Midyear outlook: What’s next for the markets and economy?

July 8, 2022

THE ECONOMY AND FINANCIAL MARKETS have faced a number of extraordinary challenges during the first half of this year. Everything from high inflation, interest rate hikes and recession worries to the war in Ukraine, lockdowns in China and persistent supply chain issues have brought on waves of volatility and unnerved investors. After several turbulent months, on June 14, the S&P 500 Index — a key benchmark for U.S. equities — officially reached bear market status,¹ defined as a drop of 20% or more from its most recent high.

What could all of this mean for the rest of 2022 and beyond? We asked Chris Hyzy, Chief Investment Officer for Merrill and Bank of America Private Bank, for his perspective on what lies ahead and what investors could do now to prepare. For a deeper dive into the Chief Investment Office’s outlook, read The Great Separation To The Reset Period.

Q: What’s your outlook for where the economy, the consumer and corporate spending could go from here?

A: The impact of inflation and other issues troubling the markets this year has been different than in prior economic cycles. This time, although consumer confidence has registered at an all-time low, many consumers are continuing to spend and have relatively low debt levels and high employment, and most corporations, after many years of very low interest rates, are still flush with cash. They also have some pricing power that lets them pass along rising costs.

That said, looking ahead, companies are beginning to forecast lower growth, and they’re likely to face a much more difficult economic environment in the next 12 months. They’re starting to adjust hiring plans, and we’ve probably already hit the low point in terms of the unemployment rate. Still, as long as consumer spending remains strong, economic growth in nominal terms is likely to remain above what might normally be expected. That said, real growth, after accounting for inflation, will probably be thin this year.

Q: Speaking of inflation, do you expect it to start falling anytime soon?

A: The Federal Reserve’s preferred gauge of inflation is the Personal Consumption Expenditures (PCE) price index, and the Fed wants to see that come down to an average of about 2%. The PCE, which measures the change in the cost of goods and services consumed by all households, is close to 5% now, so it still has a way to go. But it has already fallen from much higher levels. The Consumer Price Index (CPI), which measures the change in out-of-pocket expenditures of urban households, is a lot higher than the PCE, and it will be hard for that to come down as quickly.

Q: The Fed hopes that its interest rate hikes will achieve a soft landing for the economy, with lower inflation — but no recession. How likely is that?

A: Although the risk of recession in 2023 was still low this past April, the overall risk has been rising each week. At this point, we do expect economic growth to fall further and that there will be an “earnings recession,” in which corporate profits turn negative. As the job market begins to bottom out, households will also slow down their spending. Ultimately, financial markets will try to price in this bumpy landing, first through much lower stock valuations — which we’re already seeing — and then corporate earnings should also come down. How far earnings fall and when they might begin to rise again will become clearer in the second half of the year and early next year as corporations begin to provide forecasts for all of 2023.

Q: Will the market volatility that investors have seen so far this year continue through the second half?

A: We expect above-average volatility for the next nine to 12 months. But volatility is only one of three Vs that investors should be thinking about. The second V is valuations — the price of a stock relative to a company’s actual earnings — which have already fallen to an attractive level for long-term investors. The third V, visibility, should improve early next year as companies are able to get a clearer view of the outlook for future earnings. Together these should set the stage for opportunities for investors.

Q: Where could investors look for new opportunities?

A: It makes sense for investors to move away now from the high-growth equities — such as some areas of technology — that have fueled the past several years of market gains and toward more defensive, higher quality, less volatile investments. That may include dividend-producing companies that have high free cash flow and don’t have to depend on capital markets when interest rates are rising. Investors who have surplus cash could think about rebalancing their portfolios into these types of investments to establish a good anchor for the next five to 10 years.

But other possibilities may be specific to this cycle, including the energy sector, which is emerging from 10 years of “de-investment.” While climate solutions and the transformation toward greener technologies will continue, we think the traditional energy sector is in the early stages of what could be long-term outperformance. Finally, the automation revolution across all sectors should drive productivity higher in the coming years as companies combat above-average inflation and a labor supply pool that remains low.

Q: Bond markets, like equities, have had a tough first half of the year. What’s the outlook for fixed income now?

A: This has been an extraordinarily negative year for both asset classes, with bonds not providing the kind of diversification benefit we would normally see. That should begin to change next year. Until then, yields may continue to rise, pushing bond prices down. But as inflation starts coming down, investors are likely to shift money into longer-term bonds. That should continue well into 2023, as fixed income again helps diversify portfolios. In the meantime, today’s higher yields will be welcomed by investors looking for income. A bond ladder — made up of bonds that mature at different times — could help investors take advantage of today’s environment. If rates are rising, investors could consider reinvesting the proceeds from maturing bonds to lock in higher yields.

Q:  Are there other kinds of assets that could help diversify portfolios?

A: In our view, this new cycle — which is very different from the past decade-plus cycle — could potentially be beneficial for alternative investments and specifically for real assets, including commodities. In addition, private equity and hedge funds, for investors who qualify, can help with diversification — which we consider to be the most important portfolio characteristic going forward.

Q: Looking ahead, what positive signs could encourage investors to keep investing for their long-term goals?

A: When things get most challenging, it can be hard to see the bright spots on the horizon. But for long-term investors, the first stage of improvement has been the valuation decline in equities that we’ve been seeing. The next stage involves corporate spending and profits. Spending will come down, but this time, unlike in past cycles, corporations aren’t dealing with a lot of debt.

Earnings will also fall, but once they bottom out, we expect them to grow at an attractive rate. And the combination of favorable demographics, the long-term housing cycle and automation should be additive to the level of economic profits overall.

Taken together, these factors should provide an attractive entry point for the next stage of the long-term bull market. For investors, it’s important to have a plan in place and to stay disciplined, perhaps using dollar-cost averaging to add to equity holdings. History has consistently shown that time in the markets — that is, staying disciplined and remaining invested even when volatility is at its highest — has always outperformed trying to time the market. And remember: Nobody rings a bell when the bottom of the market occurs.