Making Sense: Market Outlook
CFA | SVP, Chief Investment Officer
SVP, Manager of Institutional Portfolio Strategy
Each month, Brent Ciliano, CIO, and Phillip Neuhart, Manager of Institutional Portfolio Strategy, help you make sense of the markets and the economy. This Market Outlook covers a summary of the September 29 Making Sense webinar.
Higher prices are starting to weigh on sentiment and spending
It's all about the consumer. As we've mentioned, the consumer explains more than 73% of real GDP—69% from consumption and 4.7% from US housing. Additionally, 90% of American households spend 99 cents of every dollar of income, after tax. We're starting to see elevated retail sales begin to slow, and sentiment is falling thanks to low home and durable goods affordability.
Where do markets go from here?
Wall Street consensus 12-month forward price target for the S&P 500 is 5,039 as of September 24, or about 13.3% return from September 23, 2021's market close.
We believe markets will continue to make higher highs through year-end 2021, with volatility and potential seasonal pullback during late summer and early fall (-5% to -7%), followed by higher highs into the end of 2021. We estimate the S&P 500 may see 4,700 (or higher) by year end, a 5.6% increase from September 23, 2021's market close of 4,448.98.
We believe the S&P 500 can potentially achieve 5,200 or greater over the next 2 to 3 years given the current earnings estimate trajectory combined with the market's current multiple (21.5x).
What's driving market returns?
The S&P 500's 18.6% year-to-date return though last Friday, September 24 has been entirely driven by corporate earnings growth. Earnings are up 26.2% year-to-date, outstripping the index's price return by about 8%.
- Full year 2021 expectations: Earnings increase of 42.6%, revenue increase of 14.9%
- Full year 2022 expectations: Earnings increase of 9.5%, revenue increase of 6.7%
But how long will it continue? We still believe there are three key headwinds for the future of corporate earnings that remain in place as we move towards 2022:
- There's a likelihood of corporate tax increases in 2022.
- Continuing supply chain issues may lead to lower revenues.
- Skilled labor shortages may lead to higher wages.
Inflation, rates and Fed Policy—what might happen, and when?
Much of what we've believed for some months was reaffirmed by Fed Chair Jerome Powell last week.
We believe the Fed will begin tapering bond purchases in November 2021. Chair Powell stated on September 22 that he "expects tapering will last through mid-2022." The sharp decrease in Treasury issuance in next year will help to neutralize the negative Treasury price impact of tapering. 10-year Treasury Yields will continue to remain range bound between 1.25% and 1.75% through the rest of 2021 and potentially in the first half of 2022. Lastly, we believe the Fed will begin to hike rates at the end of 2022, with the first hike likely during late summer or early fall of next year.
Making Sense: A Market Update
Watch the replay of the September 29 webinar, where Brent Ciliano and Phillip Neuhart discuss what's going on in the markets and economy.
Amy: Hello and welcome to the First Citizens Wealth Management webinar series, Making Sense, where Chief Investment Officer Brent Ciliano and manager of Institutional Portfolio Strategy Phillip Neuhart help you make sense of what's going on in the markets and the economy.
I'm Amy Thomas, a Delivery Specialist with First Citizens Bank. We're excited to have you with us today.
While everyone is logging in, I want to share a couple of housekeeping items with you. First, this webinar is being recorded, and a replay will be sent to you following the conference. Secondly, this webinar is interactive. You'll have the opportunity to ask questions. If you submitted a question during the registration process, you do not need to resubmit your question. Should you have a question during the call, please use the Q&A or chat feature to submit your question on the right-hand side of your screen. All questions are confidential and only visible to myself and the panelists.
I do want to remind you that we do try to keep the discussion broad. If you have a specific question about your financial plan or we don't get to answer your question during the webinar, please reach out to your First Citizens partner.
As a reminder, the information you're about to hear are the opinions of First Citizens Bank and are for educational purposes only. If you have any concerns regarding the information you're about to hear, we ask that you reach out to your First Citizens relationship manager.
We hope you'd find this information helpful and thank you again for being with us. And Brent, with that, we're ready to go, so I'll kick it over to you to get it started.
Brent: Fantastic, Amy, and good afternoon, everyone. I hope all of you are well. Before we jump into what Phil and I will be covering on today's call, I want to let you know that we'll be hosting a very special and extremely timely webinar on October 27 at noon with Dan Clifton, head of Washington DC policy at strategic research. Dan will be getting deep into all things government fiscal policy, tax policy, the debt ceiling and importantly, what to expect and when to expect it. So that webinar is going to be in place of our normal October Making Sense update. So please make sure you put that on your calendar because you're not going to want to miss that.
So for today's call, Phil and I are going to discuss the economic growth trajectory from here through 2023 as well as the current state of the labor market and the US consumer. We'll talk about the US corporate earnings picture. Earnings expectations continue to be robust. How high and how long would this last and what might get in the way? Chair Powell and the Fed met last Wednesday and gave updated perspective on tapering in the path forward for rates. We'll discuss where do we go from here and when.
Inflation certainly still high, but COVID related components continue to ease, and we might just be past the peak. Nevertheless, prices are likely to remain high for some time. We're going to dig in a little bit deeper there. Lastly, I want to get pretty specific on where we think the market goes from here as we enter the fourth quarter. Plus, we're going to discuss how long does this equity market cycle last and how high might the market go? So with that, Phil, why don't you kick us off?
Phil: Great, thank you, Brent. Amy, let's jump right into slide four US growth expectations. So while the sharp recovery persists, economists have continued to revise down their 2021 growth estimates. Unlike in past months, we are not seeing the growth expectation pushed out to next year. As a point of reference in last month's market update, consensus expected 6.2% growth this year and 4.3% in 2022, so we are lower as of today, as you could see here. Some of this revision is natural, as overly optimistic economists sharpen their pencils on out years, but also supply bottlenecks, a tight labor market and the Delta variant are having an impact on growth expectations. As you could see in the graph here, growth estimates for the current quarter are slipping as well. And if we focus on the bottom table, economists expect growth to slow on a quarterly basis as we move into next year and early 2023.
Later in the presentation, when we discuss Federal Reserve policy, remember this table. How high can the Fed push interest rates with decelerating economic growth? Moving to the US labor market after a dramatic hit during the depths of the pandemic, the job market has made meaningful progress after peaking at 14.8% last year. The unemployment rate is now 5.2%. As you can see here, this is below the long-term average. Given the tight labor market, wages have also rebounded sharply, as you could see in the graph.
Speaking of the tight labor market, job openings shown in the upper left here are at record highs. As shown the lower right, the ratio of unemployed persons per job opening is just 0.8 people, well below the average level of the last expansion. We all know of businesses struggling to find workers, and the data supports what we are seeing in our day to day lives. The supply demand dynamics are driving wages higher as we saw in the previous slide. Will we see relief in the coming months? The answer lies in labor force participation, which is well below the pre-pandemic level and has shown little improvement since the middle of last year. Hope remains that as schools reopen and expanded unemployment benefits roll off, participation will rise. But the Delta variant is also an important variable here, as we will see on the next slide.
Here we see August payrolls disappointed in their current release, and we're the smallest gain in terms of payroll gains since January. And as the lower chart shows, those unable to work because of COVID increase for the first time since last December, reflecting the resurgence in COVID cases recently. Now we have come a long way in the labor market, as you can see here, from May 2020 to this August, the US added back 17 million jobs, or 76% of what was lost, and the unemployment rate has fallen back down to 5.2% as we pointed out previously. The question the Fed and markets want answered is how fast and when will the labor market be back on strong enough footing to ease off monetary policy stimulus? Based on Chair Powell's comments last week, we believe the labor market is very close to the necessary level for the Fed to taper its balance sheet. More on this later.
If the current run rate of 700,000 plus job gains continues, we could see a full recovery to the pre-COVID trend by the end of Q4 of next year. Our belief is that the confluence of eliminated federal benefits, plus the return to school return to work will likely put the US labor market solidly on pace for recovery to the pre-pandemic trend. But Brent and I will certainly be watching the rate of COVID cases and hospitalizations, as that could throw a wrench into the labor market recovery.
When it comes to US growth, it is all about the US consumer. As you can see, the consumer explains more than 73% of real GDP. 69% from consumption and another 4.7% from US housing. So as goes the consumer, as goes our economy. Additionally, 90% of American households spend $0.99 of every bucket of income after tax, which is just incredible. And while the consumer has been spending and continues to spend today, if we turn to the next slide, higher prices are starting to weigh on sentiment and spending. Retail sales are still elevated, but slowing and consumer sentiment is falling, in part thanks to low home and durable goods affordability, as you could see in the bottom charts. With that, I'll pass it to Brent to discuss corporate earnings.
Brent: Great, well thank you, Phil. The S&P 500's year to date return has been driven entirely by earnings. Earnings this year are up an astounding 26.2% versus the S&P 500 through last night is only up 17.1%, and now that we've put Q2s rocket ship earnings of 91% year over year growth into the books, all eyes are really focusing on Q3 earnings. Estimates for Q3 are looking similar to Q2, more of the same being revised up. Earnings estimates for Q3 sitting at an astounding 28% up a little bit more than 3% versus June 30 this year. Full year, we're looking at for 2021 an incredible 43% earnings growth for the year, 15% for revenues. Folks, let's put this into perspective. The long-term earnings growth rate for the S&P has been 6.5% from an earnings growth perspective, said a 43% earnings growth for this year. We're looking at 6.6 times the long-term average, just astounding.
And then when we get to 2022, we're looking at another almost 10% above that and a revenue increase of about 6.7%, so just earnings continue to amaze as we look at both the quarter and full year. You know, and since we're only about, you know, four months, three months away from, you know, talking about 2022, which I can't believe that the year is almost over, more strategists are beginning to publish their forecasts for 2022 and the bias continues to be higher. The average estimate is now at $222 per share for 2022 which is $5 higher than where it was just at the end of August. However, I do want to point out that the normal daily EPS progression has started to slow and has actually flattened out for the first time since May of last year. So the likelihood of analysts continuing to revise up their forecasts for next year has likely been flattened and is likely to not occur.
On the bottom right, there's been a lot of talk about inflation hitting margins, you know, looking at operations and profitability and input costs. On the bottom right, we're looking at the next 12 months expectations for S&P 500 operating margins. Folks, we are sitting at multi-decade highs, sitting at 17%. I've talked about this on the last couple of WebEx, the fundamental backdrop for corporate earnings and profitability for now remains fundamentally sound, and it's really not until operating earnings and aggregate earnings overall roll over where equities face any significant dangers. But Phil and I will certainly be watching this and making sure that we keep you apprised when you start to see that signal turn.
So while much of what's going on in the financials of S&P 500 companies has certainly been record breaking, we believe that there's three potential headwinds to the slides that I just covered. The first headwind is the potential for higher corporate taxes next year and beyond. And while Washington DC seems a mess right now, we believe tax hikes will get passed in October and are likely to take effect in fiscal 22. The bottom line is that the effects of higher corporate taxes are expected to reduce EPS by only 3% to 5% next year. A whole lot less than what analysts were forecasting earlier in the year, where the expectations were more like 6% to 10%, 3% to 5% off of next year EPS, which is already materially higher than we were at the beginning of the year, is certainly important. I think it's also another reason that you're going to want to tune in to the October 27 WebEx with Dan Clifton to get his take on corporate tax policy.
The second headwind, which has been coming up on analyst calls with companies headline news stories that put a couple here down at the bottom of the slide is that we're continue to see supply chain shortages, labor shortages, production bottlenecks that could potentially feed back into both higher input costs and also input scarcity, which ultimately could lower revenues as fewer goods are produced for sale and also would relate to potentially a lower amount of services ultimately rendered. And finally, the third headwind on the next slide, Amy, is a continued skilled labor shortage, which is leading to higher wages, as Phil outlined on the previous section. Top left-hand graph you can see the NFIB survey for small and medium sized businesses, number one problem reported by firms hands down is quality of labor. Bottom right-hand graph that small businesses with few or no qualified applicants are at a multi-decade and record high of a whopping 60% of small and medium sized businesses, report few or no qualified applicants. Just truly incredible. Hopefully, that subsides. Phil, I'm going to turn it back over you to walk through interest rates and inflation.
Phil: Great thank you, Brent. We'll jump right into the bottom line. In some ways, this summary size not just what we believe it is what Chair Powell said last week after the meeting, reaffirming much of what we have been saying for some time. So what do we believe? What are our core tenants in terms of rates and Fed policy? For one the Fed will begin tapering bond purchases in November of this year. Chair Powell stated last week he expects tapering will last through mid-2022. Second, the sharp decrease in treasury issuance next year will help to neutralize the negative treasury price impact of Fed tapering. Third, 10-year treasury yields will continue to remain range bound between 1.25% and 1.75% through the rest of 2022 and potentially into the first half of next year. Finally, the Fed will begin to hike rates before the end of 2022, with the first hike possibly during the September or October meeting. The Fed has reiterated they do not expect to hike rates until they have completed the tapering process. So a hike before the second half of next year, at least right now, appears to be unlikely.
Let's turn to the future path of the Fed funds rate. During the Fed's meeting last week, they signaled one hike by year end 2022 next year, 4 total hikes by year end 2023, and 7 total hikes by the end of 2024 for an effective Fed funds rate of 1.75%. This is still very low by any historical standard tie that back, of course, to lower growth expectations. So where do we believe rates go from here? Consensus expectations have been hovering around the 1.8% to 2% mark for much of this year, expecting that this economic recovery from the pandemic would lift rates higher.
We for some time have believed that the 10 year would remain range bound between 1.25% and 1.75%, while yields post the Fed meeting had broken out higher since last week, rates are still historically low, as you can see here, and the yield curve remains relatively flat. So why have we believed the 10 year would be range bound?
For one a post Summer Equity market spike and volatility, which we have seen thus far. Two a not insignificant rise the Delta COVID variant, which has happened, of course. Three a deceleration in broad economic data post-June 30 likely peak combined with a slower than expected labor market recovery. And finally, all-time highs in equity markets keep bonds behaviorally in demand as investors worry about the potential end of the market cycle. Now, as the Fed changes course, prepare for bond volatility, in fact, you could argue this has already started over the past week as rates across much of the yield curve have risen sharply. As the bottom chart shows, with so much duration risk in the fixed income market, bonds will have greater sensitivity to interest rate movements.
So importantly, how have stocks done in a rising rate environment if we turn to the next slide? Brent and I covered this slide earlier this year, but as a reminder over the last seven rising rate cycles spanning the last 30 years, US stocks have been positive 100% of occurrences with an average cycle return of plus 17%. If you step back for a moment, this makes sense. Rates tend to rise as an economy expands, which also tends to be a good environment for stocks. In fact, you can look at the past year as an example. The 10-year treasury yield bottomed last August at 0.5%, and it currently stands at one and a half percent, so three times the yield of last August. This during an exceptional period for stocks. So despite what tends to get mentioned in the financial news media, rising bond yields have not negatively impacted stock returns historically.
As you can see here, there is an alternative than stocks, or TINA, as we call it, remains in place even after the Fed meeting, real yields remain negative. And according to market implied pricing will remain negative for some time. As Brent will cover, we think this remains a positive driver for stocks going forward. Let's turn to inflation. On the inflation front, we saw some relief in August core inflation print and positives volatile COVID related components primarily responsible for July's historic rise like airline fares, car rentals, hotels materially fell back in August. As you could see in the bottom table, these were all out monthly declines, not just a slowing in the pace of monthly inflation, but a true decline. On the negative side, in the middle table, autos and auto related components continue to see supply related issues and commensurate price increases.
Here are some of those volatile components in year over year chart form, many of which are starting to fall back. The Fed will be watching these components closely to see if the rate of year over year gain continues to slow. Now, unfortunately, US inflation expectations, which you could see here, remain quite elevated again, even if these begin to moderate inflation will still push down real returns and keep TINA in place. And then finally, as we covered last month, not all inflation is created equal, some categories are more lasting than others. Rents, for example, which you see here and home prices tend to persist more than something like airline fares. 31% of Americans are renters. This is up from 22% 10 years ago, so higher rents impact more people and rents are rising. More durable inflation drives the Fed's view that inflation will be slightly above their 2% target for several years. I'll now pass to Brent to discuss where markets might go from here.
Brent: Great well thank you, Phil. Let's jump right in and get to our bottom-line views for markets as we head into the fourth quarter, and then we'll certainly talk about where we go beyond 2021. So let's start first with Wall Street Consensus. And folks, I'm going to update this data on the fly to be reflective of what's happened yesterday. The 12-month forward price target for the S&P 500 from Friday of last week to all the way to September 23 of 2022 is sitting at a stout 5,039. And we're basically looking at almost a 13.3% return from last Friday, all the way through to September 23 of next year. If I adjust that for yesterday's sell off, that's about almost a 16% return on a 12-month forward basis from yesterday through September of next year. So let's get into what we believe, and I'm going to start first with where do we think markets can go through the end of the year?
On the last I think it was four or five WebEx, I've been mentioning that we can see a little bit of a rough patch in markets from early to late fall, which now will coincide with debt ceiling fiscal policy debates, a potential governmental shutdown and normal market seasonality. This would then be followed by a market re-acceleration into year end. The big question we need to ask ourselves and what's at hand right now is was the 4% drawdown that we saw from September 2 through September 21 all we're going to get or will there be more to come? I believe that there'll be more to come given the headline risks I just mentioned. I'm going to cover this and how much more volatility we're likely to see in just a bit. But nevertheless, we believe that the S&P 500 will finish this year at 4,700 or higher.
So why do we believe this? This year's returns, as I said earlier, has been all about corporate earnings, and we believe we're going to end this year all about corporate earnings. As I mentioned earlier, analysts’ consensus expectations for 2022 are sitting at $222 per share. If I take that and I multiply it times the market multiple today, that gets you to 4773. If the market doesn't get one dime more expensive or one dime cheaper, you're looking at about 4773 just on earnings alone. Let alone when we think about where we started trading this year, which is more than 23 times forward earnings, which would imply a level almost as high as 5,100. We don't think that we'll get there and we think that that will be much later in the cycle.
Beyond 2021 if the market merely stays at today's multiple, we don't again get any cheaper or any more expensive, and earnings come through at or around the current estimated $242 per share that analysts are at right now for 2023, that gets you to a level of about 5,200. So the bottom line here, folks, is that as long as rates remain negative in real terms, valuations can remain high and the market direction should remain on solid footing. So let's drill down and talk a little bit more about the shorter term. After bouncing off the 50-day moving average eight times year to date, the S&P 500 finally gave way last week, breaking through all the way to the 100-day moving average.
I think the one important technical thing that we noted is that during this time 63% of S&P 500 names traded at or below their one month low. This is significant because historically, when more than half of stocks trading at or near their one-month lows tend to signal shorter term washout conditions for stocks. And when you look at the bottom right-hand graph that I have here for you, when you look at returns, post these washout conditions from a technical perspective 1 month, 3 months, 6 months and 12 months later, stocks are significantly higher.
And while the S&P 500 fall from its record high of 4537 back on September 2 was relatively short lived and its drawdown was less than 5% underneath the surface, stocks have been drawing down much more significantly, and this trend has actually been in place since early May. If you look at the slide, the average S&P 500 stock drew down 12.5% almost three times with the broad index drew down. And then when you take it into technology stocks or into US small cap stocks, you can see tech stocks drew down, the average tech stock has drawn down about 14%, despite the index being down only 4.2% and the average US small cap stock has fallen 28.2% from its high when the underlying indexes only fallen 7.5%. And as I mentioned in much more detail on last month's call, the S&P 500's last 5% decline occurred a whopping 227 trading days ago, all the way back on October 30th of last year. This is now the eighth longest streak since 1930.
So you might be asking yourself, well, you know, as we're entering the fourth quarter, where do we believe stocks go from here? Well, historically the fourth quarter has proven to be one of the better and more consistent quarters for stocks. And it's not just for large caps, as you can see on the slide. On the bottom left, you're looking at small cap on the bottom right, you're looking at tech. The fourth quarter has been kind to large cap, small cap and technology stocks throughout history. But when you look more deeply into this phenomenon on the next slide, Amy, the results are even more eye popping when you bifurcate history between either a secular bull market or a secular bear market, and when you look at this graph, you can see that post 1970 fourth quarters have been positive a staggering 83% of the time during secular bull markets. Even when you look at the table, and if you can see that little line item in there, when you look at secular bear markets, even in secular bear markets, fourth quarters have been positive two thirds of the time.
When you put all this history together, fourth quarters have been positive 77% of occurrences post 1970. So let's all knock-on wood and hope that history repeats here. So this year is shaping up to be literally the spitting image of 2013 and with all the absolute and sheer craziness in Washington DC and the noise up until now, I thought it would be interesting to kind of compare these two years, given how scarily similar they are. So let's walk through this. Back then you had the S&P 500 up significant double digits, just like this year. Back then, we had Fed tapering plan being rolled out just like this year. Back then, Bernanke, we were thinking about his replacement. We're thinking about Powell's reappointment. Or if you listen to Elizabeth Warren, potential replacement. You had geopolitical risks back then with Syria, this year it's Afghanistan. We had a looming government shutdown that would occur at the end of September and 2013. Same thing this year we had a debt ceiling situation that was occurring in mid-October. We have now a debt ceiling issue that's going to occur in late October this year. Back then, we had fiscal issues with the ACA Exchanges going live, this year we have 3.5 trillion with a reconciliation package. You know, you know, we have an infrastructure, we have a lot of things going on.
So what I thought we'd do is kind of given these similarities, let's overlay these events onto market performance. So what we're looking at here is the dark blue line is 2013's S&P 500 performance. The red line is the performance of the S&P 500 year to date. And as you can see, as we got into late summer, early fall in 2013 it proved to be quite a volatile time in and around those events, and we actually saw two drawdowns that occurred, one from August 2 to August 27, where the market drew down 4.5%, and then we had another drawdown from September 18 to October 8 of 4%. Ironically, yet again, scarily, the exact same drawdown occurred in 2013 as occurred this year. Nevertheless, markets brushed off that noise and went on to make 9% higher highs. So if I went from the peak that you're seeing on that that screen, you had 9% higher highs into year end from the market troughs to the end of the year, you're looking at 13.5% return from the market troughs to year end. So again, let's all knock-on wood and hope that 2021 goes just like 2013.
So I want to take a step back and now and really kind of focus on how much gas might actually be left in the tank for this market cycle and historically speaking, just like what Phil covered in the very beginning of this presentation, economic expansions have been incredibly kind to equity markets. Almost 90% of the time periods of US growth and expansion have led to positive returns one year forward. And what we're looking at on this graph on that black bar that the returns from March 23 of last year all the way through last Friday, we're looking at 104% return. So what I did is I went back to all economic expansions post-World War II, and when you look at the median post-World War II gain during an economic expansion one year, you're looking at 138%. When I look at the average post-World War II, which has a little bit more positive skew, you're looking at 195%. And if I look at the median of the last four economic expansions, you're looking at 403%. So whether we have another 35% left in the tank, another 90% or let's all knock-on wood, another 300%, it's too early to tell. But again, if history is any guide, there is definitely more gas left in the tank in this economic expansion in this market rally.
So a question that I get a lot and you guys sent in probably three or four on this topic that we'll seek to answer and one that I see that's constantly mentioned in the financial news media is how expensive stocks are right now. And is that the ultimate death blow to the market's long running gains? Well, as you can see in the top box, no matter how you slice it, no matter how many valuation metrics you look at stocks relative to history, whether I look at the median stock or the S&P 500 in aggregate absolutely are very expensive and we're looking at that historical percentile. 100% means the most expensive in history. 1% would mean the least expensive in history. So again, as you can see, no matter how you slice it, stocks are expensive in aggregate terms.
But folks, what I believe matters more for the shorter term is the bottom box. And if I look at that bottom box and the fact that stocks relative to the alternatives think cash and fixed income are near the cheapest levels, post-World War II, the median stock in the S&P 500 is only in the 17th percentile and the aggregate index is only in the 36th percentile of expensiveness elative to bonds. Folks, until this relative valuation story changes i.e. what Phil was talking about with the unwinding of TINA or that acronym for there is no alternative, we believe stocks can continue to go up.
So while we believe that stock market returns over the next couple of years will be decent, the remaining part of the decade, we believe, will prove quite challenging for stock returns. What we're looking at here is the consensus views for 39 different Wall Street firms and banks that forecasts forward looking market returns, and the consensus quite clearly points to significantly lower returns over the next decade. And when you ask, well, Brent, well, how much lower might it be? Look at that red box on US large cap stocks. Expectations for the next decade 5.8%. If I compare that to the long-term average of 10.4% since 1925, you're looking at 4.6% less per year than the long-term average. And when I compare the expectations to what we just ended up for the decade that ended 1231 of 2020 you're talking about 60% lower returns for US large cap stocks over the remaining part of the decade.
So following this recent bout of market volatility, in addition to what I think might be coming and yes, I do believe that we will have ultimately that 5% to 7% cumulative drawdown from peak to trough. I think it's really, really important to make sure that you all remain behaviorally grounded and not react to the noise of the day. While it certainly can be easy to mentally whipsaw oneself in and out of the markets with the news headlines, it can be incredibly detrimental if you act on those beliefs. So what we're looking at here is the last 26 years from January 1st of 1995 all the way through last month, and over that period of time we saw about 6,500 trading days. So they got 26 years times the average of 250 trading days in the year gets you to 6,500 trading days. If you remain fully invested, you had an annualized return of 9%. If you missed only five of the best days out of those 6500 you gave up more than 20% of that return and your return fell from 9% down to effectively 7%. If you missed the 10 best days out of those 6,500 you lost more than a third of your return and you fell from 9% down to 5.8%.
All of this should be pointing you to make sure that you do two things. First is to make sure that you have a fundamental financial plan solidly in place and most importantly, it's not just having it, it's following that financial plan. And number two, it's hiring a professional team to guide you on the right investment path, freeing your mind from the mixed emotions that could potentially be detrimental to your financial success. You shouldn't be doing DIY investing. You should be sitting down with professionals here at First Citizens to make sure that we can guide you through, and we have forward looking views to make sure that we can get you to where you need to be. So with that, Amy, I can see the questions piling up. Why don't we turn it over to Q&A and get started?
Amy: Yes, thank you. Thank you so much, Brent and Phil, for all that information. We do have a lot of questions already in queue. Brent, this one's for you. There are so many questions in queue around market ups and downs and what's going on in Congress and fluctuations around going into 2022. Could you re-emphasize your thoughts around where markets go from here and what people should do if they're worried about a downturn and what they should do if they have any extra capital at this point?
Brent: Yeah, absolutely. Look, I hope that the comparison of 2013 versus 2021 which are literally mirror images of each other, should give you some sense that market noise and headline risk is nothing more than that. The fundamentals have been prevailing all year long, and stocks have traded purely on earnings growth. That's likely to continue beyond that. So again, we believe that you're going to have some rockiness and volatility absolutely. Probably until mid-October, maybe a little bit longer. But make no mistake, we believe that earnings will trump and come back into play, and we believe that the market will trade higher through the end of the year. And we believe that there's more gas left in this cycle. So again, please do not get scared out of these markets because there's always a wall of worry, there's always something to worry about.
As it relates to where you need to be, certainly, we use our forward-looking capital market assumptions to guide us. We dynamically adjust portfolios every single quarter to be reflective of what's coming down the pike. So if you have your money manager with us, you'll see that happening all the time. If I were to go back to previous cycles where we look at this type of situation, higher valuations, lower growth in the future inside of the equity markets, it's pointed to coming down in cap think mid cap, mid cap, core mid cap value, as well as small cap, small cap value as well as international both developed and emerging has done quite well as the rotation and cyclical environment has changed. But again, you can't be doing DIY. You need to do that in the context of a very diversified, thoughtful portfolio and your team that can guide you through that.
Amy: Thank you, Brent. I know that'll help a lot of folks on the line. Phil, we always get a ton of questions on inflation. We always covered all these calls, but we still get more. How much longer are we seeing? Do you think inflation is going to hang on and how much longer do we consider it to be transitory?
Phil: Thank you, Amy. You're right, we get this question on these calls, we also get it in client meetings pretty regularly, so it's definitely not something flying under the radar. It's very much on investors' minds. We talked about this some last week, but inflation will remain quite elevated. We think likely for a number of months and even quarters ahead. Categories like high wage inflation are somewhat sticky and are unlikely to reverse much of the gains we have seen. The same goes for rents and other categories, as we talked about during the presentation.
Much of the inflation we are seeing today, which is on the heels of years of extremely muted inflation, really 20 years of muted inflation will be baked into prices going forward. That said, we do think the rate of inflation will slow next year. Now, slowing inflation does not mean a decline in prices economy wide, and it does not mean inflation is not more elevated than what we have seen in the past 20 years, it likely will be. As we showed in the presentation, certain categories have and will see all out-price declines. Airlines and airline prices in August are an example. Lumber prices are another example. Yet in the Fed's summary of economic projections released last week, this is where they project various economic data points, including inflation, the Fed revised upward its inflation forecast. All right. They measure inflation using the PC deflator. They revised that upward for both this year and next.
In these forecasts, the rate of inflation slows from 4.2% this year to 2.2% next year. So, so pretty material decline. But inflation remains slightly above their 2% target through the year 2024. Also, Chair Powell acknowledged in the press conference that supply bottlenecks had been larger and lasted longer than the Fed anticipated. So inflation is slowing and we expect it will slow next year does not mean it's going away tomorrow. These things take time, but it does not mean inflation fully disappears. We are going to have inflation. I think the Fed is starting to acknowledge that more than they have in the past, and bottlenecks have persisted longer than many expected, including the Fed.
Amy: Thank you, Phil. Speaking of the Fed, let's talk a little bit more about Chair Powell, if you don't mind. Can you give us some of your thoughts on what it might mean for interest rates as tapering continues and goes into 2022.
Phil: Yeah, it's a good question. And really, it's an interesting thing to think about, right? So logic would tell you there's the Fed buys fewer treasuries, there's less demand in the bond market that puts downward pressure on prices and upward pressure on yields, right? That the upward move in treasury yields since the Fed meeting last week likely shows some of the bond market attempting to price such a move. So that's the rational academic perspective makes a lot of sense on paper.
In the real world, Treasury yields are far less predictable. This year is a great example. Just as consensus decided yields could only go higher after the first quarter spike earlier this year, yields proceeded to fall month after month after month until just recently.
As we mentioned, a potential sharp decrease in treasury issuance next year may help to neutralize the price impact of Fed tapering, so there are some offsets in terms of tapering. Additionally, it's our base case, but if the economy or markets were to falter, you would likely see a flight to quality and Treasury yields would decrease no matter what the Fed is doing on its balance sheet. Right people come home when there's volatility in the marketplace and home as treasury markets in this case.
Again, that's not our base case. In our view, with the economy on track, the 10-year treasury yield will continue to remain range bound 1.25% to 1.75% through the rest of this year and potentially into early next year. The 10 year currently stands at one and a half, so certainly there is upside within that range does not mean that linear does not rise. It means we think it's staying low by any historic standards.
But as you look further out, we would expect modestly higher 10-year yields nothing extreme in our view, unless the facts change on the ground. Now, as the Fed lifts off by raising the overnight rate sometime next year, we would not be surprised to see the curve flatten as short-term rates rise more quickly than the long end of the curve, which we have seen in recent cycles as well.
Amy: Thank you for those comments.
Brent: OK just say, you know, very specifically, I think there's a higher likelihood of, you know, a flattening in the curve, right? So basically we go from sort of that steepness to more of a flat curve where we have short rates and intermediate and longer rates a lot more flat than we would have or expect given previous cycles.
Amy: Yeah, for sure. Thank you, Brent. Brent, as you might guess with the news this week, we have a lot of questions around the debt ceiling and national debt and all of those sorts of issues. Would you mind giving us your thoughts on the rising debt issue?
Brent: Yeah, I'm you know, so I'm going to give you mathematical context and I'm going to steer away from anything political. Anybody that thinks that the US doesn't have the money to pay its bills and would default, it's absolutely ludicrous. I mean, we have $4 trillion in tax receipts. Our interest expense that we have to cover is only $350 billion. So you're talking about more than 11 times interest coverage. So when we talk about not being able to pay our debts and we're not going to be able to send checks out, we're talking about a procedural technical situation that is purely driven by politicians, not because of our capacity as a government to pay.
And think about it logically, if there was a risk that we physically didn't have the capacity to pay our debts, where would that be reflected? It would be exactly where the last question just was, which would be in the Treasury yield curve. If we didn't have the ability to pay our debts, where do you think interest rates would be? They wouldn't be at the lowest levels in nearly 300 years. They would be significantly higher. Now what I will say is as it relates to the debt and spending an overall, please go back and listen, I'm not going to be able to do it justice this time. Go back to the May presentation.
I get into that in a lot of detail, but I do want to hit something very quickly because our debt and the financing of our debt and the interest expense is absolutely not a problem whatsoever. And I know people might be out there saying, Brent, you're crazy. I don't understand that. Let me make it really simple mathematically. We have $28.5 trillion of outstanding debt. If I get rid of the $8 trillion dollars, that's inter-governmental, what the Fed is holding on their balance sheet from all that bond buying, you're looking at about a net debt of about $20 trillion. We have about $350 billion a year in interest expense. When I get rid of that intergovernmental transfers, you have to take out about $99 billion of interest expense, which gets you down to about $251 billion.
So let me make it really easy and give you a real-world scenario, I had to cut off a lot of those zeros, Amy, and explain it like in real terms that human beings could understand. What if I had a couple that instead of $20 trillion had a mortgage that was $200,000 and that family had $40,000 a year of net income and their monthly mortgage was $2,500. Would you throw your hands into the air and go, Oh my god, these this couple is fiscally irresponsible, and there's no way that they're going to be able to get by? No, you would say that's pretty much indicative of almost everyone out there. So at the end of the day, our net aggregate debt, the extent to which we have tax receipts at roughly $4 trillion relative to the debt service is unequivocally not a problem and won't be a problem in the future. And remember, imagine if that couple could go to their community and borrow from anybody in an almost unlimited fashion.
That couple had the sovereign right to tax their community members in perpetuity. There would be no financial risk whatsoever. And again, if we had a problem with our national debt or the interest on that, it would be reflected in interest rates and would be reflected in much higher treasury yield curve, and that's just not the problem. Now spending, people could argue, could absolutely be a problem, but we're not going to get into that. I'm going to let Dan Clifton, the expert, talk about that next October or this coming October. Sorry.
Amy: Thank you, Brent, thank you so much. We actually have a question in queue that's that I think is really poignant and I want to share it with you. How is it that we are so optimistic about corporate earnings going forward when at the same time, small and medium sized businesses are struggling to significant, struggling significantly due to supply chain and worker participation? Would this not impact corporate earnings?
Brent: That is a phenomenal question, and I'm really glad that someone actually asked that question because that shows you the fundamental bifurcation between how large cap and mega cap companies are doing versus small to medium sized businesses. And again, when you think about all, first of all, what the S&P fight, when I talk about corporate earnings and profitability, I'm rarely talking about the S&P 500, and remember on a cap weighted basis, you probably have the top 50 companies make up significantly more than half of that index. So it's a very, very bifurcated set of companies that we're talking about. And when you look at what they've actually been able to deliver, it's not like we're talking about analysts' expectations and we haven't seen anything. Month after month after month for the last 17 months, corporate earnings and profitability, what's actually come in has been higher. Analysts can't even keep up. Right so what's actually manifested itself as far as true corporate earnings and profitability continues to exceed expectations.
And with everything that we're talking about with labor shortages and higher wages and bottlenecks and input scarcity, the analyst expectations for the next 12 months, operating margins are the highest-level post-World War II. So again, there is an incredibly bifurcated store between the really big companies and small and medium sized businesses. I ultimately believe that that will somewhat come to roost later on if we can't get through this Delta variant, if we have a resurgence in cases and we can't get back on firmer footing.
I would hope to believe that some of the numbers that I showed you from the NFIB survey materially start to get better as we lifted the unemployment benefit or the unemployment benefits expired on September 6. Hopefully, we start seeing better job prints and small to medium sized businesses, start seeing more available workers coming in and more qualified workers, hopefully that starts to abate, and we also start to see an abatement of input costs and scarcity on goods, whether that's lumber, commodities, chip shortages. We do believe that we're closer to an end than a midpoint or beginning, and hopefully small to medium sized businesses start to see relief sometime in the near future.
Amy: Thank you, Brent. And I know we're over time, but we still have a lot of people on the line, so I want to ask this. I'm seeing a lot of questions around the situation with China and the Evergrande possible default. Would you mind giving us your thoughts around China on a broader scale, if you wouldn't mind?
Brent: Sure right. So as of right now, the underlying defaults that we've seen with Evergrande or broadly the contagion that we're seeing in, you know, Asia ex-Japan high yield and in Chinese high yield has not knock-on wood made its way into either investment grade or sub-investment grade US spreads. The Fed did do something interesting this week where they have started to reach out to banks and financial institutions in the US to try and gauge exposure to Evergrande and so far, so good.
But, you know, I think time will tell. I think it's symptomatic of a broader issue within the Asia-Pacific region and more specifically within China. I do think it's very interesting what's going on as it relates to Xi Jinping and the People's Bank of China and their inherent crackdowns on companies in China across various industries.
Again, it's certainly something that we've been watching for a long time. This is not something that's new. And also, think about it, it's one of the things, you know, political risk is one of the main risks when you invest in emerging markets. It's also one of the things that helps with equity risk premia and an environment like I laid out where equity risk premia is going to be harder to come by and returns are going to be harder to come by in the future. While China might be in a little bit of a problem right now. We do believe the expectations will correct themselves in the future, and emerging ex-China, as well as emerging inclusive of China, could pose, you know, potentially good investing over the next handful of years, if not the next decade.
Amy: Thank you, Brent. Phil, thank you as well. We are over time, as I mentioned. So I want to thank everyone for being on the call today. As Brent mentioned, we are hosting Mr. Dan Clifton on October 27 for an in-depth discussion on all things policy and impacts on the economy. If you haven't made it to one of our events with Dan, this is the one to attend. Also, our director of wealth planning, is hosting a webinar on October 12 to help you get your financial plan in order for the end of the year. She's going to discuss some ways to shore up your financial plan as we wait on final legislation from Congress. If you have any concerns about the potential new policies and what that might mean for your financial plan, we encourage you to go ahead and reach out to your First Citizens consultant and start that conversation.
When we send the replay for this webinar, you'll see information for both of those events and how to register, and I'd encourage you to go ahead and sign up for both of those because space is limited. Our next Making Sense webinar is scheduled for Wednesday, November 17 at 12:00 Eastern time, and we'll be sharing those details with you in the coming weeks.
But thank you again for being with us today. You can find all of our webinar replays on firstcitizens.com/wealth. And with that, just I want to thank everyone again for being with us and have a wonderful afternoon.
Brent: Thank you, everyone.
Phil: Thank you.
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