Equity Outlook: Too Much Confusion

Too Much Confusion

There must be some kind of way outta here said the joker to the thief, there's too much confusion I can't get no relief…

Today’s investors are probably feeling a lot like the joker and the thief from Bob Dylan's classic “All Along the Watchtower”: caught in the highly confusing environment of a decelerating economy and rising rates, they can’t get no relief. This rare combination has resulted in a lack of good investment alternatives, as witnessed by the fact that in 2022, even U.S. Treasuries, which are considered risk-free securities and are generally in high demand when the stock market struggles, have produced double-digit losses. As of the end of the third quarter, the ICE BofA 10-Year Treasury Index is down 16.8% year-to-date! Likewise, the Bloomberg U.S. Aggregate Bond Index is down 15% and the S&P 500 is down 24%, marking the first time since 1969 that both equities and fixed income will be on track to deliver negative annual returns in the same year. It is a head spinning change from the salad days of 2020-21 when over $8 trillion of fiscal and monetary stimulus catalyzed untenably low interest rates as well as extraordinary demand for goods, thereby providing a sugar high for both corporate profits and asset valuations. Now investors must deal with the morning after, as spent up consumers, tight labor markets, and snarled supply chains send a myriad of mixed signals about the health of the economy.

These mixed signals lie at the center of the two big questions in financial markets today: 1) is the higher inflation transitory or structural, and 2) is the Fed capable of getting inflation under control without plunging the economy into a deep recession? With respect to transitory versus structural, we think the answer is “a little of both.” There are clearly disinflationary forces that should bring the overall rate of inflation lower. Most commodities are well off their highs – though we would point out that the oil-heavy Commodity Research Bureau Index is still 40% above its pre-Covid levels. We also see strong disinflationary forces in retail sales (thanks to inventory gluts), ocean shipping rates, lumber, used cars, and other categories. All of these markets are being affected by a combination of decreasing demand and increasing supply.