Monthly Investment Letter: Why invest now?

Central bankers continue to talk tough about inflation, but markets have largely moved on from worries about rising prices as the risk of overtightening and recession has come into greater focus. What does this mean for investors today?

In the near term, we think the risk-reward for broad equity indexes will be muted. Equities are pricing in a “soft landing,” yet the risk of a deeper “slump” in economic activity is elevated. Tactically, we therefore advocate selectivity—preferring value, quality income, and healthcare—and optionality. In fixed income, we move high grade bonds, which would likely rally sharply in a “slump” scenario, from neutral to most preferred. In currencies, we keep a most preferred stance on the Swiss franc.

But what about investors with a longer-term view?

We believe a combination of below-average equity valuations, above-average yields, and post-peak private equity vintages will mean stronger long-term returns for diversified portfolios. After a 26% decline in valuations over the past 12 months, the S&P 500 is now trading at levels consistent with annualized returns in a healthy 7–9% range over the next decade (see page 3). Yields available in bond markets have improved significantly this year. And in alternatives, growth funds created following public market sell-offs have historically delivered better returns than those from prior vintages. In this context, from a longer-term perspective, many clients appear underdiversified and underinvested.

Investors often try to reconcile a constructive long-term view with a more challenging short-term outlook by simply waiting. But this approach also entails risks:

• The potential savings from waiting tend to be limited, but the potential opportunity costs can be much larger.
• And, while the near-term outlook for equities might be uncertain, we believe diversified portfolios should deliver more stable outcomes over the coming months, given the potential market scenarios we face.

By buying, or committing to buy, diversified portfolios today, we believe investors can both mitigate near-term risks and position for long-term performance, without running the risk of being left, potentially indefinitely, on the sidelines.

In this letter, we share our latest views on the short-term outlook for the market, then detail why we think the longer-term outlook has improved this year, and analyze how longer-term investors should think about the trade-off between waiting and investing.

Near-term uncertainty remains

Since our last letter, there have been two main developments relevant to our 2H outlook.

1. First, central banks are reducing fears of longer-term inflation. Although recent inflation data has surprised to the upside, markets have priced in a more frontloaded rate hiking cycle by the Federal Reserve, and this appears to be reducing long-term inflation fears. In the July University of Michigan survey of consumers, long-run inflation expectations fell to 2.8% per annum, down from 3.1% in June, and US 10-year breakeven inflation rates have declined from a peak of 3.1% in April to 2.46%. Core CPI has also now declined for three consecutive months.
2. Second, concerns about recession are rising as growth indicators have continued to fall. In the US, second-quarter GDP contracted 0.9% on an annualized basis, the second consecutive quarterly decline. S&P Global’s flash composite PMI dropped to 47.5 in July from 52.3 in June, indicating contraction. In the Eurozone, the composite PMI for July fell to 49.4 from 52 in June, also pointing to a contraction in business activity. In China, mortgage payment boycotts in response to suspended and delayed housing construction and the resurgence of COVID-19 in several cities have brought into focus potential headwinds to a second-half economic recovery.

To account for these developments, we have reduced the probability we assign to our “stagflation” scenario—in which fears of inflation running out of control drive both equities and bonds lower—from 20% to 10%. But we have also raised our estimate for our “slump” scenario—in which fears of a deeper recession lead stocks to fall and high grade bond prices to rise—from 30% to 40%.

Where does this leave us?

In our view, there is a 50% probability that broader equity indexes will move meaningfully lower over the balance of the year. The “reflation” scenario could bring upside, but this would require markets to start to believe that commodity supply challenges will be resolved, COVID-19 concerns in China will dissipate, or US labor force participation will rise significantly. We think this is a lower-probability scenario. As such, for tactical investors, this remains a market in which to stay diversified, defensive, and selective.

The long-term outlook has improved this year

The near-term outlook is challenging. Yet for longer-term investors, the sell-off so far in 2022 can be viewed as creating opportunity.

Valuations tend not to be a reliable guide to short-term performance. But they do correlate with long-term returns. Today, after a 26% derating over the past 12 months, the S&P 500 trades at a trailing price-to-earnings (P/E) ratio of 18.3x, a level that since 1960 has been consistent with annualized returns in a healthy 7–9% range over the next decade. The MSCI All Country World Index, meanwhile, trades at a trailing P/E of 15.5x, which since 1988 has been consistent with annualized returns of 6–8% over the next 10 years. Yields available in bond markets have also improved substantially this year.

Government bond yields are close to the highest level since 2018 (and 2008 before that). The starting level of yields has historically proven a reliable guide to longer-term bond market returns, suggesting that the longer-term outlook for fixed income is now stronger than it has been for most of the post-financial-crisis era.

In alternatives, although it is likely that some existing private equity funds will announce downward revisions to net asset values following the sell-off in public markets, growth funds created following public market sell-offs have historically delivered better returns than those of prior vintages. Cambridge Associates estimates an internal rate of return (IRR) of 18.6% for growth equity investments made one year after a market peak, versus 11.4% for those made one year before a public market peak.

Of course, there are some longer-term risks. Aging populations are likely to limit GDP growth, and the ongoing shift within economies in favor of services can hinder productivity growth. Profits as a percentage of GDP have risen to levels that suggest further gains might come at the expense of consumer spending. And quantitative tightening and higher interest rates imply a different liquidity outlook than has prevailed for the last decade.

However, we don’t need to believe that the next decade will be better than the past one to still see a decent outlook for portfolios. Furthermore, innovation and technological advances can promote productivity growth, even in service sectors. The Fourth Industrial Revolution can help drive economic efficiencies, which could help margins remain resilient. And, while central banks are shrinking their balance sheets, elevated levels of government debt mean they will want to keep long-term rates low to keep debt burdens sustainable.

It is difficult to know precisely how to balance competing long-term forces when calculating return estimates. But in our view the long-term valuation analysis has merit for its simplicity and track record. In short, we believe a combination of below-average equity valuations, above-average yields, and post-peak private equity vintages will mean stronger long-term returns for diversified portfolios.

Why waiting can be riskier than investing

One way that investors often try to combine a constructive long-term view with a more challenging short-term outlook is simply to wait before investing. But waiting comes with risks, too.

Let’s consider two options investors have today: 1) hold cash, and only buy if the market falls by 10% from today’s levels; or 2) buy now. How do these options play out over a one-year and 10-year horizon?

Based on our short-term S&P 500 targets and some assumptions about long-term levels for the index, we find that the risk-reward associated with waiting deteriorates notably over time. We offer a full analysis and explanations in the box at the end of this letter. But, to summarize, the longer one plans to invest for, the harder it is to rationally justify waiting.

The idea that waiting can be riskier than investing immediately is also borne out in the historical data. Since 1960, a strategy that waited for a 10% correction before buying the S&P 500 and then sold at a new all-time high would have underperformed a buy-and-hold strategy by 80x (yes, eighty). Over the same time period, a strategy of investing immediately after a 20% drop would have delivered an average one-year return of 15.6%. Staying in cash for a year after a 20% drop comes at a significant opportunity cost, and the gap in performance widens over time with the effect of compounding. And strategies investing “all at once” outperformed 12-month phased investment strategies by an average of 4.4% in the first year, considering data since 1945.

The costs associated with attempted market timing are also evident in real-world investor performance data. DALBAR’s latest Quantitative Analysis of Investor Behavior report shows that the average mutual fund investor has underperformed the S&P 500 by 3.52% p.a. over the past 30 years, including more than 10 percentage points of underperformance in 2021 alone. For many investors, the more work, time, and stress they add to their lives with market timing, the worse their performance.

In short, we think that by buying, or at least committing to buy, diversified portfolios today, investors can both mitigate near-term volatility and position for long-term performance, without running the risk of being left, potentially indefinitely, on the sidelines.

Investment ideas

Within our asset class preferences, we make two changes this month:

First, we move the 1- to 10-year segment of high grade bonds, which includes sovereign, agency, quasi-sovereign, and similar types of bonds, to most preferred from neutral.

• Significant expectations of a front-loaded rate hiking cycle are already priced in; spreads between high grade and sovereign bonds are wide compared to history; and the relatively high carry provides some insulation against volatility—yields would have to rise by 125 basis points in the 1- to 5-year segment and 50 basis points in the 5- to 10-year for the position to become unprofitable over a one-year period.
• There is also scope for yields to fall further if fears of a “slump” start to affect markets. This could be particularly beneficial for high grade bonds because, after a sharp sell-off so far this year, many bonds are now trading at a discount to their redemption values. This means a move lower in bond market yields would result in a larger increase in bond prices than a similar-sized move higher in market yields would result in lower prices. This is referred to as “positive convexity.”

Second, we move gold from neutral to least preferred.

• Increases in US interest rates, falling inflation, quantitative tightening, and continued US dollar strength are all likely to weigh on gold, and we expect prices to end the year at USD 1,600/oz, from USD 1,746/oz today. In this context, we do not think gold is well positioned as a hedge against economic slowdown and therefore think investors should either hedge existing gold positions or swap them for other defensive assets, such as high grade bonds, quality-income stocks, the healthcare sector, resilient credits, and the Swiss franc.

Elsewhere, within equities, we stay most preferred on quality income, value, and the UK and Australian markets, and least preferred on growth. We also prefer the energy and healthcare sectors.

In currency markets, we prefer the Swiss franc, the Australian dollar, and the Canadian dollar and are least preferred on the euro. We also keep a most preferred stance on overall commodities and oil.

Overall, to blend an uncertain short-term outlook with long-term opportunities, we continue to focus on ideas that can help investors build a diversified portfolio, navigate varying near-term outcomes, and grow wealth over the long term. These include:

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Adding up the cost of waiting

Does it make sense to wait before investing? Our analysis shows that, for those with one-year investment horizons, it is rational to wait if you perceive there is a greater-than-30% chance of a greater-than-10% sell-off. For those with a 10-year investment horizon, it is only rational to wait if you perceive a >81% chance of a >10% sell-off.

We assume:

• A 1-year cash return of 3%, based on 1-year US government bond yields.
• A 10-year cash return of 32%, based on compounding the 2.8% annualized yield on 10-year US government bonds.
• A 1-year return on equity of 8%, based on our June 2023 S&P 500 target of 4,200 (4.3% higher than today) and a dividend yield of 1.6%.
• A 10-year return on equity of 82%, based on our estimate of fair value in 10 years’ time. If we extrapolate trend earnings, we reach an estimate of S&P 500 earnings per share of USD 382 by 2032 (from USD 227 in 2022). The median P/E ratio on the S&P 500 since 1960 has been 16.1x. This would imply an S&P 500 level in 2032 of 6,150 (16.1 x USD 382), 56% higher than today’s level. If we include reinvested dividends, we derive a total return of 82%. (Note that trend earnings analysis can generate different forward returns than our historical P/E analysis).

Next, we consider the potential outcomes for two kinds of strategies that can be employed today: 1) hold cash, and only buy if the market falls by 10% from today’s levels; or 2) buy now.

• Returns for the “now” investor, who puts money to work immediately, would simply be in line with the market returns described above.
• Returns for the “wait” investor, who holds cash and only chooses to invest if a 10% sell-off materializes, would vary depending on whether the sell-off materializes, or doesn’t.
• For the scenarios in which a 10% sell-off materializes, the “wait” investor would buy in at 10% below the current prices. Thereafter, they would earn returns in line with our assumptions above. Depending on how long they waited in cash, they would also earn some return on cash.
• For the scenarios in which the 10% sell-off doesn’t materialize, the “wait” investor would remain in cash for the entire period.

The table below shows the potential outcomes.

• Over a 1-year horizon, “wait” investors would either earn 18–21% (if they bought the dip and the market recovered to our June 2023 target), or 3% (if they remained in cash). “Now” investors would earn 8%.
• Over a 10-year horizon, the “waits” would either earn 92–95% (if they bought the dip and the market delivered returns in line with the above assumptions thereafter), or 32% (if they remained in cash). The “nows” would earn 82%.

There is no one strategy that outperforms in all scenarios. So, how to calculate a rational course of action?

• Of course, much depends on the perceived likelihood of a sell-off. If a sell-off is likely, it is better to wait. If it is unlikely, it is better to invest now. One way to judge a rational course of action is to consider what probability of a sell-off would be required before the expected return from waiting is higher than the expected return from investing.
• Over a one-year horizon, we find we would have to assume a >30% probability of a sell-off before the “wait” investor’s expected returns are greater than the “now” investor’s return. (In this case, the expected return for the “wait” investor in the first year would be: (>30% x 18.5%) + (<70% x 3%) = >7%).
• Over a 10-year horizon, we would have to assume a >81% probability of a sell-off materializing before the “wait” investor’s expected returns are greater than the “now” investor’s. (In this case, the expected return over a 10-year horizon would be (>81% x 93.5% ) + (<19% x 32% ) = >82%).

What does this mean?

• In short, for investors putting money to work with a one-year investment horizon, it is rational to wait if they perceive a >30% chance of a >10% sell-off.
• But for those investing with a 10-year investment horizon, it is only rational to wait if they perceive a >81% chance of a >10% sell-off.
• Simply put, while waiting can be justified for investors with a short-term time horizon, longer-term investors need to be very sure that markets are going to sell off in order to rationally justify waiting to invest.

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