Coronavirus Operations Memo: Click Here | Magnus documents: Form ADV | Form CRS | Privacy Policy

Market Outlook – Q3, 2022

- July 29, 2022

When Doves Cry

SUMMARY

For much of the decade leading up to COVID-19, a combination of excellent profitability and some of the least volatile economic conditions in history implied that the U.S. stock market would trade at substantially higher valuations than long-term averages. But now, with economic growth much more volatile and inflation farther from the market’s 2% happy place than we have seen in 40 years, things suddenly look far less comfortable for investors.

– Matt Kadnar, GMO , July 2022

The late, great artist formerly known as Prince released “When Doves Cry” in 1984, and it ultimately spent five weeks as the number-one hit song in the U.S. In the song, he writes, “How can you just leave me standing? Alone in a world that’s so cold? Maybe I’m just too demanding.” In what has been an incredibly challenging year for capital markets, Prince’s lyrics eerily echo the mood of many investors. After benefiting from a 40-year decline in interest rates, capped off by far-above-average gains of 17.8% per year for a traditional “60/40” portfolio (60% U.S. stocks/40% U.S. bonds) for the three years ending December 2021, investors are now faced with the harsh reality of inflation and the terrible toll it takes on the value of financial assets.

It’s not only that investors may have been too demanding, but the pivot by the Fed from one extreme to the other has exacerbated the situation, taking markets from “party like it’s 1999” to being “left in a world so cold.” By any standard, the first half of 2022 has been extremely difficult for markets. Both stocks and bonds suffered historic concurrent drawdowns. Today, stocks are in a bear market, and the economy is clearly slowing. In the most recent GDPNow projections released by the Atlanta Fed, second-quarter GDP growth is expected to come in at -1.2%. This comes on the heels of the first-quarter GDP growth of -1.6%. Real personal consumption expenditures have also slowed to 2.1% year-over-year amid signs that consumers are starting to overextend themselves. Revolving consumer credit increased at an annual rate of 19.6% to an all-time high at the end of April (the most recent data available). It appears that consumers, squeezed by higher prices, are stretching to fund even their reduced spending levels. Wage gains are not keeping pace with inflation; real wage growth dropped to a new low of -3.9% in May relative to the year prior.

The Fed has just begun the process of withdrawing its unusually accommodative monetary policy over the past 13 years. It is attempting to slow demand, cool the red-hot labor market, and hopefully reduce inflation. Recent economic developments suggest the odds of a “soft landing”—a scenario where the Fed is able to cool the market just enough to stop inflation without doing harm to the economy—are too low to bet capital on. As a result, we think investors should still err on the side of patience when it comes to deploying capital. Although stocks and bonds are meaningfully below their record highs, the policy goosed prices of the past few years may have anchored investors to unsustainable levels of economic activity and market prices. In order to get more comfortable deploying more risk in stocks, we would like to see more compelling valuations (lower prices) or enough evidence of a material improvement in the inflation backdrop that would suggest an imminent pivot in monetary policy.

Despite this far-from-optimistic backdrop, there is good news. Lower prices are creating opportunities. Investors can now earn a 2.8% yield on a two-Year Treasury that yielded just 0.1% early last year. Further, the average high yield bond, as proxied by the Bloomberg High Yield Bond Index, now yields approximately 8%, its highest since February 2012. The pain felt today via lower prices (and higher yields) increases the return potential of all financial assets. In the adapted words of the late great Prince, “Dearly beloved, we’re gathered here today to get through this thing called… the bear market.”

2Q, 2022 MARKET REVIEW

The second quarter was unusually challenging in that both U.S. large cap stocks (-16.1%) and bonds (-4.7%) declined together... again!

SUMMARY

LONG-TERM ASSET CLASS RETURNS

Key markets in bear market territory, while inflation continues to run well above “target” exposes the challenge policymakers face

GROWTH, INFLATION & POLICY

Recent oil price hikes and tighter financial conditions have dominated the news. We use approximations of the drivers behind these developments to quantify the twelve-month outlook for CPI inflation in the U.S. and the euro area. In both regions, inflation is projected to ease somewhat but will remain elevated by May 2023.

– Jan Groen & Adam Noble, Liberty Street Economics, June 2022

CPI & PPI

For inflation to moderate in July, MoM CPI change needs to be lower than 0.5% and below 0.9% for PPI

While commodity prices rolling over will help contain inflation, house prices impact the shelter component of CPI with a 12–18-month lag

INFLATION SURPRISE

Inflation Surprise Index has rolled over, but from an extreme level; still surprising forecasts on a global scale, a first since 2008

TIPS-IMPLIED INFLATION

Market-based inflation expectations have eased after breaking out to multi-decade highs; 2-year TIPS-implieds currently at 3.2% vs 4.9% peak

2-YEAR TREASURY VS. FED FUNDS

Watch the Treasury market for policy changes: the 2-year Treasury tells you everything you need to know about pending Fed decisions

RATE HIKE EXPECTATIONS

Fed funds futures expecting peak rates as early as December 2022 and the Fed to start cutting rates again as early as May 2023

MORTGAGE RATES

Current pace of mortgage rate increase is unprecedented, but rates are still manageable in absolute terms

MORTGAGE RATES & HOUSING MARKET

With mortgage rates rising, housing is much less affordable; this will negatively impact pricing, but with a lag

REAL EARNINGS

Since early 2021 inflation has outpaced wage growth, eroding real household disposable income

PERSONAL INCOME

Real Income, excluding government transfers, is still grinding higher; total disposable income, however, has been treading water in recent months

PERSONAL SAVINGS

Savings edged slightly higher in May, largely due to consumer spending from January to April being revised lower

DEBT SERVICE & REVOLVING CREDIT

Consumer revolving credit increased at an annualized rate of 19.6% in April and 8.1% in May, now back at all-time highs

MANUFACTURING & INVENTORIES

ISM Manufacturing PMI has rolled over; retailers have seen a dramatic improvement in inventories; employment contracting in both sectors

ISM services has also rolled over but in much healthier shape as consumer spending shifts from goods to services; employment contracting in both sectors

GDP & INFLATION

Stocks and bonds declining together reflects markets adjusting to the growing likelihood of stagflation—slowing growth with elevated inflation

TRANSIT ACTIVITY

Travel, proxied by TSA throughput, is back to pre-COVID levels, while work-from-home dynamics appear to be here to stay

ENERGY PRICES & APPROVAL RATING

University of Michigan Consumer Sentiment now at an all-time low

MIDTERMS

Looking ahead to November, the race for Senate control will rely on a select few toss-up states

RUSSIA VS EUROPE

At the onset of the war, both Russia and Europe were “losing”, Russia now seems to have upper hand; Ruble has appreciated 45% vs Euro since start of the year

EQUITY

Regardless of what part of the cycle we are in, we remain fully in the camp that earnings are like gravity and prices eventually accrue to wherever the earnings are going. However, to us, there is no doubt that the prior cycle’s extraordinary monetary impulse helped to spur “confidence” and support for all things “disruptive” regardless of the durability of the earnings (or, in many cases, a hope of distant earnings to come).

– Rajiv Jain, CIO GQG Partners

MARKET RETURNS SUMMARY

Despite dropping into bear market territory, U.S. stocks have outperformed their international peers over the last year; emerging markets have outperformed YTD

SECTOR RETURNS

Tech, communication services and consumer discretionary have been hit hardest in the sell-off, but have bounced most since the start of Q3

EARNINGS

Analysts are expecting 2022 earnings growth of 9.9%

S&P 500 VALUATIONS

Forward equity valuations have come in substantially due to sell-off but are roughly average relative to history; focus now shifts to actual earnings

VALUATIONS VS FORWARD RETURNS

Forward P/Es have no predictive power for one-year forward equity returns, but have been reasonably predictive over longer time horizons

S&P 500 VALUATIONS

Trailing equity valuations are still above long-term averages, despite strong earnings growth and current bear market drawdown dramatically helping valuations

VALUATIONS

Valuations continue to contract so far this year

VALUE VS GROWTH

Growth equity prices still not supported by earnings

EXCESS RETURN CYCLES

Manager excess returns tend to go through cycles driven by investor sentiment

SALES & EARNINGS GROWTH

Sales and earnings growth expected to decelerate but remain healthy in 2022; impact of inflation and further Fed tightening huge wild cards

SPRINGTIDE EQUITY SENTIMENT COMPOSITE

US equity sentiment has rebounded to 33.1% from 12.8%, the lowest level since the GFC; extreme low readings have historically been good buying opportunities

SPRINGTIDE EQUITY SENTIMENT COMPOSITE

Average forward returns have been significantly higher when composite reading <30%; short-term range of returns however remains unpredictable

EARNINGS VS INFLAITON

Historically, inflation has been a significant issue for the stock market when it is above 4%, even more so when above 6%

CONSUMER SENTIMENT VS CONFIDENCE

Historically, when Consumer Sentiment is at extreme lows relative to Consumer Confidence, U.S. equity performance has been poor; currently at record lows

S&P 500 MOVING AVERAGE

The percentage of stocks trading above their 200-Day M.A. crossed above 15% (currently 16.4%); previously moves back above 15% have provided good buying opportunities

S&P 500 EQUITY RISK PREMIUM

A loose correlation exists between the S&P 500 equity risk premium and 1-year forward returns; S&P 500 equity risk premium currently at 3.0%

HIKING CYCLES & RETURNS

Can’t rely on averages when evaluating what the yield curve inversion means for markets; fast vs. slow hiking cycles remains the key

HIKING CYCLES & RETURNS

Fast hiking cycles correlate with poor returns following first rate hike; in order to be classified as a fast hiking cycle the Fed needs to hike more than 8 times

VENTURE CAPITAL

Venture valuations remain high while exits are on pace for lowest year since 2016

PRIVATE EQUITY SECONDARIES

Secondaries fundraising activity on pace for a 10-year low

FIXED INCOME & CREDIT

It would be silly to expect every bear market to turn into the Great Depression. It would be equally wrong to expect that a fall from overvalued, to more fairly valued, couldn’t badly overshoot on the downside.

– Seth Klarman, Investor and CEO & President, Baupost Group

MARKET RETURNS SUMMARY

All U.S. fixed income and credit asset classes were down over the quarter; international developed bonds faired the worst, are now down over the last decade

U.S. BOND RETURNS

2021 was 3rd worst year for U.S. bonds since 1989; 2022 is off to a dramatically worse start

TREASURY YIELDS & CREDIT SPREADS

U.S. Treasury yield curve has flattened with parts of the curve inverting; credit spreads have risen sharply over the quarter, but not to crisis levels

SPREADS BY SECTOR

Credit spreads remain at or slightly above median across sectors as a large portion of price declines has been due to the duration component

HIGH YIELD SPREADS

Historically, high yield spreads above 6% have resulted in above average forward returns; high yield spread currently trading at 4.8%

Historically, high yield spreads above 6% have resulted in above average forward returns; high yield spread currently trading at 4.8%

COMMODITIES & THE YIELD CURVE

Collapse in copper/gold ratio—a proxy for the real economy vis-à-vis financial assets—suggests Treasury yields may head lower

TREASURY SPREADS

Yield curve inversion signaling slowing growth; risky assets can generate strong short-term returns post inversion, but playing with fire

GLOBAL RATES

The U.S. bond market remains relatively higher yield, which could help keep U.S. rates somewhat contained

TREASURIES VS JGB’S

The yen has weakened to a 20-year low against the dollar as the BOJ continues its infinite QE; US Treasuries looking attractive vs JGB’s

TREASURY MARKET

The treasury market has been an enabler of increasing deficit spending and debt levels...is it now “fed up”?

REAL INTEREST RATES

The Fed has fallen so far behind the curve that unless inflation rolls over, they will be forced to continue to hike into an economic slowdown, likely recession

TREASURY ISSUANCE

Nearly $700bn in treasury issuance in Q1 reversed to -$23bn in Q2 due to strong revenue receipts; expected issuance of $252bn in Q3

REAL ASSETS

The real energy crisis isn’t even here yet. The U.S. Energy Information Administration forecasts U.S. oil production to average 12.5 million barrels per day for the next 30 years. This is all but impossible. Shale will likely tip into terminal decline in about five years as the main shale plays run out of locations. Unfortunately, by then, most of the individuals with incumbent knowledge about offshore and international development will have retired. The brain drain in the industry will create a real and much larger crisis in the mid-to-late 2020s.

– Dallas Fed Oil & Gas Survey, June 2022

MARKET RETURNS SUMMARY

Commodities and gold outperformed in the second quarter; U.S. REITs have struggled along with stocks and bonds given rate increases

OIL PRODUCTION/CONSUMPTION

Global oil production outpaced consumption in Q2 for the first time since Q2 2020

U.S. OIL PRODUCTION

U.S. oil production continues to deal with major supply chain disruptions

OIL & NATURAL GAS

Oil and natural gas producers have been cautious to bring rigs back online despite rising prices

National average gasoline prices are down 11% since peaking at over $5/gal in June, with more room to fall as crack spreads come down; crack spreads are down >40% from peak

YIELDS

Midstream distribution yields trending lower but remain relatively attractive, free cash flow yields of energy sector remain attractive

REITS

REIT yields may be currently attractive on a relative basis, but in keeping perspective they are at the lowest absolute levels in history

GOLD MINER FUNDAMENTALS

Gold miner performance starting to catch up to fundamentals, the industry has seen broad deleveraging and improved cash flow

GOLD FUTURES POSITIONING

Spec positioning in gold futures suggests markets are nearing capitulation, which has generally resulted in above-average forward returns

OPPORTUNISTIC

It’s good to have a view but it’s also good to be aware that you might be wrong. There might be things going on that we won’t know about for many years to come.

– David Harding, Founder & CEO, Winton Capital

MARKET RETURNS SUMMARY

Closed-end funds continued down a further 12.3% during the second quarter while global macro returned 2.4% for the quarter

MONETARY POLICY & GLOBAL STOCKS

Global quantitative easing efforts supported the recent gains in global stocks; Fed, ECB and BoJ combined 12M change in assets declined for the first time since 2019 in June

CEF DISCOUNTS

CEF discounts narrowed slightly from -7.2% in May to -6.8% in June

HIGH BETA 6040 VS GLOBAL 6040

“High beta 60/40” (Tech/junk bonds) sold off more than traditional 60/40, will bounce now bouncing more off the lows

ASSET ALLOCATION

Despite this far-from-optimistic backdrop, there is good news. Lower prices are creating opportunities. The pain felt today via lower prices (and higher yields) increases the return potential of all financial assets. In the adapted words of the late great Prince, “Dearly beloved, we’re gathered here today to get through this thing called… the bear market.”

– SpringTide Market Commentary, June 2022

STOCKS & BONDS

2021 was an unusual year for global stocks and bonds, 2022 even more so; again, highlighting the unusual predicament the Fed is in

CMEs (AS OF 6/30/2022)

Expected 10-year returns for equity and credit assets rose substantially as riskier assets sold of while yields rose modestly

CMEs

Sizable improvement in 10-year returns with a smaller improvement in longer-term as the mean reversion of higher valuations is distributed over a longer time frame

APPENDIX 1 : ASSET CLASS DEFINITIONS

ASSET CLASS BENCHMARKS

Asset class performance was measured using the following benchmarks:

U.S. Large Cap Stocks: S&P 500 TR Index
U.S. Small & Micro Cap Stocks: Russell 2000 TR Index
Intl Dev Large Cap Stocks: MSCI EAFE GR Index
Intl Dev Small & Mirco Stocks: MSCI EAFE GR Index
Emerging & Frontier Market Stocks: MSCI Emerging Markets GR Index
Global Stocks: MSCI ACWI GR Index
Private Equity: Cambridge Associates U.S. Private Equity
Venture Capital: Cambridge Associates U.S. Venture Capital
U.S. Interm-Term Muni Bonds: Bloomberg Barclays 1-10 (1-12 Yr) Muni Bond TR Index
U.S. High Yield Muni Bonds: Bloomberg Barclays High Yield Muni TR Index
U.S. Interm-Term Bonds: Bloomberg Barclays U.S. Aggregate Bond TR Index
U.S. High Yield Bonds: Bloomberg Barclays U.S. Corporate High Yield TR Index
U.S. Bank Loans: S&P/LSTA U.S. Leveraged Loan Index
Intl Developed Bonds: Bloomberg Barclays Global Aggregate ex-U.S. Index
Emerging & Frontier Market Bonds: JPMorgan EMBI Global Diversified TR Index
Public BDCs: S&P BDC Index
U.S. REITs: MSCI U.S. REIT GR Index
Ex U.S. Real Estate Securities: S&P Global Ex-U.S. Property TR Index
Private Real Estate: Cambridge Associates Real Estate
Commodity Futures: Bloomberg Commodity TR Index
Midstream Energy: Alerian MLP TR Index
Gold: LBMA Gold Price
Long-Short Equity: HFRI Equity Hedge Index
Global Macro: HFRI Macro-CTA Index
Relative Value: HFRI Relative Value Index
Closed-End Funds: S-Network Composite Closed-End TR Index
Insurance-Linked Securities: SwissRe Global Cat Bond TR Index
Digital Assets: MVIS CryptoCompare Digital Assets 25 Index
Cash & Cash Equivalents: Bloomberg Barclays U.S. T-Bill 1-3 Month TR Index
U.S. Short-Term Muni Bonds: Bloomberg Barclays Municipal 1-3 Yr TR Index
U.S. Short-Term Bonds: Bloomberg Barclays U.S. Agg 1-3 Yr TR Index
U.S. 60/40: 60% S&P 500 TR Index 40% Bloomberg Barclays U.S. Aggregate Bond TR Index
Global 60/40: 60% MSCI ACWI GR Index 40% Bloomberg Barclays Global Aggregate Bond TR Index

DISCLAIMER

Magnus Financial Group LLC (“Magnus”) did not produce and bears no responsibility for any part of this report whatsoever, including but not limited to any macroeconomic views, inaccuracies or any errors or omissions. Research and data used in the presentation have come from third-party sources that Magnus has not independently verified presentation and the opinions expressed are not by Magnus or its employees and are current only as of the time made and are subject to change without notice.

This report may include estimates, projections or other forward-looking statements, however, due to numerous factors, actual events may differ substantially from those presented. The graphs and tables making up this report have been based on unaudited, third-party data and performance information provided to us by one or more commercial databases. Except for the historical information contained in this report, certain matters are forward looking statements or projections that are dependent upon risks and uncertainties, including but not limited to factors and considerations such as general market volatility, global economic risk, geopolitical risk, currency risk and other country-specific factors, fiscal and monetary policy, the level of interest rates, security-specific risks, and historical market segment or sector performance relationships as they relate to the business and economic cycle.

Additionally, please be aware that past performance is not a guide to the future performance of any manager or strategy, and that the performance results and historical information provided displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be inferred that these results are indicative of the future performance of any strategy, index, fund, manager or group of managers. Index benchmarks contained in this report are provided so that performance can be compared with the performance of well-known and widely recognized indices. Index results assume the re-investment of all dividends and interest.

The information provided is not intended to be, and should not be construed as, investment, legal or tax advice nor should such information contained herein be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. An investor should consult with their financial advisor to determine the appropriate investment strategies and investment vehicles. Investment decisions should be made based on the investor’s specific financial needs and objectives, goals, time horizon and risk tolerance. This presentation makes no implied or express recommendations concerning the way any client’s accounts should or would be handled, as appropriate investment decisions depend upon the client’s specific investment objectives.

Investment advisory services offered through Magnus; securities offered through third party custodial relationships. More information about Magnus can be found on its Form ADV at www.adviserinfo.sec.gov.

TERMS OF USE

This report is intended solely for the use of its recipient. There is a fee associated with the access to this report and the information and materials presented herein. Re-distribution or republication of this report and its contents are prohibited. Expert use is implied.

DEFINITIONS

Asset class performance was measured using the following benchmarks: U.S. Large Cap Stocks: S&P 500 TR Index; U.S. Small & Micro Cap: Russell 2000 TR Index; Intl Dev Large Cap Stocks: MSCI EAFE GR Index; Emerging & Frontier Market Stocks: MSCI Emerging Markets GR Index; U.S. Intermediate-Term Muni Bonds: Bloomberg Barclays 1-10 (1-12 Yr) Muni Bond TR Index; U.S. Intermediate-Term Bonds: Bloomberg Barclays U.S. Aggregate Bond TR Index; U.S. High Yield Bonds: Bloomberg Barclays U.S. Corporate High Yield TR Index; U.S. Bank Loans: S&P/LSTA U.S. Leveraged Loan Index; Intl Developed Bonds: Bloomberg Barclays Global Aggregate ex-U.S. Index; Emerging & Frontier Market Bonds: JPMorgan EMBI Global Diversified TR Index; U.S. REITs: MSCI U.S. REIT GR Index, Ex U.S. Real Estate Securities: S&P Global Ex-U.S. Property TR Index; Commodity Futures: Bloomberg Commodity TR Index; Midstream Energy: Alerian MLP TR Index; Gold: LBMA Gold Price, U.S. 60/40: 60% S&P 500 TR Index; 40% Bloomberg Barclays U.S. Aggregate Bond TR Index; Global 60/40: 60% MSCI ACWI GR Index; 40% Bloomberg Barclays Global Aggregate Bond TR Index.