Q4 2022 Capital Markets Outlook Video

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By Walt Czaicki, CFA

Translation

Hello everyone, and welcome to our 4th Quarter Capital Markets Outlook. It was clearly a difficult third quarter, with the S&P 500 falling nearly 5%, adding to the painful year-to-date returns that investors across the board have experienced. This year there was no place to hide. The three major issues for the year continued this quarter: persistent inflation, central bank tightening in response, and questions about global economic growth.

Starting with the Fed, they have continued their aggressive rate hike, which is not expected to abate in the near term. While market expectations have also moved higher regarding rate hikes, they have remained slightly below the Fed’s forecast. This is based on the idea that all of this tightening will eventually lead to slower economic growth, which in turn could lead to less restrictive monetary policy. But the bottom line is that the Fed would rather be cautious than easing too quickly and ending up with bigger inflation problems in the long run.

We are already seeing signs that their policies are having an effect. For example, freight costs between areas such as the US and Asia have fallen significantly and the prices of important goods have fallen from their peaks, especially many commodities. But an ongoing concern for the Fed is that both wage growth and employment costs have accelerated rapidly and show no signs of cooling yet. This will likely keep the Fed in its tightening phase.

As a result, we lowered our economic growth forecasts and raised our forecasts for both inflation and short-term interest rates. With so much going on, many are wondering where it is going and how to invest in both the equity and fixed income markets.

Let’s start with stocks. Earnings estimates continued to rise at the beginning of the year, but have been lowered in the last few months. That is the case for this year and for 2023, with the exception of the energy sector. In addition to energy being an outlier, utilities have faced modest estimate revisions — and these two sectors make a meaningful weighting between value stocks.

But within growth stocks, their selloff so far represents not only a more attractive entry point, but also a timely opportunity to rebalance where necessary. With all the bad news out there, this could create a contrarian but good opportunity for investors with an intermediate time horizon. In times when consumer confidence has bottomed out, we have seen historically attractive forward returns for both one-year and three-year periods. But yield opportunities are not exclusive to equities – given the higher yield environment that has magnified the yield potential for fixed income investors. To get a higher return on your fixed income, you need to increase returns. And that’s exactly what happened, albeit abruptly. In fact, this is the fastest rate hike environment since the 1970s.

One area of ​​fixed income that looks particularly attractive is US high yield, where current yield to worst (which is a very good indicator of future 5-year yields) is around 10%. But it’s important to remember that during periods of meaningful high-yield bond sell-offs, the subsequent recovery was swift and vigorous.

Over the past four decades, high-yield bonds have generated an average annualized return of over 8% for those investors who have remained committed to the asset class. However, if an investor were to miss the best month of each year, the realized return would have been half.

And if they missed only the best two months of the year, returns were significantly lower. Right now, that nearly 10% yield-to-worst is at the high end of the historic US high yield range.

And we are currently near the top for select European bonds, as well as for investment grade securitized assets.

We know this has been a very challenging time for investors. But as always, we hope our comments on AB’s best thinking will help investors get through this difficult time that is truly a marathon, not a sprint.

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Editor’s Note: The bullet points for this article were chosen by the editors of Seeking Alpha.

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