Equities Are Searching for Clarity

The main issue continues to be that inflation is far too high. Because it has stayed at such a high level, it is putting increased pressure on consumer disposable income levels, saving rates, and when accom­panied by weak asset prices, is resulting in weak purchasing power for the backbone of the U.S. economy: the U.S. consumer.

The Fed does not have the ability to dampen inflation by improving supply, but it can negatively impact demand through rate hikes. Swift rate hikes throughout 2022 will act with a lag on the economy and are already starting to show up in the economic data; i.e., mortgage applications are at 25-year lows, leading economic indicators are negative, the yield curve is inverted, and layoffs/hiring freezes are being announced. We expect a recession to occur in 2023; but while the R-word can be scary, we believe it will be mild. We believe that inflation will indeed moderate over the next year – which will allow the Fed to back off, financial strains to ease, and equity markets to bottom and begin climbing into the next bull market.

Focused on the Fed

The path forward for inflation remains highly uncertain and will be a large determinant of Fed expectations, bond yields, and equity valuations. Because of this, investors will be highly data-dependent on the incoming inflationary readings. Two consecutive months of lower than expected consumer price index (CPI) data provided a potential light at the end of the tunnel. However, the Fed will need a series of improvements over time in order to raise conviction that inflation is indeed on track to a more reasonable level. We also believe it will take time for this moderation to be convincing and clear enough for the Fed to become comfortable. Still-strong demand from the services side of the economy and high wage growth sug­gest the path to inflation improvement will likely not be quick or easy. And during that time, volatile economic data could result in volatile equity markets.

Bull, bear and base

Despite the potential for further volatility over the coming months, we do believe that we are in the late stages of this bear market. Recessionary bear markets decline 33% on average over 13 months, but we have seen a 25% contraction over 11 months already. We expect the economy and corporate earnings to weaken over the next year, as Fed tightening (which remains ongoing) works with a lag on the economy.

On average historically, the S&P 500 has bottomed two to six months prior to recession end while earnings bottom eight to nine months after recession end. While equities may have further downside or time left before durable upside can occur, we do believe that the majority of this bear market is behind us at this point. Don’t lose sight of the bull market opportunity that will occur on the other side of the current weak trend. Bear markets can go down 25-33% on average over a year or so, but bull markets can appreciate 152% over four to five years.

Taking all of this into account, our base case S&P 500 target for 2023 is ~4,400. This target incorporates a mild recession, modera­tion in inflation, and equities climbing out of the current bear market by year end.

Valuation views

Given our 2023 expectation that inflation moderates and the Fed backs off, bond yields are likely to peak and valuations bottom. This will provide opportunity throughout the market, particularly in high-quality names where high inflation and bond yields have resulted in outsized pressure, i.e., high beta, Consumer Discre­tionary, and Technology-oriented areas. Small-cap equities are another area that we believe are set up for outperformance, but timing is important with these trades. Additionally, many of the areas that may outperform in a recovery scenario are also likely to under­perform should equities fall. Therefore, it is important to maintain balance in portfolios between managing risk while also keeping an eye on the longer-term opportunity. With this in mind, we rec­ommend investors refrain from chasing the rally periods and build exposure to favored areas in the weak periods as long-term risk/reward improves.

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