by the Asset Allocation Committee | PDF

• Our three-year forecast contains a dynamic economic environment comprising both a normal recession and ensuing recovery.
• Upon signs of economic fragility, we expect the Fed to suspend its current assertive drive to quell inflation, with the likelihood that policymakers will cease their balance sheet reduction but will not make cuts to the fed funds rate.
• Bond exposures are in the short-term segment as our forecast calls for a flat yield cur stemming mostly from lower rates in the one- to three-year segment.
• The prospect of an economic recovery encourages an increase in equity exposure from the low levels of last year. U.S. stocks continue to be tilted toward value with lower market caps, and strategies are now overweight in sectors that we believe are well-positioned for the recovery.
• Compelling valuations of overseas businesses combined with expectations for a weakening U.S. dollar encourage a sizable position in international developed market stocks.
• Broad-based commodities with an emphasis on Energy commodities are retained. The allocation to gold is elevated owing to its appeal as a haven during rapidly changing economic conditions.

ECONOMIC VIEWPOINTS

A broad range of indicators is flashing signs of an impending global contraction and recession in the U.S., the most prominent and oft-cited of which is the inversion of the U.S. Treasury yield curve. The spike in yields across the curve, and particularly in short-term instruments, reflects the surge in inflation over the past year coupled with the efforts of the Fed to harness it. The Fed’s relentless battle against inflation woes have caused it to raise the fed funds rate from its target of 0.25%-0.50% last March to 4.25%-4.50% at its last meeting in December and embark upon quantitative tightening (QT) through the reduction in its balance sheet of $95 billion per month. While many credit these actions with helping to settle inflation in core goods, which was certainly aided by an untangling of supply shortages since the U.S. COVID lockdowns, inflation in core services remains ascendant. The Fed’s pronouncements have been decidedly hawkish as it attempts to slow the economy through dampening demand and targeting the wide gap between job openings and the rate of hiring. The Fed’s latest statements underscore the notion that policymakers will continue to increase the fed funds rate until inflation retrenches to  its 2% target.

Despite the rhetoric, markets are anticipating a lessening of the Fed’s zeal. As this accompanying chart indicates, the spread between the fed funds target and the implied LIBOR rate, two-years deferred, has been a harbinger of a change in direction for Fed policy. While this has occurred against the backdrop of an overall decline in interest rates over the period since 1990, a negative spread has invariably signaled when the central bank has moved too far, as is now the case to an extreme.

The prospect of a global economic contraction commencing over the next several quarters helped frame our expectations for the overall economy and markets over our full three-year forecast period. Although the Atlanta Fed’s GDPNow estimates for this quarter still exhibit growth, a durably inverted yield curve, elevated inflation, and sentiment point to a recessionary environment in the near term. Confluence’s proprietary Diffusion Index indicates that the probability of a contraction in the U.S. is elevated. Nevertheless, our base case is for a garden-variety recession, as the excesses that were produced in prior severe recessions are absent, owing to the relative brevity of the recent business cycle. Accordingly, our view is that a normal contraction will be followed by a healthy recovery, with the possibility of an expansion toward the end of our forecast period.

STOCK MARKET OUTLOOK

Periods of inflation typically lead to a decline in price/earnings ratios, with both prices and earnings being affected. This is a natural adjustment, as the discount mechanism is elevated for future earnings, especially for longer-duration equities such as certain technology stocks that carry higher earnings expectations further into the future. Moreover, we typically see earnings compression with elevated inflation, not simply due to increased costs of production, but more importantly rises in the cost of labor, which is especially prominent in services. The ability of companies to push rising costs onto consumers has varying degrees of limitation, dependent upon the elasticity of demand for a company’s products or services. Essential products or services obviously have more durable, or inelastic, demand such that costs can be more readily passed onto end users.

With equity markets being anticipatory, we believe the declines experienced in 2022 were handicapping a future recession, to a degree. Although U.S. stocks may dip further, our belief is that most of the negative price movement has largely been already experienced. The Fed’s aggressive battle against inflation has at least indirectly contributed to a relaxation of formerly tight labor markets, as indicated by the recent spate of layoffs from mega-cap technology companies as well as an abrupt slowdown in housing dictated by higher mortgage rates. While it is too early to expect the Fed to pivot on fed funds, our view is that QT will be suspended over the next few quarters. Moreover, the lessons gleaned from March 2020 support our expectation that any relief the Fed may offer in a downturn will be along the lines of the “alphabet soup” type of targeted programs that were offered as support for certain segments at that time as opposed to the blunt instrument of easing fed funds.

The widely anticipated economic slowdown should be normal, by historical standards. Consequently, our three-year forecast is for positive returns for U.S. equities. That expectation extends to and is even magnified for lower capitalization stocks. We expect small cap value stocks with strong free cash flow to perform particularly well, as they typically have when the U.S. has emerged from prior recessions. In addition, we anticipate that an economic recovery within our forecast period will aid the Industrials and Metals/Mining sectors, which are overweight in the strategies, along with the continuation of the overweights to Energy and Aerospace & Defense.

Due to favorable relative valuations of international developed stocks versus U.S. counterparts, combined with the prospect of a weakening U.S. dollar, we are constructive toward international equities. The reconstitution of supply chains and China’s stimulus and emergence from COVID lockdowns further bolster the prospects for developed market stocks, particularly those engaged in the export of commodities. Accordingly, all strategies now hold a sizable position in international stocks, and overweights to Canada and Australia are introduced in the more risk-tolerant strategies of Growth and Aggressive Growth.

BOND MARKET OUTLOOK

As noted earlier, while we anticipate an end to the Fed’s current QT balance sheet reduction of $95 billion per month, in our view a decrease in the fed funds rate to the former ultra-low levels is very unlikely, even in the face of a recession. While we expect the steep inversion of the U.S. Treasury yield curve to evaporate over our three-year forecast period, it is likely that the curve will flatten through a decrease in yields in the one- to three- year segment in combination with a secular increase in long-term rates, as illustrated in the accompanying chart. Accordingly, the positions in extended duration Treasuries via zero-coupon instruments were liquidated to positive effect after their initiation last quarter as we believe their continued utility has evaporated. All bond exposures in the strategies are now short-term, with the sole exception of the Income strategy, which continues to use a 10-year laddered maturity core, an inviolate part of this strategy’s construction. The short-duration posture among the other strategies also reflects our recognition of the small potential that, in the extreme, a bond market panic could lead to a form of yield curve control.

Within corporates, the brevity of the current economic cycle has not seemed to wreak the excesses experienced during longer expansions, except in the low-rated floating rate instruments. Therefore, we expect only modest widening of spreads among investment-grade and BB-rated corporate bonds, the latter of which are employed moderately as equity surrogates in the more conservative strategies in order to provide a degree of risk control over the next several quarters.

OTHER MARKETS

Despite valuations seeming compelling in REITs with their weak performance in 2022 compared to other sectors of the U.S. equity market, the strategies remain devoid of REIT exposure. The fragmentation of the REIT market and the lack of conviction surrounding the prospects of certain segments encourage our avoidance of the sector over the near-term. On the other side of the spectrum, commodities appear well-poised for a recovery following a normal recession. We retain an exposure to broad-based commodities with an emphasis on Energy commodities across all strategies. In addition, we increase the weighting to gold for its appeal as a haven during dynamic economic environments.

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Asset Allocation Strategies Fact Sheet

by the Asset Allocation Committee | PDF

• In its battle against inflation, the Fed’s unrelenting tightening through the balance of this year and into next will be a major contributor to dampening demand.
• A worldwide economic contraction, inclusive of the U.S., is built into our three-year forecast.
• Our expectations are for a garden-variety recession in the U.S., in that we do not anticipate the depth and duration to be severe.
• Equity allocations remain underweight, with bond exposures principally in the short- and intermediate-term segments.
• Long-duration Treasuries are introduced across the array of strategies as a stabilizer against the potential for increased global geopolitical and default risk.
• The exposure to speculative grade bonds was increased in the more conservative strategies.
• Equity exposure is entirely domestic and heavily tilted to value, with larger overweights to defensive sectors than last quarter.

ECONOMIC VIEWPOINTS

The IMF recently cut its forecast for 2023 global economic growth, representing the fourth consecutive downward revision this year. In its release, the IMF expects a contraction in over one-third of the global economy next year and stated that “this is the weakest growth profile since 2001 except for the global financial crisis and the acute phase of the COVID-19 pandemic,” citing the ongoing Russian invasion of Ukraine, global cost-of-living increases, and the economic slowdown in China that will lead to a volatile economic and geopolitical environment. Despite the revisions, virtually all global central banks are engaged in various forms of tightening, with the only current exceptions being Russia, Turkey, China, and Japan. While the BOE, ECB, and BOJ are arguably engaged in various forms of yield curve control in attempts to address their respective problems of pension schemes solvency, peripheral country spreads, and a longstanding deflation mindset, the U.S. Fed is singularly focused on reducing inflation through aggressive increases in the fed funds rate and accelerating quantitative tightening through reduction of its balance sheet holdings by $95 billion per month, against a current balance of $8.2 trillion.

For the U.S. economy, the assertive Fed posture has led to a cascade of expectations for a recession to commence within the next nine months. While the increasing potential for a future recession has been our contention since the second quarter of this year, we found a degree of confirmation at the end of last month when the Confluence Diffusion Index, shown on the accompanying chart, signaled that the business cycle is headed toward a contraction. Among its 11 leading indicators, five either slipped or continued their descents into negative territory, including Consumer Confidence, Manufacturers’ New Orders Non-Defense Capital Goods, Wilshire 5000 Index, Real M1 Money Stock, and the 10-Year/3-Year Treasury Spread. The full Business Cycle Report (9/29/22) from the Confluence macro team is available via this link.

The Fed’s strides to dampen inflation through affecting demand and creating labor market slack have had a limited effect on recent economic data. Inflation has eased from its zenith of +9.1% year-over-year in June to +8.2% in September, and U.S. Customs data recorded a decline from August (-12.4%) for inbound volumes to U.S. ports. However, the most significant influence in the Customs data was collapsing imports from China, which in our view underscores the deglobalization trend. Labor markets remain strong, as evidenced by the BMWED rail union’s rejection of a 24% wage increase and $5,000 bonus, creating the potential for a strike after November 14. This potential, in combination with difficulties encountered in West Coast port labor negotiations, portends a resumption of supply chain delays and further inventory builds, which could delay a significant decline in inflation. Although supply chains will eventually adjust with a coincident decline in inventories, deglobalization will lead to an increase in the volatility of inflation, which we conclude will shorten business cycles.

While our premise is an inevitable path toward recession, its depth, severity, and duration are all in question. Since the current composition of the FOMC has in the past exhibited a tendency to pivot, the likelihood that it would do so again is well within the realm of possibility, especially as a recession takes hold. Arguments in favor of a “normal,” as opposed to deep, recession are solid fiscal positions among state and local governments, corporate balance sheets that have not become overleveraged, and the overall financial health of households. Despite the seismic shift in the yield curve that has dampened demand for housing, mortgages as a proportion of home values have declined markedly since the Great Financial Crisis. Those who prognosticate an echo of the housing crisis that crippled the economy in 2008 will find scant evidence in the current data. The lack of fiscal excesses that typically precede recessions support the expectation that an impending recession in the U.S. will be normal. Nevertheless, the potential exists for a major policy mistake, significant geopolitical event, or fracturing of a segment, such as what has occurred in the U.K. gilt market, to emerge that would cleave a deeper recession.

STOCK MARKET OUTLOOK

The U.S. equity market hit its zenith on the final day of 2021 and has been on a swooning trajectory ever since. The Fed’s zeal in combatting inflation has investors on edge regarding the potential for aggressive rate hikes and quantitative tightening to contribute to a U.S. recession. Over recent periods, good economic news has translated into bad news for markets as signs of continued strength in employment data have caused market participants to expect increased, or at least continuing, vigilance by the Fed as it wields its blunt inflation-fighting weaponry.

We believe earnings will come under pressure should labor markets stay tight, inflation remain elevated, impediments to global trade persist, supply chains adjust, and inventories continue to build. To isolate one of these facets, high inflation has always proven costly to corporate equity valuations. As this chart shows, when the rolling five-year CPI deviation is in excess of 1.8%, it exerts a gravitational pull on the S&P 500 price/earnings ratio as it increases the cost of capital for businesses. Not only is it increased through rates that must be paid on lines of credit, floating rate bonds, and through new debt issuance, but the decline in equity prices makes it more costly for companies to utilize their stock as currency for acquisitions. An additional headwind is the new 1% buyback tax anticipated to go into effect in January. Corporate share repurchase programs are likely to be pulled forward into this year in order to stave off the tax. Changes in tax policy influence capital allocation decisions, thus it could end up benefitting dividend-paying companies.

Although our outlook calls for inflation to eventually be contained over the three-year forecast period and we expect a normal recession, discretion dictates that equity exposures in the Asset Allocation strategies remain suppressed at this juncture. Among U.S. stocks, we find traditional valuation metrics of price-to-earnings, price-to-book value, and price-to-free cash flow to be favorable among lower capitalization companies, particularly mid-caps. We believe this should offer some protection in the event of a continued downturn in equity prices as well as an advantage when markets begin to recover. Beyond the U.S., given the strength of the U.S. dollar and the different monetary policies being pursued by global central banks, we anticipate headwinds in international equities for U.S.-based investors. This extends to emerging markets, especially due to the overwhelming influence that China wields, both through trade as well as its nearly 40% position in broad emerging market equity indices. The reduced foreign direct investment in emerging economies during this period of elevated sovereign risk is of further concern. Accordingly, despite attractive valuations overseas, the equity exposure in the strategies is entirely domestic. We retain the prior skew to value over growth, as it has existed since mid-2021. In the U.S. large cap asset class, we have elevated the relative overweights to the defensive sectors: Health Care, Consumer Staples, and Energy. The industry concentration of aerospace & defense is similarly elevated as a proportion of U.S. large cap exposures.

BOND MARKET OUTLOOK

The fervency displayed by the Fed in its attempt to eradicate excessive inflation encourages caution regarding the bond market. As of this date, all tenors of the Treasury yield curve one-year and beyond are inverted, indicating not only the market’s interpretation of an impending recession, but also the potential for the Fed to temper its fight and even pivot to a moderate or dovish stance in recognition that its vigor was too much and/or too late. Its data-driven approach has certainly made its future moves opaque. To a degree, this opacity has contributed to the worst bond market returns in over 30 years. Oddly, while market participants are viewing recession as a near certainty, spreads on investment-grade corporates remain close to the 100-year historical average. Although corporate balance sheets were buttressed during COVID through their staggering of maturities at attractive rates, thereby avoiding the debt refinancing wall, economic downturns, especially during bouts of inflation, have almost always led to a widening of spreads well above the historical mean. Due to our forecast, the strategies are positioned with a majority of the bond exposures in the short-intermediate segments of Treasuries.

One exception to this positioning is the introduction of a small allocation to long-maturity zero-coupon Treasuries in light of the potential for increased geopolitical strife. In the event of sovereign defaults beyond Sri Lanka and/or new manifestations of international belligerence, a long-term Treasury position is intended to function as a stabilizer. The other exception to the more conservative short-intermediate stance is an increase in BB-rated bonds within the speculative grade bond asset class, which serves as an equity surrogate, essentially moving up the capitalization structure of corporate balance sheets. Spec bonds hold high correlation to U.S. large cap stocks, yet with more muted volatility, especially in periods of economic retrenchment.

OTHER MARKETS

While REIT valuations appear compelling given that this sector of the U.S. equity market has suffered worse than others this year, we continue to regard the asset class with circumspection as offices, retail, and hospitality maintain their slog through the aftereffects of the pandemic coupled with difficulties typically experienced by REITs during economic contractions. Although we believe energy supply will be constrained by the Ukraine war, OPEC cutbacks, unrest in Iran, and lack of production investment, the potential for a global recession would not only offset the advantage of repressed supply, but also weigh on prices of other commodities. The exposure in the strategies to the commodity asset class, therefore, is now significantly reduced. Gold and broad-based commodities, with a concentration in energy, are now split equally as they can serve as havens during a period of near-term economic fragility and the potential for increased geopolitical risk.

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Asset Allocation Strategies Fact Sheet