Orienting in a Changing Investment Landscape
The 2020s have so far brought us some of the best times in the markets and some of the worst.
As we look to 2023 and beyond, it’s worth taking stock and reviewing our asset allocation.
There are plenty of factors at play, but the biggest by far is inflation. Unacceptably high and surprisingly persistent inflation, the consequence of poor fiscal and monetary policy in response to the pandemic, has forced the U.S. Federal Reserve to increase short-term interest rates sharply, with promises of more rate hikes to come. That’s driven up long-term interest rates from very low levels, to 3.8% from 1.5% in just 11 months, and forced down valuations across all major asset classes.1
When the Fed increases interest rates at this clip, a recession usually follows. At this juncture, the question really is whether it will be a mild recession – sometimes referred to as a rolling recession, in which case earnings are flat to slightly down – or a more meaningful recession, with earnings down 10%-20%. If it is a mild recession, then chances are that we have probably seen the market low for this bear market. However, if we have a recession that causes earnings to fall by 10% or more, we would expect the market to fall to new lows.
There are a number of reasons why we put a slightly higher probability on a mild recession, several of which are illustrated below.
First, we have a very strong jobs market, with a record number of open jobs relative to unemployed workers, and strong wage growth. So, we are a long way from a large increase in the unemployment rate that would usually accompany a major recession.
Second, U.S. household balance sheets are very strong, with relatively low debt levels, high net worth and considerable excess savings lingering from the government largess during the pandemic.
Third, a deep recession is almost always accompanied by a financial crisis. While it is admittedly difficult to identify a financial crisis before it happens, we do not see the early signs of one in the United States. The use of excessive debt, which is the usual precursor to a crisis, is at the government level this time around – as opposed to the corporate or household level. This has significant implications long term but should not cause the more typical financial crisis in the private markets.
Fourth, the pandemic and shift to remote and hybrid work has helped hone some great American companies. Superb management teams are generating record-high profit margins, even adjusting for low interest rates and taxes, and corporate earnings growth well in excess of overall economic growth. With reduced future profit expectations, it follows that solid returns can be achieved in the future if markets rise, a good thing considering that higher normal future returns will be required to overcome higher rates of inflation. This is an important positive factor worth keeping in mind against an admittedly still difficult backdrop.
Further good news is that even with a recession on the horizon, our 10-year expected returns for all the major capital market asset classes are up considerably from a year ago. We now expect close to 4% or more on cash equivalent investments. And we expect about a 4% tax-free return on high-quality municipal bonds, up from 2% or lower not that long ago, and about a 7% taxable return on credit strategies that take on credit risk. Most important, now that the valuations on stocks are back to, if not slightly below, historical averages, we believe the 10-year expected returns on stocks are close to the long-run returns of 9%-10%.
Here’s another, counterintuitive, positive. Negative news – which we have had plenty of this year – breeds negative sentiment, which historically bodes well for the markets. At present, we are at record lows on many measures of sentiment, which are reflected in current reasonable-to-cheap valuations. Lower valuations may set us up for favorable long-term future returns. Even the expected returns for international equity markets are up, due to extremely low valuations, which could be argued fully reflect current challenges – energy prices and a very strong U.S. dollar. (See Dollar Exchange Rates: Too Much of a Good Thing? by Brian Pollak here.)
There’s no doubt that 2022 has been a tough year in the markets. But we need to retain our perspective, keeping in mind that we previously enjoyed a 10-year strong bull market and truly extraordinary gains between March 2020 and the end of 2021. We are continually evaluating our portfolios and evaluating whether to take losses where possible to offset any realized taxable gains. We do see opportunities, among individual stocks that are at valuation levels well below their historical averages, and in extending maturities within our bond portfolios. We are also continuing to invest in real estate and other carefully selected illiquid alternative investments, which generally represent about 10% of our balanced portfolios.
The Fed has made it very clear that it will do whatever it takes to get inflation back down to an acceptable level. No one knows how long that will take. But we do know that, historically, high net worth investors are best served by riding out downturns and staying invested, remaining focused on long-term goals.
John Apruzzese is the Chief Investment Officer at Evercore Wealth Management. He can be contacted at apruzzese@evercore.com.
Note: Market yield on a 10-year U.S. Treasury bond. 10-year yield at 1.51% on December 31, 2021 and 3.81% as of November 18, 2022.
Disclosure:
Expected returns described are based on capital market assumptions and calculated net of fees. Stocks are defined as growth assets. Please refer to important additional information available on the disclosure page.
Evercore Wealth Management, LLC ("EWM") is an investment adviser registered with the U.S. Securities and Exchange Commission under the Investment Advisers Act of 1940. EWM prepared this material for informational purposes only and should not be viewed as advice or recommendations with respect to asset allocation or any particular investment. It is not our intention to state or imply in any manner that past results are an indication of future performance. Future results cannot be guaranteed and a loss of principal may occur. This material does not constitute financial, investment, accounting, tax or legal advice. It does not constitute an offer to buy or sell or a solicitation of any offer to buy or sell any security/instrument, or to participate in any trading strategy. The securities/instruments discussed in this material may not be suitable for all investors. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives. Specific needs of a client must be reviewed and assessed before determining the proper investment objective and asset allocation which may be adjusted to market circumstances. EWM may make investment decisions for its clients that are different from or inconsistent with the analysis in this report. EWM clients may invest in categories of securities or other instruments not covered in this report. Descriptions provided in this material are not substitutes for disclosure in offering documents for particular investment products. Any specific holdings discussed do not represent all of the securities purchased, sold or recommended by EWM, and the reader should not assume that investments in the companies identified and discussed were or will be profitable. Upon request, we will furnish a list of all securities recommended to clients during the past year. Performance results for individual accounts may vary due to the timing of investments, additions/withdrawals, length of relationship, and size of positions, among other reasons. Prospective investors should perform their own investigation and evaluation of investment options, should ask EWM for additional information if needed, and should consult their own attorney and other advisors. Indices are unmanaged and do not reflect fees or transaction expenses. You cannot invest directly in an index. References to benchmarks or indices are provided for information only. The securities discussed herein were holdings during the quarter. They will not always be the highest performing securities in the portfolio, but rather will have some characteristic of significance relevant to the article (e.g., reported news or event, a new contract, acquisition/divestiture, financing/refinancing, revenue or earnings, changes to management, change in relative valuation, plant strike, product recall, court ruling). EWM obtained this information from multiple sources believed to be reliable as of the date of publication; EWM, however, makes no representations as to the accuracy or completeness of such third party information. Unless otherwise noted, any recommendations, opinions and analysis herein reflect our judgment at the date of this report and are subject to change. EWM has no obligation to update, modify or amend this information or to otherwise notify a reader thereof in the event that any such information becomes outdated, inaccurate, or incomplete. EWM’s Privacy Policy is available upon request. EWM is compensated for the investment advisory services it provides, generally based on a percentage of assets under management. In addition to the investment management fees charged, clients may be responsible for additional expenses, such as brokerage fees, custody fees, and fees and expenses charged by third-party mutual funds, pooled investment vehicles, and third-party managers that may be recommended to clients. A complete description of EWM’s advisory fees is available in Part 2A of EWM’s Form ADV. Trust services are provided by Evercore Trust Company, N.A., a national trust bank regulated by the Office of the Comptroller of the Currency and/or Evercore Trust Company of Delaware, a limited purpose trust company regulated by the Delaware State Bank Commissioner, both affiliates of EWM. Custody services are provided by Evercore Trust Company, N.A. The use of any word or phrase contained herein that could be considered superlative is not intended to imply that EWM is the only firm capable of providing adequate advisory services. This material does not purport to be a complete description of our investment services. This document is prepared for the use of EWM clients and prospective clients and may not be redistributed, retransmitted or disclosed, in whole or in part, or in any form or manner, without the express written consent of EWM. Any unauthorized use or disclosure is prohibited. The Chartered Financial Analyst and CFA trademarks are the property of CFA Institute. Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner™ and CFP® in the U.S.
IRS Circular 230 Disclosure:
Pursuant to IRS Regulations, we inform you that any U.S. Federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for (i) the purpose of avoiding IRS imposed penalties or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. This information is provided for information purposes only and does not constitute financial, investment, tax or legal advice.
©2016 Evercore Wealth Management LLC. All rights reserved.
