Half agony,
half hope
Investment implications
Fixed income
Equities
Alternatives
Key themes
Macro
Global Asset Allocation Viewpoints
1Q 2023
Financial conditions set the stage for another tough year
An unavoidable economic downturn
Developed market and China Purchasing
Managers’ Index (PMI)
Basis points, recessions are shaded, 1978–present
Source: Federal Reserve, Bloomberg, Principal Asset management. Data as of December 31, 2022.
Although U.S. growth has been remarkably resilient so far, recession will likely hit in the second half of 2023, while Europe is likely already in recession. Once the COVID dust settles, China may face a more constructive outlook.
Key insight
Macro
U.S. Treasury yield term spreads and
economic recessions
May 2008–present
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Click the cards below to learn about each macro investment theme
Global Asset Allocation Viewpoints
• Stresses are clearly building for consumers and corporates, while the U.S. Treasury yield curve has inverted—a historically reliable recession indicator.
• Not only is the 2y10y curve inversion material and sustained, but other segments of the yield curve are also inverted, including the 3month1year and 3month10year curves which are typically consistent with recession risk within a 12-month period. "
The global economy has avoided recession so far, but now must confront severe challenges.
Strains are building, and the U.S. will likely enter recession in the second half of 2023. By then, Europe will likely be emerging from recession, while China and Emerging Asia may be enjoying a COVID-reopening inspired recovery.
First rate hikes, now earnings weakness: Equity markets face further challenges this year.
The struggling macro backdrop signals a meaningful fall in earnings that is yet unaccounted for by markets—a headwind that will, inevitably, further extend the equity market drawdown.
Inflation is slowing only gradually and will remain above target in 2023, despite recession.
Segments of the inflation basket will soften rapidly, but tight labor markets and strong wage pressures imply that core segments of inflation will remain uncomfortably elevated, resulting in an incomplete disinflation process.
Fixed income, once again, can offer stability and income in a challenging economic backdrop.
Central banks are likely nearing the completion of their tightening cycle, implying that bonds will be able to support portfolios both as recession approaches and during forthcoming periods of volatility and risk.
Central banks will hike further this year and will not provide any relief.
Major central banks have now decelerated their tightening, but this isn’t a precursor to a less hawkish stance. The stubborn inflation story means that policy rates are rising further and will not be cut, even as recession takes hold.
The stubborn inflation picture implies that real assets outperformance is not yet exhausted.
Their diversification benefits and defensive characteristics in this macro environment are particularly valuable, as the stubbornly high inflation backdrop should extend outperformance in commodities and infrastructure.
Hover over each title to learn more about our key themes.
• Most economies have so far avoided recession, despite multiple headwinds.
• Although Europe felt the economic brunt of the Russia/Ukraine conflict, growth has likely only just slid into contraction territory during 4Q22.
• In the U.S., while manufacturing surveys have already fallen into recessionary territory, services sector activity remains firm, with estimates for GDP growth of around 4% in 4Q22.
• If policymakers in China can combine COVID reopening with effective stimulus measures, there will likely be positive impacts for emerging Asia.
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Key Themes
The labor market remains historically strong, but this is contributing to inflation concerns. The Fed will need to weaken labor demand in order to relieve wage pressures.
Key insight
Source: Federal Reserve Bank of New York, Bureau of Labor Statistics, NFIB, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
2001–present
• Unemployment remains close to record lows and monthly payrolls are hovering around 275,000–a level consistent with strong labor demand.
• A labor supply shortfall has opened up since the pandemic, and there is now a clear imbalance between labor demand and supply.
• This imbalance points to wage pressures. Wage measures are at a series high and are entirely inconsistent with the 2% inflation target. As such, the Fed needs to drive a moderation in labor demand to soften wage pressures.
• Despite U.S. consumer spending remaining strong, personal savings are dwindling and are well below the post-Global Financial Crisis trend, resulting in consumers tapping into credit.
• New York Fed data shows that credit card balances saw a 15% year-on-year increase in 3Q 2022—the largest rise in over 20 years. These strains will ultimately weigh on consumer spending.
US$ trillion, January 2002–November 2022
Source: Bureau of Economic Analysis, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Labor shortages and wage costs
United States personal savings
Click the cards below to learn about each equities investment theme
Equities
Click the cards below to learn about each fixed income investment theme
Fixed income
Click the cards below to learn about each alternatives investment theme
Alternatives
Fixed income
Alternatives
Equities
Emerging market hard currency
Emerging market local currency
Developed market credit
Developed market sovereigns
Ex-U.S.
TIPS
Preferreds (debt & equity)
High yield/Senior loans
Investment grade corporates
Mortgages
Treasurys
U.S.
Investment preference
Our fixed income positioning moves to an overweight, with bonds likely providing risk mitigation during the coming economic slowdown. We further increase our exposure to U.S. Treasurys and shift our exposure to investment grade from underweight to overweight. Not only does IG offer more attractive yields than in recent years, but the longer duration, high-quality profile of investment grade should deliver as the economy slows. By contrast, we keep high yield at an underweight, expecting further spread widening given recession and liquidity fears. Preferred securities remain at overweight due to favorable yields, low default rates and exposure to high-quality companies. EM debt remains an underweight given concerns about global risk appetite.
Investment viewpoints
Europe
UK
Japan
Developed Asia Pacific ex-Japan
Emerging Markets
Ex-U.S.
Large-cap
Mid-cap
Small-cap
U.S.
Investment implications
Alternatives
Fixed income
Equities
Less
Neutral
More
Investment preference
Click each tab to learn more about the investment implications
Diversified asset allocation: Underweight equities, overweight bonds, with real assets providing inflation mitigation.
• IG credit heavy core fixed income for stability
• Preferred securities strategies
• Agency MBS strategies
How to implement
Less
Neutral
More
Investment preference
We keep equities underweight as weakening earnings growth will likely bring further declines, even as the Fed stops hiking. We have no preference for the U.S. over other developed market and emerging market regions given that many of the factors driving U.S. outperformance are fading. Within the U.S, we stay overweight mid-caps given their exposure to defensive sectors and relatively attractive valuations. We keep our neutral exposure to both Europe and EM. While U.S. dollar weakness and China’s reopening may deliver a strong boost, their performances will inevitably be impacted by U.S. recession and broad market weakness.
Investment viewpoints
• Mid-cap U.S. strategies
• Quality-biased active managers
• Well-diversified strategies across DM and EM markets
How to implement
Our continued constructive view on alternatives conveys not only their diversification benefits in this macro environment, but also their fundamental strengths and defensive characteristics. We maintain our overweight to infrastructure, encouraged by its inflation-protection characteristics, stability of cash flows, and exposure to the structural de-carbonization trend. Despite short-term demand concerns, we also maintain our overweight preference to commodities, as medium-/long-term structural supply shortages should continue to support performance. With the outlook looking increasingly volatile in 2023, we increase our exposure to hedge funds.
Investment viewpoints
• Diversified real asset strategies (infrastructure, natural resources)
• Private real estate markets
How to implement
Investment preference
Hedge funds
REITs
Infrastructure
Natural resources
Commodities
indicates a change in preference from the previous quarter (light blue) to the current quarter (darker blue).
Viewpoints reflect a 12-month horizon
Source: Principal Asset Allocation. Alternatives asset class include commodities, natural resources, infrastructure, REITs, and hedge funds. Allocations across the investment outlook can be proportionately adjusted so magnitudes across categories do not have to net to neutral. Data as of December 31, 2022.
What should investors expect from markets and the economy in the first quarter and beyond? Listen as Seema Shah, Chief Global Strategist and Todd Jablonski, Chief Investment Officer & Head of Asset Allocation share their perspectives including key investment themes and asset allocation preferences.
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Recorded January 17, 2023
Although inflation is declining, the tight jobs market implies progress will be slow. Recession risk is high because it is a necessary condition for price stability.
Key insight
Source: Bureau of Labor Statistics, Principal Asset Management. Data as of December 31, 2022.
Year-over-year, 2015–November 2022
• In the U.S., there are segments of the inflation basket that will soften rapidly. Food and energy prices, for example, have fallen sharply, while the supply chain recovery is finally yielding relief for core commodities inflation.
• For services, however, disinflation will be a slow process.
• As wages make up the largest cost in delivering services, loosening in the labor market is required to push inflation toward 2%. Unfortunately, the resulting rise in job losses will likely lead to recession.
• Investor questions have shifted from whether inflation has peaked, to where it will settle.
• The broad contour of recent declines suggests inflation will fall short of global central bank targets, continuing to trigger angst and anxiety in policymakers.
• The Fed expects PCE inflation to only fall to 3.1% by the end of 2023, the BOE forecasts inflation at 5.2%, and the ECB is projecting 6.3%—all uncomfortably above their 2% targets.
January 2007–November 2022
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Contribution to headline U.S. inflation
Principal Asset Allocation GDP-weighted inflation
Policy rates in most major central banks will move further into restrictive territory in 2023 and will not be cut, even in the face of rising recession risk.
Key insight
• Today, most major central banks have decelerated their blistering pace of tightening. However, this isn’t a precursor to a less hawkish stance.
• With inflation expected to remain stubbornly above target, central banks have pledged to take rates even further into restrictive territory in 2023.
• What’s more, rate cuts in most developed markets are unlikely next year—despite elevated recession risk.
• For the Fed, this implies policy rates rising above 5% in early 2023, and remaining there throughout the year.
Upper bound, Federal Reserve, European Central Bank, Bank of England
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Global central bank policy rates and projections
The U.S. dollar may still see near-term strength given the Fed’s more hawkish resolve. Yet with rates nearing their peak, dollar weakness is waiting in the pipeline.
Key insight
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Rebased to 100 on November 1, 2020
• With the Fed hiking rates further and remaining the most hawkish of all major central banks—the U.S. dollar may still enjoy near-term strength.
• However, after a few more rate increases, a Fed pause should lead to a sustainably weaker U.S. dollar.
• With a weaker dollar, many developed market central banks will have the space to recalibrate from currency defence and fighting inflation via demand destruction, to more growth-supportive policies.
Major currencies
Tightening financial conditions have created a hostile backdrop for risk assets, which will only become more inhospitable as recessionary conditions become widespread.
Key insight
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Principal Asset Allocation Financial Conditions Index (FCI), Z-score, January 2005–present
• Given the breadth of central bank tightening, last year saw a sharp tightening in global financial conditions, driving a broad risk reversal.
• Despite some loosening in 4Q, central banks reiteration of their intention to raise policy rates further and hold at the peak should result in a re-tightening of financial conditions in 1Q 2023.
• The clear outlier may be China, where, once the post-COVID reopening chaos has passed, stimulus measures should be more effective in loosening financial conditions.
Developing market and emerging market financial conditions
Consumer and labor market resilience is unsustainable
An incomplete disinflationary trend
Monetary tightening: Slower, but higher, for longer
Relief from the U.S. dollar bull run is on its way
Bloomberg Commodity Spot Index measures the price movements of commodities included in the Bloomberg CI and select subindexes. It does not account for the effects of rolling futures contracts or the costs associated with holding physical commodities and is quoted in USD.
Bloomberg EM Hard Currency Aggregate Index is a hard currency Emerging Markets debt benchmark that includes USD denominated debt from sovereign, quasi-sovereign, and corporate EM issuers.
Bloomberg Global Aggregate Bond Index comprises global investment grade debt including treasuries, government-related, corporate, and securitized fixed-rate bonds from developed and emerging market issuers. There are four regional aggregate benchmarks that largely comprise the Global Aggregate Index: the US Aggregate, the Pan-European Aggregate, the Asian-Pacific Aggregate, and the Canadian Aggregate Indices. The Index also includes Eurodollar, Euro-Yen, and 144A Index-eligible securities and debt from other local currency markets not tracked by regional aggregate benchmarks
Bloomberg U.S. Aggregate Bond Index is the most widely followed broad market U.S. bond index. It measures the investment grade, US dollar-denominated, fixed-rate taxable bond market.
Bloomberg U.S. Corp High Yield 2% Issuer Capped Index is an unmanaged index comprised of fixed rate, non-investment grade debt securities that are dollar denominated. The index limits the maximum exposure to any one issuer to 2%.
Bloomberg U.S. Corporate Investment Grade Index includes publicly issued U.S. corporate and specified foreign debentures and secured notes that meet the specified maturity, liquidity and quality requirements. To qualify, bonds must be SEC-registered. The corporate sectors are industrial, utility and finance, which include both U.S. and non-U.S. corporations.
Bloomberg U.S. Floating Rate Note < 5 Years Index consists of debt instruments that pay a variable coupon rate, a majority of which are based on the 3-month SOFR, with a fixed spread.
Bloomberg U.S. Mortgage Backed Securities (MBS) Index tracks fixed-rate agency mortgage backed pass- through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
Bloomberg U.S. Municipal Index covers the USD-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and prerefunded bonds.
Bloomberg U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint. STRIPS are excluded from the index because their inclusion would result in double-counting.
Bloomberg U.S. Treasury Inflation Protected Securities (TIPS) Index is composed of inflation-protected U.S. Treasury bonds, commonly known as “TIPS”. TIPS are securities issued by the U.S. Treasury that are designed to provide inflation protection to investors.
FTSE Global Core Infrastructure 50/50 Total Return Index comprises securities in developed countries which provide exposure to core infrastructure businesses, namely transportation, energy and telecommunications, as defined by FTSE's International Benchmark Classification.
ICE BofA Contingent Capital Index tracks the performance of all contingent capital debt publicly issued in the major domestic and eurobond markets, including investment grade and sub investment grade issues.
ICE BofA Emerging Markets Corporate Plus Index, which tracks the performance of US dollar (USD) and Euro denominated emerging markets non-sovereign debt publicly issued within the major domestic and Eurobond markets.
ICE BofA U.S. All Capital Securities (i0cs) index of preferred securities represents investment grade and below investment grade instruments in both the retail $25par market and the institutional $1,000par market.
ICE BofA U.S. Corporate Index tracks the performance of U.S. dollar denominated investment grade rated corporate debt publicly issued in the U.S. domestic market.
ICE BofA U.S. High Yield Index tracks the performance of U.S. dollar denominated below investment grade rated corporate debt publicly issued in the U.S. domestic market.
JP Morgan EMBI Global Diversified Index is an unmanaged, market-capitalization weighted, total-return index tracking the traded market for U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
MSCI AC Asia ex Japan Index captures large and mid cap representation across 2 of 3 Developed Markets (DM) countries (excluding Japan) and 9 Emerging Markets (EM) countries in Asia.
MSCI AC Asia Pacific Index captures large and mid cap representation across 5 Developed Markets countries and 9 Emerging Markets countries in the Asia Pacific region.
MSCI ACWI Index includes large and mid cap stocks across developed and emerging market countries.
MSCI Brazil Index is designed to measure the performance of the large and mid cap segments of the Brazilian market.
MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs).
MSCI EAFE Index is listed for foreign stock funds (EAFE refers to Europe, Australasia, and Far East). Widely accepted as a benchmark for international stock performance, the EAFE Index is an aggregate of 21 individual country indexes.
MSCI Emerging Markets Index consists of large and mid cap companies across 24 countries and represents 10% of the world market capitalization. The index covers approximately 85% of the free float-adjusted market capitalization in each country in each of the 24 countries.
MSCI Europe Index captures large and mid cap representation across 15 Developed Markets (DM) countries in Europe.
MSCI Germany Index is designed to measure the performance of the large and mid cap segments of the German market.
MSCI India Index is designed to measure the performance of the large and mid cap segments of the Indian market.
MSCI Japan Index is designed to measure the performance of the large and mid cap segments of the Japanese market.
MSCI United Kingdom Index is designed to measure the performance of the large and mid cap segments of the UK market.
MSCI USA Growth Index captures large and mid cap securities exhibiting overall growth style characteristics in the U.S. The growth investment style characteristics for index construction are defined using five variables: long-term forward EPS growth rate, short-term forward EPS growth rate, current internal growth rate and long-term historical EPS growth trend and long-term historical sales per share growth trend.
MSCI USA Index is a market capitalization weighted index designed to measure the performance of equity securities in the top 85% by market capitalization of equity securities listed on stock exchanges in the United States.
MSCI USA Large Cap Index is designed to measure the performance of the large cap segments of the U.S. market.
MSCI USA Mid Cap Index is designed to measure the performance of the mid cap segments of the U.S. market.
MSCI USA Quality Index aims to capture the performance of quality growth stocks by identifying stocks with high quality scores based on three main fundamental variables: high return on equity (ROE), stable year-over-year earnings growth and low financial leverage. The MSCI Quality Indexes complement existing MSCI Factor Indexes and can provide an effective diversification role in a portfolio of factor strategies.
MSCI USA Small Cap Index is designed to measure the performance of the small cap segment of the U.S. equity market.
MSCI USA Value Index captures large and mid cap U.S. securities exhibiting overall value style characteristics. The value investment style characteristics for index construction are defined using three variables: book value to price, 12-month forward earnings to price and dividend yield.
Standard & Poor's 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the stock market.
Market indices have been provided for comparison purposes only. They are unmanaged and do not reflect any fees or expenses. Individuals cannot invest directly in an index.
Risk considerations
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. Asset allocation and diversification do not ensure a profit or protect against a loss. Equity investments involve greater risk, including higher volatility, than fixed-income investments. Fixed-income investments are subject to interest rate risk; as interest rates rise their value will decline. International and global investing involves greater risks such as currency fluctuations, political/social instability and differing accounting standards. Potential investors should be aware of the risks inherent to owning and investing in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. Non-investment grade securities offer a potentially higher yield but carry a greater degree of risk. Risks of preferred securities differ from risks inherent in other investments. In particular, in a bankruptcy preferred securities are senior to common stock but subordinate to other corporate debt. Emerging market debt may be subject to heightened default and liquidity risk. Risk is magnified in emerging markets, which may lack established legal, political, business, or social structures to support securities markets. Small and mid-cap stocks may have additional risks including greater price volatility. Treasury inflation-protected securities (TIPS) are a type of Treasury security issued by the U.S. government. TIPS are indexed to inflation in order to help investors from a decline in the purchasing power of their money. As inflation rises, rather than their yield increasing, TIPS instead adjust in price (principal amount) in order to maintain their real value. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful. Contingent Capitals Securities may have substantially greater risk than other securities in times of financial stress. An issuer or regulator’s decision to write down, write off or convert a CoCo may result in complete loss on an investment.
Important Information
This material covers general information only and does not take account of any investor’s investment objectives or financial situation and should not be construed as specific investment advice, a recommendation, or be relied on in any way as a guarantee, promise, forecast or prediction of future events regarding an investment or the markets in general. The opinions and predictions expressed are subject to change without prior notice. The information presented has been derived from sources believed to be accurate; however, we do not independently verify or guarantee its accuracy or validity. Any reference to a specific investment or security does not constitute a recommendation to buy, sell, or hold such investment or security, nor an indication that the investment manager or its affiliates has recommended a specific security for any client account. Subject to any contrary provisions of applicable law, the investment manager and its affiliates, and their officers, directors, employees, agents, disclaim any express or implied warranty of reliability or accuracy and any responsibility arising in any way (including by reason of negligence) for errors or omissions in the information or data provided.
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Important information
Index descriptions
Insights team
Todd Jablonski, CFA
CIO, Asset Allocation
Director, Global Strategist
Garrett Roche, CFA, FRM
Director, Global Insights
Brian Skocypec, CIMA
Chief Global Strategist
Seema Shah
Director, Quantitative Strategist
Han Peng, CFA
Insights Analyst
Ben Brandsgard
Global Insights Team
Source: Federal Reserve, Bloomberg, Principal Asset management. Data as of December 31, 2022.
Basis points, recessions are shaded, 1978–present
•The Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
•Since early 2021, European natural gas prices have risen almost 760%. By contrast, they have risen “just” 240% in the U.S.
•A global recession may be skirted, but not without a few key economic regions falling victim to the severe headwinds confronting the global economy.
•The global economy has been buffeted by a multitude of headwinds and is now in a synchronized downturn.
•The U.S. economy is decelerating under tighter financial conditions as the Federal Reserve raises policy rates aggressively to contain inflation—but it is not yet in recession. By contrast, the Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
May 2008–present
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Europe and U.S. natural gas prices
Global manufacturing PMIs
Global growth is struggling under the pressure of tighter financial conditions and elevated energy costs, and no economic region is immune to these challenges.
Key takeaway
A synchronized global economic downturn
Click the cards below to learn about each Macro investment theme
Macro
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"High inflation is sneaky hard to beat"
U.S. labor market's strength will be its downfall
Policy rates: Higher for longer
U.S. dollar: My currency, your problem Higher for longer
Global inflation has likely peaked, but price pressures have broadened into stickier segments of the economy and will only fade with determined central bank action.
Key takeaway
Financial conditions: Still further to tighten
Global inflation has likely peaked, but price pressures have broadened into stickier segments of the economy and will only fade with determined central bank action.
Key takeaway
U.S. dollar: My currency, your problem Higher for longer
•The global economy has been buffeted by a multitude of headwinds and is now in a synchronized downturn.
•The U.S. economy is decelerating under tighter financial conditions as the Federal Reserve raises policy rates aggressively to contain inflation—but it is not yet in recession. By contrast, the Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
January 20, 2004–present
Note: Valuation discount calculated as a simple average of price/book, price/sales and price/cash flow, then normalized to the average. Numbers above zero are times when mid-caps are more expensive than large-caps, while numbers below zero show periods when mid-caps are more attractive. Source: Clearnomics, FTSE Russell, Refinitiv, Principal Asset Allocation. Data as of December 31, 2022.
Global manufacturing PMIs
Global inflation has likely peaked, but price pressures have broadened into stickier segments of the economy and will only fade with determined central bank action.
Key takeaway
Policy rates: Higher for longer
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
S&P 500 Index, earnings-per-share, recessions are shaded, 1965–present
•The Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
•Since early 2021, European natural gas prices have risen almost 760%. By contrast, they have risen “just” 240% in the U.S.
•A global recession may be skirted, but not without a few key economic regions falling victim to the severe headwinds confronting the global economy.
•The global economy has been buffeted by a multitude of headwinds and is now in a synchronized downturn.
•The U.S. economy is decelerating under tighter financial conditions as the Federal Reserve raises policy rates aggressively to contain inflation—but it is not yet in recession. By contrast, the Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
2006–present
Note: Macro model based on ISM New Orders, Consumer Confidence, U.S. dollar, Brent crude, and BBB OAS.Source: ISM, Conference Board, Federal Reserve, CME, Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Europe and U.S. natural gas prices
Global manufacturing
PMIs
Global inflation has likely peaked, but price pressures have broadened into stickier segments of the economy and will only fade with determined central bank action.
Key takeaway
U.S. labor market's strength will be its downfall
Source: National Federation of Independent Business, S&P Dow Jones, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
1991–present
•The Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
•Since early 2021, European natural gas prices have risen almost 760%. By contrast, they have risen “just” 240% in the U.S.
•A global recession may be skirted, but not without a few key economic regions falling victim to the severe headwinds confronting the global economy.
•The global economy has been buffeted by a multitude of headwinds and is now in a synchronized downturn.
•The U.S. economy is decelerating under tighter financial conditions as the Federal Reserve raises policy rates aggressively to contain inflation—but it is not yet in recession. By contrast, the Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
Index level, earnings-per-share forecast, 1990–present
Source: Standard & Poor’s, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Europe and U.S. natural gas prices
Global manufacturing
PMIs
Global inflation has likely peaked, but price pressures have broadened into stickier segments of the economy and will only fade with determined central bank action.
Key takeaway
"High inflation is sneaky hard to beat"
•The global economy has been buffeted by a multitude of headwinds and is now in a synchronized downturn.
•The U.S. economy is decelerating under tighter financial conditions as the Federal Reserve raises policy rates aggressively to contain inflation—but it is not yet in recession. By contrast, the Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
Last twelve months returns and % times cheaper, MSCI indices
Source: FactSet, Bloomberg, MSCI, Principal Asset Allocation. LTM (last twelve months) returns are total return and in USD terms. % Time Cheaper is relative to PAA Equity Composite Valuation history. PAA Equity Composite Valuation is a calculated measure, comprised of 60% price-to-earnings, 20% price-to-book and 20% to dividend yield. Composite started in 2003. EAFE is Europe, Australasia, Far East. See disclosures for index descriptions. Data as of December 31, 2022.
Global manufacturing
PMIs
Global growth is struggling under the pressure of tighter financial conditions and elevated energy costs, and no economic region is immune to these challenges.
Key takeaway
A synchronized global economic downturn
Click the cards below to learn about each Macro investment theme
Macro
Global inflation has likely peaked, but price pressures have broadened into stickier segments of the economy and will only fade with determined central bank action.
Key takeaway
U.S. labor market's strength will be its downfall
"High inflation is sneaky hard to beat"
Source: Baker Hughes, NYMEX, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
1990–present
•The Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
•Since early 2021, European natural gas prices have risen almost 760%. By contrast, they have risen “just” 240% in the U.S.
•A global recession may be skirted, but not without a few key economic regions falling victim to the severe headwinds confronting the global economy.
•The global economy has been buffeted by a multitude of headwinds and is now in a synchronized downturn.
•The U.S. economy is decelerating under tighter financial conditions as the Federal Reserve raises policy rates aggressively to contain inflation—but it is not yet in recession. By contrast, the Euro area economy is likely already contracting as soaring natural gas prices create the most severe economic conditions in several decades.
Total return, calendar year 2022
Source: Clearnomics, Standard & Poor’s, MSCI, FTSE Russell, Bloomberg, Principal Asset Management. Data as of December 31, 2022. Commodities = Bloomberg Commodity Index, Fixed Income = iShares Core U.S. Bond Aggregate Index, EAFE = MSCI EAFE Index, Balanced = Hypothetical 60/40 portfolio consisting of 40% U.S. Large-Cap, 5% Small-Cap, 10% International Developed Equities, 5% Emerging Market Equities, 35% U.S. Bonds, and 5% Commodities, EM = MSCI EM Index, Small Cap = Russell 2000 Index.
Europe and U.S. natural gas prices
Global manufacturing
PMIs
Global growth is struggling under the pressure of tighter financial conditions and elevated energy costs, and no economic region is immune to these challenges.
Key takeaway
A synchronized global economic downturn
Click the cards below to learn about each equities investment theme
Equities
Disclosures
Note: Valuation discount calculated as a simple average of price/book, price/sales and price/cash flow, then normalized to the average. Numbers above zero are times when mid-caps are more expensive than large-caps, while numbers below zero show periods when mid-caps are more attractive. Source: Clearnomics, FTSE Russell, Refinitiv, Principal Asset Allocation. Data as of December 31, 2022.
January 20, 2004–present
• Mid-cap equities offer to bridge the gap between small-caps, with their attractive valuations but elevated earnings risk and large-caps, that have significant growth exposure that will be challenged by high and rising policy rates.
• Not only are mid-caps trading at a meaningful discount to large-caps, but their greater defensive sector exposure means they are less vulnerable than small-caps to the tough economic backdrop.
Mid-caps are trading at a meaningful discount to large-caps. Their greater defensive sector exposure means they are less vulnerable to the tough economic backdrop than small-caps.
Key insight
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
S&P 500 Index, earnings-per-share, recessions are shaded, 1965–present
• With the Fed having to prioritize its inflation fight this time, and therefore unlikely to deliver any monetary relief even as earnings forecasts are cut sharply, the equity market drawdown could rival the 1980’s 30% decline.
• Importantly though, the equity drawdown may not extend the full length of the earnings slowdown. Previous cycles have shown that equity markets typically trough before earnings growth hits its low.
• The macro backdrop, with consumer spending under pressure, manufacturing activity struggling, and still further rate hikes to come, signals a meaningful fall in earnings that is yet unaccounted for by markets.
• In fact, stripping out energy already reveals underlying earnings weakness, with five sectors experiencing earnings contraction.
• A conservative model, which excludes interest rates, points to an earnings contraction in 2023—a headwind that will, inevitably, further extend the equity market drawdown.
2006–present
Note: Macro model based on ISM New Orders, Consumer Confidence, U.S. dollar, Brent crude, and BBB OAS.Source: ISM, Conference Board, Federal Reserve, CME, Bloomberg, Principal Asset Allocation. Data as of December 31, 2022..
Peak to trough drawdowns greater than 10%
S&P 500 earnings growth outlook
Markets are yet to appreciate downside earnings risk. As Fed tightening transitions into a weaker growth backdrop, the S&P 500 is likely to re-test its September 2022 lows.
Key insight
Source: National Federation of Independent Business, S&P Dow Jones, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
1991–present
• Gross margins are under threat, not just from tight financial conditions and hawkish banks, but also tight labor markets.
• With wage growth so strong and consumer anxieties building, corporate profit margins are being squeezed from both sides. Earnings growth is under severe pressure.
• If the current market drawdown ended here, it would be broadly on par with the 2018 market decline—when the Fed took three years to raise policy rates by just 225 bps, and the economy slowed only modestly.
• In 2023, not only are further rate hikes expected, but the Fed is unlikely to deliver any rate cuts.
• Investor fixation on inflation and the Fed will persist in 2023, while markets also begin focusing on the next serious concern: Earnings recession.
Index level, earnings-per-share forecast, 1990–present
Source: Standard & Poor’s, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Small business sentiment versus corporate
operating margin
Market performance and earnings expectations
Earnings growth is only just starting to show the impact of last year’s 425 basis points of Fed tightening, pointing to further equity market drawdown ahead.
Key insight
• 2022 was undoubtedly a challenging year for equities. As a result, broad equity valuations have become more attractive and can even be considered historically cheap in a number of markets.
• There is one important exception: U.S. valuations are still expensive and have been cheaper almost 80% of the time.
• Once earnings and rates concerns have passed, likely in late 2023, this valuation picture will likely provide guidance as to where the best opportunities lie.
Last twelve months returns and % times cheaper, MSCI indices
Source: FactSet, Bloomberg, MSCI, Principal Asset Allocation. LTM (last twelve months) returns are total return and in USD terms. % Time Cheaper is relative to PAA Equity Composite Valuation history. PAA Equity Composite Valuation is a calculated measure, comprised of 60% price-to-earnings, 20% price-to-book and 20% to dividend yield. Composite started in 2003. EAFE is Europe, Australasia, Far East. See disclosures for index descriptions. Data as of December 31, 2022.
Global equity returns and valuations
Global equity valuations have become more attractive, and most markets can even be considered historically cheap. The U.S. is the key exception, with still expensive valuations.
Key insight
EM Asia and Europe stand to gain from China reopening
China: A bounce, but longer-term concerns linger
Mid-caps: Attractive value and defensively positioned
U.S. equities: A downturn, but not a washout
U.S. equities: Confronting the fallout from rate hikes
Global equity valuations: Spot the odd one out
Source: Bloomberg, Spectrum Asset Management, Principal Asset Management. See disclosures for index descriptions. Data as of September 30, 2022.
Various fixed income asset classes
• As central banks around the world aggressively raised rates, the outlook for preferred and capital securities has improved.
• Preferred securities are trading at a notable discount to par with attractive valuations, and they demonstrate relatively competitive yields, even compared to lower quality fixed income assets.
• Typically, preferreds are investment grade, with lower default rates than high yield. They also offer “fixed to floating,” “fixed to variable” rate structures which may help a long-term investor as rates rise.
Current yield and average credit rating
We remain slightly overweight preferred securities. Not only are yields relatively attractive, even compared to lower quality fixed income assets, but the structure can be ideal in the current environment of still raising rates.
Key insight
Source: JP Morgan, Intercontinental Exchange (ICE), Principal Asset Management. Data as of December 31, 2022.
U.S. dollar index level, JP Morgan emerging markets bond index versus U.S. dollar, 2018–present
• Most emerging markets (EM) experienced a year of extreme weakness in 2022. U.S. dollar strength, rising interest rates, high food prices and geopolitical tensions all weighed on the asset class.
• However, forthcoming U.S. dollar weakness presents the potential for optimism for EM, with external debt levels and balance of payments composition key to finding potential outperformance.
• China’s reopening may also improve the outlook for its key EM trade partners, particularly if combined with effective stimulus measures.
U.S. dollar versus emerging market debt
U.S. dollar weakness and China’s reopening should present potential for EM outperformance. However, tight financial conditions in developed markets mean these tailwinds may take some time to materialize.
Key insight
• The case for high quality credit is more than just defending portfolios from the difficult economic environment: Valuations are also attractive.
• After a sharp yield reset in 2022, U.S. investment grade yields have not been so competitive against equity earnings yield since the Global Financial Crisis.
• Global investment grade yields have also become relatively more attractive than equity yields, although not to the same extent as in the U.S.
2003–present
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Investment grade yields versus equity yields
Investment grade valuations have become more attractive, and higher quality exposure will be increasingly important as recession approaches.
Key insight
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Option-adjusted-spread, basis points, 2003–present
• A focus on credit quality will also be important as the economy slows, where certainty of cashflows is increasingly valued.
• Agency mortgage-backed securities deliver favorable characteristics. Not only are they underwritten by the U.S. government and therefore considered high-quality credit, but agency MBS have a longer duration.
• These longer-dated, high quality securities will likely be rewarded as the economy weakens and inflation slows.
• The stopwatch has been started on a likely recession, and many sectors of the economy have already begun to contract, especially the more rate sensitive ones, such as manufacturing.
• Notably, the rise in bond yields (and drawdown in bond values) seldom maintains amid such an economic slowdown.
• As such, it is highly likely that, as the economic slowdown continues, the real value of fixed income will be re-priced, permitting bonds to flourish in 2023.
1990–present
Source: Institute for Supply Management, Standard & Poor's, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Investment grade minus agency
mortgage-backed securities spread
10-year Treasury and the ISM
Manufacturing Index
Treasurys should perform well as recession approaches, while securitized debt typically shows a greater ability to withstand weakening growth than other credit segments.
Key insight
Source: Federal Reserve, S&P Dow Jones Indices, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Spread percentage, 2009–present
• Entering 2023, U.S. 10-year Treasury bonds now yield more than twice the estimated dividend yield of the S&P 500 index.
• This presents investors with the opportunity to lock-in income with a less volatile asset. What’s more, with yields having risen and inflation apparently slowing, bonds should provide risk mitigation during the coming economic slowdown.
• The negative correlation between stocks and bonds has reasserted itself, and the diversification benefit of bonds has been restored.
• U.S. bonds suffered one of the deepest drawdowns in U.S. history in 2022. In fact, the Bloomberg U.S. Aggregate Index suffered its third, fourth, and fifth worst quarters since 1976 last year.
• As markets adjusted to Fed hikes in 2022, the diversification benefits of bonds disappeared, with both stocks and bonds suffering significant declines.
• For the first time since the 19th century, U.S. equities and bonds simultaneously recorded double-digit yearly declines.
Ranked quarterly performance, 1976–present
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
U.S. 10-year Treasury yield minus S&P 500
estimated dividend yield
Bloomberg U.S. Aggregate Index
Having soared in 2022 as markets re-priced Fed expectations, bond yields finally present an investment opportunity, and have regained their diversification benefits.
Key insight
Preferred securities: In a favorable position
EM debt: Still waiting for its time in the sun
High yield spreads are still bracing for a full unwind
U.S. Treasurys: Playing an important role in portfolios
Fixed income: Back in fashion
• With inflation still elevated and likely to decline very gradually, investors should primarily seek assets with high return correlation to inflation.
• At the same time, with economic conditions becoming increasingly more difficult, investors ought to have some exposure to low volatility assets.
• Core real estate and private infrastructure may provide mitigation against elevated inflation. Treasury inflation protected securities (TIPS) also work as an inflation-resilient diversifier.
Correlation to 12-month rolling CPI, volatility is annualized, 2003–present
Source: Bloomberg, Principal Asset Management. Calculations based on monthly returns since 2003 and in USD-terms. Data as of December 31, 2022.
Major asset class inflation sensitivity
Investors wanting to preserve portfolios against still-elevated inflation, while also seeking to reduce volatility, would be well suited to add real asset exposure.
Key insight
• Infrastructure investments are one of the few asset classes that can potentially outperform in the current slowing growth, high inflation environment.
• Since demand for critical services is less sensitive to inflation, owners of certain infrastructure assets can sustain and increase prices without significantly impacting demand, offering potentially resilient returns.
• Listed infrastructure has historically delivered meaningfully higher returns than global equities during periods of higher inflation.
Rebased to 0% at June 1, 2021
Source: Bloomberg, Principal Asset Management. Infrastructure represented by the FTSE Global Core Infrastructure 50/50 Total Return Index in USD, Global equities represented by the MSCI ACWI Gross Total Return USD Index, Global bonds represented by the Bloomberg Global Aggregate Index. Data as of December 31, 2022.
Listed infrastructure performance compared to global equity and bond markets
Infrastructure continues to offer important diversification benefits, as well as inflation mitigation and stable income streams.
Key insight
Source: Baker Hughes, NYMEX, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
1990–present
• Given the difficulty of predicting the short-term outlook for commodity prices, investors should focus on long-term factors.
• Oil refiners displayed a very muted supply response to near record prices in 2022, suggesting a decrease in the price elasticity of oil supply.
• Limited capital expenditure in fossil fuels capacity implies that commodities are likely to remain in a long-term state of structural supply deficits that will be supportive of commodity prices.
• The commodity complex was the stand-out performer in 2022, one of the few asset classes to post consistent positive gains for the year.
• Yet, 4Q saw some of the gains being unwound as fears of fading global economic strength drove prices lower.
• Near-term commodity price dynamics are unclear. China’s reopening is expected to boost demand, driving prices higher, but spiking infection rates and broader recession fears may offset those upward pressures. Geopolitical factors impacting commodities supply will also be unpredictable.
Total return, calendar year 2022
Source: Clearnomics, Standard & Poor’s, MSCI, FTSE Russell, Bloomberg, Principal Asset Management. Data as of December 31, 2022. Commodities = Bloomberg Commodity Index, Fixed Income = iShares Core U.S. Bond Aggregate Index, EAFE = MSCI EAFE Index, Balanced = Hypothetical 60/40 portfolio consisting of 40% U.S. Large-Cap, 5% Small-Cap, 10% International Developed Equities, 5% Emerging Market Equities, 35% U.S. Bonds, and 5% Commodities, EM = MSCI EM Index, Small Cap = Russell 2000 Index.
World oil prices and infrastructure
Asset class performance
While the short-term commodity outlook is highly uncertain, long-term trends are clearer. Limited capital expenditure is driving structural supply deficits that should be supportive of commodity prices in the long-term.
Key insight
An environment ripe for real
asset outperformance
Infrastructure typically shines during high inflation
Commodities: Focusing on
long-term tailwinds
Russell mid-cap versus Russell 1000 valuation premium/discount
China 1yr loan rate is 1yr best lending rate before September 2019, 1yr LPR afterwards. Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
2009–present
• With the true pain in China residing in the lack of demand, households and companies haven’t taken advantage of rate cuts or targeted relending.
• As such, China’s COVID reopening will likely unleash pent-up demand and improve employment, leading to confidence restoration among households and businesses.
• Investor exuberance, however, may not be sustained for a very long period, as future stimulus from the government is likely to be very measured. Expect uncertainty and growth concerns to likely return and challenge China’s investment story.
• China’s equity market underperformance has lasted almost two years.
• Frequent lockdowns haven’t just deterred economic mobility (airline passenger traffic, for example, has been extremely depressed), but have also restricted the impact of stimulus on infrastructure investments, in turn worsening the country’s property downturn.
Rebased to 100 at January 2020, January 2010–September 2022
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
China loan demand and loan rate
Airline passenger traffic
Although policymakers appear to have recognized the urgency for policy stimulus, they have only a narrow window to introduce important policy measures.
Key insight
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
By region, January 2022–November 2022
• In contrast, emerging Asia’s fundamentals are looking much stronger. Domestic demand is robust and inflation is moderating.
• As China’s main trading partner, emerging Asian economies will likely be jumpstarted by China’s reopening.
• Despite these encouraging developments, investors should retain some caution: Recession conditions and rising rates in developed markets may weigh on EM Asia’s performance in 2023.
• European valuations are not only attractive relative to the U.S, but also relative to its own history. Yet, European fundamentals are deeply concerning.
• Not only is the economy likely already in recession, but inflation concerns are driving the European Central Bank to continue tightening policy at an aggressive pace.
• The spring may bring positive news with China’s reopening providing a strong boost to growth but, for now, weak fundamentals match cheap valuations, arguing for a neutral exposure to Europe.
MSCI Europe, 2008–present
Source: European Commission, Principal Asset Allocation. Data as of December 31, 2022.
China imports during the first eleven
months of 2022
European valuations and PMIs
China’s reopening should boost activity in its key EM Asia trading partners. But challenging conditions in developed markets will likely weigh on performance.
Key insight
Source: Federal Reserve Bank of New York, Bureau of Labor Statistics, NFIB, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
2001–present
• Stresses are clearly building for consumers and corporates, while the U.S. Treasury yield curve has inverted—a historically reliable recession indicator.
• Not only is the 2y10y curve inversion material and sustained, but other segments of the yield curve are also inverted, including the 3month1year and 3month10year curves which are typically consistent with recession risk within a 12-month period.
• Most economies have so far avoided recession, despite multiple headwinds.
• Although Europe felt the economic brunt of the Russia/Ukraine conflict, growth has likely only just slid into contraction territory during 4Q22.
• In the U.S., while manufacturing surveys have already fallen into recessionary territory, services sector activity remains firm, with estimates for GDP growth of just below 4% in 4Q22.
• If policymakers in China can combine COVID reopening with effective stimulus measures, there will likely be positive impacts for emerging Asia.
Source: Bureau of Economic Analysis, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
US$ trillion, January 2002–November 2022
U.S. Treasury yield term spreads and economic recessions
Developed market and China Purchasing Managers’ Index (PMI)
Although U.S. growth has been remarkably resilient so far, recession will likely hit in 2H23, while Europe is likely already in recession. Once the COVID dust settles, China may face a more constructive outlook.
Key insight
An unavoidable economic downturn
Source: Bureau of Labor Statistics, Principal Asset Management. Data as of December 31, 2022.
Year-over-year, 2015–November 2022
"• Unemployment remains close to record lows and monthly payrolls are hovering around 275,000–a level consistent with strong labor demand.
• A labor supply shortfall has opened up since the pandemic, and there is now a clear imbalance between labor demand and supply.
• This imbalance points to wage pressures. Wage measures are at a series high and are entirely inconsistent with the 2% inflation target. As such, the Fed needs to drive a moderation in labor demand to soften wage pressures."
"• Despite U.S. consumer spending remaining strong, personal savings are dwindling and are well below the post-Global Financial Crisis trend, resulting in consumers tapping into credit.
• New York Fed data shows that credit card balances saw a 15% year-on-year increase in 3Q 2022—the largest rise in over 20 years. These strains will ultimately weigh on consumer spending."
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
January 2007–November 2022
Labor shortages and wage costs
United States personal savings
The labor market remains historically strong, but this is contributing to inflation concerns. The Fed will need to weaken labor demand in order to relieve wage pressures.
Key insight
• Investor questions have shifted from whether inflation has peaked, to where it will settle.
• The broad contour of recent declines suggests inflation will fall short of global central bank targets, continuing to trigger angst and anxiety in policymakers.
• The Fed expects PCE inflation to only fall to 3.1% by the end of 2023, the BOE forecasts inflation at 5.2%, and the ECB is projecting 6.3%—all uncomfortably above their 2% targets.
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Upper bound, Federal Reserve, European Central Bank, Bank of England
Principal Asset Allocation GDP-weighted inflation
Although inflation is declining, the tight jobs market implies progress will be slow. Recession risk is high because it is a necessary condition for price stability.
Key insight
• Today, most major central banks have decelerated their blistering pace of tightening. However, this isn’t a precursor to a less hawkish stance.
• With inflation expected to remain stubbornly above target, central banks have pledged to take rates even further into restrictive territory in 2023.
• What’s more, rate cuts in most developed markets are unlikely next year—despite elevated recession risk.
• For the Fed, this implies policy rates rising above 5% in early 2023, and remaining there throughout the year.
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Rebased to 100 on November 1, 2020
Global central bank policy rates and projections
Policy rates in most major central banks will move further into restrictive territory in 2023 and will not be cut, even in the face of rising recession risk.
Key insight
• With the Fed hiking rates further and remaining the most hawkish of all major central banks—the U.S. dollar may still enjoy near-term strength.
• However, after a few more rate increases, a Fed pause should lead to a sustainably weaker U.S. dollar.
• With a weaker dollar, many developed market central banks will have the space to recalibrate from currency defence and fighting inflation via demand destruction, to more growth-supportive policies.
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Principal Asset Allocation Financial Conditions Index (FCI), Z-score, January 2005–present
Major currencies
The U.S. dollar may still see near-term strength given the Fed’s more hawkish resolve. Yet with rates nearing their peak, dollar weakness is waiting in the pipeline.
Key insight
Source: National Federation of Independent Business, S&P Dow Jones, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
1991–present
•Gross margins are under threat, not just from tight financial conditions and hawkish banks, but also tight labor markets.
•With wage growth so strong and consumer anxieties building, corporate profit margins are being squeezed from both sides. Earnings growth is under severe pressure.
•If the current market drawdown ended here, it would be broadly on par with the 2018 market decline—when the Fed took three years to raise policy rates by just 225 bps, and the economy slowed only modestly.
•In 2023, not only are further rate hikes expected, but the Fed is unlikely to deliver any rate cuts.
•Investor fixation on inflation and the Fed will persist in 2023, while markets also begin focusing on the next serious concern: Earnings recession.
Rebased to 100 at January 2020, January 2010–September 2022
Source: Bloomberg, Principal Asset Allocation. Data as of December 31, 2022.
Small business sentiment versus corporate operating margin
Market performance and earnings expectations
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
By region, January 2022–November 2022
•Gross margins are under threat, not just from tight financial conditions and hawkish banks, but also tight labor markets.
•With wage growth so strong and consumer anxieties building, corporate profit margins are being squeezed from both sides. Earnings growth is under severe pressure.
• China’s equity market underperformance has lasted almost two years.
• Frequent lockdowns haven’t just deterred economic mobility (airline passenger traffic, for example, has been extremely depressed), but have also restricted the impact of stimulus on infrastructure investments, in turn worsening the country’s property downturn.
Source: European Commission, Principal Asset Allocation. Data as of December 31, 2022.
MSCI Europe, 2008–present
China loan demand and loan rate
Airline passenger traffic
Source: Federal Reserve, Intercontinental Exchange (ICE), Principal Asset Management. Data as of December 31, 2022.
Option-adjusted-spread, basis points, 2010–present
• Although the Fed will likely stop hiking rates within the next six months, it will continue to withdraw liquidity via quantitative tightening.
• Higher-quality credit typically weathers challenging liquidity conditions better than lower-quality credits.
• Both the sudden shift in the Fed’s policy stance in early 2022 and peristently high inflation, left high- and low-quality credit with historically painful drawdowns in 2022.
• A Fed pause is increasingly expected in the first half of 2023, and typically, credit does well after the last Fed hike, bringing relief to rate-sensitive assets which have suffered the most.
• Investment grade bonds, specifically, often outperform given their higher duration and higher quality versus high yield credit.
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Average of previous six hiking cycles, rebased to 100 at date of last rate hike, date of last rate hike = month 0
U.S. high yield spreads and dollar liquidity
Monthly performance relative to the last
rate hike in a hiking cycle
Typically, credit does well after the last Fed hike. But, if rates are kept on hold at an elevated level for a prolonged period, high yield will likely face a difficult operating environment.
Key insight
Investment grade: more than just a defense play
line graph of U.S. 10-year Treasury yield minus S&P 500 estimated dividend yield from 2009–2022
• Given the breadth of central bank tightening, last year saw a sharp tightening in global financial conditions, driving a broad risk reversal.
• Despite some loosening in 4Q, central banks reiteration of their intention to raise policy rates further and hold at the peak should result in a re-tightening of financial conditions in 1Q 2023.
• The clear outlier may be China, where, once the post-COVID reopening chaos has passed, stimulus measures should be more effective in loosening financial conditions.
Source: Bloomberg, Spectrum Asset Management, Principal Asset Management. See disclosures for index descriptions. Data as of September 30, 2022.
Various fixed income asset classes
Developing market and emerging market
financial conditions
Tightening financial conditions have created a hostile backdrop for risk assets, which will only become more inhospitable as recessionary conditions become widespread.
Key insight
Financial conditions set the stage for another tough year
• With the Fed hiking rates further and remaining the most hawkish of all major central banks—the U.S. dollar may still enjoy near-term strength.
• However, after a few more rate increases, a Fed pause should lead to a sustainably weaker U.S. dollar.
• With a weaker dollar, many developed market central banks will have the space to recalibrate from currency defence and fighting inflation via demand destruction, to more growth-supportive policies.
Source: JP Morgan, Intercontinental Exchange (ICE), Principal Asset Management. Data as of December 31, 2022.
U.S. dollar index level, JP Morgan emerging markets bond index versus U.S. dollar, 2018–present
Major currencies
The U.S. dollar may still see near-term strength given the Fed’s more hawkish resolve. Yet with rates nearing their peak, dollar weakness is waiting in the pipeline.
Key insight
Relief from the U.S. dollar bull run is on its way
Monetary tightening: Slower, but higher, for longer
• Investor questions have shifted from whether inflation has peaked, to where it will settle.
• The broad contour of recent declines suggests inflation will fall short of global central bank targets, continuing to trigger angst and anxiety in policymakers.
• The Fed expects PCE inflation to only fall to 3.1% by the end of 2023, the BOE forecasts inflation at 5.2%, and the ECB is projecting 6.3%—all uncomfortably above their 2% targets.
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
2003–present
Principal Asset Allocation GDP-weighted inflation
Although inflation is declining, the tight jobs market implies progress will be slow. Recession risk is high because it is a necessary condition for price stability.
Key insight
An incomplete disinflationary trend
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Option-adjusted-spread, basis points, 2003–present
• Unemployment remains close to record lows and monthly payrolls are hovering around 275,000–a level consistent with strong labor demand.
• A labor supply shortfall has opened up since the pandemic, and there is now a clear imbalance between labor demand and supply.
• This imbalance points to wage pressures. Wage measures are at a series high and are entirely inconsistent with the 2% inflation target. As such, the Fed needs to drive a moderation in labor demand to soften wage pressures.
• Despite U.S. consumer spending remaining strong, personal savings are dwindling and are well below the post-Global Financial Crisis trend, resulting in consumers tapping into credit.
• New York Fed data shows that credit card balances saw a 15% year-on-year increase in 3Q 2022—the largest rise in over 20 years. These strains will ultimately weigh on consumer spending.
Source: Institute for Supply Management, Standard & Poor's, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
1990–present
Labor shortages and wage costs
United States
personal savings
The labor market remains historically strong, but this is contributing to inflation concerns. The Fed will need to weaken labor demand in order to relieve wage pressures.
Key insight
Consumer and labor market resilience is unsustainable
Source: Federal Reserve, S&P Dow Jones Indices, Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Spread percentage, 2009–present
• Stresses are clearly building for consumers and corporates, while the U.S. Treasury yield curve has inverted—a historically reliable recession indicator.
• Not only is the 2y10y curve inversion material and sustained, but other segments of the yield curve are also inverted, including the 3month1year and 3month10year curves which are typically consistent with recession risk within a 12-month period.
• Most economies have so far avoided recession, despite multiple headwinds.
• Although Europe felt the economic brunt of the Russia/Ukraine conflict, growth has likely only just slid into contraction territory during 4Q22.
• In the U.S., while manufacturing surveys have already fallen into recessionary territory, services sector activity remains firm, with estimates for GDP growth of just below 4% in 4Q22.
• If policymakers in China can combine COVID reopening with effective stimulus measures, there will likely be positive impacts for emerging Asia.
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Ranked quarterly performance, 1976–present
U.S. Treasury yield term spreads and economic recessions
Developed market and China Purchasing Managers’ Index (PMI)
Although U.S. growth has been remarkably resilient so far, recession will likely hit in 2H23, while Europe is likely already in recession. Once the COVID dust settles, China may face a more constructive outlook.
Key insight
An unavoidable economic downturn
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Macro
Source: Federal Reserve, Intercontinental Exchange (ICE), Principal Asset Management. Data as of December 31, 2022.
Option-adjusted-spread, basis points, 2010–present
• A focus on credit quality will also be important as the economy slows, where certainty of cashflows is increasingly valued.
• Agency mortgage-backed securities deliver favorable characteristics. Not only are they underwritten by the U.S. government and therefore considered high-quality credit, but agency MBS have a longer duration.
• These longer-dated, high quality securities will likely be rewarded as the economy weakens and inflation slows.
• The stopwatch has been started on a likely recession, and many sectors of the economy have already begun to contract, especially the more rate sensitive ones, such as manufacturing.
• Notably, the rise in bond yields (and drawdown in bond values) seldom maintains amid such an economic slowdown.
• As such, it is highly likely that, as the economic slowdown continues, the real value of fixed income will be re-priced, permitting bonds to flourish in 2023.
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Average of previous six hiking cycles, rebased to 100 at date of last rate hike, date of last rate hike = month 0
Investment grade minus agency mortgage-backed securities spread
10-year Treasury and the ISM Manufacturing Index
Treasurys should perform well as recession approaches, while securitized debt typically shows a greater ability to withstand weakening growth than other credit segments.
Key insight
• The commodity complex was the stand-out performer in 2022, one of the few asset classes to post consistent positive gains for the year.
• Yet, 4Q saw some of the gains being unwound as fears of fading global economic strength drove prices lower.
• Near-term commodity price dynamics are unclear. China’s reopening is expected to boost demand, driving prices higher, but spiking infection rates and broader recession fears may offset those upward pressures. Geopolitical factors impacting commodities supply will also be unpredictable.
Rebased to 0% at June 1, 2021
Source: Bloomberg, Principal Asset Management. Infrastructure represented by the FTSE Global Core Infrastructure 50/50 Total Return Index in USD, Global equities represented by the MSCI ACWI Gross Total Return USD Index, Global bonds represented by the Bloomberg Global Aggregate Index. Data as of December 31, 2022.
Asset class
performance
While the short-term commodity outlook is highly uncertain, long-term trends are clearer. Limited capital expenditure is driving structural supply deficits that should be supportive of commodity prices in the long-term.
Key takeaway
• Infrastructure investments are one of the few asset classes that can potentially outperform in the current slowing growth, high inflation environment.
• Since demand for critical services is less sensitive to inflation, owners of certain infrastructure assets can sustain and increase prices without significantly impacting demand, offering potentially resilient returns.
• Listed infrastructure has historically delivered meaningfully higher returns than global equities during periods of higher inflation.
Correlation to 12-month rolling CPI, volatility is annualized, 2003–present
Source: Bloomberg, Principal Asset Management. Calculations based on monthly returns since 2003 and in USD-terms. Data as of December 31, 2022.
Listed infrastructure performance compared to global equity and bond markets
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