Quarterly market outlook - Third quarter 2022
Our investment strategists provide the Edward Jones perspective on the latest economic activity and what it may mean for investors.
Our investment strategists provide the Edward Jones perspective on the latest economic activity and what it may mean for investors.
Since stock markets were turbulent, we’re taking this opportunity to answer a few common questions about bear markets.
Looking ahead, we believe the economic outlook for the next three months may benefit from solid household finances and job growth. We also think bonds may prove their value by helping buffer investors from stock market volatility, but we recommend a focus on quality*. Speculation is mounting about whether the U.S. is heading toward a recession after rising interest rates and tight energy supplies curbed the global growth outlook during the second quarter.
Keep reading for more details, or reach out to a financial advisor.
Source: Morningstar Direct, 6/30/2022. Cash represented by the Bloomberg US Treasury Bellwethers 3-Month index. U.S. investment-grade bonds represented by the Bloomberg US Aggregate index. U.S. high-yield bonds represented by the Bloomberg US HY 2% Issuer cap index. International bonds represented by the Bloomberg Global Aggregate Ex USD hedged index. International high-yield bonds represented by the Bloomberg Emerging Market USD Aggregate index. U.S. large-cap stocks represented by the S&P 500 index. Developed international large-cap stocks represented by the MSCI EAFE Index. U.S. mid-cap stocks represented by the Russell Mid-cap Index. U.S. small-cap stocks represented by the Russell 2000 Index. International small- and mid-cap stocks represented by the MSCI EAFE SMID index. Emerging markets represented by the MSCI EM Index. Past performance does not guarantee future results. An index is unmanaged and is not available for direct investment.
The chart above compares second-quarter returns with three-year annualized returns in fixed-income and stock markets. Short-term returns on cash, U.S. investment-grade bonds, U.S. high-yield bonds, international high-yield bonds and international bonds all trailed the multiyear average. The same was true for U.S. large-cap stocks, international large-cap stocks, U.S. mid-cap stocks, U.S. small-cap stocks, international small- and mid-cap stocks and emerging-market stocks.
For Q2, all asset class returns in our framework, excluding cash, were negative. International and domestic small-cap stocks were the worst performers amid equity market volatility, while fixed-income asset classes had relatively stronger performance than equities. International and domestic investment-grade bonds performed the strongest among fixed income, while widening credit spreads were a drag to high-yield investments.
Softening global growth — Tighter monetary policy and tight energy supply weighed on the global growth outlook. Central banks are rapidly raising interest rates and shrinking balance sheets to tame persistently high inflation globally. A variety of factors — including slow-to-return manufacturing capacity in China, tight oil supply with increased demand, and supply chain kinks that have led to slowdowns and shortages of goods — are triggering these price increases.
Heightened volatility — Equity markets closed out their worst first half of the year since 1970 amid heightened levels of volatility, with defensive sectors such as health care, utilities and consumer staples posting the strongest returns outside of energy. We see this as a sign that investors are increasingly worried about corporate profit growth. Small- and mid-cap stocks performed the worst, but they tend to have less pricing power in inflationary environments and perform worse than large caps during economic downturns.
Negative bond returns as yields rise — Bond returns were negative again in Q2, following negative returns in Q1. Rates have been rising at a fast clip as investors price in higher Federal Reserve interest rates. For fixed-income investors, the good news is that rates may have already peaked near the 3.5% mark and have slowly receded to around 3%.
Bear markets can trigger emotional responses and knee-jerk reactions to alter portfolios. But if your goals haven’t changed, neither should your strategy for reaching them. We recommend staying true to your long-term financial strategy developed with the help of your financial advisor.
Source: Edward Jones calculations, Bloomberg, Dow Jones Industrial Average; as of 12/31/2020.
Chart disclaimer: Past performance is not a guarantee of future results; indexes are unmanaged and do not reflect the performance of an actual investment.
The chart above compares average bull market and bear market returns since 1946. While returns in bear markets averaged negative 34% in the period, those in bull markets were about 167%. Some periods in the late 1950s, the late 1990s and the late 2010s topped 300%.
In Q2, the S&P 500 index fell into bear market territory, defined as a 20% or greater drop in value. Below are the questions we hear most often around bear markets.
In our view, it’s better to have time in the market than trying to time the market. Bear markets can be challenging but ultimately may offer a chance to diversify, rebalance and, over time, add quality investment to portfolios at better prices.
Source: FactSet, Edward Jones
The chart above shows widening unemployment preceded each recession since the early 1970s. First, joblessness rose 0.5 percentage points in the single month between an unemployment low of 3.4% in 1973 and the start of the subsequent recession. Next, joblessness climbed 0.3 percentage points over eight months between a 1979 unemployment low of 4.6% and the following recession. Later, unemployment gained 0.7 percentage points over seven months between a 1980 low of 5.6% and the next recession. Afterward, joblessness climbed 0.7 percentage points during the 16 months between a 1989 low of 5% and the next recession. In the 21st century, joblessness surged 0.4 percentage points over 11 months between a 2001 low of 3.8% and the next recession. Finally, unemployment spiked 0.6 percentage points over nine months between a 2007 low of 4.4% and the subsequent recession.
In response to stubbornly high inflation, central banks are hiking rates aggressively. At the same time, several economic indicators are pointing to a slowdown. While economic risks are increasing, solid household finances and strong job growth can help offset this. For the Federal Reserve to achieve a soft landing, we are looking for signs that inflation is slowing faster than economic activity.
Slower growth ahead — Consumer spending, the primary driver of the U.S. economy, has grown at a solid pace, supported by pent-up demand, a tight labor market and pandemic-era savings. As we move into the second half of the year and 2023, demand will likely slow as consumers and businesses react to the sharp rise in borrowing costs. Interest rate-sensitive sectors, such as housing, are usually the first to slow. But Fed policy tightening typically impacts the broader economy with a lag, which is why we expect GDP growth to fall below 2% this year and next.
Labor market not suggesting an imminent recession — While the economy is losing its momentum, the labor market still appears strong. Job openings are abundant, and the unemployment rate remains near historic lows. Historically, the unemployment rate rises by 0.5 percentage points, on average, ahead of recessions. The recent uptick in jobless claims signals that the pace of employment growth will slow in the second half, but we think conditions will support household incomes for the rest of the year.
Inflation and Fed policy in the driver’s seat — Inflation has broadened and proved stickier, which we believe means the Fed will keep its foot firmly on the brakes. While a lot of the factors driving inflation are outside central banks’ control, tighter financial conditions will impact demand, economic activity and, eventually, inflation. For the Fed to move more gradually going forward, we feel commodity prices and wage growth will need to soften.
We recommend reviewing your portfolio to ensure your equity-bond mix still reflects your risk tolerance. Maintain a neutral allocation to equities in line with your strategic portfolio target, and add quality bonds to help stabilize returns, if appropriate.
Source: FactSet, Edward Jones, 6/30/2022 . Past performance is not a guarantee of future results.
The above chart illustrates year-to-date returns for sectors of the S&P 500 index. Energy was the best performer, up 29.2%. Every other segment was in the red, with utilities losing 2%, consumer staples losing 6.8%, health care losing 9.1%, industrials losing 17.5%, materials losing 18.7%, financials losing 19.5%, real estate losing 21.2%, information technology losing 27.2%, communication services losing 30.5% and consumer discretionary losing 33.1%. The S&P 500 overall dropped 20.6%.
In Q2, the S&P 500 fell into bear market territory, down as much as 23% for the year before rebounding to around -20% year to date. Markets broadly seemed to reflect growing concerns of an economic slowdown or potential recession in the U.S., as defensive sectors of the market (such as health care, staples and utilities) held up relatively well. Overall, while downturns are never comfortable, they can offer long-term investors an opportunity to diversify, rebalance and ultimately add quality investments at better prices.
What could drive a stock market rebound? In our view, for markets to mount a sustainable rebound, we would need to see headline and core inflation move consistently lower. This would give the Federal Reserve room to tighten more gradually or even pause rate hikes, which would support market sentiment. In our view, this market recovery will likely take on more of a gradual “U shape” than the more recent and quicker “V-shape” rebounds in equity markets. Nonetheless, we anticipate inflation will moderate by year-end, driven by slowing year-over-year growth and better supply and demand dynamics overall.
Watch for earnings downgrades ahead — In this market downturn, we have already seen equity valuations come down meaningfully. For example, the S&P 500 index’s forward valuation of around 17x is 25% lower than where it started the year. But we have not yet seen adjustments to corporate earnings forecasts, which still call for 10% and 9.5% growth in 2022 and 2023. We expect to see downgrades to earnings growth in the months ahead, particularly for 2023 figures, as the impact of aggressive Fed rate hikes tightens financial conditions and slows consumption broadly. While earnings downgrades may be part of a bottoming process, historically, markets can rebound even as earnings growth slows.
We continue to favor more defensive positioning, for now. We prefer quality large-cap equities over small-caps, with a tilt toward value parts of the market. Sectors such as health care, consumer staples and industrials may perform better in this environment. Longer term, if inflation moderates, growth parts of the market may come back into favor as well. Investing in equities involves risks. The value of your shares will fluctuate, and you may lose principal.
Source: FactSet, Edward Jones
The chart above shows that peaks in the U.S. Federal Reserve’s benchmark Fed funds rate have preceded or coincided with periodic highs in 10-year Treasury yields since 1986. Markets are currently predicting the Fed funds rate will peak at 3.5% in the current tightening cycle.
After two years of ultra-low interest rates, an abrupt shift to tighter monetary policy triggered market shock waves. With the 10-year Treasury yield roughly doubling in the first half of the year, bonds posted their worst start to a year since at least 1973, failing to provide much-needed portfolio protection. The upside is that yields are now more attractive, suggesting improved future returns and the potential to put some cash to work.
Interest rates have reset higher — With the two- and 10-year government bond yields at nearly 3.5% and the federal funds rate at 1.75%, the bond market has already priced in an aggressive rate-hiking cycle. We think the bulk of the adjustment has already happened, and the downward pressure on bond prices will likely ease in the second half of the year. A 10-year yield around 3.5% aligns with market expectations and the Federal Reserve’s projection of what the peak policy rate could be. As the chart above shows , long-term government bond yields have converged near the peak of the federal funds rate for the cycle. We see an opportunity to gradually increase bond maturities, which would mean more interest rate risk, or reduce shorter-duration bonds to prepare for a potential peak in yields ahead.
Positioning for slowing growth — Amid geopolitical risks and recession anxiety, we think bonds can once again show their value by helping buffer against ongoing equity market volatility. But as the economy slows and borrowing costs rise, the credit environment becomes more difficult, which is why we recommend a focus on quality. As the economic expansion moves toward the late stage of the cycle, lower-quality fixed-income asset classes become less likely to outperform their higher-quality counterparts. U.S. investment-grade bonds strike the right balance, in our view, offering valuable income and diversification benefits within a balanced portfolio.
We recommend overweighting U.S. investment-grade bonds, offset by underweighting international investment-grade bonds. Based on our view of the business cycle, we recommend a neutral exposure in high-yield bonds, whose issuers tend to be of lower credit quality. Before investing in bonds, you should understand the risks involved, including credit risk and market risk. Bond investments are also subject to interest rate risk such that when interest rates rise, the prices of bonds can decrease, and the investor can lose principal value if the investment is sold prior to maturity.
Source: Morningstar, S&P 500, MSCI EAFE NR. The S&P 500 index and the MSCI index are unmanaged and cannot be invested in directly. Past performance does not guarantee future results.
The above chart compares rolling five-year returns in the U.S. and international markets, showing the periods in which each segment outperformed the other. The U.S. has been in the lead since 2009, with some returns topping 10%.
High inflation and more restrictive monetary policies will likely drive a slowdown in global economic growth into 2023. International equities have largely performed in line with U.S. stocks this year, suggesting these risks may already be reflected in global markets. We think an ongoing allocation to international investments is warranted but expect further volatility in the near term.
Foreign central bank tightening, geopolitical disruptions are headwinds — High inflation around the developed world has prompted global central banks to join the Federal Reserve in aggressively raising rates. A return to pre-pandemic conditions is likely to take longer in international markets given:
Stock, bond markets are pricing in economic risks — European government bond yields have surged, and equities have pulled back, indicating markets are braced for more restrictive monetary policy and weaker economic growth. The European Central Bank still has a ways to go in its tightening campaign. This will likely continue to weigh on global developed-market stock and bond returns in the short run, but there are conditions working in international investments’ favor. The nearly 20% pullback in international large-cap stocks already reflects a higher likelihood of recession in Europe. In addition, European markets are more value-oriented, with a lower weighting to technology and growth investments. Global earnings are still on the rise, although we anticipate a slower rate of growth ahead, and market valuations have fallen near the lows seen during the 2020 pandemic sell-off. We think this creates more favorable upside potential.
Emerging market stocks may have a catalyst — Emerging-market equities have been under pressure over the past year. Global growth has shown signs of deceleration, and China’s economy has suffered from new COVID-19 lockdowns. However, recent manufacturing readings show factory activity is picking up markedly in China. We believe this, along with a more stimulative policy backdrop, can support more positive emerging-market equity returns moving forward. Special risks are inherent to international and emerging-market investing, including those related to currency fluctuations and foreign political and economic events.
We favor international equities over bonds. We recommend an overweight position in emerging-market equities versus a neutral allocation to developed-market large-caps. We continue to recommend underweight positions in international bonds and small caps.
Our strategic asset allocation represents our view of balanced diversification for the fixed-income and equity portions of a well-diversified portfolio, based on our outlook for the economy and markets over the next 30 years. The exact weightings (neutral weights) to each asset class depend on the broad allocation to equity and fixed-income investments that most closely aligns with your comfort with risk and financial goals.
Chart disclaimer: Diversification does not ensure a profit or protect against loss in a declining market.
The charts above show Edward Jones’ view of balanced investment diversification over a 30-year period and a one- to three-year period. For the long term, the firm favors putting the bulk of assets in U.S. large-cap stocks; in bonds, it prefers U.S. investment-grade bonds for the majority of holdings. In the shorter term, the firm suggests an underweight position in U.S. small-cap stocks and an overweight position in emerging-market stocks. For fixed income, Edward Jones favors an underweight position in international bonds and an overweight position in U.S. investment-grade bonds
Our opportunistic asset allocation represents our timely investment advice based on current market conditions and our outlook over the next one to three years. We believe incorporating this guidance into your portfolio may enhance your potential for greater returns without taking on unintentional risk.
Source: Diversification does not ensure a profit or protect against loss in a declining market.
Equity and Fixed income underweight, neutral, overweight tables
It’s natural to compare your portfolio’s performance to market performance benchmarks, but it’s important to put this information in the right context and understand the mix of investments you own. Talk with your financial advisor about any next steps for your portfolio to help you stay on track toward your long-term goals.
|U.S. High Yield Bonds||-9.8%||-13%||0%||2%|
|Intn'l High Yield Bonds||-9%||-18%||-4%||0%|
|U.S. Large-Cap Stocks||-16%||-11%||11%||11%|
|International Large-cap Stocks||-15%||-18%||1%||2%|
|U.S. Mid-Cap Stocks||-17%||-17%||7%||8%|
|U.S. Small-Cap Stocks||-17%||-25%||4%||5%|
|International Small & Mid-cap Stocks||-17%||-24%||0%||1%|
|Emerging Market Stocks||-11%||-25%||1%||2%|
Source: Morningstar Direct, 6/30/2022. Cash represented by the Bloomberg US Treasury Bellwethers 3-Month index. U.S. investment-grade bonds represented by the Bloomberg US Aggregate index. U.S. high-yield bonds represented by the Bloomberg US HY 2% Issuer cap index. International bonds represented by the Bloomberg Global Aggregate Ex USD hedged index. International high-yield bonds represented by the Bloomberg Emerging Market USD Aggregate index. U.S. large-cap stocks represented by the S&P 500 index. Developed international large-cap stocks represented by the MSCI EAFE Index. U.S. mid-cap stocks represented by the Russell Mid-cap Index. U.S. small-cap stocks represented by the Russell 2000 Index. International small- and mid-cap stocks represented by the MSCI EAFE SMID index. Emerging markets represented by the MSCI EM Index. All performance data reported as total return. An index is unmanaged and is not available for direct investment. Performance does not include payment of any expenses, fees or sales charges, which would lower the performance results.
Chart disclaimer: The value of investments fluctuates, and investors can lose some or all of their principal. Past performance does not guarantee future results.
The above charts compare first-quarter performance in varying asset classes and stock market sectors with one-year, three-year and five-year returns. Among asset classes, cash was flat in the first quarter, U.S. investment-grade bonds fell 5.9%, U.S. high-yield bonds fell 4.8%, international bonds fell 4.1%, international high-yield bonds fell 9.2%, U.S. large-cap stocks fell 4.6%, international large-cap stocks fell 5.9%, U.S. mid-cap stocks fell 5.7%, U.S. small-cap stocks fell 7.5%, international small- and mid-cap stocks fell 8.5% and emerging-market stocks fell 7%. Except for emerging-market stocks, all classes performed significantly worse during the quarter than over the longer-term periods measured. In stock market sectors, communication services dropped 11.9% in the first quarter, consumer discretionary dropped 9%, consumer staples dropped 1%, financials dropped 1.5%, health care dropped 2.6%, industrials dropped 2.4%, materials dropped 2.4% and technology dropped 8.4%. The only gainers were energy, up 39%, and utilities, which rose 4.8%. Returns were lower for the first quarter than the longer periods for all sectors except energy, where the three-month period was the second-best of the time frames measured.
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