How much pain are asset classes pricing in?

Bottom line up top

• The economy is brewing a cuppa something, but whether it’s iced or hot, diluted or full-strength remains to be seen. For much of this unusually volatile year, markets have sent a fairly consistent message with their negative performance: Wake up and smell the coffee! In other words, markets have signaled deep concerns about slowing growth, Fed tightening, geopolitical risks and other factors driving up the odds of a recession in 2022. Bearishness remains broadly elevated, although we’ve begun to see more variation among asset classes in terms of how much pain is being priced in (Figure 1).
• Mixed economic signals make it difficult to declare the cup half empty or half full. Last week, continued consumer strength was on display with the release of April’s robust retail sales numbers. However, a number of major retailers posted poor corporate earnings, sending stocks into a tailspin. On Tuesday industrial production surprised to the upside, but Thursday brought a significant miss in the Philadelphia Fed’s manufacturing index. Both housing starts and building permits fell last month, as sharply higher mortgage rates tempered demand for new construction, while severely constrained supply dampened sales of existing homes. Also telling: The Conference Board’s Index of leading economic indicators (LEI) moved lower on a year-over-year basis for the eleventh time in the past 12 months (Figure 2).
• Our view: on balance, still a modestly constructive outlook. Figure 3 shows a range of possible economic scenarios, from best-case to worst, and is accompanied by portfolio construction ideas for the two outcomes — soft landing and mild recession — that we deem more likely to occur in 2022.

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Portfolio considerations

Our best case (Goldilocks) scenario entails inflation moderating, GDP growth proving resilient and the Fed pausing on raising rates when the coffee is neither too hot nor too cold. We think the odds of this optimistic view coming to fruition are small. At the other end of the spectrum, our worst case scenario is a hard recession, which we also think is unlikely. Instead of these extremes, our expectations hover between the soft landing and mild recession scenarios.

In a soft landing, inflation moderates, GDP growth is positive and the Fed hikes to expectations (i.e., tightening is priced into markets). The employment situation weakens slightly but remains strong. In this scenario, we would have a preference for growth stocks. Within fixed income, we would favor up-in-quality credit, including higher-quality high yield, where current yields of 6.3% cushion against both spread widening and rising rates. Taxable investors could take advantage of attractive entry points for municipals. We would not recommend adding interest rate sensitivity given lower-but-still-high inflation and a resolute Fed.

In a mild recession, the Fed may have been successful in combating inflation, but at the expense of economic expansion (i.e., GDP growth is negative). In this scenario, going into a recession cyclical stocks may lose their premium. Within equities, we would therefore prefer a blend of dividend growth stocks and value equities. The trickier call is finding the appropriate level of rates duration: holding duration while the Fed continues hiking could be problematic, but it may hedge growth risk if the economy is actually in a recession. Additionally, the attractive income offered by credit could help offset the effects of spread widening in a mild recession. Here, we would emphasize investment grade corporate and short- and intermediate-duration municipals.

Nuveen’s Global Investment Committee (GIC) brings together the most senior investors from across our platform of core and specialist capabilities, including all public and private markets.

Regular meetings of the GIC lead to published outlooks that offer:

• macro and asset class views that gain consensus among our investors
• insights from thematic “deep dive” discussions by the GIC and guest experts (markets, risk, geopolitics, demographics, etc.)
• guidance on how to turn our insights into action via regular commentary and communications