Capital Markets Playbook | Q3 2022

• Equity markets finished lower for a third consecutive quarter as the Federal Reserve tightened monetary policy in hopes of deterring rising inflation.
  • U.S. equity markets experienced large declines across all sectors with small cap and growth stocks leading the plunge.
  • Continued strength in the U.S. dollar led to large declines in Non-U.S. equity. Non-U.S. value stocks outperformed Non-U.S. growth stocks by a fairly wide margin.
  • A large number of broad equity market indices have entered into “bear market territory” as prices have declined more than 20% from recent peaks.
• Fixed income markets are off to the worst start in more than 50 years as inflation and expectations for aggressive monetary policy interventions forced large bond sell offs.
  • All major fixed income asset classes sold off in the second quarter, including those with the highest credit quality (ex: Core Fixed Income).
  • Fixed income assets that exhibit higher risk characteristics (ex: high yield) sold off the most in the second quarter as investors became more concerned over future economic growth.

• While COVID-19 case counts and hospitalizations remain near the lowest levels of the pandemic, new variants continue to develop.
  • The latest variants may result in COVID-19 “surges” before the end of the year.
• COVID-19 variants may continue to create challenges for years to come, but COVID-19 is becoming more manageable in 2022.
  • Vaccinations greatly reduce the potential for severe disease, hospitalizations and death.
  • Health care professionals have made tremendous progress with treatment procedures and have dramatically improved patient recovery times.
  • New, less invasive vaccinations and therapies are likely to continue to hit the market in 2022.
  • The combination of infections and vaccinations has the U.S. population getting closer to “herd immunity.”
• Takeaways
  • The seriousness of the current or future COVID-19 variants should never be discounted, but the pandemic may show signs of evolving into an endemic in 2022.
  • The potential of “economic shutdowns” are lower than they have been since the beginning of the pandemic.

• The Federal Reserve uses its monetary policies to achieve its dual mandate of:
  • Full employment
  • Price stability
• With inflation running high and unemployment close to pre-pandemic levels, the Fed has communicated its commitment to significantly tighten monetary conditions in 2022.
• The Fed believes that its monetary policy interventions will help slow inflation without creating significant increases in unemployment (i.e. “soft landing”).
  • Higher levels of unemployment, sticky inflation and an economic recession cannot be ruled out, however.
• Takeaways
  • Inflation is likely to fall meaningfully over the next few quarters, but remain above the Fed’s 2% target through the end of 2023.
  • Despite the Fed’s hope for a “soft landing,” there is a growing risk that unemployment levels increase in the quarters ahead as tighter monetary conditions dampen overall economic activity.

• The Federal Reserve has communicated its anticipated plans for rate hikes in 2022, which will likely change as facts and circumstances evolve.
  • Fed policy rate at the end of 2022: 3.25% - 3.5%
  • Fed policy rate at the end of 2023: 3.75% - 4.0%
• As a result of softer-than-expected macroeconomic data, however, markets are beginning to price in rate cuts as early as April 2023.
• Takeaways
  • The Fed will continue with its current plans to raise rates if inflation remains high and unemployment remains low.
  • The Fed will likely pause its interest rate hikes if economic conditions warrant a less aggressive monetary policy.
  • Fed communication will continue to move markets in the quarters ahead and market volatility will likely remain elevated until market participants are more certain about the path of Fed rate hikes.

• Despite the recent explosive growth in inflation, forward looking inflation expectations remain somewhat “anchored” to the Federal Reserve’s inflation target of 2%.
• Market-implied inflation expectations have declined meaningfully in the second quarter of 2022.
  • Market-based inflation expectations have declined about 20% (on a relative basis) since the end of April 2022.
  • Example (see chart):
    • In April 2022, the market expected inflation to be 5.1% in one year’s time.
    • In June 2022, the market expected inflation to be 4.3% in one year’s time.
• Takeaway
  • Even though inflation has dominated the market’s attention in 2022, market participants are not concerned about runaway inflation over the intermediate and long term.

• U.S. economic growth projections have declined in recent weeks as investors discount the prospect of tighter monetary policy interventions from the Federal Reserve.
• The decline in growth projections reflects growing concern that economic activity in the U.S. will contract at some point in 2022.
  • The majority of market analysts still anticipate above trend economic growth in 2022, but the risk of a recession cannot be ruled out.
• Takeaway
  • The prospects of higher interest rates will likely have a more meaningful impact of future economic growth in the U.S. than any other macroeconomic variable.

• If the U.S. does fall into a recession in the near term, investors should remember that periods of economic decline are typically short term in nature.
• Historically, recessionary periods are relatively short lived.
  • Since 1945, recessions in the U.S. have averaged 10 months in duration.
    • In the past 100 years, only one recession has lasted longer than 2 years (Great Depression).
  • Since 1945, expansionary periods have averaged 64 months in duration.
• Takeaway
  • If the U.S. enters a recession in the short term, it is likely that any decline in economic activity would be short term in nature.

• In addition to being short term in nature, it is likely that any recession in the U.S. will be mild relative to other recessionary periods.
• Consumers and businesses are in relatively strong financial positions and more likely to ride out economic headwinds than during previous economic slowdowns.
  • Households have a high level of savings available.
  • Household debt service are near multi-decade lows.
  • Corporate balance sheets are strong.
• Takeaway
  • Businesses and consumers are in a healthy financial position which should help limit the magnitude of any decline in overall economic activity in the U.S.

Household Debt Payments
(As a Percentage of Income)

• The S&P 500 declined 21% in the first half of 2022, the largest first half decline in more than 50 years.
• There have been five occasions where the S&P declined by at least 15% in the first half of the year. In all five occasions, the market posted positive returns in the second half of the year.
• Takeaway
  • Investors should remember that staying invested during extreme volatility is the best way to participate in equity market recoveries.

• U.S. corporate earnings growth in the first quarter of 2022 remained strong at +9%. Second quarter 2022 earnings growth is expected to slow to approximately 4%.
• Current forward P/E of the S&P 500 is approximately 17x. This is relative to 21.5x as of the end of 2021. The decline in P/E has been entirely driven by multiple compression.
  • Corporate earnings are expected to grow by close to 10% in 2022, about 40% higher than the historical average of 6%.
  • We have not seen analysts adjust their EPS estimates despite increasing concerns of downside risk to these estimates. We believe earnings cuts are likely.
• Takeaway
  • Slowing growth, tightening financial conditions, lingering supply-chain pressures and FX headwinds could pressure companies’ bottom line in 2022. While not currently reflected in consensus estimates, we could see contraction in S&P 500 EPS in the future.

• Valuation measures of U.S. stocks have declined to more reasonable levels.
  • Most fundamental valuations for U.S. Large Cap equities are now in-line with their 10- and 15-year historical averages. This compares to the +30% premium seen at the end of 2021.
  • “Growth” stocks in the U.S. are significantly more expensive than “value” stocks, despite their significant underperformance year to date.
  • Historically, “value” stocks have tended to outperform “growth” stocks during periods of increasing interest rates.  “Growth” stocks have tended to outperform during recessionary periods.
• Takeaways:
  • While corporate earnings expectations currently point to growth for 2022, ongoing headwinds put these estimates into question.
  • Investors may be best suited to apply a balanced allocation between “growth” and “value” as we navigate the current environment.

• U.S. investors have benefited from home-country overexposure in the past 10 years.
  • Consistent outperformance of U.S. equity markets is not a natural state and will reverse at some point.
  • Historical returns over longer time periods show that return differences between U.S. and international markets are cyclical in nature (the current cycle of U.S. outperformance is the longest ever recorded).
• Even though U.S. equities entered a bear market in 2022, International and Emerging Market equities are still cheaper, and have a higher potential for upside as a result.
• Takeaways:
  • Investors that shy away from International and Emerging Market equities are likely reducing the upside potential of their investment portfolios.
  • Benefits of a globally diversified portfolio are not solely geographic. Sector exposure varies across global markets.

• Short-term fixed income yields have increased dramatically over the past year as market expectations for tighter monetary policy have evolved.
  • Short-term yields, which are highly impacted by Federal Reserve policy rates, are set to move higher in the months ahead as the Fed continues raising its policy rate.
  • Longer-term yields, although higher over the past year, have declined in recent weeks as markets begin to price in slower economic growth in the U.S. (i.e. “flight to quality”).
    • A continuation of this “flight to quality” behavior from investors may ultimately result in a yield curve inversion (i.e. longer-term yields are lower than shorter-term yields).
• Takeaway
  • An inverted yield curve may be challenging for the Fed to avoid assuming rate hikes continue as planned.

• Long-term interest rates have increased dramatically in 2022, but the risk of even higher interest rates over the short term may be somewhat low.
• Long-term interest rates are determined by market supply and demand (i.e. long-term rates are not dramatically impacted by Federal Reserve interest rate policy).
  • Supply and demand for long-term interest rates are primarily driven by the market’s expectations for economic growth and inflation.
  • Expectations for slower growth and lower inflation may put a “cap” on long-term rates over the short term.
• Additionally, it is important to note that since the financial crisis, the 10-year treasury yield has struggled to break and remain above 3% for any sustainable amount of time.
• Takeaways:
  • While rates have surprised to the upside in 2022, it is likely that long-term rates will decline if economic growth and inflation expectations continue to decline.
  • Extending portfolio duration may be the most appropriate way for fixed income investors to navigate the uncertain environment.

• The difference between corporate bond yields and treasury yields (credit spreads) has increased in 2022 after reaching historical lows in 2021.
  • Spreads for lower-quality fixed income (ex: High Yield) steadily widened during the first and second quarters of the year and now are above the past 10-year average.
  • This so called “spread widening” is a direct result of increasing investor concerns over default risk.
• Despite the recent widening of credit spreads, further deterioration in economic strength could result in more upward pressure on corporate bond yields (and lower prices).
• Takeaway
  • Repositioning the fixed income portfolio to include higher-quality credit is prudent given the current risks to the economic outlook.