Hello, everyone, and welcome. As prologues go, the first six months of this year have been a doozy. Central banks entered the year trying to aggressively fight pandemic-induced inflationary pressures, only to see them magnified by Russia’s invasion of Ukraine. That was punctuated by the May CPI report, which saw headline inflation reach a multi-decade high, leading the Federal Reserve to once again aggressively increase its expected path of rates and leading the S&P 500 to its worst first-half start in 50 years.
And also leaving the markets with an enormous amount of questions and no shortage of opinions around inflation, the path of rates, and most notably growth and the dreaded R-word, or recession. In fact, central bank models can’t seem to agree on the probability of a recession taking place. Just as a thought exercise, let’s forget the word “recession” for a moment and agree upon a meaningful slowdown in the rate of growth, because while there’s a lot of debate about the former, there’s basically none about the latter.
It is indeed a question of magnitude, and that magnitude will largely be decided by how much the Federal Reserve and other central banks have to tighten in service of lowering inflation and at the expense of growth. Well, from an inflationary perspective, it’s a little tough to dive in in a short video like this. So from a view perspective, I’ll simply say that we expect inflation to moderate to a lower level than where it is now by the end of the year, but still be uncomfortably above the Federal Reserve target. We’d be looking probably into the end of next year to see something like that, which means the Fed still has tightening to go, of course. But the good news is they don’t tighten alone. In fact, markets tend to tighten in advance of the Federal Reserve.
For example, the two-year Treasury started to rise meaningfully in the fall of last year, as did the Goldman Sachs financial conditions index. Nonetheless, the part that the Fed has to play, as we see it, is somewhere around 3.25 to 3.5% by the end of this year. So what does that portend for growth?
At a high level, we’ll simply tell you that we do believe that growth is going to slow—slow below the trend level of growth in the United States, both for this year and next year—but it won’t be a meaningful slowdown, something like we would’ve experienced in COVID or the global financial crisis. And the reason for that is how the consumer entered this slowdown.
There were 2 million jobs added this year. There’s a lot of strength in the labor market still, as well as wages, and household balance sheets were in really strong shape. We think that would mitigate the level of downturn that we might see, which leads me, when I share that story with investors, to the number one question I get: Should I be in markets right now or should I wait? More specifically, has the market bottomed or do we still have further to go?
Look, I’ve been in markets a long time and it’s taught me that the one thing that I cannot do is call a market bottom. So let me do this. I’m going to call relative value. I believe that the S&P 500 is higher three years from now than it is today. I believe there are meaningful opportunities in the credit markets for returns over the next three and five years. And as a result, I believe there’s a good case to be made for investors getting into the market now; we just need to debate how and where. I’m going to hit two.
On the equity side, just in general, one of the reasons why I feel pretty comfortable around equities is because valuations have gotten quite a bit more attractive or, I should say, more normal than we were talking about coming into the year.
This is a table we’ve shown before. By most guideposts, coming into this year and at the end of the first quarter, valuations, on any measure, were well above any of those guidepost markers. But as we entered this quarter, the valuations today are below most of those. We’ve gotten into a more normal range. In fact, the other part that’s left over is earnings to come down. Analysts’ estimates haven’t really priced that in yet, and we do believe that it is going to come down by the time the dust has settled. But we also think some of that has also been priced into markets. Now again, I’m not calling a market bottom. There’s a reason why the S&P 500 could be down another 10 to 15%. But as I look out at the horizon—and I believe that there’s a more moderate growth slowdown, which means a more moderate earnings slowdown with valuations already discounted to a large degree—I think the path to three years from now is attractive.
Now, how would I approach it in equities? There are a few ways, but I’m going to go to one of my favorites—one that shows up a lot when valuations are really elevated and when market conditions are challenging: quality as a factor. For the latter, when growth is scarce, it tends to be rewarded at a premium, particularly quality growth. And as you can see here, when there are challenges from a growth perspective, quality on a relative basis tends to do quite well.
And also for cautious investors, let’s cross over into credit. As many of you know, a lot of my career is in fixed income, and one of the things that I often share is the role of high yield as a form of an equity surrogate or an equity de-risk. One of the things that I love about credit, and specifically high yield, from an investment perspective is the predictive ability that its yield to worst has over time.
As you can see here, almost regardless of when you pick in time, the forward five-year average annual return is nearly a match for the starting yield to worst. Well, coming into this quarter, it was at 9%. And here’s another extra, if you will, as it relates to the fundamental strength of credit.
Classically, when you go into recovery, you start to see a degradation in credit fundamentals at companies. But given the rapid nature of the COVID downturn and recovery, a lot of that didn’t have time to take place. So a lot of fundamental metrics are relatively strong, despite the fact that the yield to worst in the US high market, again, is sitting at about 9%.
Now, again, I’m not going to sugarcoat this. There is a real reason why markets could go down from here, and there are a lot of wild cards at play that simply really can’t be forecasted in elements of inflation that central banks aren’t really able to fight. Which is again why, at times like this, I love to zoom out and look into the intermediate term to find opportunities and try to steady investors for the path ahead. And I believe if we do that, there are meaningful opportunities for us, but we will have a lot more to come on all of those wild cards as the months progress. But for now, as always, thank you for joining and we’ll see you next quarter.