A Professional’s Perspective
Written by Mark Haefele
Chief Investment Officer | UBS
From Our Director:
One thing I am always proud to share with new schools is the higher level of an institutional strategy that we can provide as a foundation. By creating a component fund, we have the ability to take advantage of relationships and returns that the average Christian school would not typically have the capacity to be a part of. It has been a blessing to have the backing of UBS as one of the world’s largest wealth managers behind us. In this particular newsletter, we thought it beneficial to provide you with a detailed overview of how to make sense of investing in this current economy and what can be expected in the next couple of years when it comes to returns. After consulting with our particular group, now is a great time to get started with an investment such as endowment. The potential for returns over the next couple of years is what we like to hear as it has the ability to greatly benefit you and your schools! It’s like they say, timing is everything! While this detailed report is not filled with rainbows and butterflies so to speak, it does give us a certain level of insight when it comes to the markets and future expectations. We hope you benefit from this insider’s view that we like to call…
A Professional’s Perspective
In the US, more persistent inflation in services and shelter is dashing hopes that a decline in gasoline prices and a normalization in goods supply would drive a sustained easing in price trends. Labor market supply remains short of pre-COVID trend levels, and the Federal Reserve remains committed to raising interest rates until inflation falls.
In Europe, at the time of writing, gas flows from Russia at less than 20% of their levels in prior years, and it seems likely that the measures to quickly reduce the region’s energy intensity will mean more inflation and negative growth. News that Ukrainian forces have retaken parts of the country from Russian control is prompting a more aggressive response from Moscow.
In China, steps to cool the property market have resulted in a standoff between developers and homebuyers, crushing consumer confidence in a country in which property constitutes 70% of household wealth. A path forward from restrictive and reactive COVID-19 policies remains elusive.
What do we expect from here?
Once investors gain confidence in their balancing between supply and demand, the rebound is likely to be fast. Sharp, if fleeting, rallies in July and early September were examples of this in action and demonstrate why staying invested is the only way to avoid being caught on the sidelines by a sustained upturn. Our base case is also for markets to be higher by June 2023.
But with core US inflation remaining firm, winter in Europe approaching, and the 20th National Congress of China’s Communist Party due next month, uncertainty remains around the peak for interest rates, the trough for earnings, and the outlook for energy prices. We, therefore, think that the balance of this year of discovery will continue to be volatile. In this light, we stay invested but also selective, and focus our preferences on the themes of defense, income, value, diversification, and security.
In the remainder of this letter, I review some of the global drivers of market uncertainty and volatility and highlight where we recommend investing today.
In The US: Lower gasoline prices and signs of a slower pace of core inflation had brought hope that a soft landing for the US economy was in sight. But those hopes are being dashed by recent data releases.
Inflation surprised to the upside in August as core CPI, which excludes food and energy accelerated to 6.3%year-over-year from 5.9% in July. Perhaps most concerning, the drivers of inflation broadened. Both the Cleveland Fed’s trimmed mean, which excludes the biggest price outliers in the CPI basket and the Atlanta Fed’s Sticky CPI series gained 0.6% in a month.
Meanwhile, the labor market remains tight. Job growth in August slowed to 315,000 new payrolls from 500,000 in July, and the unemployment rate ticked up to 3.7% from 3.5%. But absolute growth is still strong, jobless claims have actually started falling, and the labor market remains fundamentally unbalanced, with significantly greater demand for labor than the available supply.
Currently, there are around 6 million unemployed but 11.2 million job openings, according to the latest JOLTS data. Participation has been recovering and in August reached 62.4%, the highest since the pandemic, but it is still a full percentage point (or 1.6 million people) below pre-pandemic levels.
In our view, based on current data, the Fed will keep hiking rates aggressively. It will likely need to see several months of subdued inflation—i.e., less than0.2%month-over-month growth in core personal consumption expenditures (PCE) for at least three months—along with further evidence of a cooling labor market before softening its tone.
Continued near-term strength in labor markets is likely to give the Fed both the imperative and the confidence to raise rates in the months ahead. Market pricing now suggests a further 100–125 basis points in hikes before the end of the year, and a peak in the federal funds rate at 4.54% next spring.
Ultimately, we think the Fed will succeed in cooling inflation, allowing it to pause from rate hikes in early 2023. Inflation expectations are falling, suggesting that consumers and markets share the belief that the Fed will tame prices. Inflation expectations three years out fell to 2.8% in August, according to the New York Fed’s Survey of Consumer Expectations, and 5-year break-even inflation rates are at 2.52%.
It is difficult to avoid the conclusion that the Fed’s aggressive rate hikes will cause at least some pain to the economy. Historically, we have never seen a significant decline in job vacancy rates without an increase in unemployment, and the impact on interest-rate-sensitive sectors like housing, where data has already started weakening, will be important to watch. Against this backdrop, we need to prepare for downward revisions to earnings estimates in the months ahead, even if margins are being supported in the near term by lower rates of inflation in input costs (e.g., commodities)than in consumer prices.
What does this mean for markets?
In our base case, we think that equity markets are likely to remain range-bound and volatile. Sentiment is already weak and appears to be pricing a contraction of as much as 10% in corporate earnings. This suggests at least some cushion for stocks if the corporate profit outlook weakens. Conversely, measures of the attractiveness of stocks relative to bonds are not at levels that suggest a substantial rally in stocks.
The equity risk premium (ERP) is the excess return investors can expect from investing in stocks compared with “risk-free” investments like Treasury Bonds. The global ERP, based on earnings yield, stands at 300 basis points, which we estimate to be consistent with a 12-month forward price-to-earnings ratio of 14–15x, in line with the current level of 14.6x for the MSCI All Country World Index. Similarly, the global cost of equity—the rate of return an investor requires for an equity investment to be considered worth the risk— is currently 8.7%, a level that since 2001 has been associated with equities underperforming bonds.
The American Association of Individual Investors’ sentiment survey shows a ratio of bulls to bears that is more than 2 standard deviations below the long-term average.
Since 1991, whenever negative sentiment has been this extreme in magnitude, it has been a contrarian indicator and has been followed by average positive returns of 9% over the following six months.
Forward earnings are closely correlated with equity performance. Global equities may already be discounting as much as a 10% contraction in 12-month forward earnings per share (EPS), and US equities a single-digit percentage contraction. But leading indicators of earnings growth (including the ISM index, the ratio of new orders to inventories, and Korean exports) currently point to a low-single-digit rate of growth in 2023.
Earnings could fall by more than 10% in the event of a recession that drives up unemployment in previous recessions, global 12-month trailing earnings have contracted by 20–30%, and US earnings by 15%. Our downside scenarios, which envisage a more significant US economic slowdown, have an S&P 500 price target of 3,300, consistent with an earnings contraction of 15%.
Our forecast for MSCI ACWIEPS is for 2% growth in 2023, compared with a consensus of 6%. Revisions to consensus forward earnings estimates, which have started to weaken, reach a trough before earnings themselves. We will be monitoring the three-month change in 12-month forward earnings estimates for signs of extended negative sentiment (a contraction of 5–10%).
This backdrop does not lend itself to strong directional positioning on overall equity indexes. Instead, we prefer a selective approach tilted toward defensive, quality, and value stocks. We remain focused on those companies that we think can do well if earnings estimates start to fall because they either are in defensive sectors, such as healthcare and consumer staples or already trade on more reasonable valuations than still highly valued growth stocks.
For bond markets, we think the 10- year US Treasury yield, at 3.53%, is likely already close to its highs for the cycle (our end-year forecast is 3.5%). If inflation declines, this will likely lead to lower expectations for Fed policy hikes, supporting bonds, while if inflation and rate expectations remain high, this will likely increase the potential severity of any future recession and raise the demand for hedging assets like long-term bonds. We keep a most preferred stance on high-grade bonds and expect 10-year yields to fall to 3.25% by June 2023. Our US forecasts are consistent with a terminal fed funds rate in the mid-4% level.
As for the US dollar, it is exceptionally strong but likely to stay that way while the Fed is hiking more aggressively than other major central banks and while the US economy remains relatively resilient. We move the currency to most preferred this month and only expect it to start to weaken once the peak in US rates is more clearly in sight. As noted above, the Fed will want to see evidence of cooling in inflation and the labor market before signaling a pivot, so we will be monitoring the month-over-month trend in core PCE and the high-frequency unemployment data (initial and ongoing claims). The dollar will also likely strengthen if geopolitical tensions worsen, and we are tracking the Biden administration’s approach toward China as well as the ongoing war in Ukraine.
In Europe: After a period in which investors began to lose focus on the war in Ukraine as a key market driver, two developments have brought it back top-of-mind. First, Russia has halted all remaining flows of gas through NordStream1, saying that supplies would not resume as long as sanctions were in place that prevented pipeline equipment from being repaired and maintained. Second, Ukraine’s military success in regaining territory is prompting Russian escalation. Russia has announced the mobilization of a further 300,000 troops, and referendums will be held in Russian-controlled areas of Ukraine on becoming part of Russia from 23–27 September.
We believe the war in Ukraine is likely to continue without a cease-fire in sight at least until winter. Official statements from both sides currently suggest no room for negotiations. Ukraine has been emboldened by its recent battlefield success, and officials are underlining the objective of liberating all of Ukraine—including Crime and the Donbas region. Russia, meanwhile, continues to vow it will gain control of the Donbas completely, and voices are growing among pro-Russian military commentators to increase the war effort. President Vladimir Putin this month acknowledged Chinese “concerns” about the war in Ukraine, but there is no indication that this suggestion of differences between Beijing and Moscow over the conflict is likely to hasten a cease-fire.
This means that ongoing disruptions of Russian gas supply to major European countries, including Germany, are our base case. And although the European Union has been filling up its gas storage more quickly than expected-storage levels are already above 80%— it will be insufficient to meet expected winter demand. The prospect of rationing looms.
If Russian gas supplies to Europe remain cut off (and for a lengthy period), companies are likely to be forced to curb gas-intensive activities, and supply chains would likely come under pressure, leading to a deeper Eurozone-wide recession in late 2022 to early 2023. Rising social discontent cannot be excluded as a secondary risk factor amid the ongoing cost-of-living crisis. The European Commission, however, has announced a package of proposed emergency measures, including a windfall profit levy on energy firms, liquidity support for power companies, and fiscal measures to try and soften the blow.
What does this mean for markets?
First, we think investors should prepare for higher energy prices—and not just for gas. Oil prices have declined in recent weeks due to lower demand expectations, but supplies remain tight, and, contrary to intentions, the proposed price cap on Russian oil might well lead to lower Russian supply. Officials in the Kremlin, including deputy prime minister Alexander Novak, have pointed out that Russia would not sell oil to countries adhering to a price cap. We see this as a credible threat, and if Russia were to withhold barrels from the market, we think oil prices could move above USD150/bbl for an extended period.
Our base case is for oil prices to rally toUSD110/bbl by the end of the year and to USD125/bbl by March. Second, European assets are likely to remain volatile and under pressure, until we see either cease-fire talks or signs that Europe has secured sufficient alternative energy supplies to prevent rationing. Germany has recently announced plans for a fifth Floating Regasification Unit, allowing it to import more liquefied natural gas from around the world.
However, the lag before new capacity is available means it will not prevent near-term economic pressure. We expect the euro to weaken relative to the US dollar and hold a least preferred stance on the British pound.
Investment Ideas:
The relative strength in the US economy both reduces the risk of recession in the near term and increases the chance that the Fed lifts interest rates further and faster, raising the risk of recession later. With this in mind, we have reduced the probability of our “slump” scenario and have increased the probability of our “head fake” scenario from10% to 20%.
A sustained rally in risk assets is likely to require clear evidence that inflation is on a downward trend and that economic growth risks are well understood. Until there is greater certainty, we expect more volatility. In this environment, we recommend that investors stay invested but also selective, and build a portfolio that can prepare for a variety of eventualities, focused on the themes of defensives, income, value, diversification, and security.