MACROECONOMIC HIGHLIGHTS - Q2 2022 - WESTEND ADVISORS
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Macroeconomic
Highlights
Q2 2022
Table of Contents
WestEnd Outlook Highlights………………………………………………………………………………………………2
U.S. Equity Sector Allocations……………………………………………………………………………………………3
U.S. Economic & Market Backdrop
Recovery Continues: Despite traditional and new risks…………………………………………………………………… 5
Pace of Economic Growth: Slowed-but-healthy…………………………………………………………………………… 6
Ukraine War: Europe most exposed…………………………………………………………………………………………7
U.S. Economy: Healthy despite geopolitical turmoil……………………………………………………………………… 8
Oil Prices: Mixed U.S. economic impact from oil price spike……………………………………………………………… 9
Yield Curve: Key measures are not inverted………………………………………………………………………………10
Labor Costs: Impact varies by sector………………………………………………………………………………………11
Earnings Growth: Secular earnings growth increasingly attractive………………………………………………………12
Equity Returns: More muted than 2021……………………………………………………………………………………13
U.S. Sector Outlook
Financials: Earnings should benefit from rising interest rates……………………………………………………………15
Valuation Opportunities: Select sector opportunities in a modest return environment……………………………………16
Information Technology: Well positioned for expansionary phase of cycle………………………………………………17
Industrials: Headwind from slowing orders…………………………………………………………………………………18
Consumer Discretionary: Navigating softer goods spending………………………………………………………………19
Energy: Expect supply response to oil price spike…………………………………………………………………………20
International Economic & Market Backdrop
Developed Markets: Cyclical progress warrants greater developed market exposure…………………………………22
Japan vs. EU: Japan’s recovery remains intact, while Europe faces new risks……………………………………………23
Interest Rates & Inflation
Corporate Bonds: Strong corporate fundamentals make credit attractive………………………………………………25
High Yield: Increases in spreads and yields make HY attractive …………………………………………………………26
Inflation Expectations: Longer-term expectations remain well anchored………………………………………………… 27
Disclosures ………………………………………………………………………………………………………… 28
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 1WestEnd Outlook Highlights
• We see continuing cyclical progression toward a healthy-but-slower-growth economic expansion, driven by a mix of
consumer and business strength.
• Economic and geopolitical risks have increased over the past quarter, but we do not expect them to derail economic
growth in 2022, and market volatility, while compounded by these risks, is normal in a shift from recovery to expansion.
• Internationally, we believe the deceleration in global economic growth is likely to favor developed markets over emerging
markets, but Europe faces distinct economic risks from the Ukraine invasion, given its dependence on Russian energy.
• We have continued to adjust portfolios for the expansionary mid-phase of the economic cycle:
• In U.S. large-cap equity allocations:
– We have moved to a material overweight of Information Technology and maintain an overweight of Communication Services,
sectors which we expect will see less deceleration in revenue and earnings growth than more-cyclical sectors.
– We are also emphasizing sectors trading at a discount to the market with positive earnings outlooks, like Financials, which we
believe will benefit from higher interest rates, and the Health Care sector, which we expect to deliver steady earnings growth with
upside from a rebound in elective procedures as the recent waves of COVID-19 ease.
– We have eliminated U.S. Industrials exposure, but maintain an allocation to the Energy sector, while avoiding traditionally
defensive sectors like Utilities and Consumer Staples.
• In global portfolios, we remain underweight international equities, as a whole, including underweights of Europe and Emerging Asia,
but we are overweight developed Asia, where we see greater near-term economic upside from factors like improved vaccination trends
and pent up recovery potential.
• In balanced portfolios:
– We continue to overweight equities, given the positive economic backdrop, low absolute yields, and continued risk of upside to
interest rates.
– Within fixed income allocations, we have shifted exposure from intermediate Treasury bonds to short-term high-yield corporate
bonds, as we see attractive high-yield spreads and a low risk of default, but we also increased duration modestly, even as we
continue to emphasize shorter duration bonds overall.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 2U.S. Equity Sector Allocations
WESTEND ETF STRATEGIES
Current large-cap U.S. equity sector allocation and avoidance*
Sector Sector
Allocations Avoidance
• Information Technology • Consumer Staples
• Financials • Industrials
• Health Care • Materials
• Communication Services • Real Estate
• Consumer Discretionary • Utilities
• Energy
* For illustrative purposes only. Allocation information as of March 31, 2022. Source: WestEnd Advisors.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 3U.S. Economic & Market Backdrop westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 4
Recovery Progresses
Despite Traditional and New Risks
REAL U.S. GROSS DOMESTIC PRODUCT
$21,000 Portfolio Impact: Emphasis of
economically-sensitive sectors like
Quarterly Real GDP (SAAR), Billions
$20,000 2 Years
+3.2% Financials, Information
$19,000 Technology, and Communication
$18,000
Services is warranted, in our view,
over more defensive sectors like
$17,000 Utilities and Consumer Staples
4.5 Years
$16,000 +3.2% given our outlook for the economic
expansion to advance.
$15,000
$14,000
Source: Bureau of Economic Analysis, WestEnd Advisors
The U.S. economy has delivered a dynamic rebound after the economic fallout from the COVID-19 pandemic, and the chart
above highlights that the current expansion is materially above the prior high in GDP. This expansion’s gains were reached
in less than half the time the prior expansion took to achieve the same level of growth.
After this period of rapid recovery, U.S. economic growth is slowing, primarily for normal cyclical reasons as employment
gains moderate and the economy laps the vaccine-led rebound. Despite lower growth rates, the economy should continue
to grow as sound fundamentals, including a low level of layoffs and strong personal income growth, outweigh traditional risks
like higher interest rates and new risks like the jump in energy prices spurred by the war in Ukraine.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 5Pace of U.S. Growth has Slowed
But Economy Remains Sound
CHICAGO FED NAT'L ACTIVITY INDEX SIGNALING DECELERATION
3.0 Portfolio Impact: The
deceleration in growth for major
CFNAI (3-Month Moving Average)
2.5
2.0 economic readings continues to
1.5
play out and has coincided with a
1.0
0.5
reemergence of market
0.0 volatility. We have transitioned to
-0.5 emphasize more mid-phase
-1.0 sectors in U.S. allocations, and
-1.5
maintain an overweight of
-2.0
-2.5 equities.
-3.0
Sep-19
May-20
Sep-20
Dec-19
May-21
Sep-21
Dec-20
Dec-21
Nov-19
Nov-20
Jun-19
Nov-21
Jun-20
Jun-21
Oct-19
Feb-20
Mar-20
Oct-20
Feb-21
Mar-21
Oct-21
Feb-22
Jul-19
Jul-20
Jul-21
Apr-20
Apr-21
Aug-19
Aug-20
Aug-21
Jan-20
Jan-21
Jan-22
Source: Chicago Federal Reserve, WestEnd Advisors
A wide variety of economic metrics, including consumer spending, housing, the labor market, and business sentiment, have
shown signs of decelerating, even as economic activity remains healthy overall. This slowdown in growth has been reflected in
the Chicago Fed National Activity Index (CFNAI), which has trended lower from the elevated levels seen earlier in the
recovery.
That said, the CFNAI continues to signal an above-trend pace of growth (zero reading = trend growth), and we believe
that pockets of improvement in certain areas of the economy, including trade, inventories, and nonresidential construction,
could help offset slowing growth in areas like goods spending in 2022.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 6Europe More Exposed to Ukraine War than the U.S.
NATURAL GAS & CRUDE OIL IMPORTS FROM RUSSIA
6.0 Portfolio Impact: Our global
portfolios are underweight
Imports From Russia (MMBOED)
5.5
5.0 Western Europe and have almost
4.5 no direct exposure to Russian
4.0 equities, the two areas we view as
3.5 most likely to be negatively
3.0
impacted by war in Ukraine. We
2.5
remain overweight the U.S. and
2.0
Japan, two markets that have
1.5
1.0
appealing fundamentals and that
0.5 investors often view as safe-
0.0 havens in times of geopolitical
OECD Europe China Rest of World United States turbulence.
Source: EIA, WestEnd Advisors
The Russian invasion of Ukraine has been a major geopolitical event, but the macroeconomic ramifications are likely to be
limited, in our view. Given that Russia’s economy makes up less than 2% of global GDP, the economic fallout of the conflict
is likely to be contained largely to commodity price fluctuations. As the chart above shows, Western Europe is likely to
take the brunt of the economic impact in the near-term due to its reliance on Russian energy commodities.
Russian imports make up ~40% of Europe’s total natural gas usage.
Importantly, Russia still only represents ~5% of the EU’s total imports and exports, and less than 1% of total U.S.
trade. As such, we do not believe the conflict has significantly raised the near-term probability of a recession in the U.S. or
globally.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 7U.S. Economy is Healthy
Despite Geopolitical & Market Turmoil
INITIAL JOBLESS CLAIMS
1,000
Weekly Jobless Claims (Thousands)
900 Portfolio Impact: Positive trends in consumer
800 spending and business technology investment should
700
600
continue to support economic growth into 2023. As such,
500 allocations to mid-cycle secular growth sectors – like
400 Information Technology, Communication Services,
300
200
and Consumer Discretionary – remain appropriate, in
100 our view.
0
While recent geopolitical developments and higher inflation
Source: DOL, WestEnd Advisors
rates have led to declines in investor and consumer
RESTAURANT TRAFFIC HAS RETURNED TO NORMAL sentiment, our assessment of the overall health of the
20
U.S. economy remains positive.
0
% Change from 2019 Levels
Higher frequency data still indicate that the economy
-20
remains on a positive trajectory. Initial jobless claims fell
-40
to historic lows and restaurant traffic rebounded to
-60 pre-pandemic levels in the back half of Q1 2021 as
-80 COVID-19 cases declined (bottom chart). We expect
-100
Initial Lockdowns positive labor market trends and robust household balance
sheets should continue to support healthy (but
decelerating) consumer spending growth in the coming
OpenTable United States Seated Diners (2 Week Moving Average)
Source: OpenTable WestEnd Advisors
quarters, especially on services.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 8Oil Price Spike will have a Mixed Impact
On the U.S. Economy
GASOLINE SPENDING AS A % OF TOTAL NOMINAL PCE
7.0%
Portfolio Impact: We believe several factors have made
Percent of Total Nominal PCE
6.0%
the U.S. economy more resilient to higher oil & gas
5.0%
prices relative to history, including better vehicle
4.0%
efficiency and less dependence on energy imports. As
3.0%
such, we continue to see the risk of a U.S. recession as
2.0% relatively low, and we believe maintaining exposure to
1.0% economically-sensitive sectors is warranted.
0.0%
May-67
May-78
May-89
May-00
Nov-61
May-11
Nov-72
Nov-83
Nov-94
Nov-05
Nov-16
Feb-59
Feb-70
Feb-81
Feb-92
Feb-03
Feb-14
Aug-64
Aug-75
Aug-86
Aug-97
Aug-08
Aug-19
In real terms, the price of oil remains below where it was
Source: BEA, WestEnd Advisors
in 2010-2014, which was a period of healthy economic
PETROLEUM TRADE BALANCE growth. Additionally, gasoline spending as a percent
5 of total nominal PCE has declined consistently over
Nominal Trade Balance (USD, Billions)
0 time, as shown in the top chart.
-5
-10
Furthermore, the U.S. has become much less dependent
-15
-20
on foreign oil over time, due to the shale revolution and
-25 growth in U.S. oil production. The bottom chart illustrates
-30 that U.S. has achieved a neutral oil trade balance in
-35
recent years.
-40
-45
Oct-17
Oct-07
Oct-12
Oct-97
Oct-02
Jul-16
Jul-21
Jul-06
Jul-11
Jul-96
Jul-01
Apr-10
Apr-15
Apr-20
Apr-95
Apr-00
Apr-05
Jan-09
Jan-14
Jan-19
Jan-94
Jan-99
Jan-04
Source: Census Bureau, WestEnd Advisors
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 9A Broader Interpretation of the Yield Curve
INTEREST RATE CURVE NOT SENDING UNANIMOUS RECESSION SIGNAL
5.0
Portfolio Impact: While yield
4.5
4.0 curve inversions do tend to
provide accurate long-leading
Interest Rate Spread (PPT)
3.5
3.0 recession signals, the most
2.5
2.0
accurate yield curve spreads, such
1.5 as the 10Y-3M, have remained
1.0 wide. In our view, this should be
0.5
interpreted as a sign that the
0.0
-0.5 economy has room to expand
-1.0 further in the coming quarters,
-1.5 even if the length of this cycle is
Aug-88
Aug-91
Aug-94
Aug-97
Aug-00
Aug-03
Aug-06
Aug-09
Aug-12
Aug-15
Aug-18
Aug-21
Feb-87
Feb-90
Feb-93
Feb-96
Feb-99
Feb-02
Feb-05
Feb-08
Feb-11
Feb-14
Feb-17
Feb-20
likely to be shorter than average.
Recession 10Y-3M 10Y-2Y 10Y-5Y 30Y-10Y 30Y-3M 30Y-2Y
Source: Bloomberg, WestEnd Advisors
The speed of this U.S. economic recovery has been extraordinary, in large part due to unprecedented monetary and fiscal
stimulus. The progress made this cycle has been reflected by a flattening yield curve, as the short-and-middle tenors of
the curve have increasingly priced in a rapid Federal Reserve tightening cycle in response to inflationary pressures.
However, recent concerns regarding inversions in parts of the yield curve are overdone, in our view. As the chart above
shows, investors should place more attention on the shape of the entire yield curve, which only tends to fully
invert after policy rates have increased materially. It should also be noted that equities tend to generate positive
returns between yield curve inversions and the onset of recessions, which takes more than a year, on average.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 10Impact of Higher Labor Costs to Vary by Sector
WESTEND LABOR INTENSITY SCORE
Portfolio Impact: We see labor
0.8
cost pressures becoming the
0.7
(higher = more labor intensive)
dominant driver of inflation over
0.6 time, and Consumer
0.5 Discretionary and Industrials
0.4 are the sectors most exposed
0.3 to these labor cost pressures
0.2 based on our analysis. This labor
0.1
cost exposure was a factor in
reducing allocations to these
0
sectors in Q1.
Source: WestEnd Advisors
WestEnd developed and employs a proprietary measure of labor costs that can be applied to individual companies and then
rolled up to industries and sectors. A sample of the data that contribute to a company’s score include the profit generated
per employee, growth in average wages in a company’s industry, and a measure of the labor-to-capital ratio.
Many factors contribute to our sector allocations, but our U.S. large-cap allocations currently have no exposure to three of
the four sectors with the highest labor intensity, and the Consumer Discretionary allocation is approximately market
weight. Conversely, WestEnd has exposure to four of the five sectors with the lowest labor intensity based on our scoring
system.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 11Secular Earnings Growth
Increasingly Attractive as Cycle Develops
2022 EPS GROWTH ESTIMATES BY SECTOR
70.0%
Portfolio Impact: Energy and
2022 Consensus EPS Growth
60.0%
Industrials are expected to be
50.0%
Airlines Hotels, Restaurants, & Leisure among the strongest-growing
40.0%
sectors in 2022 as they get a lift
30.0% from a war-driven oil spike and a
20.0% rebound from COVID-19 effects,
10.0% respectively. However, sectors like
0.0% Information Technology,
-10.0% Communication Services, and
-20.0% Financials have become more
attractive, in our view, as they
appear poised to generate
durable earnings growth during
'22 Consensus EPS Growth 15-Year EPS Growth CAGR (Pre-COVID) the next phase of the cycle.
Source: Bloomberg, WestEnd Advisors
As is typical during economic transitions, we expect earnings growth to vary significantly across market sectors in 2022.
Economically-sensitive sectors are expected to deliver the strongest growth this year, primarily due to the release of pent-up demand
in pandemic-sensitive industries such as Airlines, Travel and Leisure, and Energy.
While we fully expect activity in these industries to continue to rebound, we are increasingly shifting our investment exposure to
areas that we believe are poised to do well in a post-pandemic recovery environment. Sectors such as Information
Technology and Communication Services, which continue to benefit from secular growth tailwinds, have the potential to generate
strong earnings growth, even if the pace of economic growth decelerates. Earnings estimates for Financials, which benefitted from
reserve releases in 2021, appear too depressed and, we believe, should rise as monetary policy normalization continues.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 12Expect More-Muted Equity Return Drivers in 2022
CONTRIBUTORS TO S&P 500 TOTAL RETURN
50%
45%
Portfolio Impact: Although our full
40% year 2022 return outlook for the S&P
35%
30% 500 contemplates flat to moderate
25% 30%
20% 22%
8%
returns, we believe sector
26% 28%
15%
10%
6% 8% dispersion will offer ample alpha
9%
5%
4% generation opportunities as
0% -1% 0%
-5% -10% -12%
-15%
earnings growth becomes a larger
-10% -22%
-15%
-26% -27% -11% portion of equity returns. We believe
-20%
-25% our sector allocations have us well
-30%
-35%
-12% Note: Growth figures shown for each bar positioned to take advantage of this
pertain to multiple expansion/contraction.
-40% performance dispersion.
EPS Growth Dividend Multiple Expansion/Contraction S&P 500 Total Return
*Uses consensus '22 EPS growth as of 03/28/22. Assumes flat total return in '22.
Source: Bloomberg, WestEnd Advisors
The trailing price-to-earnings multiple for the S&P 500 fell nearly 20% in 2021 alongside a rapid rebound in earnings, which
is a typical occurrence during economic recoveries. These moves in earnings and multiples, along with dividend yield,
translated into a 29% return for the S&P 500 last year.
As the economy enters a decelerating growth environment, we expect equity market returns in 2022 to be driven primarily
by earnings growth, which will be at least partly offset by further multiple contraction. These are normal market
dynamics as the economy transitions to the middle stages of a cycle (see 2011).
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 13U.S. Sector Outlook westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 14
Financials Sector Earnings to Benefit
From Interest Rate Hikes
HIGHER RATES TO BOOST BANKS' NET INTEREST MARGINS
4.0 4 Portfolio Impact: The Financials
3.5 sector is positioned well, in our
3.5
Net Interest Margin (%)
Y ear-end '22 3
view, to benefit from the next
phase of the economic cycle. We
10-Year Yield
forward rate
3.0 2.5
believe the strong economic and
2.5 2 labor market rebounds should
1.5 support continued monetary
2.0 policy normalization, which in
'2 2 Consensus Est. 1
turn should lead to higher
1.5 0.5 interest rates and above-
consensus earnings growth for
Financials sector companies.
Diversified Banks Industry - Average Net Interest Margin 10-Year Yield
Source: Bloomberg, WestEnd Advisors
The speed of the economic recovery has been swift, which we believe has set the table for the Fed to continue
on a path of rate hikes as well as monetary tapering. This, in conjunction with above-trend growth and elevated
inflation readings, could lead to sustained upward pressure on short and long-term interest rates, in our view. The chart
above highlights that consensus estimates around banks’ net interest margins remains abnormally low relative to the recent
move higher in interest rates. We believe this should provide an underappreciated tailwind for Financials sector
revenue and profits.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 15Opportunities in Discounted Sectors
In Modest Return Environment
SELECT SECTORS P/E DISCOUNTS TO S&P 500
40%
Portfolio Impact: As the economy
moves forward in expansion, we
30%
Premium / Discount to S&P 500 (Fwd P/E)
expect investors are likely to
20% reward sectors with attractive
10% combinations of growth and
0% valuation. We see the Financials,
Communication Services, and
-10%
Health Care sectors meeting those
-20%
criteria.
-30%
-40%
Financials Health Care Communications
-50%
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Jun-11
Jun-12
Jun-13
Jun-14
Jun-15
Jun-16
Jun-17
Jun-18
Jun-19
Jun-20
Source: Bloomberg, WestEnd Advisors
Jun-21
We see a positive earnings picture for the Financials, Communication Services, and Health Care sectors in the period
ahead. We expect normalization of monetary policy should provide a catalyst for Financials sector earnings, and banks in
particular, while Communication Services EPS could surprise to the upside, driven by a shift to services spending. We believe
Health Care companies should be able to deliver steady earnings growth even as economic growth decelerates. We believe
these positive earnings developments, together with attractive valuations, create the opportunity for these sectors
to outperform in our 6-to-18 month investment window.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 16Tech Sector is Well Positioned
For the Next Stage of the Cycle
INFO PROCESSING EQPT + SOFTWARE AS % OF PRIV. NONRES INVESTMENT
45%
Portfolio Impact: As economic growth rates normalize in
Tech Spending % of Private Nonres. Inv.
40%
35% the shift to mid-phase, we believe Information
30% Technology will see less revenue and earnings
25%
growth deceleration than other economically-
20%
15%
sensitive areas of the market due to strong secular
10% growth trends benefitting the sector. As a result, we used
5% the market volatility in Q1 to increase our allocation to
0%
Information Technology at an attractive valuation.
Source: BEA, WestEnd Advisors
Businesses and consumers have increasingly embraced
TECH SECTOR FWD P/E (3M ROLLING CHANGE) digital platforms like cloud computing, eCommerce, digital
10 payments, and social media in recent years. Due to the
8 growing adoption of these services, business investment
6 spending on information processing equipment and
Change in PE (Turns)
4 software rose to an all-time high last year, a trend
2
which we expect to continue into the future.
0
-2 While the Information Technology sector commands a
-4 valuation premium due to its strong growth drivers and
-6 margins, we would note that Information Technology
-8 valuations recently recorded a sharp pull back, the most
for any three month window in the last six-plus years (see
Source: Bloomberg, WestEnd Advisors
bottom chart).
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 17Moderating Orders to Create
Headwind for Industrials Sector
U.S. MACHINERY ORDERS
$45,000 Portfolio Impact: We expect
overall economic growth to
$40,000
moderate, which will provide a
$35,000 headwind to the economically-
sensitive Industrials sector. We
SAAR (millions)
$30,000 eliminated U.S. Industrials
$25,000 sector exposure in Q1 in the
face of both slower growth and
$20,000 cost pressures.
$15,000
$10,000
Dec-95
Dec-96
Dec-97
Dec-98
Dec-99
Dec-00
Dec-01
Dec-02
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Dec-14
Dec-15
Dec-16
Dec-17
Dec-18
Dec-19
Dec-20
Dec-21
Source: U.S. Commerce Department, WestEnd Advisors
The recovery in core capital equipment orders has outpaced prior cycles, particularly for machinery in recent quarters. We
believe that durable goods order growth is likely to slow as consumer spending on goods cools off and overall
economic growth decelerates in the quarters ahead.
The Industrials sector is also subject to margin pressures going forward, in our view, from both higher input and labor costs.
We expect labor costs to be a greater challenge going forward as supply issues begin to diminish.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 18Goods Spending to Slow
Even with Strong Income Growth
WAGES & SALARIES GROWTH SUPPORTS CONSUMER SPENDING
20.0%
Wages & Salaries Growth (Year-Over-Year)
15.0%
Portfolio Impact: We believe reduced exposure to
the Consumer Discretionary sector is warranted as
10.0%
goods spending moderates and as middle-income
5.0% consumers face challenges including moderate real
0.0%
income growth. Consumer Discretionary sector
companies are also likely, in our view, to face margin
-5.0%
pressure from higher labor costs.
-10.0%
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
Jan-17
Jan-18
Jan-19
Jan-20
Jan-21
Jan-22
Personal income growth has remained strong, led by
Source: BEA, WestEnd Advisors
wage and salary growth among workers. These
income gains should support a healthy consumer
backdrop, even as there are shifts among goods and
services spending.
Goods spending remains significantly above its long-
term trend both in nominal and real terms. We expect
that the level of goods spending will moderate in
2022 as real incomes are pressured and consumers
reallocate spending to services.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 19Expect a Supply Response to Oil Price Spike
OIL PRICES GREATER THAN BREAKEVEN COSTS INCENTIVIZES PRODUCTION
14,000 140
U.S. Oil Production (MMBOED)
13,000
12,000
120
Portfolio Impact: Energy exposure is appropriate, in our
Oil Price ($/BBL)
100
11,000 view, given cheap valuations and the inflationary nature of
10,000 80
9,000 this cycle. However, the risk/reward profile for the sector
60
8,000 has become more balanced, and we recently rebalanced
7,000 40
6,000 our exposure back down to target weight following strong
20
5,000
sector performance in order to achieve a modest
4,000 0
underweight of the Energy Sector in ETF strategies.
United States DOE Crude Oil Total Production Data The rapid nature of the global economic recovery has
WTI Crude Oil Price
Weighted Average US Shale Oil Breakeven Price supported oil demand, driven by rebounding production,
Source: DOE, BTU Analytics, WestEnd Advisors
trade, and travel volumes. At the same time, production
WORLD CRUDE OIL & LIQUID FUELS CONSUMPTION constraints, in part related to sanctions on Russia, created
5.0% a supply crunch that sent oil prices soaring in Q1.
2.5%
Looking ahead, we do not view the recent state of the
Demand vs 2019 Levels
0.0%
-2.5% energy market as sustainable. Oil & gas demand growth
-5.0%
is likely to decelerate moving forward, given that
-7.5%
consumption has returned to pre-pandemic levels.
-10.0%
-12.5%
Furthermore, oil producers in the two largest oil producing
-15.0% countries – the U.S. and Saudi Arabia – have breakeven
-17.5% costs below $40/bbl and, at current prices, can generate
-20.0% more profit per barrel than ever before. We expect this
incentive to lead to more supply in the intermediate term
and fill the gap left by Russian sanctions.
Source: EIA, WestEnd Advisors
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 20International Economic & Market Backdrop westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 21
Maturing Cycle Warrants
Greater Allocation to Developed Markets
2022 EARNINGS ESTIMATE REVISIONS
20.0%
Portfolio Impact: In our view, international developed
Change in FY22 EPS Estimates
15.0%
10.0% economies are likely to generate stronger sales and
5.0% earnings growth relative to emerging markets as the
0.0% economic cycle continues to age. As such, we remain
-5.0% overweight the U.S. and have a significant
-10.0% underweight to emerging markets.
-15.0%
The stability of developed market economies appeals to us as
the global economic cycle continues to mature. During
MSCI World (Developed Markets) MSCI Emerging Markets periods of economic deceleration, earnings growth in
Source: Bloomberg, WestEnd Advisors developed market countries is likely to prove more
CHINA RETAIL SALES % GROWTH (2-YEAR STACK)
resilient than in emerging markets, in our view. This has
25.0%
been reflected in diverging fiscal 2022 EPS estimate
revisions over the last year (see chart above).
2-Year Stacked Growth (Annualized)
22.5%
20.0%
17.5%
15.0%
In China, which accounts for over 25% of emerging markets,
12.5% the economic cycle is further along compared to developed
10.0% markets. Growth is now decelerating as export demand
7.5%
5.0%
peaks, the property sector slows, and household consumption
2.5% stagnates. Furthermore, the re-emergence of strict
0.0% COVID-19 lockdowns in many Chinese cities and
-2.5%
-5.0% declining real estate values have impeded consumer
spending and broader economic activity. We believe this
Aug-04
Aug-05
Aug-06
Aug-07
Aug-08
Aug-09
Aug-10
Aug-11
Aug-12
Aug-13
Aug-14
Aug-15
Aug-16
Aug-17
Aug-18
Aug-19
Aug-20
Aug-21
presents additional downside risks to earnings estimates in
Source: NBSC, WestEnd Advisors 2022 and beyond.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 22Japan’s Economic Recovery Remains Intact
Europe Faces New Risks
REAL GDP REMAINS DEPRESSED IN JAPAN
4.0%
Portfolio Impact: An overweight allocation to Japan is
Real GDP % above/below pre-pandemic peak
3.0%
warranted, in our view, given its prospects for an
2.0%
economic rebound in 2022 as well as a historically-
1.0%
cheap valuation. We have maintained an underweight
0.0%
position in Europe, given the region’s near-term growth
-1.0% headwinds and increased geopolitical uncertainty.
-2.0%
Europe and Japan have experienced slower recoveries than the U.S.
-3.0% due to lockdown measures associated with continued COVID-19
-4.0% outbreaks. We believe Japan could benefit from an economic
U.S. U.K. EA19 Japan rebound in 2022, given that real economic activity remains
Source: WestEnd Advisors, BEA, Eurostat, ESRI Japan, UK ONS (As of 12/31/21) depressed versus pre-pandemic levels (see top chart).
EUROZONE FACING SIGNIFICANT INFLATION HEADWINDS Personal consumption growth is an area of potential upside for Japan,
8.0% which has seen a more significant savings build-up as a percent
Headline Inflation (Year-Over-Year)
7.0% of GDP compared to the U.S. and Europe. This, along with a
6.0%
healthy labor market, could provide fuel to Japan’s spending upswing.
5.0%
4.0% While we believe Europe could benefit from similar growth tailwinds
3.0% as other Developed Markets, the region is likely to face more material
2.0% near-term economic headwinds stemming from the recent surge in
1.0% energy prices. As shown in the bottom chart, headline inflation in
0.0% Europe has climbed significantly relative to headline inflation in
-1.0% Japan, which could weigh on real consumer spending as
-2.0% European consumers are forced to spend more on gas and utilities.
Jul-11
Jul-12
Jul-13
Jul-14
Jul-15
Jul-16
Jul-17
Jul-18
Jul-19
Jul-20
Jul-21
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
Jan-17
Jan-18
Jan-19
Jan-20
Jan-21
Jan-22
Eurozone Headline Inflation Japan Headline Inflation
Source: Eurostat, MIAC, WestEnd Advisors
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 23Interest Rates & Inflation westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 24
Corporate Financial Strength
Makes Credit Attractive
CORPORATE PROFITS
$3,500
After-Tax Corporate Profits (SA)
$3,000 Portfolio Impact: Economic fundamentals in the U.S.
$2,500 remain sound, in our view, and corporate profitability and
$2,000 balance sheets are very healthy. In this environment, we
$1,500 favor corporate credit relative to Treasury bonds, and we
$1,000 increased our credit overweight in Q1 in balanced
$500
strategies.
$0
U.S. companies are experiencing record profits, as
Dec-90
Dec-92
Dec-94
Dec-96
Dec-98
Dec-00
Dec-02
Dec-04
Dec-06
Dec-08
Dec-10
Dec-12
Dec-14
Dec-16
Dec-18
Dec-20
seen in the top chart, driven by both strong revenue
Source: BEA, WestEnd Advisors
growth and margin expansion.
S&P 500 NET DEBT-TO-EBITDA NEAR HISTORIC LOWS
6.0 These corporate financial gains have supported corporate
Net Debt-to-EBITDA Ratio
5.0 balance sheets. The strong profitability, together with low
JB: Excel chart? overall interest rates, allowed many companies to lower
4.0
their debt service burdens while extending the maturities
3.0 on their debt.
2.0
Strong cash flow gains and balance sheet management
1.0 have resulted in the lowest leverage profile for the S&P
0.0 500 in at least three decades (bottom chart).
Dec-91
Dec-94
Dec-97
Dec-00
Dec-03
Dec-06
Dec-09
Dec-12
Dec-15
Dec-18
Dec-21
Jun-90
Jun-93
Jun-96
Jun-99
Jun-02
Jun-05
Jun-08
Jun-11
Jun-14
Jun-17
Jun-20
Source: Bloomberg, WestEnd Advisors
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 25High Yield is More Attractive
Given Increases in Yields & Spreads
HY SPREADS WIDENED TO MORE ATTRACTIVE LEVELS
500 7.0%
Bloomberg US Corporate High Yield Average OAS 6.5% Portfolio Impact: The healthy economic and corporate
450
Bloomberg US Corporate High Yield Yield To Worst
6.0% cash flow backdrop, together with rise in absolute yields
400
5.5%
and yield spreads, made High Yield bonds more attractive
Spread (bps)
5.0%
350 4.5%
in Q1. We believe this positive fundamental outlook
4.0% warrants allocation to short-duration High Yield
300
3.5% bonds in balanced strategies.
3.0%
250
2.5%
200 2.0%
U.S. corporate profitability has surged since the pandemic,
Source: Bloomberg, WestEnd Advisors
while lower interest rates and elevated inflation have
U.S. PROFITABILITY HAS RECOVERED MARKEDLY
reduced companies’ true cost of capital. The gains in
25 15 profitability can be seen in the margin and ROE expansion
in the bottom chart.
Return on Common Equity (%)
14
20
13
EBIT Margin (%)
12
In the event that the Fed raises rates in line with or more
15
11 slowly than current market expectations, we believe with
10 10 the current yield premium on short-term high-yield
5
9 corporate credit could provide better returns than low-
8 yielding intermediate Treasury bonds.
0 7
May-20
Sep-08
May-10
Sep-13
May-15
Sep-18
Nov-07
Nov-12
Nov-17
Mar-21
Mar-06
Mar-11
Mar-16
Jul-19
Jul-09
Jul-14
Jan-22
Jan-07
Jan-12
Jan-17
S&P 500 Ex Financials ROE S&P 500 Ex Financials EBIT Margin
Source: Bloomberg, WestEnd Advisors
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 26Inflation Expectations
FORWARD INFLATION EXPECTATIONS CURVE
6.0%
Inflation Swaps - Implied 1-Year Forward Rates
Portfolio Impact: Given the prospect of
5.5% higher interest rates, we continue to
5.0% favor equities over fixed income and
4.5% emphasize shorter duration
4.0% corporate credit within our fixed
3.5% income allocations. That said, with the
3.0% cycle continuing to mature, and the
2.5%
likelihood that the peak in long-term
interest rates could be lower than in
2.0%
previous cycles, we have modestly
1.5%
extended the duration of our fixed
1.0%
1 2 3 4 5 6 7 8 9 10
income allocations.
Years Forward
Source: Bloomberg, WestEnd Advisors
Inflation has become a key area of concern for both investors and the Federal Reserve. In our view, core inflation is likely to
moderate in 2022 as many transitory pandemic effects fade. As shown in the chart above, inflation expectations
remain well-anchored over intermediate-and-long term time horizons. While this may limit the risk of an upward
inflationary spiral, we still expect CPI to remain above the Fed’s 2% target, putting upward pressure on interest rates and
giving the Federal Reserve an all-clear to continue to normalize policy. In contrast, short-term inflation breakevens have
risen to the highest levels in decades, which limits the appeal of TIPS compared to equities and corporate credit,
in our view.
westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 27Footnotes & Disclosures On December 31, 2021, Victory Capital Holdings, Inc. (“Victory Capital”) acquired WestEnd Advisors, LLC (“WestEnd”). WestEnd, an SEC-registered investment adviser, operates as an autonomous Victory Capital Investment Franchise. WestEnd’s active principals continue to be responsible for managing the firm and its day-to-day operations. Registration of an investment adviser does not imply any level of skill or training. WestEnd manages equity securities for individuals and institutional clients. This report should not be relied upon as investment advice or recommendations, and is not intended to predict the performance of any investment. Past performance is not indicative of future results. It should not be assumed that recommendations made in the future will be profitable. The information contained herein is not intended to be an offer to provide investment advisory services. Such an offer may only be made if accompanied by WestEnd Advisors’ SEC Form ADV Part 2. These opinions may change at anytime without prior notice. All investments carry a certain degree of risk including the possible loss of principal, and an investment should be made with an understanding of the risks involved with owning a particular security or asset class. The information has been gathered from sources believed to be reliable, however data is not guaranteed. The Standard and Poor’s 500 Stock Index includes 500 stocks and is a common measure of the performance of the overall U.S. stock market. The MSCI ACWI consists of 49 country indexes comprising 23 developed and 26 emerging market country indexes. The total return of the MSCI ACWI (Net) Index is calculated using net dividends. Net total return reflects the reinvestment of dividends after the deduction of withholding taxes, using (for international indices) a tax rate applicable to non-resident institutional investors who do not benefit from double taxation treaties. The Bloomberg Barclays US Aggregate Treasury Index measures US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury. The Bloomberg Barclays US Aggregate Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. An index is unmanaged and is not available for direct investment. Any portfolio characteristics, including position sizes and sector allocations, among others, are generally averages and are for illustrative purposes only and do not reflect the investments of an actual portfolio unless otherwise noted. The investment guidelines of an actual portfolio may permit or restrict investments that are materially different in size, nature, and risk from those shown. The investment processes, research processes, or risk processes shown herein are for informational purposes to demonstrate an overview of the process. Such processes may differ by product, client mandate, or market conditions. Portfolios that are concentrated in a specific sector or industry may be subject to a higher degree of market risk than a portfolio whose investments are more diversified. Holdings, Sector Weightings, and Portfolio Characteristics were current as of the date specified in this presentation. The listing of particular securities should not be considered a recommendation to purchase or sell these securities. While these securities were among WestEnd Advisors’ strategies’ holdings at the time this material was assembled, holdings will change over time. There can be no assurance that the securities remain in the portfolio or that other securities have not been purchased. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities presently in the portfolio. Individual clients’ portfolios may vary. Upon request, WestEnd Advisors will provide a list of all recommendations for the prior year. westendadvisors.com | info@westendadvisors.com | 888.500.9025 Macroeconomic Highlights Q2 2022 28
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