Navigating increasingly unstable markets
Investment implications
Fixed income
Equities
Alternatives
Key themes
Macro
Global Asset Allocation Viewpoints
2Q 2023
Financial conditions set the stage for another tough year
Global growth: Here today, gone tomorrow?
Developed market and China Purchasing Managers’ Index (PMI)
Federal Reserve Bank of New York, 1960–present
Source: Federal Reserve Bank of New York, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
While current economic conditions are supportive of above-trend growth, leading indicators are signalling elevated risks of recession later this year.
Key insight
Macro
U.S. recession probability in next 12 months
May 2008–present
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Click the cards below to learn about each macro investment theme
Global Asset Allocation Viewpoints
• Even as the global economy looks strong, leading indicators emphatically signal recession.
• The New York Fed’s own recession model suggests that the probability of recession within the next 12 months is the highest since the early 1980s.
Global economic growth has surprised to the upside, but U.S. recession risk is rising.
Although U.S. growth has remained strong, even accelerating in early 1Q, leading indicators continue to signal recession. Tighter lending standards, as a result of the recent banking crisis, only increase the risk of a hard landing.
Although equities have been resilient, earnings weakness will threaten further drawdown.
While 2022 dynamics were driven by inflation and rates scares, 2023 is likely to be dominated by earnings and economic growth scares. Margin pressures will weigh on company profitability, leading equities lower.
Price pressures remain too elevated; in most economies, inflation will end the year above target.
Part of the inflation basket will soften rapidly in response to normalizing supply chains and energy prices, but other key segments still require considerable weakening in labor markets if there is any hope of approaching target.
High-quality fixed income offers stability and income in this 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 are nearing the end of their tightening cycles as financial stability risks increase.
Each additional interest rate hike increases the risk of further market turmoil. Central bank policy rates will likely peak soon, but rate cuts are unlikely unless there is a severe and dangerous spike in financial system stress.
Alternatives provide important diversification against traditional equities and fixed income.
While inflation is decelerating, it remains uncomfortably high, so portfolios still require allocations to real assets to mitigate inflation risks. Assets that perform well in elevated volatility environments should also be prized.
Hover over each title to learn more about our key themes.
• Global economic activity has continued to defy policy tightening and the multiple geopolitical shocks.
• Softness in economic data in late-2022 proved to be seasonal noise and, in fact, since the start of 2023, activity data has only emphasized the continued resilience of the global economy.
• The stabilization in global manufacturing activity can be at least partially traced back to the reopening bounce in China, while the sharp drop in energy prices has given global consumers a boost.
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Key Themes
As small and medium sized banks respond to recent stress by reducing lending activity, consumers will be under pressure and job losses will likely increase.
Key insight
Source: NFIB, Bureau of Labor Statistics, Bloomberg, Principal Asset Management. Data as of April 11, 2023
1986–present
• Recent turmoil in the banking sector suggests the labor market strength will prove short-lived.
• Small banks account for 30% of all loans in the U.S. economy. They will likely spend several quarters repairing their balance sheets, implying tighter lending standards for both firms and households.
• This will lead to greater job losses, fading wage growth, weaker consumer spending, and ultimately a higher likelihood of recession.
• Labor markets remain very strong, and the U.S. unemployment rate sits close to 50-year lows. With nearly two job vacancies per unemployed worker, employers report considerable difficulties in filling available positions, maintaining upward pressure on wage growth.
• Robust jobs and wage growth have been key tailwinds for consumers.
January 2002–February 2023
Source: Bureau of Labor Statistics, Atlanta Fed, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Small business credit conditions and
initial jobless claims
Wage inflation and job openings
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 remains at an overweight, with bonds likely providing more stability during the coming economic slowdown. We neutralize all our regional positions. Within the U.S, we keep our overweight exposure to U.S. Treasurys, mortgages and investment grade, recognizing that the longer-duration, high-quality profile of these fixed income assets should outperform 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 as concerns about the sector have likely been overdone. Indeed, their bias is towards high-quality companies, while banks generally remain ring-fenced. Emerging market debt moves to a neutral position as the various headwinds have transitioned to tailwinds.
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 and alternatives.
• IG credit heavy core fixed income for stability
• Preferred securities strategies
How to implement
Less
Neutral
More
Investment preference
We keep equities underweight as weakening earnings growth will likely bring further declines, even as Fed rates approach their peak. The growing risk of U.S. recession and expensive U.S. valuations means we have a preference for other markets over the U.S. Within the U.S, large-cap equities should fare well as bond yields drop as the economy slows. Outside the U.S, we have a preference for emerging markets. Not only will it benefit from China’s stronger growth outlook and the weakening U.S. dollar, but EM should remain relatively insulated from the recent banking crises, provided severe liquidity strains do not emerge.
Investment viewpoints
• Large-cap U.S. strategies
• Quality-biased active managers
• Well-diversified and active international managers
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. With the outlook looking increasingly volatile in 2023, we maintain our overweight exposure to hedge funds. We shift our commodities position to neutral due to short-term uncertainty, while REITs remain at an underweight given growing concerns around commercial real estate.
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 March 31, 2023.
What should investors expect from markets and the economy in the second 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.
Webcast replay
Watch webcast
Recorded April 18, 2023
Central banks have made less progress towards disinflation than they had hoped. Inflation is likely to remain sticky and will still sit above central bank targets at year-end.
Key insight
Source: Bureau of Labor Statistics, Principal Asset Management. Data as of April 12, 2023.
Year-over-year, 2015–present
• Core goods inflation should decline as supply chains fully normalize, but is hitting some road bumps recently.
• Shelter inflation will slow, but this deceleration may take longer to materialize if the economy remains resilient.
• Core services ex-housing, which Fed Chair Jerome Powell has drawn clear attention to, is closely related to wage growth. Slower economic activity and a looser labor market will be necessary to fade these pressures.
• Global inflation is moderating, but so far this deceleration has been largely driven by last year’s energy price spike unwind.
• Core inflation remains uncomfortably high and, in some economies, continues to rise.
• The broad inflation takeaway from 1Q is that global central banks have made less progress towards disinflation than they had hoped.
January 2007–February 2023
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Contribution to headline U.S. inflation
Principal Asset Allocation GDP-weighted inflation
Although central banks need to stay focused on fighting inflation, financial instability concerns could result in a lower policy rate path.
Key insight
Historically, whenever the Fed has raised rates significantly, something breaks. While the recent banking crisis appears contained, the risk of further turmoil increases with each subsequent rate hike.
Key insight
Source: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
1966–present
• The banking crisis triggered sharp market turmoil, but was rapidly contained by policymaker liquidity intervention, enabling central banks to continue raising policy rates.
• Unfortunately, each additional rate hike increases economic and financial pressures, raising the chances of further crises.
• The Fed could respond to additional financial stress by cutting policy rates. Even then, by the time the Fed pivots, historically, the economic damage is usually done, and risk assets continue to struggle even as rates fall.
Fed funds rate and crisis events
Tightening financial conditions have created a hostile backdrop for risk assets, which threatens to worsen over the coming quarters.
Key insight
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Principal Asset Allocation Financial Conditions Index (FCI), Z-score, 2005–present
• Unsurprisingly, given the breadth of financial market stress, the first quarter of this year has seen a sharp tightening in developed market financial conditions.
• Conditions are set to worsen. Currently, bond markets are pricing in cuts in Fed funds by the July meeting, suggesting that there will be a rapid further deterioration in financial conditions through 2Q which forces the Fed’s hand.
• By contrast, China’s financial conditions picture looks very different. China’s policymakers are maintaining easy monetary policy, adding modest stimulus as they encourage a robust economic recovery.
Developing market and emerging market financial conditions
Strength at the top, problems at the bottom
An incomplete disinflationary trend
Central bank dilemma: Price stability vs financial stability
Fed tightening cycles: Something always breaks
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 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. High-Yield Corporate Bond Index is a rules-based, market-value-weighted index engineered to measure publicly issued non-investment grade USD fixed-rate, taxable and corporate bonds.
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 Barclays 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.
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.
HFRI 500 Fund Weighted Composite Index is a global, equal-weighted index of the largest hedge funds that report to the HFR Database which are open to new investments and offer quarterly liquidity or better.
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. Investment Grade Institutional Capital Securities Index tracks the performance of US dollar denominated investment grade hybrid capital corporate and preferred securities publicly issued in the US domestic market.
ICE BofA U.S. Corporate Index consists of investment-grade corporate bonds that have a remaining maturity of greater than or equal to one year and have $250 million or more of outstanding face value.
ISM manufacturing index is a leading economic indicator that measures the growth in the manufacturing sector in the United States.
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 Europe Banks Index is composed of large and mid cap stocks across 15 Developed Markets countries in Europe. All securities in the index are classified in the Banks industry group (within the Financials sector) according to the Global Industry Classification Standard (GICS®).
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.
U.S. dollar index (USDX) is a measure of the value of the U.S. dollar relative to a basket of foreign currencies.
VIX is the ticker symbol and the popular name for the Chicago Board Options Exchange's CBOE Volatility Index, a popular measure of the stock market's expectation of volatility based on S&P 500 index options.
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.
This material may contain ‘forward-looking’ information that is not purely historical in nature and may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader.
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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 Bank of New York, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Federal Reserve Bank of New York, 1960–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 March 31, 2023.
Europe and U.S. natural gas prices
Key takeaway
A synchronized global economic downturn
Click the cards below to learn about each Macro investment theme
Macro
Download (PDF)
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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
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
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 Management. Data as of March 31, 2023.
2006–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.
S&P 500 12m forward consensus earnings estimates and annual headline consumer price inflation, 2015–present
Source: Bureau of Labor Statistics, S&P Dow Jones, Bloomberg, Principal Asset Management. Data as of April 12, 2023.
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: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
0 = month of rate action
•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.
Level, January 2022–present, and October 2000–October 2002
Source: Standard & Poor’s, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
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 March 31, 2023.
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: S&P Dow Jones, Macroeconomic Advisers, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Adjusted for U.S. nominal GDP, 1992–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.
2002–present
Source: Korean Ministry of Trade, Industry and Energy, Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
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
An uncertain macro environment and a volatile market suggest defensive sectors (utilities, staples, health care) could potentially outperform.
Key insight
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 Management. Data as of March 31, 2023.
2006–present
• A conservative model, which excludes interest rates, points to an earnings contraction in 2023.
• Today, the stocks of the S&P 500 are valued at about 18.4x forward earnings, above the 15-year median of 16.1x, suggesting that positive earnings growth expectations remain embedded in price levels.
• As earnings disappoint, and future earnings expectations are revised downward, this could then present a significant risk to equity levels.
• Amid these challenging conditions, investors should prioritize margin resilience.
• Even in the unlikely scenario of the Fed engineering a soft landing, an earnings recession may already be in the cards. Reported S&P 500 earnings have been slowing since their peak in mid-2022 and contracted by -3.2% in 4Q.
• What’s more, earnings growth will be further challenged in the coming quarters. Record high margins, initially padded by high inflation, are now facing headwinds as price pressures ease and wage demand plays catch-up.
S&P 500 12m forward consensus earnings estimates and annual headline consumer price inflation, 2015–present
Source: Bureau of Labor Statistics, S&P Dow Jones, Bloomberg, Principal Asset Management. Data as of April 12, 2023.
S&P 500 earnings-per-share model
Earnings estimates and inflation
Markets are yet to appreciate downside earnings risk. As macro conditions deteriorate, the S&P 500 is likely to re-test its September 2022 lows.
Key insight
Source: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
0 = month of rate action
• Fed tightening has put significant stress on the economy and, with yield curves deeply inverted, bank profitability has been under pressure.
• In response, banks are raising credit standards and likely starting to limit credit flow, weighing on consumer spending and labor markets.
• An economic recession, with a clear negative impact on earnings growth, will likely have a serious impact on the already shaky footing of risk markets.
• U.S. equities have proven fairly resilient, recording quarterly gains even as the Fed has persisted with its historically aggressive tightening cycle and as banking sector stress spiralled.
• The S&P 500 has tracked the path of the equity market during the 2000-2002 downturn, suggesting a further protracted path of weakness could lie ahead.
• While 2022 dynamics were driven by inflation and rates scares, 2023 is likely to be dominated by earnings and economic growth scares.
Level, January 2022–present, and October 2000–October 2002
Source: Standard & Poor’s, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Historical Federal Reserve rate hike cycles
S&P 500 today versus early 2000s analog
The equity and bond market disconnect is unlikely to persist for much longer. Aggressive Fed tightening will ultimately weigh on economic growth, further challenging equity markets.
Key insight
• The broad equity market performance in 1Q was fairly resilient, shrugging off concerns around banking sector stress and elevated recession risk.
• Following the quarter rally, global equity valuations have become less attractive, although most markets can still be considered relatively cheap following last year’s drawdown.
• In Europe, Germany and the UK remain attractive, while valuations in the European banking sector have only been cheaper during the GFC and the European Sovereign Debt crisis.
• Emerging markets can also be considered cheap, driven by significantly discounted valuations in Latin America.
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 March 31, 2023.
Global equity returns and valuations
Global equity valuations have become slightly more expensive. The U.S. remained the most expensive market, whereas Germany and the UK have rarely been cheaper.
Key insight
Europe’s banking crisis interrupts a strong story
China and EM: Reopening is driving momentum
Styles to the side, re-focus on sectors
U.S. equities: Earnings recession to take its toll
U.S. equities: Confronting the fallout from rate hikes
Global equity valuations: Spot the odd one out
These assets offer a yield advantage over core bonds and, with regulators and policymakers intent on containing bank risks, have a more attractive risk profile than high yield.
Key insight
Note: Above are z-scores of bond index option-adjusted-spread-to-worst versus government yields, calculated since 2004. Source: Bank of America, ICE Indices, Ltd., Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Z-scores of option-adjusted-spread to worst versus gov't yields, 2022–present
• Three months into 2023, many EM headwinds have either become tailwinds or at least abated.
• China’s reopening was smoother than expected, with a strong economic rebound and continued policy stimulus.
• Energy prices had fallen following a mild winter in Europe, fading some of the immediate EM economic constraints.
• The U.S. dollar has started to weaken as the end of the Fed’s rate hiking cycle approaches, giving EM central banks the space to ease policy and ignite domestic growth (inflation permitting).
Emerging market debt and investment grade spreads
EM headwinds have become tailwinds, improving the picture for EM debt. However, with global liquidity concerns continuing to threaten, a neutral position is advised.
Key insight
• As recession approaches, high-quality credit will become a more attractive investment proposition. A growing premium will likely be placed on solid earnings performance, and this will be reflected in disparate performance of high- versus low-quality credits.
• Corporate credit spreads to U.S. Treasurys have remained tight, however recent volatility stemming from U.S. regional banking concerns have led to some spread widening. These could be expected to widen further as macro and liquidity conditions deteriorate and lending standards tighten further.
1991–present
Note: IG represented by the Bloomberg U.S. Corporate Total Return Index. High yield represented by the Bloomberg U.S. Corporate High Yield Total Return Index. Source: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Investment grade versus high yield relative performance and loan officers' credit standards
Higher-quality fixed income assets, such as agency MBS and investment grade credit, should outperform as lending standards tighten and the economy slows.
Key insight
Source: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Basis points, 1985–present
• While the abysmal 2022 performance questioned fixed income’s ability to provide diversification, 1Q 2023 restored that characteristic.
• Not only does fixed income pay a historically high coupon rate, its cashflows are typically more stable than risk assets. As the economy slows, and corporate earnings are likely to come under pressure, the reliability of fixed income coupons will become more highly valued.
• As economic weakness permeates over the coming quarters, market interest rates will likely recede to recessionary levels. This will also provide for capital appreciation of bond holdings.
• The most pristine collateral in the global financial system is U.S. Treasurys, and their liquidity and quality was recently demonstrated amid U.S. regional bank concerns.
• This episode has proven the important diversification benefits of holding fixed income securities in a portfolio, as a hedge against both volatility and market illiquidity.
1991–present
Source: Institute for Supply Management, Standard & Poor's, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Three-day change in U.S. 2-year Treasury yield
10-year Treasury and the ISM
Manufacturing Index
Security, diversification, reliable cashflows and upside potential make a compelling case for holding U.S. Treasurys.
Key insight
Source: Federal Reserve, S&P Dow Jones Indices, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Spread percentage, 2009–present
• Despite the recent rally, bonds remain favorable. 10-year U.S. Treasurys yield more than twice the estimated dividend yield of the S&P 500, presenting investors an opportunity to lock-in income with a generally less volatile asset.
• After suffering one of the deepest drawdowns in U.S. history in 2022, U.S. bonds started the year strongly, even ending 1Q with modest gains, despite a rather eventful quarter.
• Bond diversification benefits were clear, especially as bank liquidity concerns drove U.S. spreads wider, driven mostly by lower sovereign yields.
• Global Agg spreads also widened, but less so, as European banks also came under pressure. Hard currency EM debt showed resilience, exempted from DM banking risks, to also end up with modest gains.
Rebased to 100 at January 1, 2020
Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
U.S. 10-year Treasury yield minus S&P 500
estimated dividend yield
U.S. and global bond performance
With growth and financial stability concerns outweighing inflation fears, and valuation remaining attractive, the investment thesis for fixed income is getting stronger.
Key insight
Preferred securities: A market dislocation opportunity
EM debt: Improved outlook but with lingering risks
High yield: Time to face the music
U.S. Treasurys: Playing an important role in portfolios
Fixed income: Still in fashion
• Economic policy uncertainty often leads to elevated market volatilities, and more pronounced idiosyncratic risks. This investment landscape presents headwinds to most risk assets.
• Hedge funds, however, with their low beta exposure and high alpha potential, could potentially do well in such an environment.
• Historically, hedge funds’ outperformance against global equities goes hand in hand with rising volatilities, making them attractive today for investors seeking alpha.
• However, strong manager selection is imperative, as divergence among hedge funds tends to be significant.
Hedge fund year-over-year relative performance against AC World vs. VIX year-over-year change, December 2005–present
Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Hedge fund relative performance versus equity volatility
Policy uncertainty, as is the case in the current environment, tends to lead to rising market volatilities which supports hedge funds outperformance against equities.
Key insight
• Despite recent banking sector stress which resulted in turmoil for the broader market, listed infrastructure performed strongly— true to its defensive nature.
• Listed infrastructure has historically delivered meaningfully higher returns than global equities during periods of elevated inflation.
• 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.
• Furthermore, infrastructure investments typically have predictable cash flows associated with the long-lived assets, with historically attractive yields.
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 March 31, 2023.
Listed infrastructure performance compared to global equity and bond markets
Infrastructure continues to offer important diversification benefits, as well as inflation mitigation and a more stable income stream.
Key insight
Source: S&P Dow Jones, Macroeconomic Advisers, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Adjusted for U.S. nominal GDP, 1992–present
• While the short-term commodity outlook is shrouded in uncertainty, the long-term outlook remains more constructive.
• Limited capital expenditure in fossil fuels capacity over recent years implies that commodities are likely to remain in a long-term state of structural supply deficits that will be supportive of commodity prices.
• After being the stand-out performer in 2022, the commodity complex has been under severe pressure, and underperformed most traditional asset classes in 1Q this year as concerns about economic growth have come to the fore.
• The positive China reopening dynamic is broadly offset by rising fears around U.S. economic growth, resulting in significant uncertainty around the commodity demand outlook.
2002–present
Source: Korean Ministry of Trade, Industry and Energy, Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
S&P Energy Capital Expenditure
Bloomberg Commodities Index and South Korean trade exports in U.S. dollars
The short-term commodity outlook is highly uncertain, as China growth hopes are offset by U.S. growth fears. Long-term trends are clearer and more constructive.
Key insight
REITs are vulnerable to recent banking sector strains
Infrastructure’s valuable defensive characteristics
Commodities: Caught in the global cross-currents
Source: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Share of key import regions, calendar year 2022
• Broader EM is benefiting from China’s recovery, particularly its key trade partners, with the weaker U.S. dollar also supporting EM performance. Attractive EM valuations are coinciding with improving fundamentals.
• China and the broader EM complex has also been somewhat isolated from the recent U.S. and European banking sector turmoil. However, if liquidity stress escalates, EM performance will likely struggle.
• In China, the lifting of COVID restrictions in late 2022 has seen economic activity data beat expectations by the largest margin since April 2020.
• The release of considerable pent-up demand as consumer confidence grows should ensure a continuation of this positive economic performance.
• In addition, China’s inflationary pressures have stayed muted, permitting the central bank to continue easing policy even as other major central banks tighten policy. However, incremental easing will likely be moderate.
Z-score, three month weighted moving average, January 2011–present
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
China imports in 2022
Principal Asset Allocation China Economic Surprise Index
Strong economic recovery will continue to help China and EM equities, while China’s insulation from recent banking sector turmoil is an additional positive.
Key insight
"Note: Yield differential is 2y Treasury two-years forward carry differential. Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023."
2004–present
• The weakening U.S. dollar has also been an important factor, with the recent slowing of Fed rate hikes, contrasted to the ECB’s accelerating rate hikes, precipitating the crack in the greenback’s historic rally.
• This change in dollar direction has been highly advantageous to foreign-stock investors, and, if extended, could support the non-U.S. investment story.
• European equities had been outperforming U.S. equities, modestly recovering some of the decades-long under-performance trend.
• As European fundamentals strengthened, investors took advantage of the historic discount of European equities relative to U.S. equities.
• Early in 1Q, European banks thrived, with investors finally appreciating the fact that they hold stronger liquidity positions and lower duration risk than U.S. banks, and have valuation multiples meaningfully less stretched. However, the recent European banking crisis has knocked confidence, dimming the outlook for broad European equities.
Rebased to 100 at January 2022
Note: MSCI Europe and Europe Banks are Total Return and in U.S. dollar terms. Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Yield differential and U.S. dollar Index
MSCI Europe versus MSCI Europe Banks
Although Europe outperformed in 1Q, concerns around its banking sector as well as risks that the ECB will have tighten considerably further, prompt a neutral outlook.
Key insight
Source: NFIB, Bureau of Labor Statistics, Bloomberg, Principal Asset Management. Data as of April 11, 2023
1986–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 Labor Statistics, Atlanta Fed, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
January 2002–February 2023
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 April 12, 2023.
Year-over-year, 2015–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: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
January 2007–February 2023
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
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: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
1966–present
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 March 31, 2023.
Principal Asset Allocation Financial Conditions Index (FCI), Z-score, 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: Bloomberg, Principal Asset Management. Data as of December 31, 2022.
Share of key import regions, calendar year 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.
•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.
Z-score, three month weighted moving average, January 2011–present
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Small business sentiment versus corporate operating margin
Market performance and earnings expectations
"Note: Yield differential is 2y Treasury two-years forward carry differential. Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023."
2004–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.
• 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.
Note: MSCI Europe and Europe Banks are Total Return and in U.S. dollar terms. Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Rebased to 100 at January 2022
China loan demand and loan rate
Airline passenger traffic
Source: The Conference Board, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
1995–present
• While U.S. high yield spreads now exceed the 2010-2022 average of 468 bps, they could widen further on the back of fresh liquidity issues in the banking sectors.
• Investor caution is likely to grow as the slowing economy and hawkish central banks come into tension.
• High yield put in a resilient performance in early 1Q, with spreads tightening despite economic slowdown concerns. But by the end of February, alarm bells were ringing.
• Since 2000, high yield had been more expensive 40% of the time. While this doesn’t immediately seem worrying, each of those more expensive periods either featured economic expansions or a dovish Fed, neither of which are the case currently.
• In the end, banking turmoil delivered a strong dent to risk appetite, driving a widening in credit spreads.
Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Axis crosses at February 2023 value, 2000–present
The Conference Board leading economic indicators and U.S. corporate high yield spread
Historical high yield spreads
High yield spreads could widen further on fresh liquidity issues in the banking sector and as economic slowdown concerns deepen.
Key insight
Navigate credit headwinds with high quality assets
• 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, Principal Asset Management. Data as of March 31, 2023.
2013–present
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.
Note: Above are z-scores of bond index option-adjusted-spread-to-worst versus government yields, calculated since 2004. Source: Bank of America, ICE Indices, Ltd., Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Z-scores of option-adjusted-spread to worst versus gov't yields, 2022–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.
Note: IG represented by the Bloomberg U.S. Corporate Total Return Index. High yield represented by the Bloomberg U.S. Corporate High Yield Total Return Index. Source: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
1991–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: Federal Reserve, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Basis points, 1985–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 March 31, 2023.
1991–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 March 31, 2023.
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 March 31, 2023.
Rebased to 100 at January 1, 2020
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
Click the cards below to learn about each Macro investment theme
Macro
Source: The Conference Board, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
1995–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 March 31, 2023.
Axis crosses at February 2023 value, 2000–present
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 March 31, 2023.
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.
Hedge fund year-over-year relative performance against AC World vs. VIX year-over-year change, December 2005–present
Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
Listed infrastructure performance compared to global equity and bond markets
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Disclosures
Investment implications
Alternatives
Fixed income
Equities
Macro
Key themes
Global Asset Allocation Viewpoints
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.
Hedge funds: Riding the volatility
• REITs have faced intense pressure from the recent banking crisis. U.S. banks are the largest holders of commercial real estate (CRE) debt, so any stress to bank balance sheets or tightening in financial conditions filters through to the CRE market.
• With small/regional banks likely to reduce their lending appetite, and more scarce and expensive debt likely to pressure transaction volumes, a further pullback in commercial real estate —and therefore REITs—is likely in the coming months.
Note: Data since Q4 2013 is average of Construction and land development, Nonfarm nonresidential and Multifamily. Source: Federal Reserve, Principal Asset Management. Data as of March 31, 2023.
Net % of banks, 1990–present
U.S. bank responses regarding commerical real estate loans
As a result of the recent banking crisis, REITs will face further pressure from a likely reduction in small/regional banks’ appetite for commercial real estate loans.
Key insight
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Future market priced ECB rates path as of March 1 vs. March 31
• At the start of March, the European Central Bank (ECB) was expected to hike a further 100 bps through this year.
• By the end of the month, after recent bank failures sent the financial sector into disarray, markets were expecting no further rate hikes from the ECB.
• Both the timing and rate path is unclear from here. Not only is it difficult to estimate how much further banking stresses will extend, the extent of tightening in bank lending standards that will result from recent banking sector stress is also uncertain.
• Market expectations for Fed funds rates in early March were edging towards a 6% terminal rate for the Fed and no rate cuts through 2023.
• However, recent bank failures shave emphasized the need for central banks to put extra focus on financial stability, and markets now expect no further Fed hikes, plus three rate cuts this year.
• Our own Fed forecasts see a peak rate of 5.25%- 5.50% as the central bank continues to use its policy rate to target inflation, while using its balance sheet liquidity to target financial stability.
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Future market priced fed funds rates path as of March 1 vs. March 31
European Central Bank rates path
Federal Reserve rates path
S&P 500 financials sector, banks industry group, and regional banks sub-industry, price returns, rebased to 100 at January 2019
S&P 500 financials sector, banks industry group, and regional banks sub-industry, price returns, rebased to 100 at January 2019
• The U.S. financial sector was also subject to some downward revision, but this preceded the recent events in the banking space.
• Wavering confidence, tightening lending standards, particularly in regional banks as they look to shore up balance sheets, will likely result in further downgrades in this sector.
• In the current environment of elevated bond volatility and focus on margin preservation, investors should also take closer consideration of sectors.
• In 1Q, earnings expectations were revised lower across sectors. The downward revisions were particularly large in cyclical sectors, with 2023 EPS expectations turning sharply negative for energy and materials.
• There was also a significant downgrade to the U.S. consumer discretionary sector relative to other regions, highlighting the greater concerns for the U.S. economy.
Source: Factset, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
2023, MSCI All Country World Index vs. MSCI U.S. Index
Financials sector performance
Sector EPS 3-months revisions
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Future market priced ECB rates path as of March 1 vs. March 31
• 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.
Source: Bloomberg, Principal Asset Allocation. Data as of March 31, 2023.
Future market priced fed funds rates path as of March 1 vs. March 31
Contribution to headline
U.S. inflation
Principal Asset Allocation GDP-weighted inflation
Source: Clearnomics, Standard & Poor’s, Principal Asset Management. Data as of March 31, 2023.
S&P 500 financials sector, banks industry group, and regional banks sub-industry, price returns, rebased to 100 at January 2019
•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.
2023, MSCI All Country World Index vs. MSCI U.S. Index
Source: Factset, Bloomberg, Principal Asset Management. Data as of March 31, 2023.
S&P 500 earnings-per-share model
Earnings estimates and inflation
Source: Bloomberg, Principal Asset Management. Data as of March 31, 2023.
2013–present
• With the banking crisis seemingly now contained, the extra risk attached to the hybrid assets is likely overdone, creating a compelling investment case.
• The three U.S. banks that collapsed were unique to the broader banking sector—and the risks have been further reduced by recent federal regulatory support and a new Federal Reserve lending program.
• Following the banking crisis, yields are near their highest levels in more than 10 years, and spreads to yields on risk-free Treasurys are historically wide.
Investment grade $1,000 par spread to worst versus gov't yields
• Economic policy uncertainty often leads to elevated market volatilities, and more pronounced idiosyncratic risks. This investment landscape presents headwinds to most risk assets.
• Hedge funds, however, with their low beta exposure and high alpha potential, could potentially do well in such an environment.
• Historically, hedge funds’ outperformance against global equities goes hand in hand with rising volatilities, making them attractive today for investors seeking alpha.
• However, strong manager selection is imperative, as divergence among hedge funds tends to be significant.
Note: Data since Q4 2013 is average of Construction and land development, Nonfarm nonresidential and Multifamily. Source: Federal Reserve, Principal Asset Management. Data as of March 31, 2023.
Net % of banks, 1990–present
Hedge fund relative performance versus equity volatility
Policy uncertainty, as is the case in the current environment, tends to lead to rising market volatilities which supports hedge funds outperformance against equities.
Key takeaway
Hedge funds: Riding the volatility
