FAQs on the Markets and Economy
Has CNR’s Outlook for Stocks Changed?
Investors are increasingly concerned about the risk of a recession as the U.S. stock market enters a bear market and the Fed’s fight against inflation intensifies.
Regarding the outlook for the economy, we see both positives and negatives: U.S. fundamentals, especially those for households, are still broad and powerful and should provide some cushioning against rising headwinds. Conversely, inflation is more sustained than originally estimated and geopolitical uncertainty is increasing, slowing economic momentum and reducing consumer and corporate confidence from 30% to 50% in 2023. Executing a soft landing is difficult under the best of circumstances, and Fed officials have no standard playbook for the multitude of uncertainties that exist around today’s outlook, raising the possibility of a policy mistake.
As risks have increased over the past few months, we have been proactively lowering our overall equity exposure in client portfolios and are now at a modest underweight. Although the S&P 500 has corrected roughly 20% so far, recessionary bear markets have historically declined 30-35% on average, suggesting further declines in stock prices are possible in coming months. Despite valuation adjustments, consensus earnings estimates have not yet discounted an increasing risk of an economic downturn.
Before a more durable bottom in markets is reached, we think investors will need better clarity on the path of inflation and Fed tightening, as well as the outlook for sustainable economic and earnings growth. In the meantime, we remain focused on holding high-quality, reasonably valued U.S. companies with durable franchises and strong management teams to help weather a recession should one occur.
Yields and Inflation: A Rough Rule of Thumb?
Over the past 20 years, interest rates have only been this volatile three times before today, according to the MOVE Index – a measure of implied volatility in U.S. Treasury options.
In environments like this, emotions run high, and fear grips the market. As investors, what can we do to look through the volatility and gauge longer-term results, especially when it comes to rates?
Inflation hasn’t been around in 50 years, which means we need to break out old tools to understand how rates might behave and what the longer-term 10-year Treasury yield could average over the next 10 years. In that pursuit, we use a simple calculation to adjust yields for inflation and analyze this historically. Over 20 years, for pre-and post-quantitative easing as a policy tool, the average is about 1.4%. Compared to today’s 0.70% level, the market is only half of the long-run average. There are two ways this number can increase. The first is from rising Treasury yields and the second is from falling long-term inflation expectations. Amazingly, longer-run inflation expectations have remained incredibly well anchored, with 10-year expectations only moving up 0.26%. As a result, most of the increase over time will come from rising Treasury yields.
This doesn’t mean the market will not overshoot the long-term average or stay lower for longer, but by using this as an anchoring point, we should expect Treasury yields to eventually reach 4% beyond 2022, which is also consistent with the Federal Reserve’s long-run estimates.