Market Outlook

December 31, 2022

In 2022, a confluence of factors led to the sharpest decline in a portfolio comprised of 60% equities and 40% fixed income in years. High starting valuations in equity markets and initially low interest rates set the stage for declines in both asset classes. When Russia’s invasion of Ukraine, persistently high inflation, and the Federal Reserve’s (the Fed) monetary policy tightening were added to the mix, the result was a significant compression of both equity and bond prices. As we look forward to 2023, we expect continued volatility, followed by stability and potentially reaccelerating GDP growth later in the year. Consequently, we anticipate opportunities to position portfolios for a subsequent economic acceleration. Equity returns are likely to start the year with continued volatility, but stocks are increasingly attractively valued, and we anticipate increasing client exposure to equities – and risk assets within equities – throughout the year. Interest rates are now high enough that prospective fixed income returns should be in line with historical norms, and we see opportunity across the fixed income spectrum. Alternative investments have not yet fully reflected the impact of higher real interest rates; we expect that to the extent that alternative investments get marked closer to the values already reflected in public markets, private market valuations may pause or even decline.

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Macroeconomic Outlook

The biggest dynamic of 2022 was higher-than-expected inflation and the Fed’s tardy response. The Consumer Price Index (CPI) has moderated from a 9.1% peak in June 2022 but remains well above the Fed’s long-term target of 2%. The Fed attempted to compensate for its late start by embarking on a rapid path of monetary tightening, both increasing the Federal Funds rate at the fastest pace in over 40 years and reducing the size of its balance sheet at a pace of $95 billion per month. As the Fed increased short-term rates, the yield curve became more inverted, with shorter-maturity bonds yielding more than longer-maturity bonds. This inversion is one of the key reasons investors are concerned about a recession in 2023 – historically, yield curve inversions have been followed by recessions. At the same time, long yields also increased: the 10-Year Treasury Bond yield increased by over 2.3 percentage points during 2022. This increase in longer rates is putting downward pressure on assets whose value is far out into the future, including growth stocks and long-duration bonds.

We expect that 2023 will be a continued tug-of-war playing out between the Fed attempting to quell inflation by tightening monetary policy and episodic fears of recession as various areas of the economy weaken in response. Because the labor market has remained unusually strong in the face of a slowing economy, the Fed may keep interest rates higher for longer than the markets initially anticipated. This tighter monetary policy regime is what will cause continued high volatility as we enter 2023.

The US dollar strengthened notably in 2022, capping a 10-year run of strengthening versus other major currencies. This may be in the process of reversing (the dollar has been weakening since September); if so, it would indicate non-US assets may be a compelling investment at some point this year, for the first time in many years.

The complexion of the equity market clearly changed in 2022, with the large-capitalization growth darlings of the previous decade struggling as a result of both nominal and real higher interest rates. Earnings estimates are still likely too high for 2023 given a slowing economy, but valuation excesses have largely been squeezed out of domestic equity markets. Even if earnings decline by as much as 20% in 2023, measures such as a 5-Year Schiller Cyclically Adjusted Price to Earnings (CAPE) ratio suggest that large-capitalization stocks are fairly valued or even cheap. Value stocks, smaller-capitalization stocks, and international stocks are all even less expensive, and may all outshine large-capitalization US stocks. Any volatility resulting from estimate declines will provide opportunity to position portfolios for economic acceleration as we exit 2023 and look to 2024.

Fixed income investments are currently significantly more attractive than they were at the start of 2022, given the higher starting rates and the associated higher yields on offer. Although uncertainty around Fed policy may cause gyrations in fixed income markets in the near term, we anticipate increasing exposure to risk assets as clarity increases around an economic reacceleration. We favor Treasury bonds over corporate bonds and envision reversing this opportunistically. Finally, for the first time in a dozen years, cash may be a legitimate asset class as 3-month Treasury Bills are yielding over 4%.

Alternative investments have not yet fully reflected the valuation reduction that we have seen in public equity and fixed income markets caused by higher interest rates. As these less-liquid investments are marked to market, valuations may pause or even decline. This anticipated weakness will provide more attractive opportunities to allocate funds to private markets.

Looking forward, equity and fixed income markets may begin to anticipate economic recovery later this year and into 2024. When combined with undemanding valuations, we believe this will present the opportunity for solid long-term investment returns.


Equity Markets 

Global equity markets closed out 2022 with the same weakness that characterized the year as a whole. After a remarkable 14% rally from the lows in October through November as inflation data began to improve, the S&P 500 gave up almost half of those gains in December and finished the year with a total return of -18.1%.

While an 18.1% loss is problematic enough, these losses have also been compounded by inflation. We will not have full-year CPI data until mid-January, but the current consensus estimate for the year stands at 6.7%. The loss of purchasing power from inflation can be added to the total return in the stock market to calculate the “real” return. The 25.6% loss in 2022 by this measure stands as the sixth worst year on record for the S&P 500, and has been exceeded only by 1946, 1931, 2008, 1937, 1974 in ascending order of losses. The chart below illustrates the rarity of losses of this scale, but the consensus among investment strategists seems to be that we are due for more volatility for at least the next 6 months.

There are many reasons to expect ongoing stock market volatility, and we remain focused on the disconnect between the economic outlook and corporate earnings estimates as noted in our recent market updates.  While S&P 500 earnings estimates for 2023 have declined since our last update, they still reflect an expectation of 6.7% growth next year.  At the same time, recession risk is unusually high given the inverted yield curve and the decline in the Leading Economic Index (LEI).  Earnings often fall 10-20% in a recession and we continue to see lofty earnings expectations as a significant challenge for stocks to overcome in 2023.

While earnings expectations for next year still appear too high, longer-term valuations are becoming appealing.  When corporate profits are unusually volatile at economic turning points, it can be helpful to consider current prices relative to a rolling 5-year average of corporate profits rather than the profits of a particularly good or bad year.  The blue line in the chart below displays this measure for the S&P 500 going back to 1958.  The 21.1x median valuation over the past 40 years (the beginning of the low inflation era) is displayed as a dotted red line. This valuation measure declined precipitously in 2022 to 22.6x, which is just above that long-term median but well above the valuation levels reached in the crisis environments of 2002 and 2008. There is not much evidence of a severe downturn or credit crisis at this time, so we expect a more modest decline in valuations and earnings in 2023. Over the next year, this five-year average will incorporate 2023 earnings that replace 2018 earnings, which were more than 30% below the 2022 level.  In fact, if we replaced the 2018 earnings in this measure with a 2023 estimate 20% below 2022 earnings, the S&P 500 would only need to drop 4% to match that 40-year median valuation of 21.1x.

Equity valuations could drop further as the stock market grapples with declining corporate profits, but we are likely to view this as a long-term investment opportunity.  One risk of this approach is that valuations from the past 40 years of increasing productivity and profitability could become irrelevant if the Fed fails to contain inflation.  This risk is highlighted by the valuations of the 1970s, which were persistently lower than in subsequent decades.  This may not be a perfect parallel because the economy has changed significantly since then: population growth is slower, businesses are less focused on commodity intensive production and more on services, and technology continues to increase productivity.

We remain mindful of emerging long-term inflation risks and short-term corporate earnings risks, while also considering the increasingly enticing long-term valuations.  For the moment, we remain cautiously positioned with a bias towards high quality and reasonably valued shares, but with an eye to use meaningful further weakness in equity markets as an opportunity for long term investment, barring further disruption to the economic outlook.  At this point, stocks look poised for a period of volatility that leads to modestly positive returns in 2023 and a brighter outlook by the end of the year.


Fixed Income Markets

In 2022, interest rate volatility spiked, and yields surged higher as the Fed embarked on the most aggressive monetary tightening campaign in forty years. After 4.25% worth of rate hikes in fewer than twelve months, the Fed seems ready to slow down and gauge the effects. As the dust settles and the calendar turns, interest rates are meaningfully higher, credit spreads are modestly wider, and the yield curve is deeply inverted. In addition, 2022 saw inflation become broad-based and US economic growth slow. As the US economy weakens, the Fed’s singular focus on subduing inflation creates a challenging backdrop for lower-rated fixed income securities. Alternatively, we see better value in high quality sectors such as investment grade corporate bonds and Treasury Inflation Protected Securities (TIPS). As we look beyond anticipated market volatility, we expect to have ample opportunities to position fixed income portfolios at attractive yields and for the long term. We expect higher market yields to improve the diversification benefits and the total return outlook for bonds going forward.

When evaluating the potential paths of interest rates in 2023, we see a wider range of possible outcomes than previous years. Barring a market shock, a continuation of the current economic path seems most likely, which is one of stubborn but declining inflation, lackluster GDP growth, and a Fed with a high bar to loosen financial conditions. In that environment, the 10-Year Treasury Yield has likely peaked in this economic cycle, (4.24% in October) and may do most of its trading between 3.5% and 4%. In this scenario, the curve remains inverted and credit spreads are likely to drift wider. Other less likely economic outcomes include a soft landing, a deep recession, or stagflation. A soft-landing scenario is one where inflation declines meaningfully without much harm to the US economy. In this situation we would expect a decline in interest rates, which would buoy risk assets. A deep recession scenario would also lead to much lower rates across the yield curve as the Fed may be compelled to reduce the Federal Funds Rate. Stagflation is arguably the worst-case scenario, one that is characterized by unchecked inflation and economic stagnation. In this case the Fed would have to move short-term interest rates much higher than expected, with resulting damage to the economy. The curve would likely invert further, and risk assets would suffer. In most other outcomes, we believe that the shape of the yield curve will normalize and become less inverted. We expect this to be driven by an eventual decline in short-term rates, which should prove positive for markets.

Heading into 2023, we favor corporate bonds of high-quality issuers due to their reasonable spreads and strong company balance sheets. At +130, the Option-Adjusted Spread (OAS) of the Bloomberg US Aggregate Corporate Index is slightly higher than its 30-year median. Similarly, the spread of the Bloomberg US Corporate High Yield index sits at +447, also slightly above its 30-year median. While neither offers exceptional value, we favor investment grade due to our expectations of increased defaults and credit deterioration in lower credit quality cohorts. Within government securities, we maintain an overweight to TIPS, with the belief that inflation protection looks underpriced by the market. Based on TIPS breakeven rates, the market expects inflation to average 2.25% over the next two years. Given the most recent US CPI measuring 7.1% and the market’s recent history of underestimating inflation, we think that future inflation estimates could be wrong again. Municipal bond issuers also look strong from a credit perspective, and they maintain the valuable tax exemption, but the sector currently looks over-valued.

History will view 2022 as an unpleasant year for fixed income returns, with unrealized losses in bond principal, caused by the dramatic increase in interest rates. As the 5-Year Treasury Yield went from 1.25% to almost 4%, the Bloomberg Intermediate US Government/Credit Index returned -8.2%, the worst total return in its history. Notably, the index has generated negative total returns in only 4 of 49 years, with two of those coming in 2021 and 2022. With pain in the rear-view mirror, the index now boasts a healthy 4.55% yield to maturity, its highest yield to begin a year since 2007. For this primary reason, fixed income should provide improved diversification benefits and higher total returns in the years ahead.

Fixed Income Focus: Cash as an Asset Class 

An overlooked beneficiary of the Fed’s rate raising campaign is the yield on short-term cash instruments. While “zero interest rate policy” (ZIRP) seems like a distant memory, it was as recently as February that the US 3-Month Treasury Bill yielded a mere 0.30%. Now, ten months and seven rate hikes later, the current 3-Month Treasury Bill yields 4.33%. In addition to individual bonds, higher yields have crept into bond mutual funds and ETFs as underlying securities mature and are reinvested at higher rates. With money market fund yields approaching 4%, is cash now a viable asset class? On one hand we would say yes; utilizing a tactical cash allocation provides a free option to wait out any anticipated market volatility at an attractive yield. Cash was also one of the best performing asset classes in 2022. On the other hand, the “invisible tax” of inflation may cause real returns to remain negative. In other words, a 4% nominal return only looks good if inflation falls back to historical trends. It is also important to note the perils of market timing and the importance of sticking to an asset allocation, even in times of volatility. Missing even a few of the best days in nascent equity bull markets can severely diminish future returns.


Sustainable Investing

As we look back on sustainable investing in 2022, our outlook for a more challenging market growth and product development environment as industry standards and regulations developed was on the mark. What we underestimated was the level of politicization and backlash as confusion around sustainable investing went mainstream. The media, politicians, and even a major electric vehicle company CEO created a cacophony of confusion as they tied ESG to values-based exclusions around oil and gas, weapons, and even failed government policies. Against this backdrop, the investment industry has retrenched and reevaluated its sustainability marketing, creating a foundation for improved transparency and future growth.

As we have discussed many times in our communications, ESG is simply the analysis of material environmental, social, and governance risk factors. It is not values-based exclusions, thematic growth opportunities, or impact (please see our 2022 Q2 Market Outlook Sustainability article for more detail). The investment industry is increasingly centering on this understanding of ESG and differentiating ESG from these other sustainable investing approaches. The CFA Institute ESG Disclosure Standards along with European regulations and proposed SEC guidelines have started to create momentum toward a common language. The keys to combatting confusion and greenwashing are a common language, improved communication, and increased transparency.

Emerging standards and regulatory scrutiny have put a spotlight on sustainability marketing claims and fund classifications. The US- SIF, a long-standing industry organization, modified guidelines for fund inclusion in their biennial sustainable investing industry survey. The recently released 2022 report shows total sustainable assets under management (AUM) in the US of $8.4 trillion, down from $17.1 trillion in 2020, as firms deemed to have insufficient disclosure were no longer counted in the latest report.

The retrenchment and reevaluation of sustainable funds in the US and around the world in 2022 is a healthy development. F.L.Putnam has carefully distinguished between sustainable investing approaches because we know that each has distinct risk and return characteristics, and clients have a range of implementation needs. We are encouraged to see the broader industry moving beyond marketing taglines and toward better communication of the detail and nuance that matters in this part of the market. Our hope for 2023 and longer-term is that some of this clarity feeds through to the broader conversation around sustainability in media and political circles.

For 2023, our top 5 trends to watch are:
1.      Regulatory developments lead to additional refinement of fund development and marketing
2.      Corporations are pressured to provide consistent disclosure, improving credibility of data and targets
3.      Private market investors seek greater detail and transparency around sustainability approaches
4.      Climate adaptation increasingly an area of focus for investors as are biodiversity and natural capital
5.      A growing acceptance of credible improvement or transition plans at corporations


A note on improvement and transition opportunities:

An improver is a company moving toward better management of its ESG risk, while a transition company is one where the mix of products or services is shifting to something more environmentally or socially beneficial.

An academic paper published in April of 2022, ESG Rating Score Revisions and Stock Returns, explored the effects of ratings changes on stock returns over medium-term holding periods. Among many interesting conclusions, the authors found a 3-percentage point spread between upgraded and downgraded stocks and note that downgraded stocks experience a drop in return on assets relative to upgraded stocks after a revision. The takeaway is that ESG ratings changes can contribute to relative performance as investors assess the information content of revisions including fundamental factors.  It is increasingly important for investors to assess the potential for ESG rating changes along with other return drivers in active investment strategies. Identifying improvers may well add value over time.

In contrast to changes at the margin around ESG risk ratings, transition opportunities are more about a shifting business model or product/service mix. Recent research from Morgan Stanley identified businesses that are transitioning toward more environmentally beneficial products or services. One notable conclusion from the report was the relative performance spread between utility companies that are actively shifting from a higher carbon intensity toward a lower carbon profile and those that have already lowered their carbon footprints. From the end of 2014 through mid-2022, Morgan Stanley’s “Active Rate of Change” basket outperformed the lower carbon intensity utility basket by about 8% per year. In this case, shifting from higher-cost coal generation to lower-carbon and lower-cost sources of generation has been beneficial both economically and environmentally.

While there are opportunities ahead for both ESG improvers and environmental transitions, it is important to note that these businesses often don’t “screen” well on traditional sustainability metrics for most sustainable investors. Therein lies the challenge and the opportunity.  Our approach to both improvers and transitions is to focus on the details, assess past performance, current targets, and likelihood of success. We will explore these opportunities in more detail in future letters.


Alternatives: 2022 in Review and 2023 Outlook

2022 in Review:

Alternatives broadly held up well for 2022, as fundamentals in the economy remained resilient despite growing macroeconomic headwinds. Performance differences across asset classes were primarily driven by whether market participants were on the right or wrong side of the dramatic increase in interest rates. For example, while real estate valuations have begun to decline, stabilized properties with fixed financing largely held their values as Net Operating Income (“NOI” – the primary valuation variable) remained robust. For private equity, valuations were steady as both earnings and margins remained stable. Within the alternatives asset class, variability was driven by differences in commodity exposure, interest rate exposure, and the degree of hedging of floating rate debt. Broadly speaking, income-producing assets, particularly real assets tied to energy and agricultural commodities, performed best for the year.

Despite the aforementioned resiliency, there were pockets of weakness within private markets. Late-stage venture capital and growth equity that had priced at very high valuations in 2020-2021 exhibited the beginning of a markdown cycle in concert with public growth equities. For loss-making early-stage businesses, we expect that capital markets will remain shut for at least the short- to medium-term. Similarly, real estate developers, which typically borrow at floating rates until properties are stabilized, found it extremely difficult to source fixed-rate financing and thus to achieve reasonable sales valuations. In many instances, underwritten cap rates for expected sales values were below prevailing financing rates. Referred to as “negative leverage,” this implies that prices need to decline until a market-clearing level is achieved. In addition, investors in private markets are struggling with the “denominator effect.” Because public asset values have declined more quickly than private asset values, portfolios comprised of both have drifted far from their targeted allocations. With transaction activity slowing dramatically in private markets as a new valuation/leverage paradigm is established, managers are likely to call more commitments than make distributions in the near-term. Allocators are concerned that portfolios will drift even further from target allocations and become less liquid as the market enters a period of higher uncertainty.

2023 Outlook:

While private market valuations follow public market valuations over the long term, illiquidity means that shorter-term valuations change more gradually in private markets. Thus, private market valuations generally avoid the positive or negative excesses observed in public markets. Private market valuations do partially reflect changes in public market multiples, growth rates, margins, and other asset-class-specific valuation factors; however, forecasting and discounting processes smooth these private market valuations over the short term. We believe liquidity will be a crucial factor in determining the path of private market performance in 2023. Weaker businesses used a variety of tactics to avoid marking valuations down in 2022, effectively kicking the can down the road with respect to valuations. However, those that run out of liquidity in 2023 may be forced to transact at valuations that are meaningfully below their current carrying values.  While individual assets and strategies may be able to outperform on their own merits, general market conditions suggest 2023 will be an environment that presents more downside risk to prevailing valuations. As a result, liquidity providers should be compensated with strong risk-adjusted returns going forward across asset classes.

With respect to providing liquidity to the market, we are actively working towards opportunistic allocations within “distressed” and “secondaries” strategies. Distressed strategies capture a wide range of transaction types, from relatively liquid mis-priced market credit, bespoke lending structures such as capital solutions or rescue financing, and deep distressed restructurings, such as buying heavily discounted debt, leading creditors committees, converting debt to equity, and eventually selling or re-listing a business. While credit spreads widened in 2022 and improved opportunities for more liquid trades, the deep distressed opportunity set in which private equity-like returns can be earned has not yet arrived. An increase in defaults, particularly of higher quality businesses, is what we and these managers are looking for before deploying significant capital. Compared to the V-shaped recoveries that followed every brief market sell-off of the past 10+ years, we expect a more prolonged and attractive opportunity set within distressed over the coming 2-3 years, as levered balance sheets struggle to refinance debt at higher interest rates. Within secondaries strategies, it is typically the sellers rather than the underlying assets that require liquidity. This is because while the underlying assets may be performing in line with expectations, a seller that needs liquidity may be willing to sell for a more material discount than normal. We expect the volume of transactions in secondaries markets to materially increase in 2023, because of both the private/public mix sift issues visible in 2022, which reduce the capital available to private markets managers, and the likely increased capital calls across the private market universe in 2023.

Importantly, weakness in legacy private market allocations typically creates robust opportunities for new allocations. With institutional balance sheets constrained and fundraising periods for funds thus likely to be extended, we expect compelling idiosyncratic opportunities to allocate after funds have deployed some of their capital. This will give nimble investors the ability to find funds late in their marketing periods where blind pool risk has been minimized and there is  opportunity to buy into appreciated assets at a discount.