The S&P 500 rallied 13.8% in October and November on hopes of less aggressive Fed policy and a soft landing, but recent data has led to uncertainty over the outlook, calling the rally's sustainability into question. (UBS)

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 yet to see an inflation moderation. This was illustrated by the latest ISM data, which showed the manufacturing sector dropping into contraction territory, while the service sector accelerated. The ISM nonmanufacturing purchasing managers’ index rose unexpectedly to 56.5 in November from 54.4 in October, driven primarily by a jump in business activity.

The implications are that economic growth, while slowing, is resilient and inflation is sticky, and trajectories for both are hard to predict. This increases the 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 -79bps) 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.

The UBS Chief Invesment Office (CIO) still expects the Fed to moderate the pace of rate hikes to 50bps at this week's FOMC meeting, but the new dot-plot, economic projections, and comments around the likely trajectory of rates next year, will be key drivers for markets and are likely to spark further volatility.

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 years tightening. The fact that Fed Chair Jerome Powell did not push back on this point in his speech at the Brookings Institution last month helped spark a sharp rally. But evidence of still-strong wage growth in the November 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 this week's meeting.

How do we invest?

CIO expects the fundamental challenges of higher rates and slowing growth to 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 more defensive areas of the equity market, including healthcare and consumer staples, which should be relatively resilient as growth slows. With inflation still well above central banks’ targets, we maintain our preference for value stocks over growth stocks. In an uncertain environment, we think the potential to earn more predictable returns is especially valuable, and we see income opportunities in higher-quality and investment grade bonds, along with quality-income stocks.

Seeking less correlated sources of return, including in certain hedge fund strategies, can also help mitigate portfolio volatility. Macro strategies, for example, returned 8% on average in the first 11 months of the year (HFRI Macro (Total) Index), and we expect them to continue to fare well in volatile times. We also think equity market neutral strategies stand to benefit from divergent stock performance in 2023, while multi-strategy funds can offer a simple way for investors to build a diversified hedge fund allocation.

Read the original report, Equities falter as risks come back into focus, 12 December 2022.

Main contributor: Mark Haefele

This content is a product of the Chief Investment Office (CIO).