As we approach the halfway point of 2022, investors remain uncertain of what to expect throughout the next six months. A perfect storm of stagflation, geopolitical tensions, rising rates, slower growth, value beating growth equities, a tightening job market, supply-side constraints, demand headwinds, the commodity supercycle, historically high oil prices, equity volatility, and fixed income underperformance riddled the first half of 2022, frustrating investors along the way. Peeling back the layers of the economic whirlwind, some of the risks listed above some may persist, ease or arise. Below we provide an economic backdrop, and then a sector-by-sector look at what we’re expecting for the rest of 2022 and beyond.
The Federal Reserve’s (Fed) Quantitative Tightening (QT) and plan to continue raising rates will likely persist as supply-side inflation weighs on the economic demand and growth. Especially as some reports indicate that the Fed’s rate hikes so far this year have not (yet) reigned in inflation (as US Manufacturing activity and job openings rose) to start to slow economic growth. Additionally, downside risk on consumer sentiment, household budgets, and savings may adversely impact the structurally robust consumer. This indicates that a few more 50 basis point and potentially a 75-basis point rate hike remain on the Fed’s docket through 2023. This will aim to slow economic growth (targeting a soft landing) enough to tame inflationary pressures. However, with inflation originating from supply related constraints, it remains challenging for the Fed to completely tame inflation without disrupting the employment rate (potentially leading to higher unemployment). Thus, if the Fed is successful in easing supply-side inflation, the tight job market may be short lived according to traditional macroeconomic theory.
Furthermore, geopolitical tensions fueling the commodity supercycle may selectively persist in certain commodities throughout the remainder of the year. Broad-based commodity outperformance may start to slow into the second half of 2022 with opportunistic soft and hard commodities remaining attractive. Though the wheat outperformance seems to have plateaued (with Russia trying to amend concerns with open promises to ensure Ukrainian exports) the structural damage to Ukraine’s harvest may result in an upward bias for the commodity despite accommodative domestic harvest weather in the US. Corn, as described by Jacob Shapiro’s “Corn Prices Will Remain High”, will likely retain higher prices as geopolitical tensions directly impacted the Ukraine (third largest corn producer in the world) corn harvest fueled by droughts in the US. Soybean prices may start to moderate as the growing of soybeans remain cheaper than corn due to historically high fertilizer prices amid Russia’s natural gas prowess (an important component of urea- and ammonia-based fertilizers). The inflation support of agricultural commodities appears stagnated as rising prices have shifted to slower demand. On the other hand, industrial metals remain rangebound (amid China demand worries) with the potential to breakout after the economic headwinds subside amid structural support. However, natural gas and crude oil will likely remain elevated (especially after the EU’s partial ban on Russia oil) and volatile until the geopolitical tensions ease and production/relations can resume (though unlikely in the near-term), potentially leading to persistently high oil & gas prices.
Capital Markets: Equity and Credit
Amid the current macro dynamics, equity markets will likely maintain their current volatile negative bias with potential for continued underperformance. Based on the current market dynamics and priced in risks of some of the macro events lists, our base case is that the S&P 500 Index appears poised to finish the year in the $3750-$3800 range with an upper bound of $4200 and lower bound of $3600. However, if stocks breach the $4200 level, bears may start to capitulate to cover their short positions (leading to upward bias or another bear market rally). We believe that equities have a tough next six months ahead amid downward earnings revisions, poor company forecasts, etc. (especially in disruptor names or high growth companies – specifically Technology and Consumer Discretionary sectors – down the most YTD as their intrinsic valuations became oversaturated from the 2020 and 2021 rally). Moreover, we believe that value equities, especially dividend and low beta stocks in the small cap space, remain the sweet spot to weather equity overvaluations (market wide), volatile intra-quarter price swings, and rising rates. This pattern will likely persist through 2023 with value overshadowing growth in the near-term (though fundamentals will likely persist for years). Thus, the momentum trade may be over, and the company fundamental strength may be starting.
Recent bond underperformance and volatility may continue in the near-term as the Fed raises rates. However, some corporate bonds (specifically high yield), convertible bonds, and municipal bonds appear to have upward potential with yields aggressively compensating for increased risks amid falling cents on the dollar. Therefore, opportunistic short duration and municipal bonds reside at an attractive entry point for credit investors. Additionally, uncorrelated asset classes such as legacy non-agency RMBS with high principal amounts and opportunity bias remain an alternative for outperformance amid headwinds. However, investors should remain caution to traditional mortgage-backed securities, as their negative convexity could intensify their risk profile driven by the homeowner’s prepayment option. Bank loans/floating rate bonds may also provide relative value amid rising rates. Thus, short duration (specifically high yield), legacy NARMBS, Floating Rates, and Municipals appear the most attractive credit investments.
Lastly, as discussed in “The Gray Rhinos: The Long-Term investment that Hedges tactical Volatility Opportunities”, the housing market appears to have peaked aimed toward a downtrend with prices likely to drop more than 10% over the next 12 months as mortgage rates continue to rise and weaker seasonality weigh on demand. For the first time since the pandemic, the housing market is starting to slow with more homes for sale and with unsold homes increasing YoY. Since the housing market is slower moving than other capital markets, the Fed’s QT will have little immediate impact on the housing market, potentially leading to uncorrelated softening.
All in all, markets remain in open waters as the economic backdrop continues to search for a defining trajectory. This structural compression (or battle between bulls and bears) has seen bears overshadowing. Stagflation, geopolitical tensions, rising rates, value outperformance, equity volatility, opportunistic credit investments (short duration high yield corporates, legacy NARMBS, municipals, bank loan/floating rates, etc.) and selective commodity outperformance (corn, wheat, crude oil, natural gas, base metals, etc.) appear to remain the highlights for the second half of 2022. Additionally, a weaker job market and slowing housing market will likely augment the complexity of the market outlook.