After The Revaluation, The Slowdown

By Erik L. Knutzen

Our Asset Allocation Committee believes that, whether we enter a recession or not, the expected slowdown and ongoing market volatility could feel like one for investors.

Neuberger Berman’s Asset Allocation Committee met to discuss its latest views last week. We will publish the full Outlook in two weeks’ time, but here we present some key highlights.

Following a tumultuous quarter of aggressive central bank hawkishness, rapidly rising interest rates, tumbling equity market valuations and widening credit spreads, we think we are at an important juncture.

The first six months of 2022 saw markets pricing for tighter financial conditions: The sell-off so far has been all about downward adjustments to valuations. For the next six months, markets are likely to price for downward revisions to growth and earnings forecasts.

That means we remain cautious in equities. But in fixed income, investors now have more yield and credit spread to work with, both to pick up long-term value and to build defensiveness into portfolios. We think the latter will be helpful as we head into what we expect to be a substantial economic slowdown.

A Substantial Slowdown Is Likely

It’s four weeks since we wrote about investors focusing away from the impact of rising real yields on the “P” of equity valuations and onto the impact of slowing growth on the “E”.

The first six months of 2022 appeared to be almost all about revaluing the same set of forecast earnings with a higher discount rate.

We think that the Federal Reserve’s rate hikes for this cycle are becoming increasingly priced into the yield curve. We do not anticipate a meaningfully higher discount rate.

But we also think those rate hikes will crimp demand, slow the U.S. economy, and help bring U.S. inflation down to as low as 4% by the end of the year. Earnings arrive as nominal dollars, and so they could face a decline of almost five percentage points just through the inflation adjustment, even before factoring in any economic slowdown.

We think a slowdown is coming. Although the odds shorten with every month of persistent inflation, we believe the U.S. can avoid a technical recession. But recession or not, the important point is that we think this slowdown will feel like a recession for equity investors. Lower earnings are still not priced in, and we think that could put additional downward pressure on equities.

Benign Outlook For Defaults

By contrast, we think recession is closer to being priced into credit markets. High-yield spreads at around 500 basis points, offering 8%-plus yields, look to us like a relatively attractive way to take risk.

Our fixed income team has stress-tested for a full recession, which is worse than our current base case, and even in that scenario the outlook for defaults remains relatively benign.

The energy sector, which has been a significant source of credit stress in recent years, is benefitting from the run-up in commodity prices. Over the past decade, riskier private equity deals have tended to be financed with leveraged loans rather than in the high-yield bond market. We also think this slowdown will be consumer-led rather than emerging from problems in the financial or industrial sectors; that might suggest a relatively shallow downturn, with much of the pain concentrated in consumer discretionary companies.

Dry Powder

There is also more yield to work with in investment grade corporate and Treasury markets — and, as we mentioned, we think we are close to or even past the point of peak yields.

As investors wait for more clarity on the path of inflation and the impact of tighter financial conditions on the economy, we believe that means bonds can provide some meaningful ballast for defensive portfolios, for the first time in a long while.

And defensiveness is what the Asset Allocation Committee favors for the foreseeable future: lower-beta exposures in equities, continued exposure to commodities, an overall tilt to fixed income, a favorable view on uncorrelated strategies and meaningful dry powder for opportunistic investing.

The coming months are likely to be difficult, but difficult periods are those in which the foundations for potential long-term returns are built.

In Case You Missed It

• U.S. Existing Home Sales: -3.4% month-over-month to SAAR of 5.41 million units in May
• Japan Manufacturing Purchasing Managers’ Index: -0.6 to 52.7 in June
• Eurozone Manufacturing Purchasing Managers’ Index: -2.6 to 52.0 in June
• U.S. Manufacturing Purchasing Managers’ Index: -4.6 to 52.4 in June
• Japan Consumer Price Index: +2.5% year-over-year in May
• U.S. New Home Sales: +10.7% month-over-month to SAAR of 696,000 units in May

What to Watch For

• • Monday, June 27:
    • U.S. Durable Goods Orders
  • Tuesday, June 28:
    • S&P/Case-Shiller Home Price Index
    • U.S. Consumer Confidence
  • Wednesday, June 29:
  • Thursday, June 30:
    • U.S. Personal Income and Outlays
    • China Purchasing Managers’ Index
  • Friday, July 1:
    • Eurozone Consumer Price Index
    • ISM Manufacturing Index

Investment Strategy Group

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