Investors have endured a rough start to the year, with financial markets unsettled by a challenging macroeconomic and geopolitical backdrop. The financial impact of the pandemic has mostly eased, but inflationary pressures remain stubbornly elevated, forcing a tightening of financial conditions.
As markets have priced in a gloomier inflation and growth landscape—as well as growing concerns of a US recession—many investors are feeling the squeeze. The S&P 500 index, which is down (20)% year-to-date, slid into bear market territory while the global MSCI ACWI IMI index fell (22)% from its November peak. And with markets turning hostile after three solid years of upbeat returns, there have been few places to hide. Even municipal bonds retrenched by (5)%, followed closely by hedge funds at (6.3)% (Display).
As we gauge where things go from here, it’s helpful to compare where they stood at the end of the first quarter (Display). Unfortunately, conditions have deteriorated on several fronts—especially in the US and other developed markets, as the focus has further shifted from inflation to growth pressures. China stands out as the sole improver, with growing signs of normalization and an increased likelihood of government stimulus.
How the Bottom Could Already Be In
With elevated uncertainty across the economy and markets, several possible paths could unfold from here. However, our base case calls for US economic growth to slow meaningfully below trend—perhaps toward 1%—then hover.
How might this play out? Thanks to tighter financial conditions and easing pandemic-related supply constraints, inflation would start receding. However, growth would take a hit. The economy may even slip into what’s technically considered a “recession,” though at 1%, it’s a distinction without a difference. With the Fed forced to be aggressive, interest rates could climb toward 3.5% by the end of 2022 and 3% by the end of 2023 (up from 3% today). Nominal earnings growth would falter due to lackluster economic activity—perhaps coming in flat year-over-year in 2023—and valuations would reset from levels north of 20x last year to closer to mid-teens, reflecting the subdued backdrop (Display).
In many ways, today’s markets already incorporate our base-case scenario, as the US equity market has re-rated to trading at a mid-teen multiple on next year’s earnings versus last year’s 21x multiple. For this reason, we think there’s a chance that today’s pullbacks already reflect the coming economic and corporate malaise. What’s more, certain pockets of the market have declined disproportionately, setting up greater opportunity for reversal along with a stock selection opportunity.
But that’s not the only scenario. There’s also a chance inflation definitively eases over the next several months, allowing the Fed to back off sooner. That would cause growth to slow only modestly, but not enough to cause a recession, or earnings and valuations to reset much lower. Alternatively, in a worse case, the Fed’s inflation fight could lead to a more severe economic contraction. Here, we’d expect earnings to decline double-digits—in line with previous recessions—and PEs to fall to the mid-teens.
What Should Investors Do?
Volatile times are almost always poor decision points for material asset allocation changes. The same is likely to be true today given the substantial decline we’ve already experienced. Keep in mind that when uncertainty rises, so do the potential rewards for taking risk in your investments. And while real challenges exist, we’re actively looking for signs of recovery and finding long-term opportunities.
For instance, municipal bonds seem quite compelling given the higher move in interest rates. Within equities, we’d suggest focusing on companies with pricing power. In today’s environment, active management can be a powerful ally in finding these potential outperformers. When it comes to alternative investments, low beta hedge funds have been successful dampening the recent volatility, while income alternatives with floating rates harness the Fed’s tightening as a tailwind. Private equity and venture capital remain attractive—vintages created during volatile markets often prove exceptionally rewarding long term. Above all, consult your advisor about what’s right for you. And remember, this is not a time to panic. It’s a time to find comfort in an asset allocation that was built assuming years like 2022 will occur… and occur more than once over a lifetime.
- Alexander Chaloff
- Co-Head—Investment Strategies
- Beata Kirr
- Co-Head—Investment Strategies