Mid-year outlook: How low will it go?

How low will it go?
Francis A. Scotland

Disinflation expected to support bonds
Jack P. McIntyre, CFA

Currency performance diverges on shifting expectations
Anujeet Sareen, CFA

Local currency markets lead the way
Michael Arno, CFA

No valuation anomalies
Brian L. Kloss, JD, CPA

Up front about high yield
Bill Zox, CFA and John McClain, CFA

Defensive with more patience
Tracy Chen, CFA, CAIA

Europe and Asia quietly take the baton
James J. Clarke and Sorin Roibu, CFA

Halfway there, livin’ on a prayer?
Patrick S. Kaser, CFA and Celia R. Hoopes, CFA

Macroeconomic outlook

How low will it go?

Francis A. Scotland
Director of Global Macro Research

The macroeconomic landscape is flooded with crosscurrents: the S&P 500 Index is up over 20% from last year’s low despite perpetual forecasts of recession and investor pessimism;¹ there is a mania in artificial intelligence (AI); war rages on in Europe; and climate change anxiety is persistent, to name a few. The Organization of the Petroleum Exporting Countries, or OPEC, keeps trying to prop up oil prices while an underwhelming reopening in China underscores how national security concerns trump the growth outlook in that economy. In the US, few seem overly concerned by the dire long-run outlook for budget deficits, and escalating political and social polarization seems unlikely to be diminished by the indictment of former President Donald Trump.

We think the macro factor that still matters most, at least for now, is inflation, notwithstanding how important these other elements may turn out to be. Inflation has been in retreat since peaking in June 2022 and is the main macro trend currently lending support to both bond and equity markets. The critical question for investors from here is: how low will it go? Can it retreat back to the Federal Reserve (Fed) target and validate rate cut expectations? Or will it get stuck above the goal range, forcing the Fed to keep rates high—or higher as some forecast—and risking a credit crunch and the economic recession so many are predicting?

We have said it before but it’s worth keeping in mind: Booms follow busts which follow booms. The pandemic lockdown bust triggered a massive policy reaction that fueled a boom in cryptocurrencies, equity markets, real estate, the economy, and ultimately inflation. But the boom then triggered a reflexive policy reaction in the other direction. In the last year, the federal funds rate moved to 5.25% from 1%,² money supply growth measured by M2 nosedived to -4.6% from 8.4%,³ and the balance sheet growth rate retreated to -6% from 12%.⁴ Correspondingly, economic and financial conditions have been normalizing with the dominos falling in the same sequence that they rose during the boom, beginning with last year’s demise of the crypto markets and the compression in equity multiples. Then came softer real estate prices even in the US, despite little inventory and strong household formation trends. Real economic growth in the US has fallen back in line with pre-pandemic levels while nominal income and spending growth rates have realigned after three years of complete distortion.

Inflation is the last domino to fall in this sequence of normalization. We believe its retreat to date has been well in advance of any expected effects stemming from Fed tightening. More lies ahead. The Fed’s supercore service inflation measure, excluding food, energy, and shelter, is in retreat. The ISM Services Purchasing Managers Index (PMI) of business prices is back to 2019 levels. Leading indicators of shelter bode well for lower headline inflation for the duration of the year. How low will inflation ultimately fall? Fiscal policy clouds the outlook, but we are optimistic.

Developed markets fixed income outlook

Disinflation expected to support bonds

Jack P. McIntyre, CFA
Portfolio Manager

We are all six months older and, hopefully, a little bit wiser since we penned our previous developed market bond outlook. Nothing has fundamentally changed in 2023. Conviction levels among the bond bears and remaining bulls diminished, reflected in the range-bound nature of most developed market bond markets. We see this mixed outlook reflected in positioning, with some money managers long duration versus their respective benchmarks—but not aggressively so—while leveraged market participants, like hedge funds, appear to still be massively short duration.

We initially said 2023 was going to be “The year of the bond market” but it may turn into “The year of the coupon” if the dominant ranges persist into 2024. What is the catalyst to break out of these ranges? It must be economic data as opposed to central bank rhetoric. Hence, this year will also be “The year of the data” since that is what will drive central bank policy and market biases. On the economic data front, the outlook is mixed, but inflation remains the critical variable for markets. The bond bulls see inflation as having declined with more to come, but the bond bears are fixated on its persistent elevated levels. This duality likely means central bank policy will not get much more restrictive but monetary easing is deferred into late 2023 or 2024.

Our conviction level remains high for inflation declining toward the vicinity of central bank targets, but it is the timing and path where the uncertainty lies. This uncertainty means that a range of economic scenarios, from recession to soft landing, is possible before inflation falls further. We expect developed market bonds to do much better in a disinflationary bust scenario as opposed to a disinflationary boom, but they should do well in both. If we are wrong and inflation re-emerges, cash will be king. However, we believe that was a 2022 story, which we do not think will happen again, based on three key developments that are currently unfolding:

1. Tight financial conditions
2. Slowing economies
3. Declining inflation

Whether a recession or soft landing is in the offing revolves around the timing and path of these three primary developments. With the lagged impact of tightening of financial conditions for this cycle, it may be that the economy will not see the real influence of these factors until 2024. Why is that? Well, this has been a unique cycle. We have frequently described the pandemic through the lens of a natural disaster, which means that the initial recovery phase forms more of a “V” shape. However, policymakers treated it like an economic crisis and overstimulated, using both aggressive monetary and fiscal policies. This battle of legacy stimulus and tighter policies will not change the course of lower inflation, just the timing of when it occurs. This normalization is unfolding in the world of developed market central banks that are now in the late stages of their respective tightening cycles after the heavy lifting of their restrictive policy occurred last year. This year is about experiencing the cumulative impact of the 2022 tightening cycle. Yes, there could be more “tweaking” of policy by raising rates further, but these will be in smaller increments. Or the tightening cycle may be extended a little further by pausing at a meeting. Central banks want flexibility and optionality, which makes sense as the lagged impact of last year’s aggressive tightening should impact the economies in the back half of 2023 and into the first half of 2024. Further rate hikes in 2023 will not impact respective economies until late 2024, if not early 2025, in our view.

We are monitoring these signs to increase our bullish conviction on bonds:

• Further tightening of lending standards by banks, particularly regionals
  Historically, banks tighten lending standards right into recessions. We expect this time should not be any different (see Exhibit 1).

• Softness in labor markets
  It might be that we need to see weaker labor markets to take inflation rates back toward central banks’ 2% goals. We are tracking the 4-week moving average of initial jobless claims in the US. Once they start moving higher, it gives an early sign that a recession is forthcoming.
• Labor supply and demand
  The supply of labor in the US is also worth tracking as it should increase as immigration, after a slow 2020 and 2021, returns to more normal levels. Lower demand for labor and increased supply of labor point toward lower wages and, therefore, lower inflation.
• China’s economy
  After an unexpected “COVID opening,” China’s slowing growth should be a tailwind for slower growth in the developed market portions of the global economy, which would be good for lower inflation and a positive for the bond bulls.
• Inflation expectations and surprises
  We will know we are wrong about our more constructive view of inflation if two things begin to change. The first is if inflation expectations become unanchored and start rising on a sustainable basis. This is currently not the case, evidenced by the still low five-to-ten-year inflation expectations reflected in the University of Michigan surveys. The second is if we begin to see a significant reversal in the inflation surprise indices for the G10 economies, using the Citigroup inflation surprise data (see Exhibit 2). Again, this is currently not the case. The inflation data generally continue to come out in line with market expectations.

The US and Europe are on similar cycles with some slight timing differences and influences. The European Central Bank (ECB) lagged the Fed in tightening, and their more open economies leave Europe more exposed to China’s economic struggles. We expect these bond markets to be more correlated in direction of yields, but the magnitudes of these moves may present some relative value opportunities. At this juncture, we still expect an overall narrowing of yield spreads between the US and European bond markets. We have more duration exposure to US Treasuries but are open to swapping some of that into European bonds if positive developments unfold. The outlier in our more constructive call on developed market sovereign bonds is Japan. Japan is on a different monetary policy cycle but not on a different inflation cycle. Inflation is running at levels above current Japanese government bond (JGB) yields, which is evidence of expensive bond markets and should be avoided. We do expect that the Bank of Japan, under new leadership, will back off yield curve control, which favors significant potential underperformance of Japanese government bonds. Again, just like other factors influencing our investment decisions, we believe timing—not direction—is the primary uncertainty in this call.

Global currencies outlook

Currency performance diverges on shifting expectations

Anujeet Sareen, CFA
Portfolio Manager

The US dollar weakened modestly in the first half of 2023 in trade-weighted terms, but this decline belies a large degree of dispersion between individual currencies. The currency leaders this year have been emerging market currencies, particularly those that raised interest rates earlier and more aggressively than the Federal Reserve (Fed). These currencies were primarily in Latin America, including Colombia, Mexico, Brazil, Chile, and Peru, and Eastern Europe, including Hungary, Poland, and Czech Republic. With inflation rolling over broadly, trailing and forward real yields in these markets are rapidly improving. The primary exceptions have been Asian emerging market currencies, led by the Chinese renminbi. Asia generally has not experienced the same inflation surge in recent years, and has, therefore, not needed to tighten monetary policy to the same degree. In the case of China, growth has disappointed, and monetary policy is actually now easing. Hence, real interest rates are not rising prospectively in the same way.

Meanwhile, in the developed world, currency performance has been more mixed. The outperformers this year have been the British pound, Canadian dollar, and euro, supported by generally more hawkish central banks in these countries. The currency laggards have been the Norwegian krone, Swedish krona, and Japanese yen—all marked by central banks that generally have been more dovish on monetary policy.

The Fed raised interest rates another 75 basis points (bps) in the first half of the year, but the broader message is that the Fed is nearing peak interest rates as the full negative impacts of policy start to manifest in the economy. The regional banking sector challenges in March, while not systemic, nevertheless reflected the weight of restrictive monetary policy on consequent lending conditions. Despite the higher level of US interest rates, the dollar has struggled in 2023 because investors question the sustainability of current Fed monetary policy.

Indeed, looking forward, we expect both US economic growth and inflation to move below market and Fed expectations. History suggests the deleterious impact of the rapid 500 bps increase in the federal funds rate will become more apparent in the data over the coming 6 to 12 months. As the policy effects manifest, we expect investors will lower their expectations for monetary policy, and the dollar is likely to weaken as a consequence.

We also believe the Japanese yen currently offers a particularly attractive entry point to gain exposure. The yen has retraced more than half of its appreciation from last fall, as the Bank of Japan has remained very dovish. But the Japanese economy continues to perform very well—broad business surveys are consistent with sustained above-trend growth, and the equity market is reflecting this message. The Tokyo Stock Price Index, commonly known as the TOPIX, has been one of the top performers in 2023. Moreover, Japanese inflation is still accelerating, which is in stark contrast with developments in the US and Europe. The Bank of Japan’s yield curve control (YCC) policy seems increasingly inappropriate for the Japanese economy, and a change in such policy is likely to support yen strength.

There are nevertheless risks to this broadly negative view on the US dollar:

• A hard landing in the US and the world economies might lead to a flight to quality, benefiting the dollar against more growth- and trade-sensitive currencies.
• Alternatively, if US growth were to stay more resilient and inflation pressures more persistent, investors likely would raise their expectations of peak Fed policy, which, in turn, might drive the dollar somewhat higher cyclically.
• Chinese growth has disappointed in recent months. If this trend were to persist with no sign of policy support from Chinese authorities, investors likely would lower their global growth expectations, particularly in those countries sensitive to Chinese demand. Commodities would then likely weaken, leading to weakness in commodity sensitive currencies as well.
• The Bank of Japan may opt to retain extremely easing monetary conditions for longer, given Japan’s lengthy history of disinflation.

Emerging markets outlook

Local currency markets lead the way

Michael Arno, CFA
Associate Portfolio Manager and Senior Research Analyst

Emerging markets have performed well year-to-date despite continued rate hikes from the Fed, regional banking issues in the US, a swift takeover of Credit Suisse by UBS, geopolitical concerns, and a slower-than-expected China reopening. Local currency sovereign markets have outperformed hard currency emerging markets (see Exhibit 3), with a number of higher-yielding local sovereign markets generating double-digit returns so far this year. Latin American and Central European local markets have been leading the way, with Colombia, Hungary, Brazil, and Mexico among the stronger performers. Lower-yielding Asian markets, including Malaysia, China, and Thailand, have lagged.

We have been writing about the attractiveness of local currency emerging markets since last summer, given historically elevated nominal yields coupled with peaking inflation, aggressive monetary tightening, and lower food and energy prices. In addition, political constraints have led to a reduction in risk premia in a few markets. While we are no longer at the 10% nominal yields (see Exhibit 4) we saw in 2022, we believe there is scope for yields to fall further as inflation remains on the decline (see Exhibit 5), driven by reduced consumer demand due to tight monetary policy, lower global food prices, and continued easing of supply chain pressures. Falling inflation should allow emerging market central banks to start rate-cutting cycles in the second half of 2023 and into 2024, leaving duration as a possible driver of returns over the coming months (see Exhibit 6).

Over the second half of the year, we will be following China’s policy response to a lackluster reopening. The People’s Bank of China recently cut policy rates, followed by an announcement of $150 billion to support the troubled local government financing vehicles. Another risk to the emerging market fixed income asset class is Fed policy and whether the central bank will have to continue tightening further. We believe the Fed is likely ending its tightening cycle, and we see a number of signs that US inflation will continue to decelerate back toward target. The draw on liquidity from the US Treasury rebuilding its general account and debt issuance following the debt ceiling deal is another situation we are following given the potential for draining of liquidity. If most of this funding comes from a decline of the overnight reverse repurchase facility (ON RRP), we would expect a smaller drag on risk markets. We think emerging markets remain attractive; so far, high-yielding markets have been the outperformers, but we will be watching for any potential shift back toward the low yielders.

Global credit outlook

No valuation Anomalies

Brian L. Kloss, JD, CPA
Portfolio Manager

The first two quarters were marked by some expected outcomes being met and an unexpected crisis bubbling up. Expectations around inflation moving down generally were realized, although the potentially much harder challenge of reaching the Federal Reserve’s target remains. There have been expectations that the Fed would keep cutting until “something breaks.” What was unexpected was the breaking of the banking sector and the collateral damage to US regional banks that it inflicted. Meanwhile, the labor market has remained unexpectedly strong.

Amid the first half’s ups and downs, global corporate credit markets, measured by the Bloomberg Global Corporate Credit Index closed the first half of the year with a reasonable six months, posting a return of 2.83%. Industrials and utilities were the strongest sectors in the index, posting returns of 2.99% and 2.89%, respectively. Even financials logged a respectable 2.61% return despite the stresses caused by the US banking crisis and the merger of Credit Suisse into UBS. The global aggregate corporate option-adjust spread (OAS) was essentially flat for the year to date. All data are as of June 12, 2023.

What do global credit investors need to know for the next six months and into 2024?

Normalization is still the story for the foreseeable future for global credit. The pandemic and the policy responses distorted much of what investors know around business cycles. The unwinding and normalization will take time. These adjustments do not happen overnight, and there will be disruptions and bumps in the road along the way—and hopefully lessons learned and new ideas will augment existing business practices. Inflation remains front and center for global central bankers and the full effects of their policy responses are still to be felt. Chief executive officers and Chief financial officers are feeling the pressure from rising rates and are still challenged on the labor front, but they are seeing offsets as inflation recedes and supply chains normalize.

Just as company management teams must do in a global world, investors need to look globally as well. China’s economic recovery has been anemic compared to prior economic recoveries. Our expectations are that any Chinese policy response will be more targeted and more focused on internal growth—such as services—rather than a broad policy response that would benefit global growth, namely commodities. However, while China’s lackluster recovery could dampen commodities demand, one major offset is the greening of the global economy, which should continue to support key inputs, like copper.

And to the west, the war in Ukraine continues to impact the European recovery. Thus, corporate management teams are tasked with navigating a choppy recovery, evidenced by challenged G20 Leading Indicators (see Exhibit 7).

For Brandywine Global, the discussion above is only one part of the equation. The other parts are valuation and timing. What are markets pricing into corporate spreads relative to an estimation of credit’s intrinsic value given the previous discussion? Valuation models offer conflicting answers. Some models show corporate credit as “cheap” and others show corporate credit as “rich.” In our view, there is not a true valuation anomaly in corporate credit anywhere, with the exception of possibly US regional banks (see Exhibit 8).

Coupling valuation with macroeconomic data, one can see that caution is warranted in the chart below (see Exhibit 9). The timing of any potential recession—or even the avoidance of one—remains unclear. Based on our thought process, prudence is required. We remain positioned in short duration investment grade and high yield credit, a conservative stance given the uncertainties in the outlook. Until greater clarity emerges, we will remain defensive, looking to take additional risk on an individual, idiosyncratic basis where opportunities arise.

US credit outlook

Up front about high yield

Bill Zox, CFA
Portfolio Manager

John McClain, CFA
Portfolio Manager

Short-duration US high yield can be a dangerous part of the market. There is often a good reason why these bonds have not been refinanced when they are close to maturity. However, this time we believe is different. Today, we find it to be one of the most attractive parts of the market, and we see a lot of high-quality opportunities on the front end of the curve.

There are many high yield bonds that are likely to be called in the next year or two or that mature in the next two to three years. Their spreads are reasonable, but when you combine that with the inversion of the Treasury yield curve, you get very high single-digit yields for good high yield credits that we believe have minimal risk of default.

Furthermore, there is greater visibility to companies’ business models over the next two or three years versus farther out, and these management teams have had time—and access to capital—to prepare for higher interest rates and recession. In our view, this segment has one of the best risk/return profiles across bond markets because despite not taking much duration risk, investors are still getting paid a significant yield. There are opportunities farther out on the high yield curve as well, but we really think it is an optimal time to focus on the front end. However, skilled active portfolio management will be valuable if the market becomes irrationally concerned about the likelihood that certain short-duration bonds will be refinanced.

Defaults expected to remain subdued

Supporting the case for high yield is a potentially benign default outlook. Defaults are increasing modestly but are still very low. In most cases, high yield issuers are servicing fixed-rate debt obligations with highly inflated assets and cash flows, which makes it much more difficult to default. For example, interest coverage continues to be elevated at near record levels (see Exhibit 10).

Meanwhile, the smaller, more aggressive leveraged financings have been taking place in the leveraged loan and private credit markets. This trend makes sense as the high yield market has been relatively stable in size over the last 10 years while first leveraged loans and then the private credit have grown rapidly (see Exhibit 11). This demand from the rapidly growing leveraged loan and private credit markets has been satisfied with lower-quality issuance. As a result, we expect leveraged loans and private credit to absorb more of the defaults than the high yield market in this credit cycle.

Where we are finding opportunities

While we currently are more constructive on US high yield, we do see some opportunities in the investment grade space. One is regional banks, although given the risks, you must be judicious and well diversified. It is possible we will see more issues in banking, but we know the sector’s importance to the US economy. Regional banks will end up with access to reasonably priced debt and equity capital. And if banks do come under further pressure, we would expect the fallout to be even worse for other parts of the financial markets that do not have the same implicit and explicit support from the government. Some high triple B (BBB), low single A regional bank bonds trade at spreads as wide as high yield, and that will not persist; their spreads will return to well inside of where they are now, in our view.

Despite the recent pressure on oil and gas prices, we believe higher-quality energy issuers are attractive because the management teams have become much more disciplined capital allocators after the difficult lessons learned in 2016, 2018, and 2020. Non-bank financials also are compelling to us as they should benefit from any tightening of lending standards by banks. We have exposure to non-bank consumer lenders, auto lenders, and mortgage originators and servicers. As the banks back away from some opportunities, the lending environment likely will become less competitive for some of these non-bank financials.

An attractive entry point for high yield

Some asset allocators may be waiting to build exposure to high yield until spreads widen further. Their approach to the high yield market involves spread-based “rules” formulated during the recessions in the early 2000s and the global financial crisis of 2008–2009. These investors may be waiting for spreads to reach 600 to 800 basis points, or even wider. However, we believe those targets are outdated and should be adjusted lower. The high yield market and the broader leveraged finance market have changed dramatically over the last ten years. High yield has improved, becoming much more of a BB-rated market than a B-rated one. And the secured part of the high yield market has been growing rapidly, while subordinated high yield bonds have dwindled to next to nothing. Lastly, high yield issuers have become larger, and they are more likely to have publicly traded equities. These strong fundamentals may help keep high yield spreads contained such that today’s spreads of 400 to 600 basis points are comparable to the 600 to 800 basis points seen in prior cycles. Adding a reasonable high yield spread to a very attractive Treasury yield results in all-in yields that should produce attractive returns over time. Passing up current spread and yield levels may mean passing up a good entry point for increasing a strategic allocation to US high yield.

Structured credit outlook

Defensive with more patience

Tracy Chen, CFA, CAIA
Portfolio Manager

Valuations have cheapened significantly in most sectors of the structured credit market, due to recession fears and idiosyncratic fundamental reasons. The spread of agency mortgage-backed securities (MBS) to 7- to 10-year Treasuries has widened over 50 basis points (bps) from its tightest recent level in early 2023, pricing in the FDIC liquidation, Fed quantitative tightening (QT), and weaker bank demand. On the non-agency front, asset-backed securities (ABS), collateralized loan obligations (CLO), commercial mortgage-backed securities (CMBS), and credit risk transfers (CRT) of both AAA and BBB and below ratings have become cheaper, with some by multiple standard deviations from their averages, presenting attractive valuations relative to their trading history and to comparable corporate bonds (see Exhibit 12 and Exhibit 13).

Housing fundamentals still solid

Mortgage rates in the US moderated at the mid-to-high 6% level in the first half of 2023. As home builder incentives aim to boost new home sales and address the housing shortage, housing prices appear close to bottoming, if the economy can achieve a soft landing. Compared to the housing boom that led to the global financial crisis (GFC), we believe housing prices currently are well supported in this cycle. Additionally, further tightening of lending standards resulting from the recent banking crisis should support future performance of residential mortgage-backed securities (RMBS) collateral.

Healthy household balance sheets

Credit fundamentals started to return to pre-COVID levels as consumers spent their increased savings, built up from the generous stimulus packages and large wealth effects due to rising asset prices. The accumulated home equity of over $31 trillion and remaining excess savings of roughly $500 billion, based on estimates from the Federal Reserve Bank of San Francisco, still provide consumers with some buffers (see Exhibit 14).⁵

Commercial real estate (CRE) market—the long reckoning

There is no question that the secular shift to working from home and hybrid work arrangements poses tremendous challenges to the office sector within the CRE market. However, the prevalence of improved underwriting standards and other mitigating factors, including a decade of embedded price appreciation and the likelihood of loan extensions and modifications, lead us to expect a prolonged reckoning for the sector, which could span several years. In addition, there are other CRE sectors, including industrials and multi-family, which have been performing well. We see a collapse with massive liquidation losses that trigger systemic financial risk as an unlikely scenario. In our base-case scenario, we estimate that CMBS office losses ultimately settle in the mid-to-high single digits. In this scenario, most investment grade investors are protected from write-downs, given sufficient credit enhancements. Credit curve steepening has turned drastic since 2022. Price discovery and transaction volume in CRE remain very low, particularly in the office sector, making value assessment quite challenging and the ability to formulate high conviction difficult. However, we speculate that we may be near peak CMBS credit curve steepening, which would herald the entry of distressed investors as a welcome source of demand. Current yield levels are becoming increasingly compelling as prices reflect overly draconian CRE fundamentals.

Higher collateralized loan obligations (CLO) tail risks

We believe leveraged loans should underperform high yield and investment grade corporate credit as higher funding costs, lower earnings, and a higher tail risk of credit distress become more dominant. This trend would likely lead to lower coverage ratios for lower quality and junior parts of the CLO capital structure. We already are starting to see rating downgrades exceeding upgrades. However, the floating rate nature of CLO assets should continue to provide some hedges against duration risks.

Favorable market technical

Reduced net new issuance and still-high demand are buoying the market technical. Spreads have widened this year, which should improve with lower supply in 2023.

Where we see the best value in the second half of 2023

Given cheapening valuations and more uncertain fundamentals, hampered by the aftereffects of Fed tightening, credit tightening, less appetite for long-duration assets from banks, and slower economic growth, we believe valuations will likely have more downside. We will continue to be defensive and cautious by pivoting our investments up in quality, up in the capital structure, and short in duration within various sectors. We currently believe the most attractive opportunities include: current coupon agency mortgage-backed securities (MBS); seasoned credit risk transfer (CRT) securities rated BBB and BB; non-qualified MBS rated AAA; seasoned subprime auto ABS AAAs to BBBs; CLO AAAs; and seasoned commercial MBS AAAs to As, among others.

Global equities outlook

Europe and Asia quietly take the baton

James J. Clarke
Portfolio Manager & Director of Fundamental Research

Sorin Roibu, CFA
Portfolio Manager & Research Analyst

Our favorite chart on global markets shows the long cycles of US outperformance and underperformance (see Exhibit 15). These cycles can last years as investors who fell in love with an investment theme or geographic region reluctantly unwind their overweight positions.

In 2022, a nearly 14-year cycle greatly favoring the US appears to have ended, which has left both the US stock market and the dollar very highly valued relative to alternatives, but no longer outperforming. The US underperformed in 2022 and even in the first quarter of 2023, which was supposedly led by US tech, but European markets quietly did even better (see Exhibit 16).

We are looking to places like Europe, China, Japan, and Korea for future equity market leadership. These markets are far cheaper than the US, even for very similar global companies. These regions are all deeply out of favor with investors but for different reasons, enabling a degree of potential diversification.

European stocks have done well since last September as the bear market case of a crippling energy crisis simply did not happen. Investors remain cautious, however, so stock prices are relatively attractive, in our view. China draws fear from investors, mainly about geopolitical risk, yet many of those same investors appear quite comfortable owning large U.S. tech companies completely dependent on Taiwan chip production. Chinese internet megacaps are among the cheapest stocks in the world, trading at single-digit price-to-earnings (P/E) ratios.

In Japan and Korea, we would expect to capitalize on appreciation in the currency as well as the stocks. In Japan especially, the currency is clearly undervalued with everyday items in Tokyo costing half what they cost in New York City.

US equities outlook

Halfway there, livin’ on a prayer?

Patrick S. Kaser, CFA
Managing Director & Portfolio Manager

Celia R. Hoopes, CFA
Portfolio Manager & Research Analyst

As we think about US equity market performance year to date and reflect on the trajectory for the second half of the year, we cannot help but be reminded of Jon Bon Jovi’s hit song, “Livin’ on a Prayer.”

One of the most widely forecasted recessions has yet to come to fruition. For months, the debate has been between a “hard landing” versus “soft landing,” but now the possibility of “no landing” has entered the range of potential outcomes. On first quarter earnings calls, many management teams were optimistic about the second half of the year. We have a tough time being as hopeful.

According to some definitions, we are now in a bull market, but as every market commentator will surely remind you, the breadth of the rally is one of the narrowest on record. The 10 largest stocks in the S&P 500 accounted for nearly 90% of the index’s year-to-date returns, the highest percentage in history.⁶ Earnings growth has become scarcer, and the premiums investors are willing to pay for those companies with it have skyrocketed. Indeed, price-to-earnings (P/E) expansion as opposed to an improvement in earnings outlook has been the primary driver of market performance. Earnings estimates for the year have risen from the beginning of April but remain lower than consensus estimates at the beginning of the year.

We see a myriad of headwinds as we enter the second half. Household excess savings have been worked down with Morgan Stanley estimating, based on Bureau of Economic Analysis data, that those for the lower-income quartile were exhausted by the end of the first quarter.⁷ Beginning in September, student loan repayments will resume, which some sources estimate will be a $128 billion to $148 billion annualized headwind on consumer spending.⁸ The Bureau of Labor Statistics reported that April’s core CPI was 0.4%, which was in line with consensus expectations, but this rate annualizes to nearly 5%. While prices for core goods, excluding used vehicles, were nearly flat, price inflation for services remained persistently strong. It will take a weaker labor market for services inflation to slow. The debt ceiling debacle has come to an end, but the Treasury needs to refill its coffers, which likely will create a drain on liquidity.

There have been twelve Fed tightening cycles since 1960, eight of which have resulted in hard landings and 4 of which have resulted in soft landings, according to Piper Sandler.⁹ The recipe for the former tends to be underscored by a sharp deterioration in unemployment while the latter experiences little to no downturn in employment. Piper Sandler also writes that precursors to a hard landing have been rapid Fed hikes coupled with tight bank lending standards and sticky inflation while precursors to a soft landing have typically consisted of modest Fed hikes, easing bank lending standards, and low inflation.¹⁰ Current conditions seem very similar to those that preceded hard landings in the past.

We never wish for market downturns, but we believe it is prudent to be positioned more defensively at this time.