Earnings estimates for equities had continued to climb during the early part of the year and only started to moderate downward in the last few months. That lowering trend should continue for the rest of 2022 and into 2023, with the only exception being the energy sector. Price-to-earnings multiples have declined as interest rates have risen, in line with typical trends during most periods since the late 1970s. And significant multiple compression from here will likely be limited.
This is creating opportunities in quality growth, most notably in selective technology and healthcare. For value equities, an area of focus is financials, where the breadth of the sector allows for numerous stock selection opportunities. And higher yields may provide a tailwind for financial stocks, especially banks. Small-cap stocks present a compelling case for a rebalancing opportunity since they are currently far below their long-term average portion of the overall market. Taking advantage of such meaningful pullbacks has historically proven rewarding, but investors should stay selective, focusing on profitability in smal¬l- and mid-cap value and positive earnings in growth. Overall, prior times of high fear have proven rewarding for contrarians: when consumer sentiment has been at low points over the past 40 years, the following one- and three-year returns for the S&P 500 have often been notable.
Return opportunities are not exclusive to equities, considering the higher yield environment that has enhanced the return potential for fixed-income investors. It’s worth noting that to get a higher yield on your fixed income, you need yields to rise. They’ve risen strongly this past year—but painfully quickly. In fact, the sharp hike in rates this past year is the quickest rate-hike sequence since the 1970s. The ensuing volatility in the Treasury market has roiled most other fixed-income areas. But fixed-income opportunities now look compelling, with yield to worst (a strong indicator of forward five-year returns) in many parts of the bond market near their 10-year highs. Notably, US high yield currently has a yield to worst of nearly 10%. 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 time so far in 2022, with outflows that are the largest on record. The pace and severity have generated significant pressure on munis, but now the yields, in many cases, are three times what they were at the beginning of the year. And munis aren’t simply cheap right now, they also have strong fundamentals. For example, rainy day funds—the reserves that states have in place to weather potential economic downturns—are approaching US$120 billion. As a percent of spending, that’s roughly three times what it was before the Great Recession.
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.