Assessing the Bear's Depth and Duration

What might happen when markets more properly discount a large drop in profits as well as higher capital costs. After a 20% decline in US equity markets and a 200-basis-point increase in long-term corporate bond yields, CIO believes markets discount a severe rise in the cost of capital, but not a major decline in corporate profits.

While much has been made of the likely first half 2022 US real GDP contraction, true recessions require losses in employment and production widespread across the economy. The US stock market’s current performance is consistent with mild net job declines in 2023. We stand between two very different outcomes, one where the Fed induces a recession to fight inflation with resultant job losses and credit issues, and another where the Fed sees “green shoots” in terms of wage inflation, inventory levels and moderating energy prices, and provides time for markets to normalize.

These near-term policy decisions will determine the depth and duration of this bear market.

We have previously posited that the majority of the sources of this inflation are exogenous and, as such, that the underlying sources of these price increases do not present a risk for an everlasting acceleration in inflation. For example, goods inflation is far greater than wage inflation, implying that temporary supply shortages are responsible for a large portion of today’s inflation.

Nonetheless, the Fed’s view is that there is a major risk that inflationary expectations are rising and sticky. As such, it must act swiftly and decisively to mitigate inflation. It certainly appears that the Fed is willing to drive a self-reinforcing collapse in the US economy with the goal of driving inflation lower. How do we know this? Monday’s bond market tells the story. It is pricing about 70 basis points of Fed rate cuts in 2023 after another 175 basis points of rate hikes in 2022. This implies that the Fed will, in fact, cause a major slowdown in the US economy and will need to reverse course in 2023 to support growth.

If the Fed pauses rate hikes, there may be some relief in debt costs, but the combined impact of higher capital costs and lower profits will impact markets very differently depending on whether a recession occurs or is avoided.

Portfolio Considerations

As CIO considers the market’s need to reprice earnings expectations during a period of credit uncertainty, Citi will maintain its overweight to “quality” overall. Unless the Fed veers away from recession-inducing policies, CIO will continue to position equity and bond assets in portfolios with above-average balance sheet quality, stable profits and dividends, while tilting away from most cyclical industries. CIO does not believe in timing markets with speculation over when gains and losses will occur for broad portfolios. Fortunately, however, historically high quality, consistent dividend growth equities have had a strong track record of outperforming both cash and broader equity markets.

The US Treasury market reflects tempered expectations for both future Fed rate hikes and future inflation. Since March, the expected five-year average US inflation rate has fallen from 3.6% to 2.6%. As a result, the US Treasury market has rallied after record losses, albeit in increasingly illiquid market conditions. This is all consistent with CIO’s “Bonds Are Back” call in May. CIO maintains the view that high quality bonds are attractive relative to cash and offer potential diversification benefits.