By Walt Czaicki, CFA
Hello everyone, and welcome to our 4th quarter Capital Markets Outlook. Clearly, it was a difficult third quarter, with the S&P 500 down nearly 5%, which added to the painful year-to-date returns investors have experienced across the board. This year, there has been no place to hide. The three big issues for the year continued this quarter: persistent inflation, central bank tightening in response to it, and questions surrounding global economic growth.
Starting with the Fed, they’ve continued on their aggressive rate hiking path, which is not expected to abate in the near term. While the market’s expectations have also moved higher regarding rate hikes, they’ve remained a bit below those of the Fed’s projections. This is based on the notion that all this tightening will ultimately lead to slower economic growth, which, in turn, could lead to less-restrictive monetary policy. But the bottom line is that the Fed would rather err on the side of caution than to ease too soon and wind up with bigger inflationary problems down the road.
We already see signs that their policy is having an effect. For example, freight costs between areas such as the US and Asia have declined meaningfully, and key goods prices have declined from their peaks, in particular, many commodities. Yet a lingering concern for the Fed is that both wage growth and employment costs have quickly accelerated and show no signs of cooling yet. This will likely keep the Fed in its tightening phase.
Consequently, we have lowered our forecasts for economic growth, while raising our forecasts for both inflation and short-term interest rates. With so much going on, many wonder where things are headed and how one should invest in both the equity and fixed income markets.
So, let’s begin with equities. Earnings estimates continued to climb in the early part of the year only to be lowered in the last few months. That is the case for this year, and for 2023, with the exception of the energy sector. Beyond energy being an outlier, utilities have seen modest estimate revisions – and these two sectors comprise a meaningful weighting among value stocks.
But within Growth stocks, their year-to-date selloff represents not only a more attractive entry point, but also a timely opportunity to rebalance into them, where appropriate. With all the bad news that’s out there, this may be creating a contrarian but good opportunity for investors who have intermediate time horizons. In times when consumer sentiment has reached its lowest levels, we have historically seen attractive forward returns for both one-year, and three-year periods. But return opportunities are not exclusive to equities – considering the higher yield environment that has enhanced the return potential for fixed income investors. To get a higher yield on your fixed income, you need yields to rise. And that’s exactly what has happened, albeit abruptly. In fact, this has been the fastest rate hike environment since the 1970s.
One area of fixed income that looks particularly enticing is US high yield, where the current yield to worst (which is a very good indicator of forward 5-year returns) is roughly 10%. But it’s important to remember that during periods of meaningful selloffs in High Yield bonds, their subsequent recoveries have been swift, and powerful.
Over the past four decades, high yield bonds have generated an annualized average return north of 8% for those investors who remained committed to the asset class. However, if an investor missed the best month in each year, the realized returns would have been half that.
And if they missed just the best two months each year, the returns were severely lower. Right now, that nearly 10% yield-to-worst is at the high end of the historical range for US high yield.
And we’re currently near the high end for select European bonds, as well as investment-grade securitized assets.
We know this has been a very challenging time for investors. But, as always, we hope our comments on AB’s best thinking will help investors endure through this trying time that’s truly a marathon, and not a sprint.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.