Case in point, the S&P 500 Index gained 31% in 2019, 18% in 2020, and 29% in 2021—the best three-year streak since the 1990s.1 This massive rally in stocks started to reverse course in early 2022 as stimulus faded and central banks began tightening aggressively to fight elevated inflation. Looking forward, we expect the cycle to continue to age rapidly as we move from a late-cycle environment toward a likely recession. While this may limit the return potential in stocks, we believe the income that can be earned on bonds is compelling—and something investors may find they need to consider given the challenging economic backdrop.
Let the cycle be your guide
In our view, one of the most important determinants to cross-asset returns is the economic cycle. Our analysis suggests that investors historically tend to get rewarded for taking risk early in the cycle (when the economic data stops deteriorating and gradually shows signs of improvement) and benefit from pruning risk later in the cycle (as the data starts to worsen). Today, the U.S. Composite Index of Leading Indicators (LEI)—historically, one of the most accurate guides to the cycle—has been in negative territory year over year for three consecutive months. This suggests that economic growth is decelerating and that a recession is likely imminent. Historically, the S&P 500 Index and the LEI often bottom around the same time. As shown below, a typical bottom for the LEI occurs at around the –10% mark. At the current rate of deceleration, our analysis suggests that point would be reached in about 8 months, putting the worst of the recession in or around mid-2023.
Income opportunities abound
One of the most notable dynamics across markets in 2022 has been the sharp move higher in bond yields. To take just one example, the yield on the 10-year U.S. Treasury moved from 1.5% to start the year to over 4.0% in November as markets priced in persistent inflation, a hawkish U.S. Federal Reserve (Fed), and higher commodity prices. Since we believe inflation concerns will be eclipsed by growth concerns in 2023—leading the Fed to start cutting rates in the back half of the year—we find the income offered by bonds as extremely attractive, especially relative to other investment options. In addition, the income investors can now earn on bonds is generally high enough that the asset class can potentially offer solid forward-looking returns even if there is some future volatility in rates. In our opinion, we’re bullish on investment-grade corporates, mortgage-backed securities, and municipal bonds, all of which offer a favorable combination of moderate risk and an appealing total return potential.
Looking for value in an economic downturn
As the LEI continues to deteriorate, we want to look for parts of the equity market that have already priced in the prospect of a recession. Broadly, U.S. stocks are now cheaper than they were 20 years ago, as the forward price-to-earnings ratio has dropped from about 21x to roughly 17x today. In fact, investors are now paying less for 2023 S&P 500 Index earnings than they were at the beginning of the year. Within the U.S. equity market, mid-cap value stocks offer the steepest discount relative to other parts of the style box. The S&P MidCap 400 Value Index is now trading at 12x forward earnings—near the same level it was trading at during the global financial crisis in 2008. While macroeconomic data may still deteriorate from here, given that mid-cap value stocks are currently trading at recessionary levels, we believe they can offer significant value relative to other equity market segments.
Darkest before the dawn
It has no doubt been a tough year for investors with monetary and fiscal policies no longer supporting markets, creating headwinds for both stocks and bonds. However, long-term investors have historically benefited from seeking value in stocks during recessionary periods. In fact, the average returns for the S&P 500 Index coming out of a bear market are nearly 40% on a 12-month basis and almost 16% annualized on a three-year basis. In our view, bonds may do more of the heavy lifting within a balanced portfolio heading into a recession in 2023, while equity investors are likely to do better on the way out as economic data recovers. By adapting portfolios to the stage of the economic cycle, we would look to increase higher-quality bond exposure heading into the new year and then look to increase equity exposure when a new cycle begins.
1 FactSet, as of 10/31/22.
Investing involves risks, including the potential loss of principal. Events in the U.S. and global financial markets, including actions taken by the U.S. Federal Reserve or foreign central banks to stimulate or stabilize economic growth, may at times result in unusually high market volatility, which could negatively impact performance. Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities include a higher risk of default. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, and may be subject to early repayment and the market’s perception of issuer creditworthiness. Value stocks may decline in price. The stock prices of small and midsize companies can change more frequently and dramatically than those of large companies.
Views are those of the authors and are subject to change and do not constitute investment advice or a recommendation regarding any specific product or security. This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. No forecasts are guaranteed. Any economic or market performance is historical and is not indicative of future results.
The Bloomberg U.S. Aggregate Bond Index tracks the performance of U.S. investment-grade bonds in government, asset-backed, and corporate debt markets. The Bloomberg U.S. Corporate High Yield Bond Index tracks the performance of the U.S. dollar-denominated, high-yield, fixed-rate corporate bond market. The Bloomberg U.S. Corporate Investment Grade Index tracks the investment-grade, fixed-rate, taxable corporate bond market. The Bloomberg U.S. Mortgage-Backed Securities (MBS) Index tracks the 15- and 30-year fixed-rate securities backed by the mortgage pools of Ginnie Mae, Freddie Mac, and Fannie Mae. The Bloomberg U.S. Treasury Index tracks U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. The Composite Index of Leading Indicators (LEI) is published monthly by The Conference Board and tracks 10 economic components whose changes tend to precede changes in the overall economy. The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The S&P MidCap 400 Value Index tracks value companies in the S&P MidCap 400 Index. It is not possible to invest directly in an index.