Forward-looking market guidance with a 1960s twist
Four key metrics are expected to "carry that weight" through short-term volatility, says Raymond James CIO Larry Adam.
To read the full article, see the Investment Strategy Quarterly publication linked below.
It has been 60 years since the Beatles signed their first record deal. The English rock group from Liverpool created timeless tunes that we can borrow today to describe our economic and financial market outlook.
Optimism rose as the omicron variant subsided, but as the unprovoked Russian invasion of Ukraine escalated, surging commodity prices pushed inflation even higher. Few consumers were saying “it’s all right” as they eyed higher prices in stores and at gas stations. We believe Western nations will come together to punish Putin’s actions and hope Russia might give peace a chance. Despite geopolitical tension, rising interest rates, higher commodity prices, and an uptick in volatility we see upside potential for the economy and financial markets in the months ahead.
Fab Four metrics
Taking our cue from the Beatles' nickname – the "Fab Four" – we have identified four key metrics we believe suggest the economy is not on Recession Road, despite the Federal Reserve's (Fed's) tightening cycle and rising gas prices:
- Resilient labor market conditions
- Healthy manufacturing
- Still-attractive lending standards
- Advancing real-time activity data (i.e., airplane traffic, driving, restaurant activity)
These Fab Four metrics seem to point to above-trend economic growth of ~2.5% for 2022. The sustained reopening and pent-up demand (particularly for services) should also keep us off a long and winding road. While the psychological impact of lingering $4+ per gallon gas prices poses the greatest downside risk, we do not think it will outweigh these positive catalysts and cause the economy to lose its stride.
Fed can no longer let it be
Count on Chairman Powell to speak words of wisdom as inflation is at the highest level in 40 years. The market is pricing in an additional eight-plus Fed rate hikes this year. While our year-end inflation target is higher than we originally thought, we expect inflation to decelerate. Our expectation is that the Fed will be less aggressive than the market anticipates, raising interest rates slowly and steadily through year end to maintain maximum flexibility. The Fed will also closely monitor the yield curve (as an inversion often serves as a precursor to a recession), and will reduce its balance sheet as another means to unwind its ultra-accommodative policy.
The 10-year Treasury yield will struggle to get back, get back to where it once belonged, as history shows it trends lower after each successive tightening cycle. Inflationary pressures and the repricing of rate hike expectations could lift it temporarily above 2.50%, but ease back to the 2.25% level by year end. The high interest rate sensitivity of the economy and the attractiveness of yield-producing assets should limit how high interest rates can go. From a sector perspective, credit spreads have widened due to economic concerns rather than a deterioration in credit fundamentals or rising default rates. Since the economy is still on solid ground this recent move may be exaggerated. But are corporate bonds and municipals still potential opportunities for income focused investors? Yeah, yeah, yeah.
Equities have ticket to ride higher
Calls for a recession may be overstated as a robust macroeconomic backdrop, resilient earnings, attractive valuations, and positive shareholder activity should guide the S&P 500 to our year-end price target of 4,725. The Fed’s tightening cycle may cause further volatility, but historically life goes on, as the bull market tends to last an additional 3.6 years and rally an additional ~100% after the first hike.
From a sector perspective, we remain biased toward the cyclical sectors (Energy, Financials, and Industrials), but have dialed back Consumer Discretionary exposure as it tries to carry the weight of higher energy costs. Attractive valuations are the rationale for our recent upgrade of Health Care. For long-term investors, we suggest exposure to small-cap equities as relative valuations are the lowest in 20 years and earnings estimates continue to trend higher.
European equities need somebody (help!) not just anybody (help!) as the crisis could cause stagflation (rising inflation with tepid growth). The tragedy has stunted tourism, pushed gas prices to nearly double U.S. levels, put key imports in the crosshairs, and caused the worst European refugee crisis since World War II, on top of the continuing pandemic. As a result, we continue to favor U.S. equities over the other developed international markets. Emerging markets have also been adversely impacted by rising commodity prices and a resurgence in COVID cases, but compelling valuations may make select regions, like Asia, an opportunity for long-term investors.
You say you want an energy revolution
The Russia-Ukraine crisis has revealed the deep global dependency on oil and gas. Some investors fear the events of the Beatles era might repeat themselves – hour-long gas station lines and astronomical prices. But the U.S. is now much more energy independent, and the International Energy Agency has ~1.5 billion barrels of strategic reserves: enough to replace Russia’s export production for over six months. Since production around the world has not been reduced and there are no shortages, markets are likely to say goodbye, goodbye to the recent calls for a conflict-induced price of $150+ per barrel. In addition to an eventual (hopeful) resolution in Ukraine, increased OPEC and U.S. production are expected to moderate prices toward $95 per barrel by year end. Ultimately, higher energy prices should accelerate the global development and adoption of alternative energy sources such as solar and wind.
A little help from your financial advisor
Despite the recent volatility, we still believe the economy and markets can be full steam ahead by year end. We’re hopeful for a peaceful resolution and an end to the devastation in Ukraine. In the meantime, we encourage you to get by with a little help from your financial advisor. All you need is confidence in a comprehensive financial plan when these difficult times arrive, so that emotionally driven decisions can be avoided. Overall, we remain optimistic for the world, U.S., and financial markets.
All expressions of opinion reflect the judgment the author, the Investment Strategy Committee, or the Chief Investment Office and are subject to change. Past performance may not be indicative of future results. There is no assurance any of the trends mentioned will continue or forecasts will occur. The performance mentioned does not include fees and charges which would reduce an investor’s return. Dividends are not guaranteed and will fluctuate. Investing involves risk including the possible loss of capital. Asset allocation and diversification do not guarantee a profit nor protect against loss. Investing in certain sectors may involve additional risks and may not be appropriate for all investors. The indexes mentioned are unmanaged and an investment cannot be made directly into them. The S&P 500 is an unmanaged index of 500 widely held securities.