Key Private Bank Investment Brief

Key Takeaways

Our Current Tactical Asset Allocation Recommendations (versus long-term strategic asset allocation targets):

Stocks: Neutral.

Bonds: Neutral (recently raised from underweight).

• Once again, there is income in fixed income. As inflation cools, bonds can offer some support if earnings disappoint and the narrative shifts from a bond bear market to an earnings bear market.

• Until recently turning neutral, we had been “underweight” fixed income in client portfolios for several years. This year, as interest rates rose quickly, high-quality bonds suffered one of their worst years on record.

• Yields on all types of fixed income are now much more attractive. Bonds now project for higher forward returns than they did at this time in 2021. Additional methods of portfolio diversification are still needed, however, as noted below.

Cash: Neutral (recently reduced from overweight).

Alternatives: Still attractive for alpha generation.

• Implementation varies by client. New portfolio tools are needed in a highly uncertain environment.

Real Assets: Still attractive for diversification purposes.

• Most investors are underweight in nonfinancial assets outside of real estate.

Two Scenarios for a slowing economy in 2023 – Base Case/Bearish Case:

1. Base case rationale – a mild recession (“softish” landing):

   • Corporate and consumer balance sheets are strong due to the post-COVID stimulus, and private sector debts have been extended at low interest rates.

   • High inflation boosts corporate top-line revenue growth, allowing companies to meet rising interest costs.

   • Recent banking reforms (post-2009 Great Financial Crisis) have significantly mitigated financial contagion risks.

   • Deglobalization and onshoring have led to increased infrastructure and defense spending.

2. Bearish case rationale – a deeper/longer recession (“hard” landing):

   • Policymakers are constrained by high inflation. Interest rates will continue to rise, and rate cuts may not occur until much later than expected.

   • Balance sheets could deteriorate quickly – much of the world is still highly leveraged.

   • Monetary policy tightening is occurring at the fastest rate in the past 40 years.

   • A divided US government, while being viewed as favorable by many, is likely to limit fiscal support until after a recession has already begun.

   • Valuations on most asset classes are (were) high relative to historic averages.

   • Bottom line: the range of potential outcomes is larger than normal for 2023.

Equity Takeaways

After rising about 1.5% last week, stocks dipped in early Monday trading. The S&P 500 fell about 0.6%, while small caps fell about 0.9%. International shares were mixed on concerns of increasing COVID-19 cases in China.

Relative equity performance has shown wide dispersion in 2022. Compared to the S&P 500, Value stocks have outperformed by over 10% year-to-date (YTD), while Growth stocks have underperformed by over 10%. Small caps have outperformed the S&P 500 by about 3% YTD.

Developed international stocks have slightly outperformed US stocks YTD, while emerging market equities have lagged. However, the strong US dollar has been a headwind for US investors in foreign companies for most of 2022.

A key overhead resistance level for the S&P 500 remains at 4100. The index closed at 4026 last Friday. A break above the 4100 level would bode well for the end of 2022/ early 2023. We think it is more likely that the market will stumble as it approaches 4100.

Private equity funds are indeed more illiquid than public equity, as private equity managers require a stable capital base to execute their long-term plans. However, in some ways illiquidity can be an asset to investors. The illiquidity of private equity investments can help investors avoid behavioral mistakes by staying invested during market downturns. This week’s Key Questions article has more details on private equity.

Fixed Income Takeaways

Treasury yields fell slightly last week, with both the 2-year and 10-year note yields falling about 8 basis points. The 2-year/10-year Treasury curve was inverted by 78 basis points early on Monday. For context, 2-year yields were 4.47%, while 10-year notes yielded 3.69%.

A significantly inverted yield curve indicates several things. First, it indicates that market participants are expecting a slowdown in economic growth. Second, it shows that market participants expect the Federal Reserve (Fed) to begin cutting rates relatively soon (contrary to recent messaging from the Fed itself).

The minutes of the latest Fed meeting were released last week. Quoting: “a substantial majority of participants judged that a slowing in the pace of increases would soon be appropriate.”

The Fed is not talking about a pivot back to rate cuts; rather, a slowing in the pace of future rate increases. Market expectations are for the Fed Funds rate to rise to 5.00% in May/June of 2023, before falling to 4.50% by early 2024. The current Fed Funds rate is 4.00%.

Corporate credit performed well last week in conjunction with the rally in stock prices. BBB-rated bonds outperformed higher-rated credits, and spreads tightened about 5 basis points across the board. High-yield spreads also tightened, indicating an increased appetite for risk.

Key Takeaways

Our Current Tactical Asset Allocation Recommendations (versus long-term strategic asset allocation targets):

Stocks: Neutral.

Bonds: Neutral (recently raised from underweight).

• Once again, there is income in fixed income. As inflation cools, bonds can offer some support if earnings disappoint and the narrative shifts from a bond bear market to an earnings bear market.

• Until recently turning neutral, we had been “underweight” fixed income in client portfolios for several years. This year, as interest rates rose quickly, high-quality bonds suffered one of their worst years on record.

• Yields on all types of fixed income are now much more attractive. Bonds now have greater potential for higher forward returns than they did at this time in 2021 and 2020. Additional methods of portfolio diversification are still needed, however – as noted below, stocks and bonds remain correlated with each other, meaning they may provide less diversification within a portfolio.

Cash: Neutral (recently reduced from overweight).

Alternatives: Still attractive for alpha generation.

• Implementation varies by client. New portfolio tools are needed in a highly uncertain environment.

Real Assets: Still attractive for diversification purposes.

• Most investors are underweight nonfinancial assets outside of real estate.

Midterm Election Update:

Control of the House of Representatives has flipped to the Republicans, albeit with a very thin majority. The Senate will remain under Democratic control.

Gridlock is typically viewed as a positive by markets; however, the current situation could present its own challenges. In general, we expect less fiscal support, more oversight (crypto, China, big tech) and a political battle over the debt ceiling next spring.

Equity Takeaways

Stocks dipped slightly in early Monday trading. The S&P 500 fell about 0.4%, with small caps down a similar amount. International shares were also lower.

The S&P 500 remains in a year-long downtrend channel. The recent rally has taken the S&P 500 toward the top end of this range, near 4100. Last week’s price action saw the market pull back at this resistance level – discouraging price action for the bulls.

The week of Thanksgiving tends to have a positive seasonal tailwind, as do the weeks around the Christmas holiday. Price action for the remainder of 2022 will give some clues as to the underlying health of the market as we move toward 2023.

The American Association of Individual Investors (AAII) releases a weekly investor sentiment survey. Over the past year, every time bullish sentiment in this indicator rose to 32%, the stock market experienced a short-term peak.

Last week, AAII bullish sentiment once again reached 32%, implying that individual investors are becoming more bullish. Recall that bearish sentiment is a tailwind for the market (and vice versa) – the more bearish investors are, the more selling has already taken place.

The US dollar peaked and reversed sharply lower over the past six weeks. US dollar strength is a headwind for corporate profits for US multinational companies; thus, a strong dollar can also be a negative for the stock market. A weakening dollar could be especially beneficial to cyclical sectors (industrials, materials, semiconductors), as well as commodities.

Oil prices have fallen about 10% over the past three weeks on concerns over the strength of the global economy, especially China which has been hampered by its “zero-Covid” policy. Front-month futures spreads went into contango (the current oil contract is trading at a discount to the second month) for the first time since 2021.

Indications are that demand for petroleum is falling faster than OPEC+ production cuts. Contango in the oil market usually occurs when supply is rising faster than demand.

Due to a combination of high storage and higher-than-expected temperatures, European energy prices have fallen sharply in recent months. That said, prices are about twice as high as they were prior to the recent crisis.

Fixed Income Takeaways

The 2-year/10-year Treasury curve inversion reached 71 basis points last week, its largest inversion since the early 1980s. In early Monday trading, the 3-month T-bill yielded about 4.25%, while the 10-year Treasury yielded about 3.80%.

Recent Federal Reserve speakers maintained a hawkish tone despite several recent reports that indicated inflation could be slowing. Federal Reserve Governor James Bullard went as far as to suggest that the Fed Funds rate would need to be raised as high as near 5.00% to 7.00% (versus its current level of 4.00%). Market expectations of future rate increases rose after his comments.

The shape of the Treasury and Fed Funds futures curves indicate a terminal Fed Funds rate above 5.00%. Market participants are pricing in continued sharp near-term tightening, followed by an economic slowdown/recession and subsequent rate cuts.

Despite the potential for a recession next year, credit markets remain well-behaved, with spreads showing limited signs of stress. The ICE BofA BBB-rated corporate bond index is currently trading with a spread of 182 basis points to Treasuries. For context, this index peaked with a spread of 788 basis points during the 2008 Great Financial Crisis.

Key Takeaways

Our Current Recommendations (versus long-term strategic asset allocation targets):

Stocks: Neutral.

Bonds: Neutral (recently raised from underweight).

• Once again, there is income in fixed income. As inflation cools, bonds can offer some support if earnings disappoint and the narrative shifts from a bond bear market to an earnings bear market.

Cash: Neutral (recently reduced from overweight; allocate to bonds).

Alternatives: Still attractive for alpha generation.

• Implementation varies by client. New portfolio tools are needed in a highly uncertain environment.

Real Assets: Still attractive for diversification purposes.

• Most investors are underweight in nonfinancial assets outside of real estate.

Election Results:

• The red wave broke early, and a purple swirl emerged. The Democrats outperformed expectations by maintaining control of the Senate. Republicans seem likely to take control of the House by a narrow margin.

• Next year, investors should expect less fiscal support, more oversight, more gridlock and more confusion for the Federal Reserve (Republicans want inflation to be the focus, while Democrats want the focus to be maximizing employment).

• Gridlock is generally good for the markets. That said, the debt ceiling will be up for reapproval next spring which could be a source of volatility once again.

Inflation and Economic Update:

• Last week, the Consumer Price Index (CPI) surprised to the downside. After this cooler-than-expected report on inflation, the stock and bond markets both rallied sharply. Market participants immediately priced in a lower terminal Federal Funds Rate, which supported the sharp rally in risky assets.

• Key advises caution in extrapolating one month of data far into the future. While last week’s CPI report was a welcome sign, inflation, while falling, is likely to remain elevated for quite some time.

• It is not likely that the Federal Reserve (Fed) will change its current restrictive policy stance based on one month of data.

Cryptocurrency Update:

• FTX, one of the top-three cryptocurrency exchanges in the world, filed for bankruptcy last week.

• Effectively, the exchange experienced a classic “run on the bank,” whereby FTX did not have sufficient liquidity to meet about $8 billion in customer withdrawal requests.

• Many institutional investors used FTX as a custody platform, so we could see some contagion and/or short-term pressure on risky assets and cryptocurrency prices.

• Key does not have direct exposure to FTX through any of our recommended investments, and we have historically been cautious about cryptocurrencies (but intrigued by Blockchain). We will continue to monitor the situation.

Equity Takeaways

Stocks fell slightly in early Monday trading. The S&P 500 dropped about 0.2%, while small caps fell about 0.4%. International shares were mixed.

The end of last week saw a sharp rally that was touched off by Thursday morning’s CPI report, which showed lower-than-expected inflation for October. The S&P 500 rallied over 5% on Thursday and closed the week about 6% higher. The tech-heavy Nasdaq fared even better, rallying over 7% on Thursday before closing the week over 8% higher.

Going into last Thursday’s CPI report, the bears had been in control of the market. The favorable inflation data allowed bulls to go on the attack once again. Advancers outnumbered decliners by 11:1 during last Thursday’s sharp rally.

Liquidity remains poor. We are in a reactionary market, not a forecasting market. In a bear market environment, rallies tend to be very sharp as the market reacts to every new piece of data.

The stock market likes to inflict the maximum amount of pain possible. Sentiment and positioning can dominate short-term trading patterns, especially in a low-liquidity environment. Heading into last week’s CPI report, sentiment was negative and thus when inflation was slightly below forecast, bearish trades had to be unwound which further propelled the rally in equities.

Over two days last week, the US dollar fell about 4%, a sharp move for a currency. This year’s very strong dollar has been a headwind to corporate profits for US multi-nationals. Combined with falling Treasury yields, a falling dollar could be a short-term tailwind for equities into year-end.

Corporate earnings forecasts for 2023 continue to trend lower. Over the next six weeks or so, positive seasonal patterns could support the market, but if earnings estimates continue to move lower, it will be tough for the market to mount a sustained rally into 2023.

Fixed Income Takeaways

Treasury yields plunged across the curve last week, led by the 5-year note. 5-year Treasury note yields fell 31 basis points in a single day alone after last week’s CPI print. Overall, 5-year yields fell 39 basis points last week.

After last week’s sharp market moves, 14 Federal Reserve members will be making speeches this week. It is likely that these Fed governors will stick to their recent message of controlling inflation via restrictive monetary policy.

The 3-month/10-year Treasury curve inverted in recent weeks, following curves such as the 2-year/10-year Treasury. The inversion of the 3-month/10-year Treasury curve tends to be a timelier harbinger for a recession than the 2-year/10-year curve.

Investment-grade (IG) bond spreads tightened 2-6 basis points last week. New issuance activity was much heavier than expected, as corporations took advantage of lower all-in yields.

High-yield bond spreads widened slightly last week with BB-rated paper outperforming weaker-rated issues.

Key Takeaways

1. New Key Tactical Asset Allocation recommendations (versus a client’s long-term strategic asset allocation and investment objective target):

   Stocks: Neutral (no change).

   Bonds: Neutral (change from De-Emphasize).

   • There is income in fixed income again. In addition, as inflation cools, bonds can offer some support to portfolios if earnings disappoint and recession risks continue to rise.

   • For example, one year ago, the core aggregate bond index was yielding 1.68%. Today, the yield on that index of high-quality bonds is about 5%.

   Cash: Neutral (from Emphasize). Use previous higher cash allocation recommendation to now purchase bonds.

   Alternatives and Real Assets: Continue to emphasize where appropriate (no change).

   • Stocks and bonds have once again become correlated. New diversification tools are needed in a highly uncertain environment, and thus alternative/ real asset strategies may be beneficial for some clients, but selectivity is important.

2. Current Economic Environment:

   • Today’s environment of high inflation and low unemployment is in many ways unprecedented. Employment trends are cooling, but very slowly.

   • Technology companies have been large job creators. Layoffs in the technology sector have begun to increase, which could eventually put some downward pressure on wage inflation, all else equal.

   • The Federal Reserve remains primarily focused on trying to cool inflation and will likely continue with hawkish monetary policy into 2023. That said, the pace of rate increases is likely to slow as we move into 2023.

Equity Takeaways

Stocks were slightly higher in early Monday trading. The S&P 500 rose about 0.20%, with small caps rising a similar amount. After rising sharply last Friday, international shares were mixed.

Within our recommended equity allocation, Key is now recommending a slight increase in our weighting towards US small and mid-cap stocks than previously recommended, relative to large-cap stocks. Due to the uncertain forward outlook, we are also recommending a tilt towards defensive equity sectors (consumer staples, etc.) within portfolios.

Both small and mid-caps are historically cheap versus large caps on both an absolute and relative basis. Small caps are generally more cyclical (more exposed to recession). However, small caps are also less exposed to weakness overseas.

S&P 500 forward earnings estimates have begun to fall but could fall further if a recession were to materialize. Typically, earnings fall about 15% during a recession. The stock market has already dropped significantly in 2022, but it is unclear how much earnings weakness is already priced in.

Fixed Income Takeaways

Last week’s Federal Reserve (Fed) Meeting Key Takeaways:

• In a move that was expected, the Fed increased interest rates by another 75 basis points to 4.00% (upper limit of the range).

• Going forward, the pace of rate hikes may slow, but the Fed is not done yet.

• During his press conference after the Fed’s policy announcement, Fed Chairman Powell stated that his preference would be to over-tighten rather than under-tighten. In other words, the Fed is still focused on bringing inflation down to its long-term target of 2.0%.

• The terminal Fed Funds rate is likely to peak at over 5.00%, which would be considered a restrictive policy stance. Even if the future pace of rate increases were to slow, this terminal rate is higher than market expectations of just several months ago. At this point, it’s more about the destination (the terminal rate) than the journey (pace of rate increases).

• A direct quote from the Federal Reserve statement: “… incoming data since our last meeting suggest that the ultimate level of interest rates will be higher than previously expected.”