The Jekyll and Hyde market continues. After the worst month since the pandemic in September, stocks roared back in October with the S&P 500 gaining 8%. The Dow Jones Industrial Average jumped 14%, its best month since 1976. At the end of October, we used the sharp bounce to further downgrade equities to less attractive, move to a value tilt, upgrade fixed income and extend duration given much more attractive yields.
In last month’s letter, as stocks closed at the lows for the year, we discussed that markets had become the most stretched to the downside, or oversold, since mid-June, and expected a reprieve. While we saw a rebound play out over the past month, our core view for choppy markets, up in quality and defensive positioning over the next six to 12 months, remains intact.
Part of the recent rally for stocks has been based on the possibility that the Federal Reserve (Fed) pivots to a less aggressive monetary stance. While we have anticipated such a discussion to energize a short-term rally, even if the Fed does pivot or inflation softens, it wouldn’t be a cure-all over the intermediate term. One only needs to look back to 2000 or 2008 to see that a shift in Fed policy alone is not always enough to stop an economy on a downward trajectory or start a new bull market.
Indeed, monetary policy works with a lag. And with the most aggressive U.S. and global central bank monetary tightening cycle in 40 years underway, this is likely to weigh on the economy into 2023.
Our view is supported by the recent inversion of the 3-month/10-year U.S. Treasury yield curve, which followed the 2-/10-year yield curve earlier this year, the sharp slowdown in the housing market, and the negative trend in the Conference Board’s Index of Leading Economic Indicators. Collectively, these indicators suggest recession risks remain elevated.
Risk/reward more favorable in bonds
On a fundamental basis, although stocks have become cheaper on an absolute basis this year, they have actually become more expensive relative to bonds given the sharp rise in interest rates. We see the risk/reward for fixed income relative to equities as much improved given these higher yields alongside a wide range of potential market outcomes and our expectation for slower economic growth in 2023. Indeed, the weight of the evidence in our work suggests recession risks over the next 12 months remain elevated as does downside risk to corporate profits.
Even if corporate earnings for the next year stay close to current consensus expectations, instead of lower as we anticipate, consistent with a slower economy, applying an optimistic market valuation assumption (17x to 18x for the S&P 500 up from the current 16.7x) suggests the upside in equities from current levels is limited to 5% to 8%, while high quality bonds are yielding around 4%, with arguably a lot less downside risk.
Although the current rally could extend further given markets are in a positive seasonal period and the fear of missing out may lead some investors to chase prices higher into year end, this is not enough to offset our more cautious intermediate-term stance given rising recession risks and weakening fundamentals.
Upgraded value style
Within our equity outlook, we upgraded our view on value relative to growth to more attractive from neutral. Our sector strategy continues to favor market segments that have larger weights in the value style, such as industrials, energy, health care, and consumer staples. Conversely, the growth style remains heavily influenced by the technology and communications services sectors, which make up more than 50% of the index; relative earnings and price trends remain weak, and valuations are not compelling for these sectors. Moreover, value’s relative price trends are improving after more than a decade of underperformance.
Maintain less attractive view of international markets
While U.S. markets rallied strongly last month, emerging markets were down by 3%. Relative earnings and price trends remain weak. In China, President Xi Jinping officially secured his third five-year term during the Chinese Communist Party’s 20thNational Congress. This also resulted in more concentrated leadership with Xi loyalists as well as a doubling down on policies less market friendly and more unpredictable. International developed markets have fared better recently, but economic challenges and geopolitical concerns remain.
Upgraded fixed income and extended duration
Yields in the fixed income space are productive again given the sharp upward move in interest rates, especially in the high-quality sectors. Year to date, yields have risen for U.S. Treasuries across most of the curve and are flirting with 15-year highs.
Moreover, during periods of economic stress, high quality fixed income, and specifically longer-duration U.S. government bonds, tends to outperform shorter alternatives as demand for safe haven assets strengthens. Additionally, the recalibration in yields puts intermediate and longer-duration bonds in a far better position to deliver more compelling income and portfolio ballast in the event of decelerating economic activity.
Quick note on the U.S. midterm elections
The U.S. midterm elections are here, and this often creates many questions surrounding market implications. Our main mantra over the past decade is what happens in Washington matters, but collectively factors outside of Washington matter more. Indeed, where we are in the business cycle, as well as monetary policy, geopolitical issues, valuations, and other factors can all be significant drivers of the markets. The election is unlikely to meaningfully change the near-term trajectory of the economy given the aforementioned extreme tightening cycle that is already in the pipeline nor change the near-term trajectory of corporate fundamentals. We will be hosting a special post-election call on November 10 to discuss potential policy and market implications from the results. Please reach out to your Truist advisor to learn more.
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