Tech stocks were prominent in Tuesday’s broad-based decline, and the Nasdaq index dropped 2%. Reports that the European Union has ruled against Meta Platforms' use of behavioral advertising based on tracking users' personal data dented appetite. Broader economic sentiment was not helped by predictions of a US recession in 2023 from the chief executives of two major US banks.
With the focus shifting more to concerns about weakening economic momentum, bond yields moved lower. Yields on 2-year and 10-year US Treasuries fell by 2.5 and 5 basis points, respectively, while the terminal federal funds rate implied by futures markets dipped below 5% once again. Amid risk-off sentiment, the US dollar gained a further 0.25%, based on the DXY index.
What do we expect?
The S&P 500 rallied 13.8% in October and November on hopes of smaller rate hikes and an economic soft landing, but recent data has highlighted uncertainty over the outlook, calling the sustainability of the rally into question.
The US is a two-track economy right now—the manufacturing and housing sectors are in recession territory and experiencing disinflation, while the labor-intensive services sector has slowed very little and has had no inflation moderation. This was illustrated by the latest ISM data, which showed the manufacturing sector dropping into contraction territory, while the service sector unexpectedly expanded at a faster pace. The prices paid component of the ISM non-manufacturing index declined, but only modestly.
The implications are that economic growth, while slowing, is resilient and inflation is sticky, and trajectories for both are hard to predict. This increases uncertainty about the timing of the 2023 inflection points for growth and inflation, and that is likely to prolong market swings until those points are reached.
The picture is further complicated by a disconnect between the macro scenarios currently priced into equities and Treasuries. The S&P 500 forward price-to-earnings multiple is around 18 times, a level consistent with a soft landing. Meanwhile, a deeply inverted yield curve (the 10-year minus 2-year Treasury yield is about 84bps) has historically preceded recessions. Convergence to the same implied scenario is more likely to be led by equities pricing in a deteriorating earnings outlook, in our view.
Finally, investors may be showing greater caution ahead of next week’s FOMC meeting. The Fed has been focused on tightening financial conditions to cool the economy and slow its growth. But since mid-October, financial conditions have eased, retracing almost a quarter of this year’s tightening. The fact that Fed Chair Jerome Powell did not push back on this point in his speech at the Brookings Institution last week helped spark a sharp rally. But evidence of still-strong wage growth in last Friday’s nonfarm payroll report might prompt Powell, who has spoken of the risk that tight labor markets pose to non-shelter services inflation, to push back at next week’s meeting.
How do we invest?
We think the fundamental challenges of higher rates and slowing growth will linger when we enter 2023, and we do not think the economic conditions for a sustained upturn are yet in place. But given the prospect of periodic rallies, we prefer strategies that add downside protection while retaining upside exposure.
Against this backdrop, we favor defensive sectors and value stocks within equities; income opportunities in higher-quality and investment grade bonds; “safe havens” like the US dollar and Swiss franc, and seeking uncorrelated returns through alternatives.
Main contributors - Mark Haefele, VinJason Draho, Vincent Heaney, Patricia Lui, Jon Gordon
Content is a product of the Chief Investment Office (CIO).
Original report - Equities struggle as recession concerns resurface, 7 December 2022.