Review the latest portfolio strategy commentary from Mike Gibbs, managing director of Equity Portfolio and Technical Strategy.
The Fed elected to raise rates by 75bps at its eagerly-anticipated September FOMC meeting (below some estimates of 100bps) but increased forward rate expectations above what was priced into the market. The Committee now expects the fed funds rate to reach 4.4% by year-end 2022 and peak at 4.6% in 2023. This implies a 75bp hike in November, 50bp hike in December, and one more 25bp hike early next year. While the even “higher for longer” rate path will be helpful to dampen inflation, it also further increases the odds of economic contraction. Bond yields rose in the meeting’s aftermath, and equities continued their downward slide (now approaching the June bear market lows).
Of course, the major influence remains the trajectory of inflationary pressures ahead. We expect inflation to moderate over the next year, but the path is unlikely to be quick or smooth- volatile data is likely to correspond with volatile markets. And with the inverted yield curve signaling an increased likelihood of recession, equity risks skew to the downside for now. Despite the recent dataflow and Fed message supporting our position that equities may struggle in the coming months, it does not dissuade our long-term positive view. Nor does it change our belief that a lot of negative news is already priced in.
In assessing risk/reward for the long-term investor, we believe worst case S&P 500 downside resides in the 3000-3200 area (not saying this has to happen)- which would be on par with the -33% average decline experienced in recessionary bear markets historically. Recessionary bear markets also bottom 13 months from their peak on average, which would line up as early 2023. The index has already declined 24% over ~9 months, so the majority of this bear market’s weakness is likely behind us at this point. The depth and/or length of economic weakness and earnings decline will determine the depth and length of market struggles. But we do believe this bear market will avoid resemblance to the deeper and longer declines historically, such as 1974 (deep recession), 2002 (dotcom bubble), and 2008 (banking system in disarray). We do not see widespread excess on corporate balance sheets, supply has been hard-pressed to meet demand this cycle, Technology sector fundamentals are solid, and banks are very well-capitalized. Moreover, CPI is a lagging indicator. Leading indicators on inflation show some promise- though the timing and degree of improvement remain unknown.
Regardless of potential downside over the coming months, the long-term risk/reward from current prices skews heavily in investors’ favor. Applying historical averages of earnings and P/E growth out of recessionary bear markets results in a 5-year potential S&P 500 value of ~6000, or ~10% compounded annual growth before dividends from current prices. So while we expect equities to remain volatile for now (with a bias for further downside), we encourage long-term investors to keep their focus. Picking a bottom is a challenge when volatility is high; but even in further downside, investors are still looking at strong returns over the next several years.
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