What is the Most Likely Economic Scenario Over the Next Year?
Looking out over the next year at what the most likely economic scenario is should help to position your portfolio. When making longer-term forecasts you have to start with some assumptions. The most reasonable assumption is that the Fed will be raising rates, possibly a bit more than the market has priced in at this point. I expect 75 to 100 bps is fair; slightly more than that is priced in to the Fed funds futures market. The tax cuts and weaker US dollar over the past year should boost earnings, but with equity markets fundamentally overvalued, it’s harder to figure out how equities might behave.
Indicators like the New York Fed’s recession probability forecast is nowhere near levels we have seen leading into past recessions. That would indicate that it’s too early to price in a Fed tightening induced bear market just yet. Historically, a recession would hit equity earnings by about 20%, and push the market multiple to a discount to the long-term average. That points to the S&P 500 in the 1800-2000 range. It’s a significant concern for when that next recession does hit, but we are not there yet.
But market valuations are high and that demands that equity portfolios tilt towards being a bit more defensive. Inflation expectations are on the rise with average hourly earnings at the highest in a decade.
In this scenario, both bonds and stocks could decline together and the traditional balanced portfolio may not give you the protection you expect.
Shifting fixed-income exposure into reset preferreds and floating rate notes that provide for increased yield and price protection in a rising rate environment could help.
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