Bernstein's 2022 Mid-Year Outlook

Audio Description

After a rough first half of the year for most markets, our Co-Heads of Investment Strategy, Beata Kirr and Alex Chaloff, join The Pulse to lay out our perspective on where we stand and what may come in the second half of the year and into 2023. Will there be a recession? Will inflation ease? What should investors do?


This transcript has been generated by an AI tool. Please excuse any typos.

00:03 - 00:42

Hi verybody. And welcome to The Pulse, where we cover trends in the economy, markets and asset allocation for long term investors. I'm Matt Palazzolo, senior investment strategist at Bernstein and national director of Investment Insights. As you're no doubt aware, the first half of 2022 has been a rough period for financial markets, with investors facing sizable drops in both stocks and bonds. The pillars of most portfolios. And with that tough start to the year behind us, I'm especially excited to welcome Bernstein's Co-heads of investment strategy, Alex Chaloff and Beata Kirr to discuss where we go from here. So, Alex and Beata, welcome to the show.

00:42 - 00:44

Thanks. Great to be here.

00:44 - 00:56

Thanks for having us back. So, guys, why don't we kick things off with a look at how we got to where we are with the markets down as much as they are through the middle of July? Beata, why don't we start with you?

00:57 - 01:38

Well, Matt, I think that's one of the toughest places to start. But everybody that's listening already knows that having looked at their statements and watching the news for the first six months, it's been a really tough start to this calendar year. But let's just level set on what that means for actual returns. So in the stock markets, both U.S. and non-U.S. really global equities are down about 20% at this taping. There's been big differences in the types of stocks and their performance growth stocks that are growing at much faster rates or down close to 30% in value. Stocks that are really cheap relative to their long term valuation down closer to 15%.

01:39 - 02:23

I think one of the toughest aspects of the market year to date is that most investors and hopefully our clients recognize that stocks are always volatile and can be down this much. But we expected bonds to provide a lot more protection. And it's tough to watch Bonds being down somewhere between 5% to 10% for core intermediate duration, high quality strategies, and then the high yield bonds down more in the mid-teens. So that's been tough for what we would call the moderate allocation and the 6040. And so if you're looking for glimmers of hope this year, what would you have been excited about? Well, energy stocks and commodities, high teens, although they've given back some gains in the last month.

02:24 - 03:07

So, look, I think it's been a really tough 2022, not only in the drumbeat of negative headlines, but in the actual market outcomes. And I think before I turn it over to Alex to really contextualize this, I'll start that process by saying we have to look at 22 in context of the longer term investing experience. We've had several years of double digit annualized growth and in fact, cumulative growth stocks were up 140% in the last three years. Value stocks are up 60% over that time, and even bonds that safe asset class are up between ten and 20%.

03:08 - 03:58

So let me take what Beata commented on in the markets and translate that into the broad economy and what's going on in the world of economics. Coming into this year, the expectations were for continued growth around the world and markets had to deal with inflation. There was some belief that we would have higher than near term historic levels of inflation, but they wouldn't be as extreme as we'd seen because what people couldn't have baked in to the scenario was looking at Russia's invasion of Ukraine, thinking about how dramatic the impact of China's shutdown and full lockdown would have been on normalizing the supply chain. And so we've seen levels of inflation, which we'll talk about much higher than what we're expected coming into the year, much higher than what we've seen in almost 50 years.

03:59 - 04:32

So now the attention of investors and really of the market has turned to how can we battle inflation? How can the Fed do its best to bring inflation levels down and questions around their ability to do so without causing the U.S. in particular and other economies around the world to fall into recession? Because as the Fed tightens as aggressively as they have and that they've signaled that they'll continue to do so, then the likelihood of a of a recession increases.

04:32 - 05:13

We came into the year probably too dovish as it relates to interest rate expectations and the we is really the market and investors in general. And now the question is, has the market become too hawkish and thinking about interest rate increases over time that are much higher than what we've seen. So a lot of what we ought to talk about as far as what's going on in the markets is because there's so much uncertainty. The question marks are really much larger than they have been in the past. We think about what's important as investors, it comes back to earnings. And that's where the Fed's policy and the impact of what's going on in the broader macro picture really comes home.

05:14 - 05:34

Will companies suffer because of what the Fed does, or can they maneuver in some fashion to nail what what many people are calling the soft landing, where they can raise rates enough to battle inflation, but not too much to throw us into recession. That's the delicate balance.

05:34 - 05:59

So all of the macro discussions really focus on the inflation levels and when will they come down and what actions the Fed and the US has to take to bring them down. So Beata Alex has posed a lot of good questions that certainly we and the markets are grappling with. We're going to look to you for some answers. What's our base case for the balance of the year and looking into 2023 from an economic standpoint?

05:59 - 06:45

Well, the best way to transition to the base case is really in many ways where Alex and this idea that the Fed is landing this plane on a pretty narrow strip. Right. That soft landing concept is in many ways our base case. But let's give some more context around what we mean for that. We mean that we think the Fed will continue to raise rates and that will impact GDP growth downwards. So we think GDP growth will slow materially. And now this big question of the upper keys are right. The recession risk, whether it's actually a recession or not, is less meaningful than the idea that growth will slow and that will impact earnings on the downward trajectory.

06:45 - 07:16

We think that the Fed rate hikes are going to slow the economy and supply chains are also going to normalize over time. It's not going to be a perfect line. There's going to be stops and starts on both fronts. But ultimately, we do think the Fed has a chance of bringing inflation back down toward but not quite to target on inflation 2023. And, Matt, I'm sure what you're really asking is, what does that mean for markets? I'm sure that's what our listeners are really wondering as well.

07:17 - 07:51

So back to the story around earnings and what markets care about. So we do think earnings expectations that are currently baked into the market right now will fall a bit, but growth could stay positive. So we're talking about S&P 500 earnings per share of $220 this year, and that could be in the low 200 and thirties next year. And so, look, we're recording this today where the market's actually up about two and a half percent and the S&P is sitting at 3932 right now.

07:51 - 08:18

So what does that mean? That means valuations around 17 times. And I know Alex is going to talk about this a little bit, but at 17 times, that's more of a normalized valuation, multiple for the market. That's four points lower than where we started at the beginning of the year. So the market in many ways has already priced in the fact that there will be this slowing growth and slowing in earnings expectations.

08:18 - 09:13

Alex, before you jump in, I think these are important enough points that just to underscore them and highlight them. Again, the auto, if I heard you correctly, were calling for a deceleration in economic growth down towards 1% or so on from an economic standpoint, GDP standpoint for the United States. That is as the Fed raises interest rates in order to slow down inflation. That's job number one for them, that slower economic growth will ultimately lead to slower earnings growth. And with that and alongside higher interest rates, a lower p e multiple on the market and putting that all together, maybe the big conclusion is that if that base case is correct, the market may have already priced in all of that bad news about what's to come from the economic standpoint. And from here, we're just going to wait for either better news meeting, a more bullish case or a bearish case relative to those expectations.

09:13 - 10:04

And I know, Alex, you were going to highlight those to both the bull and the bear case relative, to be honest, base case. That's right. So the base case is the case that we feel has the highest probability of occurring. And if you think about that, rough numbers as a 50% scenario outcome, the barricades and the bull case probably are 25% each. And so I like the bad news first. So let's cover the barricades first. The bear case is what everyone's worried about, that we go into recession, that the Fed goes too far, if you will, and that economic activity falls, earnings declines substantially. You get the strength and the job market pulls back and you would have an associated reduction in p multiples. So you don't. Just get the the macro feel to it.

10:04 - 10:33

It hurts in the markets now. There's different kinds of recessions be able to talk about the uppercase R recession. I would talking about the lowercase r recession. A lot of recessions occur really just for some general slowing for people keep their jobs. That's when recessions impact everybody. Not everyone in America invests in the stock market. Not everyone in America watches the S&P, but everybody watches the jobs market because there's such a large workforce in this country.

10:34 - 11:02

So if we go into recession, then there's also multiple scenarios that you could think through, some of which are more extreme than others. But again, the barricades for us is that the Fed is unable to manage that soft landing. Now, if we talk about the barricades, we have to give ourselves a chance to talk about the bull case. And we have a bull case announced that the Fed is able to elegantly withdraw its support for the economy without causing us to go into recession.

11:03 - 11:34

Now, at the same time, you've got the supply chain disruptions that have really haunted the global economy and markets over the last couple of years, that they start to fade away naturally. As Beata noted, you have some reduction in earnings, but it's not extreme. So whether you're a low two thirties or high two thirties for next year, whether you push even higher with some surprise, as our belief in the US consumer continues to be strong and they continue to power the market and the economy higher.

11:34 - 12:17

But that really is the bull case. So even our most optimistic scenario doesn't really have a clear path out that it's not as if suddenly everything is solved. Even in the bull case, there is some stress that we have to live through, and that's as we talk about market movement from day to day, we have to expect to continue to see what we've seen over the last few weeks that one day you have a piece of information that provides the market a boost, and then the next day you give it all back. Because until we get more certainty on a number of these different variables, we all have to expect higher levels of volatility. So we had a 50% probability in our base case. That's how we've handicapped at 25 on either side for the Bear in the Bull case.

12:18 - 12:27

I guess the big question and I touched on this a little bit, but I'd like you to flesh it out. What's priced into the market today, given where we are on the S&P 500, for example?

12:28 - 12:50

I think it comes back to that earlier discussion of where earnings are and what that multiple looks like and what a normalized multiple is in a high inflation environment and a regular inflation environment in a low inflation environment. And today, it's 17 times what looks to be next year's earnings forecast that we think could be pretty realistic within a band of a couple of percentage points.

12:51 - 13:42

Now, maybe the market's at fair value today. So that feels to us like a lot of the downside risks are priced in. The market is already at down 20% year to date, effectively pricing in a large earnings downgrade. And just a kind of anecdotal note, I know we're going to throw out some facts and figures like this in a bit, but in the average recession, historically, markets have been down about 20%. Of course, at times it's been worse than that. But when you look at where we are at in many ways for long term investors, we see good opportunity to continue to invest today. But Alex, this point around, volatility is very real. The market's been incredibly macro driven. It's going to be looking for direction in today's earnings season as well as the inflation prints. Those are going to be the data points that really matter.

13:43 - 14:16

Right. I mean, I think when we came into the year and various economists from around the world published their views and forecasts, the likelihood of a recession in 2022 for most was close to zero, you know, single digit percentage. And then when notable economists said, well, now it's 20% or 25%, then that created shock waves in the market. And then some said 33% and some said 49%. And all of these numbers are interesting, but they're less helpful than what actually occurs when you get a new piece of information.

14:17 - 15:08

But as I noted, there's probably there might be a little bit more downside from here as there's a number of different high profile data releases that we expect to come out, continue to come out over the summer with the Fed meeting coming up later this month. We have a new inflation print in the first part of August. Got a number of different really important data releases, all of which have the chance of spooking the market. And all of a sudden there's a new likelihood of recession and we have to watch that meter. And frankly, that's why one of the reasons why in our primary risk management strategy, dynamic asset allocation, that we're in a slightly defensive mode where we've taken some capital that would otherwise be invested in equities and allocated it to more conservative, what we would characterize as risk mitigating assets.

15:08 - 16:08

And so as we think about what's priced in to the market and what are investors considering, there is another little piece of information that I would share with the listeners is this idea that for years and years, the biggest complaint about bonds was their paltry yields were really forcing a lot of investors to come out of bonds and into equities, and that's changed as yields have picked up. The downside is, of course, bonds have been hurt on a mark to market basis. But the upside from here is really interesting in bonds of all types. And so you may see some investors who should have been in bonds the whole period of time but had to move into equities to find return, come back to bonds. And as we watch, as of noted, the fund flows and looking at the impact of of various flows on a week to week or month to month basis. Part of what we're seeing from a volatility perspective is investors re weighing their options that exist as a result of this dislocation that's occurred so far this year.

16:09 - 17:08

Can I jump in on something you said earlier and not on the bond point, Alex, but on this discussion of our base case and barricade symbol case, you had talked about how we started the year we opened the books and the recession forecast, right. With such kind of false precision around the probabilities, the 39% chance and the 73% chance. And what nobody was really predicting and what I meant by the market being moved by macro was Russia, Ukraine. What nobody was predicting was the length of Russia, Ukraine, nobody was predicting Shanghai going back on full lockdown. Right. So I think it's just a humble reminder for all of us, including us day to day, who are doing this professionally. We can look at earnings, we can look at multiples and we can look at history. But we have to recognize the impact that macro and geopolitical and of course, still COVID is effectively having on the market. So I think some of those long term principles of diversification remain really important in this new world order, if you will.

17:09 - 17:22

And they're not only having an impact on the markets, they're having an impact on the story of the year inflation. So be to bring us all up to speed on our latest thoughts on inflation and what we're seeing with some of the prints that are coming out on a monthly basis.

17:23 - 18:13

Well, first of all, we're watching every data point and every print with enormous level of. Scrutiny, as I'm sure you're seeing that on your own grocery bill and at the pump and booking your travel and going out to eat the price increases are very real and they are happening across what's called both goods and services in the CPI print. We alluded to the last print coming in at over 9%. It was a very disappointing print, in fact, last week because of the pervasiveness and stickiness of prices. It wasn't just in one area. There's this issue called owners equivalent rent where you're really taking what is the perceived value of a home. If you were to rent it out and how much is that worth? And that's going up, right? Despite the fact that mortgage rates are going up, there's this perverse impact on the rental market at the same time.

18:13 - 18:34

So this most recent print was, I think it's fair to say, quite worrying in its stickiness and pervasiveness. And it really is pushing the Fed, in all likelihood, to do potentially even more in terms of their rate increases. So I think that's the latest breaking news, if you will. And what we've noticed most recently.

18:34 - 19:13

Right now, I would just add that part of the trouble that we as a market in the economy have with inflation is that for very wealthy and affluent U.S. citizens, a pickup of a dollar or two at the gas pump is troublesome, but it doesn't change their lives. They're going to continue to behave in the same way as they have, and their spending patterns aren't really impacted. But if you are not in that upper income or middle income strata and instead really are forced to spend everything you make on rent, on food, on gas, that's where the problems really occur.

19:13 - 20:11

And so, as Beata noted, we scrutinize every single data print and last month had a few things that were promising, a few things, obviously, that were troublesome. But we expect to get some relief for the future as gas and energy were big contributors again. But we think that will roll over and we'll get some of that back. Automobiles were still big contributors. We've been waiting for 18 months to be able to say, okay, the supply chain is back to normal and autos and it still hasn't happened. We talked about China and the slowdown there and how that's impacted that. We all know what's happened in the ports of the United States and that continues to be a problem, but that we can point to some end point, whether it's next month or three months or six months, the situation in automobiles and the pressure they've created on inflation, that's not a permanent change. It's very much something that we will get through, but agree that this was a really high level.

20:11 - 20:43

The CPI created a lot of stress for all of us observers, as you mentioned, the supply chain as it relates to inflation. I'll just have our listeners know that we've built a proprietary index that looks very closely at the supply chain to give us a sense for whether or not it's improving or getting worse, at least over the last six weeks or so, that the supply chain tightness or constraints have certainly improved. So that might bode well over the next few months for what that ultimately means for inflation. But there are there are more things that we're watching.

20:43 - 20:52

So Alex, Beata, maybe highlight a few of the other data points that we're looking at scrutinizing, as you say, to give us a sense for where and when the turn might occur.

20:53 - 21:35

One, that I think it is really important to build proprietary data analytics that are what we would call higher frequency, this idea that is a more current, more new. This is things we spent a lot of time building during COVID, as we could tell that the regular monthly surveys or quarterly surveys were not nearly enough to pick up on the inflection points, especially to judge consumer behavior. Now, in this case, we're watching consumer behavior, as well as what's called purchasing manager behavior. When you look at indications of manufacturing confidence, these surveys that say how much our business is going to stand and how much are they going to hire, these higher frequency data points still imply positives for the economy, but they're varying.

21:35 - 22:22

There are some areas of weakness and areas of challenge. You may have seen articles recently about companies talking about in their earnings. Yes, we're worried about recession, but it's not affecting us yet. It depends what sector you are in. It depends, as Alex noted, whether you're serving a high income consumer, a low income consumer. So, for example, travel is off the charts. Any of you that have been to Europe this summer, that picture behind you, Alex, is reminding me of the beaches over there that I'm sure are incredibly crowded. Right. People are traveling at unprecedented rates. So we're looking at this higher frequency data around consumer confidence and purchasing confidence that we think is important to get back to what the real economic, the kind of purchasing impulse looks like for both consumers and companies.

22:22 - 22:58

Yeah, there's a lot of data points on the macro side. I'd point to something on the more related to markets. So that's earnings estimates, right? The E in the P e and obviously earnings estimates we've talked about where earnings will go. And that's really another big question mark in the market. It's normal to have a slowdown in earnings during recessions. That's nothing. That's a surprise. And it's also normal to have Wall Street, if you will, the community that builds these earnings estimates to be behind the curve as it relates to catching up to a slowdown in the macro picture.

22:58 - 23:27

So we've seen earnings estimates that were expected to grow nicely this year. We started to see a couple of reductions here and there. But if you really think about the key indicators as a market investor earnings and the direction not just of estimates but of actual earnings, we're in earnings season right now literally as we speak. And as Beata noted today, the S&P is up dramatically because there's some positive sentiment around what earnings will actually be this quarter.

23:28 - 24:23

So there's a difference between looking at macro indicators and actually looking at what's important in the operating fundamentals of companies that you can invest in. And earnings are the key driver behind that. And so as we watch the earnings season that we're in the middle of now, as we think about what the Wall Street community in general adjusts earnings estimates for 2022 and for 23, that's a key indicator that that needs to be watched closely, because, you know what? We're always trying to base investment decisions based on where we think the market or the economy or consumers are going in the future. But sometimes it's useful to look in the past. And so, as you well know, we've done a lot of analysis recently to look at the period of time that we're in the landscape that we have at the moment, and try and find periods of time historically where where there are similarities and if there's anything to take away from that.

24:24 - 24:51

The one data point that sticks out with me is that when you look at periods of time where the Fed has started to raise rates and you look at that first rate hike and then how the market did 12 months later, on average, the market is up 8%. Totally counterintuitive to, admittedly, what I would have thought and many people I've shared that data point with, but I know there's others. Beata You had an interesting one that you talk about a lot as it relates to inflation.

24:52 - 25:25

Yeah, I want to keep the good news going, so I'm going to turn another data point like that. Now, like I said earlier, we don't think we're at the peak yet on inflation. We think the Fed's got more work to do and we're going to start to see this normalize. But maybe, maybe we're getting close to that peak. So the question you asked, Matt, was really what's the average after an inflation peak? And again, here, too, I think people might be surprised to learn that that average is a positive 12% again, on average. But that's an encouraging data point. Alex, do you have another one for us?

25:26 - 26:11

I'm going to see your eight Matt and your 12 Beata and I'm going to go 27%. Stocks have averaged a 27% return after a trough in drum roll, please. Consumer sentiment. Now, of course, if we go into recession, consumer sentiment will continue to fall. But if you're talking about buying that dip, buying the dip in consumer sentiment, is a key driver, a key factor in looking at future returns. So that's the that the one that we're I'm watching. And as consumer sentiment continues to come out on a semi frequent basis, it's an interesting indicator to look at for future returns. Alex has always been an overachiever. Right. The data topping our numbers, guys.

26:11 - 26:28

Let's start to bring it together and conclude this this podcast. I guess the most important question, given everything that we've shared to this point, is where do we go from here? What's our advice? What are we telling clients at this point in time, given the landscape that we've just laid out?

26:29 - 27:19

Okay. Well, the first thing is, obviously, every client's situation is unique. Every client's liquidity preference, risk profile spending is unique. So we spend time individually with clients understanding what the best opportunities are for them and what the needs are. But if you're asking me to generalize, right? So let's let's start with first of all, how do we define success? So for clients who are concerned about the volatility, who perhaps have near-term spending needs or spending needs are going up for, let's say they're in retirement with a fixed set of cash flows and assets, it's possible that derisking the portfolio or adding some form of hedging strategies would be helpful to keep that client really exposed to their overall asset allocation or somewhere close to it.

27:19 - 28:05

. Again, I want to say we are not recommending a tactical de-risking for all of our clients. It's really a clarification point around what's right. For the individual. But if. If there is that need for de-risking or is that need for introducing some lower volatility strategies? There are ideas out there, in particular something called the buffered ETF that provides some downside protection from the market with a cap on your upside return. And I think for people that are actually in cash looking to get invested into the market, this has been a great tool, but also for some of our clients who maybe want to de-risk some of their stocks. I'd be remiss if I didn't mention alternatives managers that have more tools at their disposal. More flexibility.

28:05 - 28:29

How they invest? Depends on the manager. Depends on the fund. But they could be de-risking today and providing more of a buffer versus the downside in the equity markets today. We still haven't found that free lunch. There's nothing on the sidewalk that I can pick up and eat for free, as they say, or on a table I guess would be better. But, you know, there are these trade offs between asset classes and we haven't found the magic panacea.

28:29 - 29:19

Yes, we Beata on behalf of everyone at Bernstein, please don't eat anything off the sidewalks here. Too important to us. I will echo Barbara's caveats around specific situations, and every client is different. But there are some interesting opportunities that I would say might even be a little bit on the other side of the spectrum as be able to talk about de-risking. I'm not talking about up risking per se, but but revisiting investment asset classes that have been especially profitable over the long term but are in the near term have been under pressure. And I'd point to growth stocks. Now, the age old playbook is that when interest rates go up, growth stocks must go down. But in this environment, there are growth stocks that have current profitability, terrific current cash flow. They're not the growth stocks of old and they deserve a second look.

29:20 - 30:02

The other area I'd look at is private markets. Private assets in general have more stability in general than public assets. So if you're investing into things like a private equity space where you're you're owning a private company, and if you think about public companies, public companies four times a year, I get on a conference call with analysts and talk about what they're going to do for the next 90 days and what they did for the last 90 days. That's not a long term growth strategy. But when you're invested in private companies that don't have to get on the phone with analysts four times a year, you're able to really invest in long term growth strategies and think about truly growing the business. So private markets specifically provide that opportunity.

30:02 - 30:49

And then the last thing a little Nicky, but we've seen a really interesting investment opportunity in the fixed income space that's a little bit out on the risk frontier for fixed income and that's in both the securitized assets space and in the high yield domain. These are investments that are very much income oriented. They produce tremendous cash flow, they have pricing volatility. But the sell off has occurred in a way that that those markets have created something that's very attractive. And our view is that the US consumer continues to be strong through this cycle, regardless of our lowercase R or uppercase R that we can continue to power through. Then both of those areas are really interesting.

30:49 - 31:28

Let me just underscore a really important point by the most important point that you just made both of you to this question, which is there is no one size fits all advice really is bespoke to the individual, to the client. And so we put these ideas out there just as a starting point for conversation for our advisors with you as it relates to what might be appropriate given the place that we are with the markets and the economy. Alex and Beata, we run out of time, so I apologize, but I want to thank you both for your insights and your perspective today. I think it's been a valuable 30 minutes or so on the pulse. So thanks. And we're certainly going to have to have you back in another six months. Great. Thanks, Matt.

31:28 - 31:29

And Matt.

31:29 - 32:10

And thanks to all of you for listening. You're now up to speed on all of the latest economic events and our perspective on them. It's been an action packed year so far for the world and for the markets, and our team is standing ready for whatever comes next. As always, we'll continue to monitor the key trends and risks in the economy and share them with you here on The Pulse. If you've enjoyed this podcast, please subscribe and rate us on Apple Podcasts or Google Play, Spotify or wherever you listen to podcasts and email us with any of your thoughts or questions or feedback to insights at Bernstein dot com. And be sure to find us on Instagram and on Twitter at Bernstein. Thanks and be well.

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