Capital Markets Outlook: 3Q 2022

What You Need to Know

The second quarter added to the capital-market woes that began in 2022, resulting in the worst first half since 1970. All areas of the markets turned in negative performances. Inflation remained persistently high as the Russian invasion of Ukraine dragged on, with commodity prices rising sharply, new COVID variants spreading globally and supply-chain bottlenecks remaining. A more hawkish Fed raised rates twice in the second quarter, to bring the year-to-date rate hike total to 1.50%.

As we enter the second half of 2022, predictions of a possible recession range widely as the key drivers of inflation shift from goods to commodities and services, notably housing. Some leading indicators, such as Institute for Supply Management (ISM) new orders and consumer sentiment, are flashing red. But US households seem quite strong—with high total liquid assets, low debt and robust employment. Recession or not, US and global growth will likely see a meaningful slowdown. We’ve lowered our US forecast to 2.5% for 2022 and dropped our 2023 forecast to 1.0%. We see 2022 global growth (ex Russia) at roughly 3.1%, slowing to 2.4% for 2023.

Equity valuations have come down significantly, prompting investors to turn their attention to earnings guidance, which we expect will face headwinds as consumption moderates and inflation pains persist. Despite an economic slowdown, there are potential areas of relative value during times of uncertainty. A quality bias—companies with favorable attributes such as high profits, strong free cash flow and pricing power—has often worked in times of uncertainty and slower growth. And with valuations for growth stocks coming down closer to their long-term averages, investors may consider this an improved entry point. There are also compelling indications for investors to consider small-cap stocks, especially growth.

For bond investors, the sharp rise in the rate landscape has had an outsize impact across the board, with yields continuing their ascent during the second quarter. The Fed will almost certainly continue raising rates, which may cause more pain in the short term. But long-term investors should welcome rising yields if their time horizon is longer than the duration of their bond portfolio. One area in the credit markets that appears quite compelling now is US high yield. Currently, the yield-to-worst is approximately 9.0%. Historically, yield-to-worst has been a strong indicator of five-year forward returns under many different market conditions. And fundamentals—such as low net leverage and very low default rates—indicate that high yield should remain resilient.

Munis have also faced a grueling first half of 2022, with significant outflows playing a large part in driving yields up. However, muni credit fundamentals are strong, with 49 states reporting revenue collections above budget projections in fiscal 2022. Munis present an appealing opportunity on a tax-equivalent basis. And in times of economic slowdowns and recession concerns, munis can be viewed as a flight to quality second only to Treasuries.

As with all parts of the capital markets, investors need to be selective. In these volatile and uncertain markets, it’s important to be active as you position your portfolio to participate and defend.