Monthly Investment Letter: Stagflation, reflation, soft landing, or slump?

Equity and bond markets are driven by stories, hopes, and fears about the future path of growth and inflation. The story of the first half of 2022 has been one of “stagflation,” with fears that the Federal Reserve will need to hike rates faster and further to contain inflation driving bond yields higher and equities lower.

The question now is what story will drive the market over the second half of the year: “Stagflation,” “reflation,” “soft landing,” or “slump”? And how will markets react? Now that Fed officials have indicated how closely they are watching and reacting to monthly CPI prints, each inflation data point will likely cause volatility. Yet it will take several months of data, at a minimum, for the market to gain some clarity on what narrative will dominate the second half of 2022. We want to be prepared for that volatility as it presents both risk and opportunity.

In this letter, we analyze each of these potential scenarios, how we might get there, their likelihood, and the market implications. We also map our investment ideas against each scenario.

Four scenarios that could drive the market

This is not a market to position for any one scenario with high conviction. As always, our goal is to build a robust portfolio that can help protect and grow wealth under a wide range of scenarios.

In our own portfolios, we use these scenarios to uncover a broader set of investment opportunities across asset classes or structures. This helps us respond with portfolio actions when volatility creates opportunities.

We think investors looking to build a robust portfolio should take the following progressive steps:

1. First, to manage portfolio risks in the event of the “stagflation” narrative continuing to drive markets, investors should build and manage a Liquidity* strategy portfolio, sized to meet 3–5 years of cash flow needs. This will likely consist of a mix of cash, cash alternatives, and short-duration bonds. Investors should also consider an adequate allocation to hedge funds, which have the potential to deliver performance even if both bonds and equities are falling.
2. Second, to build up defenses against a potential “slump,” in which lower corporate profit expectations drive weakness in stocks, we believe investors should add exposure to quality-income stocks, the healthcare sector, resilient credit, and the Swiss franc. Capital-protected strategies may also allow investors to use volatility to work in their favor and mitigate potential downside risks.
3. Third, invest in value, including energy stocks and UK equities. We think value would perform particularly well in our “soft landing” scenario as increased confidence that corporate earnings can stay resilient benefits some of value’s cyclical sectors, such as financials and energy. Inflation above 3% also supports the style. We also like stocks linked to the “era of security.” As governments and businesses aim to bolster energy, data, and food security, we think this will spur demand for carbon-zero, cybersecurity, and agricultural yield solutions.
4. Fourth, and finally, consider using the sell-off to build longer-term positions. A quicker-than-expected alleviation of market concerns about inflation could trigger a rally in certain growth stocks, even if this remains a low-probability scenario at this stage. Meanwhile, investing in private equity following public market declines has historically been associated with strong returns: The average annual return on global growth buyout funds launched a year after a peak in global equities has been 18.6%, according to Cambridge Associates’ data since 1995.

*Timeframes may vary. Strategies are subject to individual client goals, objectives, and suitability. This approach is not a promise or guarantee that wealth, or any financial results, can or will be achieved.

1. Equities and bonds fall again: “Stagflation”

How might we get there?

As we have seen in recent weeks, fears that the Fed remains “behind the curve” can lead to sudden sell-offs in Treasury markets, which in turn drive equities lower. All else equal, we estimate that a 50-basis-point increase in US 10-year real yields has a –7% impact on fair value for the S&P 500. If Treasury yields rise, it is likely stocks will fall.

What’s the likelihood?

We see a low probability of Treasury yields moving meaningfully higher on a sustained basis.

1. First, assuming a real neutral rate of 0.5% and long-term inflation rates of 2–2.5%, we believe 2.5–3% is a fair fundamental yield for 10-year US Treasuries. The emergence of a wage-price spiral may justify higher yields than this, but for wages and prices to “spiral” upward, wages need to be rising more quickly than prices, which is not happening at this time. In the US, real average hourly earnings declined 3% from May 2021 to May 2022.
2. Second, higher bond yields exact costs on the economy that in themselves should start to lower yields. Higher mortgage rates, corporate borrowing costs, and savings rates should reduce inflation and economic growth, and start to drive expectations of future interest rate cuts.

That said, despite the longer-term fundamental picture, the past two months have proven that we cannot dismiss the possibility that yields can spike around “stagflation” fears. It is likely that every US CPI report in the coming months will create volatility as traders respond to whether it is worse or better than expected. At the time of writing (with the 10-year Treasury yield at around 3.16%), the derivatives market is quoting a roughly 20% probability that the 10-year would rise above 4% by year-end.

We assign a 20% probability to this scenario.

Market implications

In a scenario of bonds and equities declining together, a well-managed Liquidity strategy—with cash as an important component—is key. Hedge funds could be expected to deliver relative outperformance versus equities and bonds.

How bad could it look for equities? If 10-year US Treasury yields were to hit 4%, we believe it would imply around 10% further downside to the S&P 500, a level of about 3,300, leaving earnings estimates and equity risk premium assumptions unchanged. This would represent a 31% decline from the January 2022 peak, broadly in line with the average drawdown of 34.5% for the S&P 500 during bear markets since 1946.

Of course, it is probable that such a jump in Treasury yields would start to trigger growth concerns and potential downgrades to equity earnings. However, it is likely that such downgrades would also start to trigger considerations of Fed rate cuts.

“Stagflation” scenario assumptions

2. Equities fall but bonds rally: “The slump”

How might we get there?

For this narrative to play out, investors will need to start believing two things:

1. that the damage done to the economy will trigger cuts in corporate earnings expectations similar to those experienced in prior recessions; and
2. that the Fed will be able to consider future interest rate cuts without risking reigniting inflation.

With these two beliefs in place, bonds would likely rally as expectations of future rate cuts get baked in. Such a decline in bond yields would offer some support for stock markets, but likely not enough to offset lower earnings expectations and heightened risk aversion.

What’s the likelihood?

A number of recent data points support the notion that the US economy could soon enter a recession. Retail sales are falling. New home construction is at a 13-month low. The Philadelphia Fed New Orders Expectations index has fallen to levels consistent with prior recessions. And the Atlanta Fed’s GDPNow tracker is pointing to zero growth for the second quarter, which, if accurate, could lead to substantial media commentary on recession.

With this in mind, how likely is it that investors will now start to believe in a 15% drop in earnings next year, similar to the magnitudes of earnings cuts experienced in prior recessions? High rates of employment are likely to support consumption, consumer balance sheets are relatively strong, and companies have demonstrated pricing power thus far.

But we note a 33% option-implied probability of the market falling by a further 10% by year-end. And if investors start to think that “only the Fed can save the market,” then logically the market can only bottom when the type of recession that might trigger rate cuts is also priced. We note that all of the past seven bear markets only bottomed after the first Fed rate cut.

Taking all of this into account, we assign a 30% probability to this scenario.

Market implications

Applying earnings cuts typical of prior recessions to our 2023 S&P 500 earnings per share estimate of USD 235 would give trough earnings of USD 190. Applying a 17.4x multiple to this would imply an S&P 500 target of 3,300 in this scenario. It might seem counterintuitive to expect a higher price-to-earnings (P/E) ratio in such a scenario, but lower yields would be supportive of valuations. A 17.4x P/E ratio with a 10-year yield at 1.5% would imply an equity risk premium of 426bps—more than 100bps higher than today’s levels.

“Slump” scenario assumptions

Higher-quality parts of fixed income would likely perform best within this scenario. We estimate that 10-year bond yields could fall as low as 1.5% as the market begins to price Fed rate cuts and potentially a period of disinflation over the longer term. Although credit spreads would likely widen, we believe higher-quality bonds with an investment grade rating would remain relatively robust.

Within equities, defensive stocks and sectors would likely outperform. Based on data since 2003, when the ISM falls below 50 and changes in the ISM are negative, the global healthcare sector has on average outperformed the MSCI All Country World Index (ACWI) by more than 6%.

Dividend styles would also likely outperform because cuts to dividends have historically not been as great as cuts to earnings. For example, during the early 2000s downturn, earnings per share for the MSCI World Index fell 50.7% peak-to-trough, while the peak-to-trough decline in dividends per share was just 11.9%.

We would expect the safe-haven Swiss franc to be the best-performing currency in this scenario. The US dollar typically rallies during recessions (by an average of 3% during recessions since the 1990s) but may not respond as positively this time because the US interest rate advantage over the rest of the world would likely erode quickly.

3. Modest equity recovery: “The soft landing”

How might we get there?

For equities to regain their footing, we think investors will need to start to believe two things:

1. that inflation is sufficiently under control that they will no longer demand higher yields on US Treasuries; and
2. that corporate earnings can remain largely resilient to the tightening in financial conditions already experienced.

What’s the likelihood?

Although various data points are slowing, a recession—let alone a deep one—is not yet a certainty. The US job market is tight: Wages and salaries were up 7.2% year-over-year in March. Based on the latest New York Fed household debt and credit report, the level of bankruptcies remains very low. Around 91,000 US consumers had a bankruptcy notation added to their credit reports in 1Q22, the lowest level since the data series began in 1999. Corporations have shown good pricing power so far: Profit margins are still near record levels. And parts of the economy continue to fare well: US industrial production grew 5.8% in the 12 months to May.

Importantly, we also note that core US CPI, excluding food and energy, is on a downward trend, falling to 6% in May from 6.2% in April and a peak of 6.5% in March. We expect this trend to continue in the months ahead as a combination of lower goods inflation, price competition (prices are adjusting to lower demand), and base effects bring inflation lower. This could start to reduce fears that the Fed will be forced into driving the economy into a deeper recession.

That said, after repeated upward surprises to inflation and downward surprises to growth in recent months, investors are likely to be hard to convince that inflation is under control and earnings can remain resilient.

So we only assign a 40% probability that markets will choose to believe this story in the coming months.

Market implications

We think a dimming of inflation fears would likely keep 10-year US Treasury yields contained at around 3.25% by year-end, and, if earnings estimates remain relatively resilient, support a reduction in risk premiums. Applying a 16.6x multiple to our 2023 earnings estimate of USD 235 would imply an S&P 500 target in this scenario of 3,900.

“Soft landing” scenario assumptions

Within equities, we would expect the value style to perform well in this scenario. Although an environment of stable or falling yields and rising equity markets would ordinarily be thought of as most supportive of growth stocks, our analysis shows that in environments of high inflation, value should continue to outperform. And even though we expect inflation fears to ebb in this scenario, we think absolute rates of inflation are unlikely to fall below 3% until 2023.

Those parts of value that have recently been negatively impacted by fears of a sharper economic slowdown, such as the financials and energy sectors, would also likely rebound strongly in this “soft landing” scenario.

4. Strong equity recovery: “Reflation”

How might we get there?

What could trigger a stronger rally in equities that might bring us closer to previous highs?

Given that fears about inflation and monetary tightening have been central to the sell-off, we believe we would likely need to see a series of developments that would allow investors to quickly and definitively rule out the possibility of our “stagflation” or “slump” scenarios.

This could involve some combination of the following:

• A rapid resolution to commodity supply challenges, potentially stemming from a cease-fire in Ukraine, or an agreement with respect to gas flows from Russia to Europe. Such a drop would alleviate the upward pressure on headline CPI and potentially allow the Fed to reduce the pace of tightening, or even loosen policy, much more quickly than investors currently suspect.
• A swift dissipation of COVID-19 concerns in China. Investors remain nervous about supply chains in part due to the “stop-start” nature of lockdowns in China. Increasing confidence that the economy can reopen on a more sustainable basis could alleviate some market concerns about growth in the country and supply chains globally.
• A significant increase in US labor force participation. Market fears about stagflation have partly been driven by the fact that the number of job vacancies in the US is significantly higher than the number of unemployed, and that a recession may be the most plausible way this can be resolved. A jump in US labor force participation could help investors see a potentially favorable “way out.”

What’s the likelihood?

The S&P 500 option market implies just a 10% probability that the index will cross above 4,500 by year-end, and, with inflation high, financial conditions tightening, and growth slowing, it is hard to envisage this scenario materializing in the next six months. We assign a 10% probability to this scenario.

At the same time, one of the key investment lessons resulting from the pandemic is that political intervention in markets is increasing. We cannot have a failure of imagination about the range of outcomes.

Market implications

An alleviation of market concerns about inflation and monetary policy would likely trigger a significant rally in equity markets. Assuming consensus forecasts for 2023 earnings and the 10-year US Treasury yield stay where they are today (USD 252 and around 3.2%), and equity risk premiums drop slightly below the long-term average, the S&P 500 would trade at around 4,500.

All sectors would likely perform well, though growth stocks would likely deliver the strongest absolute performance given that they have suffered the most in the recent sell-off.

“Reflation” scenario assumptions

How to invest?

There are a lot of potential outcomes for markets, and the only near-certainty is that the path to the end of the year will be a volatile one. It can feel overwhelming for investors considering how to position their portfolios. But we think investors can implement progressive steps to protect against the “bad” scenarios—“stagflation” and “slump”—and to position for “good” scenarios—“soft landing” and “reflation.”

Investment ideas

Of course, striking the right balance between protection and growth will be personal to each investor: Those with a lower risk appetite or shorter time horizon may wish to focus more on steps to protect against downside risk, while those with a higher risk appetite or longer time horizon may focus more on building exposure. But by working through these steps, we believe investors can reduce portfolio risks and improve potential returns in what is a highly uncertain environment.

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