What are the risks and opportunities in an unsettled investment environment?

By Joseph Wu, CFA

Amidst mounting economic pessimism, it is worthwhile to take a step back
and consider potential areas that could produce constructive surprises. To
begin with, we think the prospects of inflation cooling over the coming
months appear reasonably good, a view underpinned by the recent pullback
in commodity prices, which have historically exhibited a close
relationship with price pressures (see chart). Other indicators that
typically lead inflation—global supply chain pressures, prices paid
components of Purchasing Managers’ Indexes (PMIs), and shipping costs—also
point towards moderating goods inflation in the near term.

Softening resource prices should filter through to lower inflation

Meanwhile, despite persistently elevated inflation and higher borrowing
costs, household expenditures have held up quite well. Sustained strength
in the labour market is underscored by solid wage gains and ample job
openings. This, coupled with a still-sizeable amount of savings that
households can tap into, suggests to us that consumer spending—a crucial
pillar of the U.S. economy that makes up nearly 70 percent of GDP—could
remain well supported in the quarters ahead.

Lastly, now that the U.S. midterm elections are in the rearview mirror,
this likely resolves one of the overhangs that may have hindered risk
appetite in recent months. As of this writing, the election outcome
remains unclear. Depending on recounts and runoffs, the balance of power
in Congress may take days or weeks to determine. But based on initial
results, the “gridlock” outcome, featuring a Democrat president alongside
at least a split Congress, remains likely. As we outlined in September,
equities have historically fared well in the year following the midterms
since 1932, with the S&P 500 generating an average return of 16.3
percent. While the historical returns data around midterm elections paint
a relatively sanguine picture, we believe investors should focus more on
fundamental factors, including economic conditions, corporate earnings,
and monetary policy, which together typically have much greater
explanatory power for equity market trends over the medium and long term.

Profit estimates will need to “catch down” to worsening business
conditions

Consensus forward 12-month EPS estimate (Jan. 1, 2022 = 100)

But outlook still murky

We believe the outlook for the world economy and, by extension, corporate
profits, remains challenging with risks broadly skewed to the downside.
Part of the reasoning for this downbeat assessment derives from thinking
about whether the main macro forces that have hampered the economy and
financial markets, namely inflation and hawkish central banks, have faded
or stabilized to a degree that would inspire sufficient confidence that
the worst is behind us.

Although we may be getting closer to that inflection point, the main
concern is that we have not yet seen concrete signs of an inflation peak.
Goods inflation may be in the process of coming back down from very
elevated levels seen over the last two years, but we believe more
persistent price increases in services and shelter (housing) could prove
to be more difficult to control, which may necessitate further monetary
tightening beyond what’s currently anticipated by markets.

While the Fed and other central banks must balance the risk of inflation
becoming entrenched with the prospect of a severe economic slowdown, their
mandates are currently focused on taming inflation. The Fed ostensibly
opened the door to slowing the pace of rate hikes “as soon as the next
meeting” in December, but policymakers also reiterated that the path of
interest rates will remain higher over the coming quarters.

Unless inflation declines faster than expected over the months ahead,
additional rate hikes by the Fed will keep tightening pressure on
financial conditions, which should continue to dampen economic activity.
Against this backdrop, consensus corporate earnings forecasts still seem
too optimistic, in our view, and will likely need to be recalibrated lower
to reflect the significant downgrades to 2024 GDP growth projections
across major economies and the sharp deceleration in global PMIs.

Risks and opportunities

When considering the full picture of this economic uncertainty, we believe
investors should maintain a modestly defensive stance in portfolio
positioning. Given coordinated global monetary tightening and ongoing
geopolitical turbulence, many of the global leading indicators we monitor
continue to trend unfavourably.

For equities, uncertainties about the economy, interest rates, and
inflation indicate the range of potential outcomes in the near term is
unusually wide. And even though we believe stocks are more reasonably
priced today following the selloff year to date, the focus here could
shift to weakening fundamentals, where limited downward revisions to
consensus earnings estimates this year despite a decelerating economy
point to downside risks.

Meanwhile, we believe the risk-reward profile in fixed income has improved
considerably. Virtually every segment of the bond market has suffered
negative returns in 2022 as a result of the historically rapid rise in
rates this year. But the silver lining, in our view, is that substantially
higher yields have greatly improved return expectations going forward. In
addition to boosting return potential, we believe higher starting yields
also provide bonds with a relatively greater cushion to absorb further
increases in rates.

While we are cognizant of intensifying economic headwinds, the higher
all-in yields in fixed income, which appears to have undergone a more
pronounced risk-adjusted repricing than equities, suggest to us that it is
still a timely opportunity to rotate portfolio risk budgets towards bonds.

Relative value has shifted in favour of fixed income

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