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Capitol Building

Wealth Insights | Economy/Politics | Asset Allocation

Weekly Market Analysis: Market Uncertainty - What We Have Not Yet Seen

3 Things to Know         

Valuing the Unknowns

There are many unknowns that markets cannot easily value. The most obvious of these is a possible recession, of undetermined length and breadth. Less obvious are the short and longer-term impacts of higher energy prices on European households and businesses, with near-term risks tied to Europe’s weather this winter.

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The Fed Has Put Markets on Edge

The biggest unknown is the Fed itself. The Fed is determined to fight inflation urgently, doing so with its two major tools: raising short-term rates and quantitative tightening, the combination of which is very potent amid an atypical tightening cycle.

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Our Revised Scenario Weightings

CIO has revised our three scenarios. The chance of a ROBUST economy in 2023 is just 10%, the probability of a RESILIENT outcome is now 20% and the chance of RECESSION is 70%, in our view. This reflects the unpredictable nature of major events.

 

Summary

Markets are deeply unsettled. Through the remainder of 2022, CIO expects US employment to be positive, profits to marginally grow further, and inflation to start slowing. However, we also expect a likely 10% decline in US corporate earnings for 2023. A rapid “change of weather” for the economy appears on the horizon. .

CIO has changed its scenario weightings to 10% Robust, 20% Resilient and 70% Recession. The Fed is fighting inflation with a potent combination of higher interest rates and Quantitative Tightening. They are moving very quickly, so fast that the impact of their tactics is not apparent, yet. The Fed’s speed will also diminish its ability to counter policy mistakes.

Short-Term US Investment Grade Yields

Portfolio Considerations

The rough end to 2022 and the likely uncertain entry for 2023 is a mere “moment” in the life of an investor’s portfolio. CIO’s defensive actions for portfolios seek to help avoid making decisions that may negatively impact long-term wealth-building strategies.

 

Valuing the unknowns

With inflation appearing to run hot in the US, the Fed’s rate and balance sheet actions are both bold and unprecedented. How high will rates go and how long will they stay there? How much tightening can the economy endure before credit costs rise and credit availability falls dangerously? In its experiment to drive down inflation and ensure it does not become embedded in the US economy, the Fed’s medicine will have intended and unintended consequences. Its ability to counter mistakes will diminish over time. CIO’s purpose here is to prepare for what is likely to come in the next six months and help avoid shock

The Fed has put markets on edge

There are several reasons why this is an unusual tightening cycle. This coming week, the Fed is likely to raise its policy rate target by 75 basis points for a record third time. In the strong tightening cycle of 1994-1995, the Fed raised rates by 75bps only once. The rate hikes of the past four months would ordinarily unfold over an entire year. By tightening policies rapidly, there is a greater immediate shock to the economy. It is also unusual for the Fed to be tightening as labor markets improve. Now that economic growth has slowed and many areas of the economy – such as housing – have already begun to contract, the Fed’s continued tightening are likely to exacerbate weakness in the economy to come. Finally, tightening during a supply shock has become quite unusual. The effects of the war in Ukraine will slow the economy, and loss of energy supplies will be a continued drag.

Risks rising quickly: Revised scenario weightings

The case for a “recession” or “stall” in the economy in 2023 is quite strong and rising. CIO revised its three scenarios accordingly, raising the chance of recession in 2023 to 70%. Given the unpredictable nature of major events, some of these could unfold less negatively than CIO outlines here. Fortunately, there are no industry “booms” to unwind such as those of the housing or tech bubble cycles circa 2000 and 2008. This suggests no need for a very deep retrenchment. And there is also no evidence to suggest inflation will have a life of its own during the slowing ahead. Both long-term inflation expectations and nominal wage gains are moderate. Thus, the Fed will be the “wild card” as only it can determine when to pivot to support what will be an ailing economy, if trends unfold as expected.

Portfolio considerations

In CIO’s view, while uncertain, the chance is high that the economic “bottom” will become visible by the end of 2023. Putting the forward outlook together along with the declines in equity markets to date, CIO continues to believe it is premature to buy cyclical assets on recovery prospects before the recession has yet to begin. Even after 2022’s global equity declines, CIO believes in tactically focusing on reliable sources of return: sustainable dividend payouts from the highest quality industry leading firms and bond coupon income from strong investment grade issuers and governments.

Note: Past performance is no guarantee of future results. Real results may vary.