An extreme shift in macroeconomic conditions over the course of 2022 and the corresponding impact on financial markets have significantly altered the relative attractiveness of asset classes.
Markets are moving away from a “TINA” world (where “there is no alternative” to equities) to one in which fixed income is increasingly appealing.
Yet, as we navigate a period of elevated inflation and an economic slowdown, our starting point is one of caution. PIMCO’s business cycle models forecast a recession across Europe, the U.K., and the U.S. in the next year, and the major central banks are pressing ahead with policy tightening despite increasing strain in financial markets. The economy in developed markets is also under growing pressure as monetary policy works with a lag, and we expect this will translate into pressure on corporate profits.
We therefore maintain an underweight in equity positioning, disfavor cyclical sectors, and prefer quality across our asset allocation portfolios. The return potential in bond markets appears compelling given higher yields across maturities. As we look toward the next 12 months and the eventual emergence of a post-recession, early cycle environment, we will assess a range of market and macro factors to inform our thinking on when and how to re-engage with risk assets.
Key market signals
We will watch for several conditions to shift before we would consider risk assets as attractive investments again. First, in order to gain confidence around estimates of fair value, we need convincing evidence that inflation has peaked and that the “risk-free” interest rate has stabilized. While the U.S. Federal Reserve remains focused on taming inflation, there still may be upside risk to the hiking path as the central bank weighs the risk of a hard landing.
Next, we believe corporate earnings estimates globally remain too high and will have to be revised downward as companies increasingly acknowledge deteriorating fundamentals. At the time of this writing, Bloomberg’s consensus 2023 earnings growth estimate for the S&P 500 is 6%, or 8% excluding the energy sector. In addition, consensus estimates embed expectations of expanding profit margins, even though revenue is likely to slow along with demand while costs stay elevated. Bloomberg’s consensus estimates for earnings growth stand in contrast to the −11% growth suggested by PIMCO’s Earnings Growth Leading Indicator – see Figure 1. Historically, earnings per share (EPS) estimates have declined by 15% on average during recessions; this would indicate a mild recession could see a smaller drawdown in the mid-single-digits. In summary, only when rates stabilize and earnings gain ground would we consider positioning for an early cycle environment across asset classes, which would likely include increasing allocations to risk assets.
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