Expanded house views

Highlights

We are making changes in our House views, which has a tactical time horizon of 3 to 12 months, given a shift in the weight of the evidence. 

• We are taking advantage of the recent stock market rally to further downgrade the outlook on equities to less attractive from neutral.
• In conjunction, we are using the sharp rise in interest rates to upgrade fixed income to more attractive from neutral.
• Within equities, we are upgrading our view of the value style relative to growth from neutral to more attractive given value’s higher exposure to our more favored sectors, such as industrials, energy, health care, and consumer staples. Relative performance for value is also improving after more than a decade of underperformance.

Downgrading equity to less attractive

We are shifting our view on equities to less attractive from neutral.

• 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 risks 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 16.2x) 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.
• 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 and the potential of softening inflation data. 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.

And, as mentioned, despite the stock market correction, the equity risk premium (ERP), which compares the earnings yield of stocks relative to the yield of bonds, has become less favorable with the surge in interest rates, making bonds the most competitive relative to stocks in more than a decade. While the ERP is still at a level where stocks tend to outperform bonds on a 12-month basis, Fed policy and earnings downgrades remain risks.

Upgrading value relative to growth to more attractive

Within our equity allocation, we are upgrading 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.

Upgrading fixed income to more attractive following the sharp rise in yields

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. This was important in our changes to our last update to House Views, where we upgraded our view on duration to more attractive from neutral.

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