall from here. An alternative approach is to add to positions in yield-generating structured investments—building indirect, and somewhat more defensive, exposure to equities.

Asset classes in review

Our asset allocation views are centered around the themes of defense, diversification, income, and value. We have a focus on hedging near-term downside risks, and a preference within global equities for value, quality income, and healthcare and consumer staples relative to growth, technology, and industrials. By region, we prefer the UK to the US. Within fixed income, we prefer high-quality and investment grade bonds relative to US high yield, and are also cautious on US senior loans. And in currencies, we prefer the safe-haven US dollar and Swiss franc relative to the British pound and euro.

Equities

• We have a least preferred stance on US equities. While many global equity markets face similar challenges, those issues are less well reflected in US equity valuations, which are still close to long-term averages. Given the possibility of a short-term relief rally around any incremental improvement in inflation or labor market data, we focus on using structures that aim to protect against near-term downside risks rather than selling US equities outright.

• We also have a least preferred stance on the technology sector given its heightened exposure to interest rate volatility, decelerating global growth, and the ongoing technological decoupling between the US and China.
• We prefer more defensive sectors, including healthcare and consumer staples, and the value style—which tends to outperform growth sectors, including technology—during periods of rising yields and high inflation.

Bonds

• We have a least preferred stance on US high yield credit, and are also cautious on US senior loans. While benchmark yields have risen, we don’t believe that high yield spreads, relative to investment grade or high-quality bonds, adequately reflect the risks to the segment. In an environment of tightening liquidity, the potential for stress in high yield credit is elevated, and we prefer more resilient credits.

Commodities

• We have a neutral stance on broad commodities. We believe investors should hold their existing exposure and, rather than add more broad exposure, be more active and selective within the asset class. Heightened risks to global growth, including the continued holdup in China’s economic rebound, mean that demand expectations are likely to come down. We maintain our preference for oil and energy equities.
• We believe supply-side challenges will prove more significant than any slowdown in demand and expect oil prices to rise in the months ahead.

Currencies

• We like the US dollar and Swiss franc relative to the British pound and euro. The Fed’s rate hiking cycle remains the most aggressive of any major central bank, and we believe both the dollar and franc should continue to attract inflows in a risk-averse environment. Meanwhile, although the pound and euro are relatively cheap, downside risks remain because energy supplies are tight, posing risks to European economies this winter.

Alternatives

• Hedge funds have been a rare bright spot for investors in 2022, with some strategies, like macro, doing particularly well. With inflation data and central bank policy likely to continue to drive a high correlation between equities and bonds in the near term, we recommend investors diversify into less correlated hedge fund strategies to navigate market uncertainty.

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