(Bloomberg) — It’s not just the damage that high inflation does to consumer purchasing power that worries David Bianco, chief investment officer for the Americas at DWS Group, an investment firm with more than $1 trillion under management. It’s also the bad decisions that distorted price signals inspire throughout the economy.
Caught between the risks of either a prolonged period of destabilizing inflation or a recession triggered by Federal Reserve efforts to cool off consumer prices, Bianco has a rather cautious outlook on the markets. He says the S&P 500 potentially will fall back to the neighborhood of 4,000 in the near term — a drop of about 11% from current levels — before it rebounds back to record highs. Bianco shared his outlook on the markets in the latest episode of the “What Goes Up” podcast. Below are condensed and lightly edited highlights of the conversation. Click here to listen to the full show and subscribe on Apple Podcasts or wherever you listen.
Q: Can you lay out how you’re thinking about the market right now?
A: It’s a difficult market right now. You don’t know if you’re going to get burned by inflation or get frozen by a recession — although I don’t expect a recession this year or so. We’re quite concerned about the longevity of this cycle. I feel as if this cycle has aged quickly. It’s aged mostly from very high inflation, much earlier than you typically see in the first couple of years of a new economic expansion.
The causes, as everybody knows, it’s the pandemic, the supply-chain disruptions from that, the really strong monetary and fiscal response, and having to pay back some of that. And then the war that broke out with Russia’s invasion of Ukraine. So we’re worried about inflation. We’re worried that the Fed might try to fight inflation too quickly or too aggressively — that could bring a recession earlier than necessary. But I’m just concerned in general about the way inflation is eroding the purchasing power of consumers in the United States.
And inflation at these levels, with this type of volatility and associated uncertainty, it begins to disrupt the effectiveness of the economy. It disrupts price signals. And when price signals are distorted, manufacturers, consumers, capital allocators, we all begin to make bad decisions. And I’m concerned that this economic environment is one where the risks are high and it’s difficult to navigate it.
Q: Is the recent bounce in the market a bear-market rally? Could we revisit lows or set new lows this year?
A: Volatility’s elevated. We’ve expected volatility to be high this year, it’s playing out. And when you have volatility, you tend to get it more to the downside. But when you’ve got big declines, as we had certainly since the outbreak of the war, you can get a big rally. And the question is: What from here? My view is the S&P is more likely to return to something like 4,000 before it breaks to new highs such as 5,000; 5,000’s not totally out of reach, but to me, it’s something more of a 2023 target rather than this year at this stage. So I don’t think it’s a dead-cat bounce, but this cat’s injured and I don’t think this cat can bounce higher from here.
Q: What was your thinking behind cutting your annual target for the S&P?
A: We cut our target twice so far this year. We went into the year with a 5,000 target for the S&P 500 at the end of this year. I’m thinking that’s more appropriate for the end of 2023 at this stage — maybe a little bit higher, if inflation finally does come back down close toward the Fed’s 2% target. But we cut our target from 5,000 to 4,800 in mid-February on very high inflation and that causing us some concerns. And then all of the fuel being added to the inflation fire with the invasion. So then we cut again to 4,600 on the S&P.
What we’ve tried to explain is that we only slightly trimmed our S&P earnings estimates. We went into the year with a $228 S&P earnings (per share) estimate for 2022. We trimmed it to $225. I do think there’s a little bit of risk to the downside of that $225, but we try to convey that we were raising our estimates at the energy sector by $3 or $4, but trimming it everywhere else by about $6. And I think there still remains to be seen how well the consumer sectors, and the manufacturing part of the S&P, will weather these high costs of production and high costs now of consumption.
Q: Is the message sent by the yield-curve inversion distorted this time around?
A: The yield curve is an important indicator. We watch it; we watch it all the time. But its effectiveness is just not as strong as it’s fabled to be. In fact, the yield curve, it has been wrong. It’s been wrong each of the long cycles in the United States. In the 1960s, and the 1980s and the 1990s, we had flat-to-inverted curves on the 10-year yield to overnight rate, or even the three-month bill rate, which is the part of the curve that we watch. Some people debate this — I think of the 2-to-10 year part of the curve as more about term premiums. But when you look at the overnight rate relative to 10 years, you’re getting more of an economic signal. And you’re also getting the impact of what the Fed’s doing to the economy immediately with the Fed funds rate.
So I look at the 10-year yield minus the Fed funds rate and the curve went flat-to-inverted in 1966, 1994. And we had an economic expansion that continued. It also happened in 1984. And what’s interesting about that is that of the 10 times that the curve has really gone flat or clearly inverted — three of the times, it was wrong. We had economic expansion for several more years. And the seven out of 10 times it was right — 70% of the time — it still took one or two years for a recession to hit. So it’s a useful indicator, but it’s not infallible. And I think of it as being just about as accurate as simply the length of the economic cycle.
And we always have this mental model of how long should a US expansion be. We’ve shortened our expected lifespan of this cycle, given the inflation problems. So the cycle age is as much of a prediction of the next recession as is the inversion of the curve. Recessions happen. That’s why the yield curve is right. Recessions just eventually typically happen, but they don’t happen in a short time frame after yield curve inversions, and the curve has been wrong, I would say, 30% of the time.
This was just the higlights. Click here to listen to the full show.
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