Key Private Bank Investment Brief

General Takeaways:

1. Last week, the bear market turned even grizzlier.

   • This year’s sell-off in equities widened as the Federal Reserve (Fed) and other central banks around the world grew increasingly hawkish.

   • Last Wednesday, the Fed raised rates 75 basis points (bps), after noting that a 75 bps hike was not under consideration just a month ago.

2. Central banks, starting with the US Fed, are now determined to fight inflation and appear willing to take the economy into a recession.

   • The Fed does not believe that a recession is inevitable, but inflation is clearly their #1 focus.

   • The Fed is likely to raise rates an additional 50-75 bps in July. Other central banks around the world are also embarking on tightening programs after years of very low rates. China is the exception – Chinese officials are holding off on rate increases for now.

   • The Fed expects that the Fed Funds rate will peak in 2023, before declining in 2024.

3. Recent data points indicate that the economy is cooling.

   • Corporate earnings estimates are likely still too high, as Wall Street analysts are typically late to revise estimates lower.

   • Much of the Fed’s work (damage/financial tightening) has likely already been done.

   • Metrics that the Fed is likely watching include wage growth, job openings, consumer sentiment, existing and new home sales, etc.

4. Not all bear markets are alike.

   • Last week, the decline from the 1/3/22 peak in the S&P 500 eclipsed 20%, placing us in bear market territory.

   • KeyBank Investment Center views the current situation as a cyclical bear market within an ongoing expansion, as opposed to a long-term structural or secular bear market.

   • Cyclical bear markets tend to resolve more quickly, with shallower peak-to-trough drawdowns, than structural bear markets.

5. Resilient portfolios are needed – in this type of environment, diversification is paramount.

   • Alternatives, including private strategies and hedge funds, have held up much better than traditional stocks and bonds this year.

   • Where appropriate, we continue to recommend that clients consider adding alternative strategies to portfolios (including real assets).

Equity Takeaways:

Stocks rose in early Tuesday trading. The S&P 500 rose 2%, while small caps rose 0.75%. International shares also rose.

The S&P 500 has dropped over 10% in the past two weeks. The Consumer Price Index (CPI) report on June 10 exacerbated fears of persistent inflation. As noted above, Fed officials have become increasingly hawkish on inflation in recent weeks, which has weighed on markets across the globe.

The typical bear market takes about 289 days to move from peak-to-trough, however, durations can vary wildly. As noted above, KeyBank Investment Center believes that the current drawdown is likely a cyclical bear market related to a slowing economy, not the start of a new long-term structural bear market.

Equity Price/Earnings (P/E) ratios have contracted significantly during the recent sell-off. For example, the S&P 600 SmallCap Forward P/E ratio has declined to 10.8, which is approaching levels last seen in the 2008-09 and 2020 market drawdowns.

Fixed Income Takeaways:

US Treasury yields have risen sharply in recent weeks in conjunction with increasingly aggressive Fed policy. 10- year Treasuries yielded 3.30% early on Tuesday, up from 2.85% at the end of May. 2-year Treasuries yielded 3.23% in early Tuesday trading, up from 2.55% at the end of May.

Up until a few days before last Wednesday’s Federal Reserve meeting, Chairman Powell seemed to be against a 75 bps rate hike. A key quote from Powell at last week’s meeting: he “doesn’t expect moves of this size to be common.”

Powell did note that a 50-75 bps hike is likely at the July meeting as well. After these moves, the Fed’s forward guidance has been called into question. Aggressive rate hikes are likely at the next several meetings. The pace of hikes is expected to slow later in the year.

The Fed’s updated Summary of Economic Projections does not call for a recession over the next few years; however, it does call for an increase in the unemployment rate. Powell would not use the term “soft landing” at his press conference last week.

Even municipal bonds were swept up in last week’s market sell-off. Last Monday, municipal bond yields rose 25 bps in a single day, and over 35 bps on the week. It was the worst week for municipal bond prices since April 2020.

Fund flows continue to weigh on municipal bonds. Over $70B has flowed out of municipal bonds year-to-date (YTD). After looking cheap earlier this year, with treasury yields also having risen, municipals are back to fair value or slightly expensive vs. treasuries.

General Takeaways:

1. Inflation is too hot.

   • Eventually, inflation will moderate, but the Federal Reserve (Fed) may have to induce a recession to squelch it.
   • Last week’s Consumer Price Index (CPI) report showed that inflation has not yet peaked. The largest contributor was gasoline prices, but food and shelter prices also continued to rise sharply.
   • The Fed is still likely to raise interest rates by 50 basis points (bps) during their meeting later this week, although some forecasters are now predicting a 75 bps increase during at least one of their upcoming meetings.
   
   

2. Four things to watch when gauging recession risks.

   • Indicators like the Sahm Rule, which captures a reversal in the unemployment rate of at least 50 bps, are very good at identifying recessions once they’ve occurred, but are not good at predicting them. Currently, it is not sensing a recession as the employment backdrop is still quite healthy.
   • Treasury yield curves continue to send mixed signals (see fixed income section for details).
   • Credit spreads have widened, but the move has been orderly for the most part. That said, over the past several days, trading in the credit markets has become increasingly volatile.
   • The price of oil remains a major headwind to the economy. History suggests that when the price of oil spikes above 100% year/year, a recession may be lurking.
   
   

3. Near-term risks are skewed to the downside.

   • Economists will be closely watching consumer spending. The US consumer is a bigger contributor to World GDP than Japan, Germany, the UK and Italy’s economies combined.
   • Investors should watch for negative earnings revisions – Wall Street analysts are generally slow to move their numbers lower.
   
   

4. More resilient portfolios are needed.

   • KeyBank Investment Center continues to recommend additional diversification in the form of real assets and alternative investments (where appropriate). Active managers may also be able to add value in the current environment.
   • Holding a bit of extra cash also makes sense due to the recent volatility.
   • The economy and the stock market move at different speeds. Inflection points/reversals in the stock market can come without warning and are generally positively skewed.
   • Many times, the stock market will begin to anticipate an economic recovery before the data itself begins to improve. In other words, stocks lead the economy.

Equity Takeaways:

After a sharp fall last Friday, stocks continued to lower in early Monday trading. The S&P 500 fell 2.5%, while small caps fell over 3%. International stocks also fell. The proximate cause of last week’s sell-off was Friday’s CPI report, which showed higher-than-expected inflation.

Since 2009, credit spreads have been a good leading indicator for stocks. High-yield bond spreads are gapping out again Monday morning. Disorderly trading in high- yield bonds generally spills over to stocks.

After a stock market drawdown of 20%, stock market returns are generally positive looking out on longer timeframes. That said, in the recent past, the Fed has stepped in to support the stock market during downturns, a dynamic that does not exist in the current environment. In other words, the Fed does not currently have the market’s back.

This morning, the S&P 500 is breaking through the recent interim lows in the low 3800s. 3600 on the S&P 500 is the next obvious level of technical support

Fixed Income Takeaways:

US Treasury yields gapped higher last Friday, with the 2- year Treasury yield increasing 25 bps, the largest one-day move higher in yields since 2009. In total, 2-year yields rose 36 bps last week.

The longer end of the Treasury curve also rose sharply last week (although not as much as 2-year yields). In early Monday trading, yields were rising again – the 2-year yield was 3.22%, while 10-year Treasuries yielded 3.28%.

The US Treasury yield curve is showing conflicting economic signals. The 3-month / 10-year spread is still solidly positive; however, the 2-year / 10-year spread is close to inverting once again. Recall that an inverted yield curve implies that market participants are concerned about slowing economic growth.

Traders are now pricing in 50 bps rate hikes over the next three Fed meetings (June, July and September). For the July meeting, market participants are assigning a 55% chance to an even larger, 75 bps rate hike.

Investment-grade (IG) spreads moved 4 bps wider on Friday and 6 bps wider on the week. High-yield spreads moved 10 bps wider on Friday and 32 bps wider on the week.

CDX spreads (a measure of the cost to insure against corporate default) also moved sharply wider last week and are moving wider again Monday morning. High-yield CDX spreads are at their widest level since 2018.

The reduction of the Fed’s balance sheet, also known as Quantitative Tightening (QT), began recently. This dynamic is akin to an additional 25 bps rate hike. The Fed is not actively selling bonds, it is simply letting existing holdings roll off.

General Takeaways:

1. Good News: inflation may be coming down (at the “Core”) – excluding food and energy.

   • According to the Federal Reserve Bank of Cleveland, the Core Consumer Price Index (CPI) is expected to fall from 6.1% in April, to 5.9% in May and 5.5% in June.
   • Both total employment and the labor force participation rate have recovered significantly and are now near pre-pandemic levels. As workers continue to return to the labor force, upward pressure on wages may abate.
   • The Biden administration is considering the reduction of certain Chinese tariffs to counteract inflation. Combined with a possible re-opening of the Chinese economy, the supply situation out of China may improve in the coming months.
   • In the United States, a recession in 2022 still seems unlikely. If the price of gasoline does not stabilize, the likelihood of a recession will grow in 2023.
   • Europe’s economy, in aggregate, is holding up better than feared several months ago, too.
   
   

2. Bad News: company earnings estimates are also coming down.

   • Overall, earnings have held up reasonably well given all the macro challenges we have faced, but forward estimates are beginning to flatten out.
   • If inflation has indeed peaked, market participants may become more focused on long-term earnings potential/growth.
   
   

3. Big News: we may be witnessing the end of a two- decades-long regime.

   • For the past 20 years (2000-2020), inflation was low. Stock prices and bond prices were inversely correlated during this time. As stock prices fell, bond prices generally rose – thus, bonds were a good hedge for stocks.
   • In the prior 40 years (1960s-2000), inflation was elevated and volatile. During these times, stock and bond prices were positively correlated, tending to move in the same direction.
   • If inflation has once again risen to a secularly high level, the diversification benefit from holding bonds may be reduced.
   • For these reasons, KeyBank Investment Center continues to recommend additional diversification in the form of real assets and alternative investments where appropriate.
   
   

Equity Takeaways:

Stocks rose in early trading on Monday. The S&P 500 rose about 1.5%, while small caps rose 0.7%. International shares also rose.

The 12-Month Forward Price/Earnings (P/E) multiple of the S&P 500 has fallen recently to about 17.5x. The multiple has contracted for many reasons, including rapidly rising interest rates and flattening earnings estimates.

The current P/E level of about 17.5x is close to the long- term average for the S&P 500. Technology stocks, even after a steep recent pullback, are still relatively expensive, trading about 18% above their long-term average P/E. Energy stocks, even after a significant recent rally, are still trading 32% below their 10-year average P/E multiple.

In recent years (1998, 2011, 2015, 2018), “growth scares” with no ensuing recession have seen average drawdowns in the S&P 500 of about 18%.

The recent cycle peak occurred on 1/3/22, and the year- to-date maximum drawdown occurred on 5/19/22, with the market closing down 18.7% from the peak.

Fixed Income Takeaways:

US Treasury yields drifted higher last week and continued that trend in early Monday trading, with the 10-year note yielding 2.99%, 5 basis points (bps) higher on the day and about 25 bps higher in the past week.

Early on Monday, the 2-year note was trading at 2.70%, 2 bps higher on the day and about 20 bps higher in the past week.

The Federal Reserve does not want to cause a recession. Even if we avoid a recession and obtain a “softish” landing, the macroeconomic environment will likely feel like a recession at times.