Market Outlook · May 26, 2022

Making Sense: May Highlights

Brent Ciliano

CFA | SVP, Chief Investment Officer

Phillip Neuhart

SVP, Director of Market and Economic Research

Making Sense: May Highlights webinar replay

Amy: Hello, everyone. Welcome to the First Citizens Wealth Management webinar series, Making Sense, where Chief Investment Officer Brent Ciliano and Director of Market and Economic Research Phillip Neuhart help you make sense of what's going on in the markets and the economy. I'm Amy Thomas, a strategist with First Citizens Bank. And while everyone's logging in, I want to share a couple of housekeeping items with you. First, today's call is being recorded, and a replay will be available after today's conference. Secondly, this webinar is interactive, so you'll have the opportunity to ask questions along the way. Please use the Q and A and chat feature on the right-hand side of your screen if you have any questions. Also, all questions are confidential and only visible to myself and the panelists. I do want to remind you that we try to keep our discussion broad so if you have any questions about any of that information, please let us, please reach out to your First Citizens partner. As a reminder, the information you're about to hear are the views and opinions of First Citizens Bank and should be considered for educational purposes only. Before I kick things over to Brent, I want to let you know that we are having a couple of technical difficulties today, so we are going to be audio only for Brent and Phil, but we are going to get started in just a second. Thanks, everyone, for being with us.

Brent: Thank you, Amy, and good afternoon, everyone, I hope you're well. What a crazy and incredible start to the year it's been. We've had rampant, multi-decade high inflation, deep global supply chain issues and shortages, a war in Ukraine, geopolitical tensions, an incredible about face in monetary policy, all compressed, Phil, into a very short period of time that's leading to tighter financial conditions. And, by the way, the worst start to a year for the S&P 500 since 1939. The worst start to a year for US aggregate fixed income since the benchmark started in 1976. So just an awful lot to talk about today. So what are we going to cover today? So Phil and I are going to give you an overview of what's going on in the economy. We're going to talk about US economic growth. We're going to talk about the labor market, the ever-important US consumer corporate earnings and profitability and then inflation, interest rates, and the Fed. For today's special topic, Phil and I are going to get deep into bear market drawdowns and importantly, recoveries, the underlying characteristics, nuances, and idiosyncrasies that make them similar and different. And probably what you're most concerned about listening in is how much pain am I going to endure? How long and when do I recover? So we're going to get deep into that. And then certainly like we always do, Phil, we're going to get into, where do markets go from here over the next 12 to 24 months? So I mean, why don't we jump right in?

So from an economic growth perspective, after unprecedented amounts of monetary and fiscal policy stimulus that helped pulled us out of the depth of the pandemic, and you can see Phil, the incredible swing in the bars as far as contraction towards recovery and growth, we are now entering a new phase of this cycle and that's one of lower and slower growth. So where are the expectations right now for this year? 2.7% growth for this year. 2% for 2023 and 1.9% for 2024. And again, those numbers don't mean a lot unless you put that into perspective. So over the last 20 years, our economy has been growing at about 1.9%; over the last 50 years, 2.7%, so despite all the inflationary pressures in global supply chain issues and geopolitical tensions, this year we're expected to grow about 0.8% faster than the 20-year average and right on top of the 50-year average and certainly for 23 and 24 right on top of the 20-year average. The problem, though, Phil, is month over month we've been decelerating, right?

Phil: Right.

Brent: So it really depends on what we see over the next couple of months. But by and large, at least for now, we seem to be in OK shape. The real shining star to our economy is the labor market, right? The pandemic brought about the largest labor market contraction in the history of our country. We lost 22.4 million jobs in only 2 months in March and April of 2020. The unemployment rate skyrocketed to 14.7%, but since then, the labor market has been healing since April 2020. The unemployment rate has now fallen back down to 3.6%, and consensus expectations are for 3.3% by the end of this year. The Department of Labor basically came out at the end of April and said, we now have the fewest number of Americans collecting unemployment insurance benefits then since any time since the early 1970s. So just an incredible turn of events. But when you look at the graph on the right here, you can see that despite recovering 21.3 million jobs, Phil, we still have 11.55 million open positions. That's four and and a half million more open jobs than where we were pre-pandemic. So talk about a tight labor market. It's an incredibly environment, incredible environment. On the left side here, you can see that from a labor force participation rate, we've covered significantly from the depths of the pandemic. 152.5 million people employed in February of 2019 fell back down to 130. We're now back at 151.3 million people working, right which is only about 1.15 million people short of the pre-pandemic record. And folks, we added 1.7 million jobs in the first quarter alone, so the labor market is on path for more than a full recovery. And the good news is when you look at the chart on the right, wages have been growing at a very stout 5.5% year over year, though, Phil, when you take into account real wage growth and the ravages of inflation, consumers are actually losing money year over year. So let's talk about the US consumer, and before you look at anything on the slide, let's just talk about the consumer from an overall financial statement perspective. Household net wealth, so think net assets minus net liabilities, the highest level ever recorded debt payments as a percentage of disposable income. So think about what you owe every month, divided by what you bring in every month. While it's been rising over the last couple of months, still near the lowest level in more than 50 years and the savings rate is still sitting at a robust 6.2% so from a historical perspective, still robust savings. You know, on the downside, you can see the chart on the left. It's how you all feel on the phone. Consumer sentiment is sitting, Phil, at the lowest level since 2011 at 59.1. And it's interesting, the University of Michigan cited three things. Two we all probably expected, one which is rampant inflation, and the other one is global supply chain issues and shortages across grocery stores and car dealerships, et cetera, et cetera. But the other one that I thought was pretty interesting is that they cited discord in Washington, DC, and the political landscape and environment for consumer sentiment. The good news, though, is when you look at the chart on the right, that has not yet fed back into consumer spending. And remember, 73% of our economy is made up of the consumer, 69% is consumption, another 4.8% from housing. So as goes the consumer, as goes our economy.

Phil: And the real question here, Brent, is does the consumer start to vote with their wallet, right? Do we start to see a shift in consumer spending? Is sentiment leading us to that shift in consumer spending?

Brent: Yeah. So let's talk about supply chains still fundamentally under pressure, feeding back into higher food costs, higher transportation costs, higher shipping costs, higher everything and you can see both on the left and the right, whether you look at the New York Fed's measure or ISM Manufacturing Supplier Deliveries all significantly elevated. Good news, we're seeing, and you can see in the charts, you know, the line's coming down a bit. So we're seeing a little bit of relief, but by and large, it's just significantly heightened levels. So unfortunately, the supply chain disruptions are going to be here for quite a while.

Phil: And as we flip ahead here, you know, you hear Brent talking about, look, we have a really tight labor market, we have incredibly tight supply chains. How's that express itself? Well, expresses itself as inflation, right? In addition to a huge amount of fiscal policy stimulus and monetary policy stimulus. So whether you're looking at producer prices, which are PPI here, or consumer prices, which is CPI here, we're at four-decade highs.

Brent: Yeah.

Phil: Really dramatic inflation. Flipping ahead, we often get the question, what is driving consumer inflation? So if you look at that 8.3% CPI number, here we show the breakout. What is driving that year-on-year gain in CPI? So the biggest bucket is energy. That you can see as the orange box at the bottom here. That's about 2% of the overall 8% plus, so about a quarter of the gain, so there's still 75% that's not energy, and that's a big part of the problem here. If you take the other important categories, big categories you see here, food, add energy in there, shelter, motor vehicles and parts, that's nearly 80% of the total year-over--year gain. So this is unfortunately a multifaceted issue. It's not as simple as the prices at the tank or the prices to fill up your tank, rather, have gone up. As we flip ahead, a real issue for the Fed is not just realized inflation, which we're talking to a moment ago, but expectations. So we are seeing a real rebound in inflation expectations one year ahead, north of 6% 3-year ahead, now near 4%. That is problematic for the Fed when you think about the Fed target at 2%, unfortunately, inflation is now becoming embedded in expectations. That is why the Fed is becoming so aggressive. In terms of consensus estimates, consumer price index on the right side here. Consensus thinks that the pace of inflation is coming down but coming down from a 4-decade high. So you're still incredibly high. Look at fourth quarter of this year at 5.9%, first quarter of next year, north of 4%. Still very elevated inflation, well above the 2% target.

Brent: Yeah, and Phil, and I think what's critically important for listeners to understand is that just because the pace of price increases is moderating does not mean that prices fall. It usually takes an awful lot of time, multiple quarters for prices to come back down if they do at all, right? Think about wages being sticky and sometimes wages rarely ever fall. How often do you pay somebody X amount of dollars only to reduce that a year or two later, they're going to certainly vote with their feet. Usually, it takes an enormous demand impulse reduction to actually see prices come back down and usually get that through a recession.

Phil: And to that point, the Fed is being forced to act to address this inflation. Here we're showing Fed Funds Rate Probabilities. This is for the Fed Funds Futures market by the end of the year, the December 14 meeting. The target rate of the Fed funds rates at the bottom. This is expressed in basis point. So when you see 2.50 to 2.75, that's 2.5% to 2.75%. The Y axis is the probability. What Fed Funds Futures are telling us is that the Fed's going to be really active this year, right? Anywhere from 2.5 to north of 3% on the Fed funds rate. We are seeing an active Fed and they're coming out and being pretty open at this point on their statements that look, they were behind the curve and they're playing catch up now. And the yield curve, if you look at the next slide, has had to react. So when you see Treasury rates, the 2 year or the 10 year, both markets really caught flat footed coming into this year. Look at that 2-year line, basically nearly straight line up. That is because the market did not believe that the Fed was going to be as active as they've now had to come to terms with.

Brent: Yeah, it's incredible. I mean, you have a year to date, the 10-year yield has doubled. The 2-year yield has almost quadrupled. So talk about being late and being behind the curve.

Phil: And to that point, in terms of the difference between the 2 and the 10-year, which was on the right side, it's compressed, right? This you'll hear market participants referred to as yield curve flattening, right? The spread between the tens and the twos that has flattened, as an indicator of slowing economic growth. In fact, the yield curve inverted, you can see it went below this line negative for a short period of time earlier this year. That's also indicative of a slowing economic picture. On the positive side, let's look at corporate earnings. So despite inflation, geopolitical concerns, first quarter earnings were actually revised up through earnings season. We have a 9.1% growth. Think about where the economy is. There's a lot of disruption, 9.1% pretty good number. Consensus expects full year 2022 earnings to grow 10% that, compare that to a long-term average of around 6%, you're well above the long-term average. Now, a point of caution on the right side: operating margin. We're still at essentially all-time highs, but it is starting to turn over. A lot that operating leverage companies had coming out of the last recession, the 2020 recession is now waning. We are seeing margins start to come in a bit still very high by any historic standard. So, if we flip ahead, you know, this is a slide we've been showing for months now. Are we going into a recession or not? And when we look at it, what have we been saying? We say the US economy is slowing and inflationary pressures remain high, and we do believe the risk of recession has risen pretty notably, as we have been saying, we do not have recession in our base case. Something clients have been asking us and we've been presenting too, but thought we'd show in this case is, so what's your probability, right? So we have the world broken out into a bear, base and bull case. Bear case being the bad case, base case being sort of the norm and bull case being the real positive case. So in our view, the bear case is a recession. That probability is probably around 40%.

Brent: Yeah.

Phil: We've been saying 35, 40%, it's material. If you think about normal times. If you ask me that question, Brent, in the depths of a really strong expansion, I'd say, 5 to 10%.

Brent: Right. So materially moved up.

Phil: This is material. We are not saying that it's a slam dunk, that we do not have a recession in the next 12 months. The base case, 55%, that's the odds-on favorite modestly. That's a mid-cycle slowdown. That's what we are seeing now. There are disruptions. There's really no such thing as a soft landing. No landing feels good for an economy.

Brent: Yeah.

Phil: So that is the base case in which we muddle through. But it is a tough road to get there. The bull case is the re-acceleration, right? That's the least likely scenario. That is where you see supply chains loosen, a lot of positivity and a true re-acceleration of the economy.

Brent: Yeah, and I think if there's a silver lining to, you know, a significant increase in the expectations for a bear case to play out and a recession is, the good news is that the consumer and the labor market are in the best shape that they've been in more than 50 years. Corporate earnings and profitability, cash on balance sheets, corporations are in the best shape that they've been in decades, right? So we believe that if, God forbid, we were to go into a recession, that it might likely be a shallower recession and much shorter in duration than some of the previous cycles that we've had in the past. So let's transition, and let's kind of get to where I think many listeners want to understand is, well, guys talk to us about what do you bear market drawdowns look like? What should I expect? How long do they last? How long until they recover? What are the underlying nuances and idiosyncrasies that make some of these bear markets similar or different to the environment, we might find yourself in today? So why don't we jump in and talk about where we are right now.

So year to date through last night, Tuesday, the 24th of May, the market's down about 16.8% from peak to trough, right? The peak of the market, the highest level ever for the S&P 500 was on January 3 of this year, right? We are down about, you know, almost 17.5% from peak to trough. We've had seven consecutive weeks of market selling. And Phil, we've only had four other times post-World War II where that's happened: 1970, 1980 and the last time was 2001. So we're sort of in some, you know, you know, small observations relative to history. And I'm knocking on wood as we say this. But through today's action, we're actually positive about 1.3% for the week. So maybe again, I'm throwing some salt over my shoulder as well as I'm saying it, we can end it at a 7-week slump and not get into an eighth week. So what we're looking at on the next slide is all bear markets over the last 122 years, so from 1900 to now. And let me explain the graph what we're looking at from left to right at the very top. We're looking at the type of bear market, and I'm going to get into Phil in just a minute, the different types of bear markets and their characteristics. When did that bear market start? When did it end? How long did the pain last? So from the start of the bear market to the end? How long, in months, did it last? How far did we fall? And then how long in months did it take us to recover? And this is a really important point of interpreting this chart. This is price level, right? Because there's dividends that get paid on the S&P 500 and usually reinvested, especially if you owned an index product, the amount of decline and the time to recover would actually be a little bit less draw down a little bit shorter period because of that reinvestment in the dividend income. But when I pull it all together, over the last 122 years, the average time of the pain was about 20 months. It fell on average, about negative 37% and took about almost 4 years to recover. So all in from the beginning to the full recovery is about 5 and a half years. But the big thing Phil to notice is that look at the median. There's some big observations that skew this data on from a median observation. You're talking about only about a year and a half of pain. And again, a 33% drawdown. But, you know, a little bit less than 2 years to recover. So about a three-ish year full round trip versus the 5 and a half year for the entire sample. So let's talk about the different types of bear markets. There's three.

The first one is cyclical bear markets. Cyclical bear markets basically start with interest rates rising and that leading and feeding back into a corporate earnings and profitability recession and then an overall recession for the economy. It is the most common type of bear market. 42% of observations since 1900. So it's the most common. The second is event driven bear markets and as the name implies, it's event driven. So think about an oil shock, a war, a pandemic in the most recent example, Phil, is one that we just went through from February 19th to March 23rd of 2020. So an event-driven bear market that draws down. Usually the quickest down and quickest to recover. Then the last one, which is structural bear markets, where you have long-term structural things that end up breaking, bubbles popping. It's a buildup of excesses over long periods of time that ultimately break things down. So think about the technology, media and telecom bubble. Think about the Great Financial Crisis years of excess that build and build and build, then finally pop. So let's break down the experiences across these different types of bear markets in the top left. We're looking at the most common one, which is cyclical bear markets, which and I'm going to look at median observations. Median observation, you basically last about a year and a half of pain. They draw down about 29%, but they recover in about 2 years. So kind of the average outcome. On the right, you can look at the event driven. You can see from a median and average perspective very, very quick falls, not insignificant falls 32 to 34%, you know, average and median, but the recovery time tends to be very quick about a year to year and a half recovery. And we just saw that coming out of 2020, right? We dropped, fell 35% in about a month. You got all your money back in about 4 and a half months. So very quick down, very quick to recover. Structural bear markets on the, on the other hand, which are only about 20% of observations. Very, very long drawdowns, right? You're talking anywhere 2 to 3 years down, large declines, 50 to 60% drawdowns, time to recover, you know, 5 years, 7 years long time to recover. So the $64,000 question probably on everybody's mind is OK, Brent. Well, given what you've just described, are we potentially headed to a cyclical bear market or a structural bear market? Well, hold on. We'll get to that in just a second.

So this next slide, I want to break down those 122 years of bear markets into two eras. The first is pre-World War II, and what you can see is we, you know, long periods of drawdown, significant drawdowns on average 44% median, 33 long time to recover. But what you can really see is that the bottom is post-World War II. We've seen the period of drawdowns massively compressed to like a year, year and a half. You know, declines have not, been about the same, about 34% average in median. But the time to recovery is what's accelerated the most. You're just looking at, you know, less than 2 years on average and median to get your money back. So completely different eras pre-World War II and post-World War II. This next slide, I think, is really interesting because it lends itself to talking about that post-World War II era, right? Over the last 166 years, the length of recessions, Phil, has been more than cut in half from 22 months down to 10 months, and the length of expansions has almost tripled. So when I look at the ratio, expansions are almost six to one the length of recessions post the World War II era. So when you think about what's happened in bear markets post the World War II era, the reason we've seen such shorter periods of drawdown and shorter periods of recovery is very much linked to the length of recessions and the recovery of expansions. I think this next chart is probably most important in this entire presentation deck, and it really talks about, well, Brent and Phil, talk about what it was like as it relates to drawdowns, whether we go into a recession or we do not go into recession. So on the left, what we're looking at is S&P 500 drawdowns of 15% or greater, post-World War II, and I'm going to go across and explain what we're looking at, right? So you see the start date of when the bear market started. When did it end? How long did the pain last? And you can see in first line, 1.1 months. How far we fell, and we fell about 35.4%. But the last two columns are probably most important for listeners. Post the low, how quickly did the markets recover and how fast did I get my money back, right? So you can see, one year post the market's low in that first example, you got, you had a 75% recovery in the S&P 500. And when you look at the last column, which is incredibly important, in the first year after the bear market trough, what percentage of the peak level index did I recover? So basically 113%. So as you can see in these examples, as I go down the entire list, on average, market, average in median, the average drawdown is 8 to 9 months, you fall 20 to 27%, But here's the important thing, folks, you've recovered between 102 to 109% of your value one year after the bottom.

So, Phil, when we talk about stepping out of the market and trying to tactically time things, you run an incredible risk stepping out of the market at incredibly the worst time you could possibly imagine. And even when you go to the right side of this chart and you look at non-recessionary periods of time, right? You know, 6 to 6 and a half months down, same type of pain 22 or 23% down. So not too dissimilar whether we have a recession or not as far as drawdowns. But look at the percent recovery, you know, 99 to 102% recovery. So it's incredible.

Phil: And you know, we often get questions on how is this drawdown compared to past periods? And it's easy. We have to remember that the history doesn't necessarily repeat itself, but it does rhyme. So if you look at, say, mid-70s to the early 80s in which were inflationary environments, it is interesting to see one year post that four out of those five periods, you do see a recovery of the previous high. And we know there were many structural differences between now and then as well, including monetary policy, probably the most, most important. Other interesting periods. 2020, we had a recession, but it was due to a pandemic, right? Really unique scenario. 2018, non-recessionary event, but there were a lot of worries during that period. We were late in a cycle, we had a tightening Fed trade policy. 2011, non-recessionary environment. Many people, if you think back to that period, thought we were going into recession, right? We had a debt crisis in Europe. We had US credit rating was downgraded. So it is easy to now step back and say, oh, well, look at these periods. It's similar not to today. We have to remember that every period has something pretty unique and different than today. None of these are created equal.

Brent: Absolutely.

Phil: If we flip ahead, so you've heard all of this, you say, well, you know, if returns going forward and now are lower, does this mean I get out of stocks and, you can see here this is what's referred to as the lost decade. So end of 1999 to end of 2009, the top row here, this is S&P 500 return, the annualized return negative 1% on an annualized basis.

Brent: Per year over an entire decade.

Phil: Per year.

Brent: Unbelievable.

Phil: So, so, and look, this changed a lot of investors' behavior. People really became skeptical of investing in stocks because of what's referred to as the lost decade. Our answer is, don't get out of stocks; diversify. So if you look here, international mid and small cap US stocks outperformed the S&P 500 by 4 to 10% per annum in that timeframe. So the answer for us is not to exit the market, to stop investing, it is to invest in an intelligent manner.

Brent: Yeah and I think, Phil, we cannot emphasize enough how important diversification going forward is likely to be because we've talked about in previous examples where valuations are and expected for returns.

Phil: Gotcha, so let's jump back into where we are today. Brent touched on quickly, so I won't dwell. But under the hood, as you can see on the left side, both large and value are outperforming growth stocks, which has been a real rotation and mid and small. So that is where the focus of performance is. But what's most interesting to us is the right side. So you think about the price of the S&P 500, it's made of two components. One, earnings per share; and two, the multiple. What's the multiple? You hear the price-to-earnings ratio. That's a multiple. It is what you're willing to pay for a dollar of earnings. So you take that price to earnings ratio, you multiply it by EPS or earnings per share, and you get a price. What we're seeing in this year, as you can see on the right side, the dark line, earnings revisions have actually been positive, right? We discussed that for first quarter. We're seeing upward-sloping earnings revisions, but price has dropped pretty sharply. What does that mean? That means that the multiple has contracted, which is not necessarily a bad thing as you look forward. It means that today the market is cheaper than it was just a few months ago. So let's look at this from a historical perspective. This is the market multiple since 1970 in the lines of the PE ratio after the start of a hiking cycle. So the Fed starts hiking in that vertical line. What do you see after it? So if you look on average in these periods over the last few decades, the dark blue line. In the first 6 months, usually you don't see that much contraction in the PE ratio. That is not what we've seen this period.

Brent: That's right.

Phil: We've seen dramatic PE ratio contraction, as we mentioned. Now, as you look further out, PE ratio contracts, you know, roughly 10% on average, 12 to 24 months after the first hike. What's interesting is we've priced far more than that already.

Brent: That's right.

Phil: If you look at the worst periods in the orange line, you see a 15% to 20% contraction. Again, we've done more than that today. So really, we have priced in quite a lot into the marketplace. So how do we think about the start of the year from a historical perspective? So going back to 1939, this is the first, the worst first 4 months start to the equity market since 1939, the second worst. So you could see 1939 16.4% drop in the first 4 months of the year, 13.2 today in the first 4 months. So what does that tell us going forward? If you look at the second column, which is the end of April to year end, on average, it's a mixed bag, 1% growth. But this is a great example of how averages can lie to you. Look at the diversity of numbers. I see a positive 29, negative 24, et cetera. So the real story here is you're in a period of volatility seeing what the market's going to do. The last 8 months of the year is very difficult. But as you look longer term and most of our investors on the phone are long-term investors, one year out, 3-year out, you do, and 5-year out, you start to see positive returns, as you could see in the green box and the frequency increases. So 82% of one-year periods, up 90% of 3-year periods positive 100% of 5-year positive. So entry points matter and for long-term investors, we are starting to see some interesting entry points. And intra-year drawdowns are normal. The S&P 500, as you can see in the red dots here, has experienced average intra-year drops of 14%, yet has finished the year positive in 32 of the last 42 years.

Brent: Incredible.

Phil: So on average, you have a 14% drop. And of course, we've done more than that this year. But also look at how the extreme drops you can see in equity markets. 34% just 2 years ago in 2020, 49%, followed by an intra year of 28% in the Great Financial Crisis, you see the tech bubble, so the equity markets are volatile, and you could see some pretty extreme drops.

Brent: Yeah, and it's incredible, Phil, when you go through this and you take out the big ones 30% or greater and you normalize for some of these bigger drops that can tend to skew averages, the intra-year drawdown average is still negative 11% so even with, you know, taking those big ones out, it's still, you know, average volatility.

Phil: Exactly. So let's talk bonds for a moment. It's been a tough start for the equity market, but really much more severe for the fixed-income market. So here we're looking at the Aggregate Bond Index, data dates back to 1976. You can see we are by far the worst start to the year, the first 4 months compared to past periods and by multiples, 2.6 times worse than the second worst. This has been dramatic by other measures; this is more like 100-year event. We are really seeing a rough start to fixed income. Remember, yields go up, price goes down and we talked about yields going up. What's interesting with bonds, of course, is there's always a positive side to the coin. Now, yields are higher. As you invest, you're getting return. You could see for, you know, April 30th to year-end, positive returns 1, 3 and 5-year positive returns you can see in the green box and much higher frequency, right? 100% of 3-year or 100% of 5-year positive returns. And we are starting to see this in our client base.

Brent: Yeah, and it's incredible. As painful as it is to see the fixed-income markets drop and the way that they have, we've been talking about and hoping for this turn, right, because we talked about this lower for longer environment and how significant parts of client portfolios weren't going to be able to do the heavy lifting that they used to do in the past. Now that we've had to fundamentally reset and normally spot yields tend to portend longer term returns, it's going to lend itself to better returns for fixed income going forward and in the context of diversified portfolios, there's going to be a lot more balance in returns as it relates to income and total returns from fixed income and equities we believe going forward versus what it was in the last decade, where to is very myopically focused on the equity part of your portfolio doing a lot of the heavy lifting.

Phil: That's right. If we flip to the next page, intra-year drawdowns are normal for bonds as well, just not this severe. So on average, if you compare this to what we saw with equities, average of 3.2% intra year drawdown, but much like equities, 38 of 42 years have been positive, which has definitely fed into behavior. When you look at the red dots on this chart, nowhere near the big numbers you see with equities and really what we're seeing this year, as you could see, has been much more of an outlier.

Brent: Yeah, so when we talked about the recoveries from a lot of these bear markets, I think one of the things that, Phil, we cannot emphasize enough, is that it is time in the market not timing the market that matters. So what we're looking at here is the S&P 500's annualized return from 1995 all the way through April of this year. And what you could say, if you stayed fully invested, your return was 8.4% per year for that entire period. If you missed only the 5 best days, your return fell by 22% annualized.

Phil: Incredible.

Brent: If you missed the 10 best days, you dropped from 8.4 down to 5.3%, which is a 36% annual contraction in your returns. So just incredible. And I think in the bull, in the box on the right is what really hammers it home to me is that 48% of the S&P 500's best days occurred during a bear market. Another 28% occurred during the first 2 months of a bull market when nobody knew it was a bull market. So a whopping 76% of the S&P 500's best days occurred when you wouldn't want to be an investor, Phil. So let's try and bring this home, and let's talk about our bottom-line views. Let's start first where market consensus is. It might be hard to believe, folks, but the broad market consensus believes that from a 12-month forward price target perspective, the S&P 500 is looking at 5,128, which is an astounding 31.5% return 12 months forward from May 19th of 3,900. We came into this year, Phil, right, being much more conservative than the market. Back then in December, when we put out our forecast, consensus was about 5,300 or 5,400. We came into the year saying about 4,900, which was only about 3% growth year over year, right? And we had said 8% to 10% earnings growth and about 5% to 7% multiple contraction got you to only that 3% growth. Where we've revised our forecasts, Phil, for what we believe the returns are going to be for this year, we're looking at 4,600 for year-end value. That's about a 3% contraction in returns year over year. Where does that come from? 8% to 10% earnings growth. We still think earnings growth is going to be robust, but we now believe that the multiple given where we've contracted already is probably likely going to settle between a 10% to 15% multiple contraction. If you take the central point of tendency between both of those bullets, you're looking at about a 3 to 4% contraction, so about 4,600.

Big picture, though, we do believe that over this cycle, maybe by the year end, 2023 you know, first half of 2024, we do believe that earnings will be robust enough, inflation pressures will moderate and the Fed will be, you know, starting to slow their hiking cycle. We do believe that we could see 5,000 or higher in the S&P 500 before the cycle is over. So what should you be doing now as it relates to all this market volatility? First of all, number one, you have to have a financial plan. This is what you pay us for to have a comprehensive, disciplined financial plan to make sure that it's updated, to make sure that you, your family, your business, have all the fundamental inputs that you need to tie yourself to the mast. Just like Ulysses, when the sirens are screaming to make sure that you don't do something foolish and react when market volatility has already affected your portfolio. This will help you to prevent that behavioral reaction that we normally see, Phil.

Phil: Yeah, and in addition to that, truly assess your risk tolerance. It's one thing to have a plan, as Brent said. It's another thing to have the ability of fortitude to stick to it, right? If you cannot sleep at night, when markets do what they're doing right now, which is normal, they get volatile. Unfortunately, it is what happens. Sit back down with your FCB team and readdress your asset allocation and your goals and objectives for various buckets of assets. It might be an issue, where, what is your risk tolerance by bucket? That matters a lot. It is why we are here for you.

Brent: Absolutely and it's a great way to wrap it up, Phil, right? You, if you haven't worked very closely with your First Citizens Financial Partner, you need to be joined at the hip with them. Whether it's updating your financial plan, assessing your risk tolerance, going through what-if scenarios as it relates to your portfolio, your money, your wealth, the things in your life that are critically important. This is when we think that we shine and being able to be proactive and coming to you with information when times are tough. So, Amy, I can see that the questions are absolutely piling up, so why don't we jump in?

Amy: Thank you, Brent. Yes, they are just piling up, we've got a number already in the queue. If your question isn't answered today, please reach out to your First Citizens Relationship Manager. We'll get to as many as we possibly can today. Brent, we spent a lot of time talking about market volatility, and we're seeing a lot of ups and downs, especially recently. There's a lot of questions, and we talked a little bit about this, how people are worried about recessions coming and where the bottom might be. What are your thoughts? Can you give people some takeaways there?

Brent: Yeah, well, I mean, look, look, calling market bottoms and tops is a fool's errand, right? That's why we sort of, you know, went and showed you a lot of that historical data, right? You know, if, God forbid, we do end up in a bear market again, the average bear market drawdown is, you know, kind of anywhere between, you know, negative 21 and negative 27%, depending on whether we have a recession or not. And again, that's in the post-World War II era. So if in fact, we do end up in a bear market, there might be a little bit more pain to come. But again, it's impossible, Amy. It's impossible to call that bottom. And if you're out of the market for even a minute, look at the recovery percentage that we said in the first year. If I broke that down even further and showed you what the recovery was in the first month, 3 months, 6 months, a vast majority of those numbers that I showed you on the slide are encapsulated in that first month, third, you know, 3 months in or 6 months in. So stepping out of the market at the wrong time can really impair a portfolio's ability to recover. So you have to really stick with it and stick with your plan.

Amy: Thanks, Brent. For the next question, Phil, we talked a lot about the housing market a couple of episodes back, spent a lot of time on it as our special topic. We've got a question around how inflation is going to impact the housing market.

Phil: Yeah, it's a great question and something we've been pretty focused on. We've talked in the webinar and a number of presentations on. Obviously, some of the things have been happening in the housing market feel a bit frothy when you hear the stories and look at the data. Well, we are starting to see in recent data points is, a little bit of softening in sales and when sales soften, all of a sudden inventory looks higher because month supply of homes demand matters for that. So the question was around inflation. I think it's all connected. One, as we saw with the cost of shelter, housing inflation actually feeds into inflation. So these are self-fulfilling circular things, right? The price of building a home goes up, the price of shelter goes up. That is impacting consumers' overall inflation. So I think inflation impacts housing, but housing impacts inflation as well. When we think about that market, clearly we are starting to see a bit of a slowdown. Why is that? And as we've discussed previously with you all, it's about affordability, right? When you see dramatic increase in pricing, prices ,19% nationally and you compound that with mortgage rates going up. Affordability declines starting to see a softening in the sales data is not all that shocking.

Brent: Yeah, and it's incredible. I mean, the average home price went from about $407,000 to about $550, right, and then you've had interest rates go from 3% to 5 and one fourth. You geometrically link that all together and you're talking about a 95% increase year over year. And total cost of home ownership when you look at price appreciation and what you had to pay to get into that home, plus the ability to finance that, it's just been a lot.

Amy: Brent, we've got a question, actually several questions around investment strategy with rebalancing and that sort of thing during a down market. What are your thoughts there?

Brent: Yeah, I mean, Amy, rebalancing in volatile markets is incredibly important. Number one, to make sure that you're maintaining your risk discipline and especially when it comes to market drawdowns, you want to be able to not only rebalance to make sure that you have the right balance between return generating and risk managing assets, right? Because obviously, as markets fall, the percentage of risk assets that you have relative to your shock absorber tends to decrease, right? So you're rebalancing in times to make sure that you're thoughtfully balanced is incredibly important as far as it relates to the recovery, but also thinking about your ability when the markets throw a lemon at your head, making lemonade out of that and doing some tax loss harvesting, especially in taxable accounts, is an important strategy. And I know that our wealth consultants and our portfolio strategists and our financial advisors and consultants have that on the forefront of their minds when they're talking to clients. That's important, but I would make sure that depending on whether you're in a non-taxable account or a taxable account, usually that 5% differential, right? So if you are 60-40 and you've now drifted down to 55-45 or lower, it might be time to rebalance and vice versa. When the markets are really running, if you're in a 60-40 portfolio and we're now at 65-35, there might be times to start thinking about it. But obviously taxes and trading costs come into play when you have a taxable account. So there's sort of an art and a science to doing that, but it's usually that 5% to 10% differential between risk assets and risk managing assets.

Amy: Phil, we've got time for one more question and the story around inflation continues, the question around inflation rather, should, continues to be, what lessons have been learned from past historical times of high inflation like the 70s?

Phil: Yeah, it's a great question. It's a relevant question. We're at 4-decade high inflation, so you look back, well, 4 decades. You go back to the mid-70s into the early 80s, the number one thing that has changed. And look, you know, you're hesitant to say this time is different. That is not necessarily what we're saying. What we're saying is that there have been some material changes. The number one primary difference is monetary policy, right? You think about the influence of Volcker at the Fed and the emphasis on inflation and the degree to which to fight it. So we do believe the Fed is still committed to fighting inflation as it always has been. They misjudged this in terms of timing, and they were late, but I think this year is showing that they're committed to it. They know and we know that when there's supply constraints, demand needs to soften to lessen inflation. Now, one caveat to that is that there is some inflation here and things that are driving inflation that are not necessarily under the Fed's control, right? The zero-COVID policy in China, that's not under the Fed's control. The invasion of Ukraine is not, and that is why I think inflation expectations are sticky because there are things they can control and things they cannot.

Brent: Yeah, and I think for me, for people on the phone listening, certainly you're getting hit at the grocery store, at the gas pump, right? Everything is going up, right? So there's no denying that. I think from my perspective, and I'll take it from a market perspective, if you go back to that slide that we showed you during those recessionary periods or non-recessionary periods, what really came to my mind when we put together the data was looking at the returns in 1973, 74, 77, 80, 81, which were inflationary environments that arguably were much worse than where we are right now, or at least as bad. Again, if I look at the performance from the market low one year out, four out of those five times you got all your money back inside of, you know, within a year, right, and above that only one other time you are barely below that. So again, while every time is a little bit different but the most recent parallel as it relates to the environment, we might find ourselves in with high inflation, at least from a market perspective, historically, there's times periods of higher inflation did not prevent the market from recovering fast.

Amy: Brent, Phil, thank you so much for your time today and for bearing through some technical difficulties as we've gone through this. I appreciate everything that you've done and shared with us. I want to thank everyone for being on the line with us today. If your question wasn't answered, please reach out to your First Citizens Relationship Manager. Our next market update will be on June 22nd. That's a Wednesday, and we'll continue to meet at noon Eastern. We'll be sharing more details about that call in the coming days. We also recently launched our Making Sense: In Brief series. You can find that on, along with a lot of other helpful information for you during turbulent times of the market. On behalf of all of us here First Citizens, I want to thank everyone for being with us, and we hope to see you again on our next webinar. Thanks, everyone.

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Are we going into a recession?

The US economy is slowing, and inflationary pressures remain high. Both factors are causing concerns about the potential for a recession. We believe the risks for one has risen, but we don't have a recession as our 1-year base case. If we're wrong, the good news is that both the consumer and operations are in the best shape they've been in for decades. This indicates to us that if a recession were to occur, it would likely be shorter and potentially less severe than previous recessions.

  • Bear case (40%): Recession
  • Base case (55%): Mid-cycle slowdown
  • Bull case (5%): Re-acceleration

Drawdowns: Recession versus non-recession

Both the length and magnitude of the major S&P 500 drawdowns since 1950 are about the same with and without a recession. But focusing on the percentage recovery of previous highs one year following the bottom, most observations met or exceeded 100% of their initial peak.

Bottom line for markets

  • Wall Street consensus S&P 500 12-month forward price target is 5,265.87, or 31.5% return from close on May 19 close of 3,900.79.
  • Our revised 2022 S&P 500 price target is 4,600, equating to around 3% growth over 2021. This includes 8 to 10% earnings growth and 10 to 15% multiple contraction.
  • We believe the S&P 500 can potentially reach 5,000 or higher (2024 EPS of $271 at around 18.5x) by the end of 2023 or early 2024 as inflationary pressures moderate and Fed interest rate hiking cycle slows.
  • What should you do? Have a financial plan, truly assess your risk tolerance and work with your First Citizens partner to make sure you're staying on track.

This information is provided for educational purposes only and should not be relied on or interpreted as accounting, financial planning, investment, legal or tax advice. First Citizens Bank (or its affiliates) neither endorses nor guarantees this information, and encourages you to consult a professional for advice applicable to your specific situation.

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First Citizens Wealth Management is a registered trademark of First Citizens BancShares, Inc. First Citizens Wealth Management products and services are offered by First-Citizens Bank & Trust Company, Member FDIC, Equal Housing Lender; First Citizens Investor Services, Inc., Member FINRA and SIPC, an SEC-registered broker-dealer and investment advisor; and First Citizens Asset Management, Inc., an SEC-registered investment advisor.

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