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Turning Point

2022 Redefines the Investing Calculus

09 December 2022

10 min read

Christopher W. Marx| Global Head—Equity Business Development

What a difference a year makes. Over 12 turbulent months, dramatic changes to markets and economies left investors with almost nowhere to hide across asset classes. These market convulsions appear to be the birth pangs of a new regime that will redefine the investing calculus for years to come.

Equities and fixed-income assets fell in tandem in 2022 as inflation surged, interest rates rose and recession fears mounted. The breakdown of the uncorrelated return streams of stocks and bonds shocked investors as the benefits of diversification vanished. Beneath these recent trends, seismic shifts were taking place. We appear to be at a turning point: future investing challenges will be profoundly different than those that dominated capital markets in recent decades. Investors must adjust their expectations to begin preparing for an unfamiliar set of macroeconomic and market conditions ahead.

Why Did Diversification Fail?

In recent decades, the 60/40 stock/bond portfolio was a reliable recipe for effective diversification. That formula has now been thrown into question. In 2022, a burst in inflation, the aggressive monetary policy response and concerns about its broader economic impacts triggered extreme uncertainty that delivered a simultaneous shock to stocks and bonds.

It’s hard to acclimatize to long-term changes amid such extreme volatility. But eventually, inflation will stabilize. If central banks succeed in their mission, we believe inflation will ultimately settle into a 2%–4% range—much higher than in recent decades, yet much lower than in 2022. In other words, the 2% inflation that was typically seen as a ceiling by the US Federal Reserve and the European Central Bank, would become an inflationary floor in the coming years.

This won’t happen overnight. And some inflationary forces are beyond the control of central banks, such as European energy prices driven by the war in Ukraine or supply chain bottlenecks. However, we believe the commitment of central banks to combat inflation is a defining characteristic of today’s economic landscape that wasn’t as dominant during previous inflationary outbreaks. Institutional vigilance should ultimately keep inflation in check and help clear the outlook for financial markets.

There are growing signs that inflation may have peaked. When actual inflation stabilizes, the hurdles to achieving positive real returns will be higher. For example, if annual inflation settles at 3% and real growth is 1.5%, nominal growth would be 4.5%. This will require a mindset-shift by investors to find sources of consistent, real returns at a time when the underlying conditions that supported asset gains in recent decades are evaporating.

Deglobalization and Demographics Define the New Normal

Since the 1980s, returns of stocks and bonds have benefited from a combination of broad, powerful trends: globalization, demographics, automation, and falling inflation and interest rates.

Globalization was a transformational force. When China joined the World Trade Organization in 2001, it turbocharged globalization by redefining the way companies manufacture products and generate profits. The globalization wave was accelerated by favorable demographics, as more than 1 billion working-age people were added to the world’s labor force between 1980 and 2000. Labor was cheap and capital was relatively expensive. Meanwhile, technology and automation boosted productivity and profitability.

Potential De-Globalization Is Only One Part of the Challenge

A graphic depiction of four forces that have powered market returns in recent decades and are now waning: globalization, low interest rates and inflation, demographics and automation.

Historical analysis and current forecasts do not guarantee future results.
For illustrative purposes only.
As of November 30, 2022
Source: AllianceBernstein (AB)

Disinflationary trends—along with policy responses to major market crises—helped keep interest rates at historic lows. Together, this “super-cocktail” of powerful macroeconomic forces supported relatively steady gains for stocks and bonds that were only derailed temporarily by crises such as the dotcom bust in 2000 or the global financial crisis in 2008.

Some of these trends gradually weakened, though persistent investment gains obscured the underlying shifts. In recent years, the rise of populist politics has threatened globalization. At the same time, the world’s working age population is poised to fall as the global population ages while birth rates decline. And sharp productivity gains have moderated in developed countries.

Pandemic Shock Triggers Upheaval

Then came COVID-19. At first, the pandemic extended the “old regime” as governments around the world deployed quantitative easing and supportive fiscal policies to prop up growth and broad asset class gains. But these policies sowed the seeds for a resurgence of inflation and the need for higher interest rates to combat it. Supply chain bottlenecks developed during the pandemic and were intensified by Russia’s invasion of Ukraine, pressing companies to rethink their global processes and reshore operations. Capital intensive industries that underperformed in recent years may enjoy a renaissance as onshore capacity is added in industries including energy to semiconductor manufacturing.

Deglobalization comes at a cost. Companies will no longer necessarily produce in the most cost-efficient locations and will be forced to maintain higher levels of inventory to protect against supply chain shocks. Labor costs are rising, exacerbated by lower workforce participation, and we’re seeing increased labor disputes. The global push for sustainability also creates inflationary pressures, given the costs of transition to renewable energy.

Geopolitical strains aggravate the uncertainty. From the Ukraine war to China-Taiwan tensions, geopolitical threats to macroeconomic stability have escalated. And as China and the US wrangle over competing economic and geopolitical interests, companies will be compelled to tiptoe through the tensions with a foot in both worlds.

Technological progress will alleviate some of the stress. From tech-enabled infrastructure to robots and the Internet of Things, innovation will continue to unlock efficiencies that counter inflation. Yet even so, global inflation and interest rates are likely to be structurally higher—and economic growth structurally lower—for years to come. To begin preparing for this new reality, we need to understand how markets have been reshaped—and how stocks and bonds have repriced—in this year’s correction.

Evaluating Equities: Earnings Reset Sets Stage for Quality Rebound

Equity market valuations are a key signal, and often a source of confusion. After sharp share price declines in 2022, the valuation question is still clouded by the uncertain earnings outlook. That’s because price/earnings ratios are determined by both a company’s share price and earnings per share. In many cases, earnings forecasts haven’t come down enough to reflect the potential business deterioration ahead in the new market reality.

Comparing valuations with interest rates can help shed light. From the beginning of 2022 through the end of November, the 10-year US Treasury yield jumped from 1.51% to 3.68%. Over the same period, the forward price/earnings ratio of S&P 500 stocks fell from 22.3x to as low as 15.8x in June, before recovering to 17.9x in November.

Looking at the relationship between interest rates and US equity valuations since 1978, a clear pattern emerges: In most periods when yields were between 4% and 6%, P/E valuations didn’t fall much below 15x (Display). P/Es only fell below significantly below that level when rates exceeded 8%. The main exception was in the period after the global financial crisis, when a deep recession prompted both low rates and low P/Es—a very different mix of conditions than we are experiencing today, especially if a deep economic downturn can be avoided.

Have US Stock Valuations Fallen Enough for New Inflation Era?

Significant Multiple Compression from Here Is Likely Limited

Scatter chart shows the relationship of S&P 500 price/earnings valuation and 10-Year US Treasury Yields since 1978.

Historical analysis and current forecasts do not guarantee future results.
Tech bubble is December 31, 1996 through September 30, 2000. Post-global financial crisis is December 31, 2007, through the present. Chart trend line is 1978–2007.
*Forward P/E multiples represent earnings estimates for the next 12 months.
Through November 30, 2022
Source: Bloomberg, FactSet and AB

We believe this implies that P/E valuations are not likely to fall much further from here—assuming inflation has peaked and rates won’t go much higher. Since the earnings reset is still underway, expect further adjustments to individual company P/Es. But overall, we believe current market conditions are ripe for investors to begin considering equity strategies for the new regime.

Fixed Income Focus: Higher Yields Herald New Era

Similarly, fixed-income markets are ready for a rethink after historic losses in 2022 across almost every bond-market sector. As a result, yields are now significantly higher in investment-grade and high-yield markets (Display). We believe bond yields are being reset at structurally higher levels that are likely to prevail in the years to come. Investment-grade corporate bond yields and spreads are at multiyear highs. The US high-yield sector’s yield to worst, historically a reliable indicator of high-yield returns over the next five years, reached 8.6% at the end of November.

Bond Yields Are Near 10-Year Highs Across Much of the Market

Chart depicts 10-year yield-to-worst range across seven key segments of global bond markets, from maximum to minimum since 2011, and recent value as of November 2022.

Past performance does not guarantee future results.
HY: high yield; IG: investment grade; CMBS: commercial mortgage-backed securities; EM: emerging markets; EMG: emerging; LC: local currency;
USD: US dollar
Historical information provided for illustrative purposes only. US High Yield is represented by Bloomberg US High Yield Corporate Index; Pan-Euro High Yield by Bloomberg Pan-European High Yield; Pan-European EMG HY by Bloomberg Pan European EMG High Yield; EM LC Gov’t HY by Bloomberg EM Local Currency Government High Yield; EM USD High Yield by Bloomberg EM USD Sovereign High Yield; EM USD Corp + Quasi-Sov by Bloomberg EM USD Corp + Quasi Sovereign High Yield; BBB IG CMBS by Bloomberg CMBS IG BBB Index.
As of November 30, 2022
Source: Bloomberg, Morningstar and AB

Such high yields might feel abnormal. But in fact, the era of near-zero yields was the real anomaly in financial history. It left investors thirsty for income and reliant on bond prices for returns. Investors can now tap into sources of resilient income that have been extremely hard to come by for years.

Are today’s yields attractive? If inflation has indeed peaked, then current yields look attractive in both real and nominal terms, in our view.

Credit metrics bolster the opportunity. After the COVID-induced recession triggered a big default cycle, many companies got their balance sheets into shape by restructuring debt and extending maturities. Today, interest coverage ratios for investment-grade and high-yield companies are the strongest they’ve been over the last 15 years. Other measures of fundamental strength—leverage ratios, free-cash-flow-to-debt and EBITDA margins—are also exceptionally strong by historical measures. Fundamental strength varies across different segments of the corporate bond market, so security selection is critical.

Across the spectrum from credit to interest rates, yields have reached a level that we believe prices in a lot of the potential bad news ahead. And in many cases, current yields offer levels of income that can potentially keep up with—or stay ahead of—inflation as it starts to moderate. Today, with more issuers producing attractive coupons and positive real yields, fixed-income assets have become a much more interesting asset class with an important role to play in a world of higher inflation.

The New Calculus: Four Points to Ponder

Across asset classes, we believe current valuations offer a good starting point for repositioning. As the dust settles on 2022, a few principles can help guide the way forward.

Prepare for higher risk-free rates—When the risk-free rate was zero, it had a profound impact on valuations, particularly for longer duration assets such as high-growth stocks and private equity. In equities, for example, low discount rates disproportionally inflated valuations of higher-growth stocks, whose cash flows are generated much further into the future; many have fallen back to earth in 2022. In private equity, higher rates are likely to constrain valuations, limit exits and reduce returns.
Real returns will be lower—Higher inflation will raise the hurdle for real returns, so your investments will have to work harder. Strong nominal returns won’t be enough. That means investors will need more risk assets to meet financial goals. In fixed income, higher yields for credit and high-yield bonds can play a bigger role in meeting long-term goals. Equities have generally delivered solid returns during periods of moderate inflation for more than seven decades. In order to facilitate a higher allocation to risk assets, investors might also want to consider risk assets that also offer stability features, such as low-volatility equity portfolios.
Corporate profitability will face new pressures—rising labor costs will present challenges across industries, making it harder for companies to maintain or increase margins, which could erode investment returns. Active investment managers must find companies with the right business models to survive and thrive in the evolving business conditions. Identifying companies with quality businesses will be especially important. Companies with pricing power, competitive advantages, innovation and management skill will be better equipped to overcome the profitability headwinds created by inflation in general and labor costs in particular. Businesses that benefit from long-term growth trends, whose fortunes are not tied to the short-term economic cycle are also likely to find favor, in our view. In this environment, we expect more differentiated performance within asset classes, so active managers will have an opportunity to add value to portfolios.
Be balanced and dynamic—in bond portfolios, global multi-sector approaches are well suited to a quickly evolving landscape. For example, duration (sensitivity to interest rates) tends to benefit investors when the economy slows and inflation starts to fall. Consider strategies that pair government bonds and other interest-rate sensitive assets with growth-oriented credit assets in a single, dynamically managed portfolio. In equities, investors who have been overweight growth stocks may want to consider balancing an allocation with value equities and/or low-volatility equities. Multi-asset portfolios can adjust asset class positions in real time as conditions change.

There is no single formula for implementing these principles. Much depends on the particular circumstances, goals and risk appetites of each investor.

But the first step is to acknowledge that the tailwinds investors enjoyed in recent decades are gone, so the investing playbook must change accordingly. In investing, as in life, change can be daunting. But by understanding how our world is evolving, investors can make strategic, informed choices that will position portfolios and allocations to deliver results in a radically different environment.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams, and are subject to change over time.

About the Authors

Scott DiMaggio, CFA

Scott DiMaggio is a Senior Vice President, Head of Fixed Income and a member of the Operating Committee. As Head of Fixed Income, he is responsible for the management and strategic growth of AB’s fixed-income business and investment decisions across the department. DiMaggio has previously served as director of Global Fixed Income and continues to be a portfolio manager across numerous multi-sector and multi-currency strategies. Prior to joining AB’s Fixed Income portfolio-management team, he performed quantitative investment analysis, including asset-liability, asset-allocation, return attribution and risk analysis for the firm. Before joining the firm in 1999, DiMaggio was a risk management market analyst at Santander Investment Securities. He also held positions as a senior consultant at Ernst & Young and Andersen Consulting. DiMaggio holds a BS in business administration from the State University of New York, Albany, and an MS in finance from Baruch College. He is a member of the Global Association of Risk Professionals and a CFA charterholder. Location: New York

Christopher W. Marx

Christopher W. Marx is Senior Vice President and Global Head of Equity Business Development. He is responsible for overseeing the firm's team of equity investment strategists and product managers, setting strategic priorities and goals for the global Equities business, developing new products, and engaging with clients to represent market views and investment strategies of the firm. Previously, Marx was a senior investment strategist and a portfolio manager of Equities, and in 2011 he cofounded the Global, International and US Strategic Core Equity portfolios with Kent Hargis. He joined the firm in 1997 as a research analyst covering a variety of industries both domestically and internationally, including chemicals, metals, retail and consumer staples. Marx became part of the portfolio-management team in 2004. Prior to joining the firm, he spent six years as a consultant for Deloitte & Touche and Boston Consulting Group. Marx holds a BA in economics from Harvard University and an MBA from the Stanford Graduate School of Business. Location: New York

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