06.09.22 2022 has been very busy so far. Equities are off to one of their worst starts in years and bonds are suffering their roughest stretch in generations. The maelstrom is swirling around the uncertainty of inflation, monetary policy, interest rates and their impact on the profits and the economy. The 2020 pandemic, coupled with global lockdowns, represented the biggest threat of a global depression we’ve experienced in our lifetimes. Even the financial crisis of 2008-2009 pales by comparison, because it was concentrated in the United States and Europe.
In response to COVID, for the first time in more than a decade, governments across the globe linked arms with their central banks and flooded the world with liquidity. Overnight rates were slashed to zero and in some cases went negative, and central banks purchased more than $10 trillion in bonds. By the end of 2020, the value of negative-yielding bonds globally approached $18 trillion. At the same time, fiscal spending skyrocketed. The US government alone spent over $5 trillion in an attempt to combat COVID.
Policymakers willingly over-stimulated their economies and financial markets to avoid irreparable economic damage from prolonged global lockdowns. Naturally, economies and markets responded. Between March 2020 and December 2021, the US economy rebounded from a 10 per cent plunge, a modern-day record for a drawdown and recovery. It took only six quarters to restore the US economy to pre-pandemic levels. Large-cap equities, meanwhile, surged nearly 90 per cent and inflation hit seven per cent year-over-year, its highest reading since the 1980s.
With a global depression averted, the world entered 2022 with households flush with cash, plentiful jobs, and high and rising food and energy prices. Governments, declaring victory, closed their checkbooks and central banks prepared to raise overnight rates and unwind unprecedented stimulus, leaving investors wondering how bad the hangover would be now that the punchbowl is gone.
Cresset’s equity market outlook is a function of several factors including the 10-year Treasury yield, the BBB corporate bond yield (a cost of capital proxy), forward 12-month (FTM) S&P 500 earnings per share, the expected “Risk-Neutral Yield,” the Fed Funds target rate, inflation and the ISM Manufacturing PMI (a diffusion measure of manufacturing activity).
My colleagues and I developed three equity valuation models, each incorporating three scenarios:
- Base Case (55%): S&P earnings growth meets current expectations, the 10-year Treasury yield edges lower due to a gradual slowdown in economic activity and inflation, the Fed Funds rate peaks below current expectations and corporate credit spreads widen incrementally.
- Bear Case (30%): Earnings fall 20 per cent as persistent inflation and higher interest rates weigh on growth and margins. The Fed Funds target rate rises as the Fed is forced to be more aggressive in fighting inflation. The economy weakens while corporate credit tightens.
- Bull Case (15%): Earnings growth is five per cent higher than current expectations as companies maintain their margins. The 10-year Treasury yield edges lower on moderating economic activity and slower inflation. Corporate credit spreads narrow, making cost of capital cheaper.
We blended three models to arrive at our results: 1) an aggregate P/E model employing a variety of inputs, including the neutral Fed Funds rate, the economy, inflation and cost of capital; 2) a BBB yield model discounting projected earnings growth at a cost-of-capital proxy rate; and 3) a 10-year Treasury model discounting projected earnings at the 10-year yield. The median S&P 500 price target of all three models is just over 4,000, less than five per cent below current market levels. However, when we weight the models based on historical accuracy and relevancy, we arrive at a target price that’s nearly 10 per cent below current levels.
The expected price pullback is consistent with market returns converging toward organic earnings and dividend growth.
A high single-digit drawdown, while notable, does not necessarily warrant an asset allocation shift given the friction of turnover, taxes and reentry point risk, with the potential benefit of avoiding a degree of downside eclipsed by missing out on subsequent upside opportunity. For those clients interested in hedging our 12 per cent bull case against our -19 per cent bear case, it is possible to structure a one-year option strategy by selling upside opportunity in exchange for downside protection. For new clients with cash looking to enter the market, we would recommend extending your investment period and consider writing 10 per cent out-of-the-money puts to capture a roughly five per cent option premium yield.
Please talk to your Cresset advisor to learn more about our outlook and what it means for your investment strategy. We’re here to help.