UBS’ Solita Marcelli: Why I’m Optimistic About the Market

Speaking with Barron’s Advisor, Marcelli says advisors must steer younger investors who are shaken by the bear market away from overly conservative portfolios. She explains why the strong dollar is bad for domestic stocks. And she spells out the lesson investors should take from the meltdown of digital assets. 

What’s your market outlook for the rest of the year? What I can say most confidently is that we should expect more of the same high volatility that we’ve seen for months now. The overarching market dynamic hasn’t changed: As long as inflation is too high and the labor market is too tight, the Fed is going to continue to raise rates and try to slow growth and bring down inflation. This makes for a very difficult environment for risk assets, and it’s unlikely we will see a sustained rally in stocks until inflation comes down in a conclusive way and the Fed starts to pivot. 

I think the Fed will likely want to see at least three consecutive months of slowing inflation and a cooling labor market before it even considers a pause. That’s unlikely, I think, in the next few months. All of that being said, we’re already about 15% off mid-August highs, and investor sentiment is very pessimistic. So I won’t rule out that a short-term bump is possible. But I don’t think investors should confuse this with being out of the woods just yet. 

On the interest-rate side, of course the big news recently was the 10-year Treasury hitting 4% at one point. I think this was mostly due to the U.K. situation and its effects on global fixed-income markets. However, interest-rate volatility will likely remain elevated through the end of the year. In our view, though, we think we’re close to, if not past, the cycle highs, and we expect the 10-year to drift lower, toward about 3.5% by the end of the year. So I would say the next couple of months will be volatile; I think we haven’t probably seen the bottom of the market yet. 

What are some scenarios for how the Fed’s inflation battle turns out? Our base case is that the Fed hikes another 125 basis points this year. But we also think that inflation will have slowed enough by the start of next year that the Fed will be able to pause. This would put the fed-funds rate target range at 4 ¼% to 4 ½% when the Fed pauses. In this scenario, the economy would grow below trend for a while and might slip into a mild recession, but the unemployment rate would rise to 4.5% and not much more than that. The Fed likely wouldn’t cut until late 2023, though, so risk assets might not find direction until the middle of next year. 

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In a much more optimistic scenario, inflation falls faster than expected and the Fed is able to pivot sooner. Progress on supply chains leads to rapid declines in prices of autos and other durable goods, and oil prices stay low. More people return to the labor markets, helping to relieve labor shortages and reduce inflationary pressures that are driven by wage growth. The Fed goes on hold at the first meeting of 2023 while the economic expansion continues, which then could allow risk assets to turn around quicker. 

The worst-case scenario is that inflation stays stubbornly high, partly because wage growth declines relatively little, which forces the Fed to hike even more than the markets are currently pricing. The fed-funds rate goes over 5% in the first half of 2024 and remains elevated for longer, which causes a much deeper recession and poor performance for risk assets. 

Why have bonds been hit so hard this year? The recipe for disaster has been a low starting point for yield plus a Fed behind the curve, plus inflation surprises and drivers like the energy crisis that have sped the Fed up even further. The bottom line is that Treasury yields are normalizing after years of fiscal and monetary accommodation, and because of the inflation picture, the Fed has had to move at a much faster pace than almost anyone was anticipating to remove these accommodations. Yields have adjusted at a similarly rapid pace to account for this great restructuring. 

Given that the starting point was so low, the duration impact from any move higher in rates has been very painful. Also the U.S. doesn’t work in a vacuum. Central banks around the world are aggressively raising interest rates. Because of this normalization of interest rates, people haven’t seen Treasuries as a safe haven. Typically when equities are volatile, people flock to Treasuries—but they have remained unattractive for most of the year. 

The good news for fixed-income investors is that now, with the 10-year having flirted with 4%, bonds can once again play the role of the safe-haven assets. So the outlook for bonds as a diversifier, I think, is much brighter from here. Basically, when inflation is the main concern, the correlation between stocks and bonds goes to one. But when the worry shifts from inflation to growth, then I think fixed income is going to play its role as a diversifier.

Can you talk about the pros and cons of the strong dollar? The strong dollar has been a key story this year as well. It’s helping with inflation right now by making anything we import into the United States cheaper. Therefore, I think it can be a net positive in terms of helping the Fed achieve its goal. The main con of the strong dollar is that it’s tightened financial conditions for the rest of the world. And this is adding fuel to the fire for foreign central banks to tighten their own policy, which further complicates the global picture. 

We’re effectively witnessing a reverse currency war right now. In a currency war, countries are accused of devaluing currencies to gain a competitive advantage. But right now, it’s the opposite as most major economies are trying to get control of inflation and avoid further currency depreciation. On top of that, U.S. multinationals that earn a chunk of revenues overseas are taking earnings hits when they translate revenues back into dollars. We estimate that the impact here is material but manageable: Every rise in the dollar of roughly 10% over the past year is about a 2% to 3% headwind for S&P 500 earnings. We believe the dollar will stay strong in the near term before potentially cooling off next year.

What are some of the serious tail risks that the markets might be overlooking? I don’t think there are any risks bigger than the Fed and inflation. But there are a couple of risks that may not be receiving enough attention. First, over the past 15 years, governments could increase debt without repercussions. But the last few weeks have shown that we might be seeing a broader shift. The markets could be now less tolerant of continuous government debt increases. We just saw what happened in the U.K. But guess what? The U.S. is not in a great position either, with gross debt to GDP of about 120%. Right now, it seems markets are comfortable with this level of debt. But additional interest-rate increases will be an incremental headwind, and it probably limits how much support the federal government can provide to the economy during future recessions. 

I’ll also say that there seems to be less focus on some of the issues in China right now, probably because Europe is such a mess. There’s a belief that after [China’s] National Party Congress, there could be more done to accelerate growth next year. But China is still facing some systemic issues with the zero-Covid policy and the real estate sector that have yet to be solved. So the China situation is simmering right now; it’s not too bad just yet. But if it gets much worse, it could impact the global economy’s ability to recover after a recession, especially since China’s supposed to be one of the global growth engines over the next decade.

The financial headlines are very gloomy these days. What if anything are you optimistic about? I’m certainly cautious in the near term. But I think there are reasons to be a little more optimistic on a 12-month horizon. I think inflation has peaked and will start to come down more meaningfully this year and early next year, and the labor market can start to cool without a significant increase in unemployment. And I think that suggests that we’re closer to the end than the beginning of the hiking cycle. 

Stretching the investment horizon even further certainly increases my optimism. First of all, the longer-term picture has become more attractive for stocks as valuations have come down. Price/earnings multiples are back in line with long-term averages, so stocks are now more likely to provide returns close to long-term averages over the next decade, meaning about a 10%-type of return on an annualized basis. 

Yields also have come up to levels last seen around 2008, so the long-term outlook for fixed income is much brighter. At the same time, our research shows that investing in private-market vintages following sharp equity market declines is typically a rewarding strategy. 

Overall, I think investors looking to put money to work in a diversified portfolio are in a much better spot than they were in January. Also, through all the awful inflation prints and growth numbers, you’ve had some silver linings in the economic data from a long-term perspective. Specifically, I think the recent durable goods orders were strong. I think it’s clear that companies are still investing. There’s a lot of investment needed in automation, energy transition, digital technologies, which should be a catalyst for the next few years and over the next decade.

What’s your advice to financial advisors at the moment about how to invest for their retirement-age clients? We’ve already covered fixed income becoming more attractive; this is especially exciting for retirees, who likely have a larger allocation to fixed income. I think this part of the portfolio can finally do its job of providing steady income. One of our favorite opportunities in fixed income are agency mortgage-backed securities. With inflation high, it’s as important as ever for retirees to upgrade their liquidity investments. I think there are some easy wins here that can boost income versus just holding cash. This can be done without taking on much if any risk, in areas like short-term Treasuries and short-term munis, and even by upgrading CDs and core savings to offerings that may now offer higher rates. 

Dividend stocks typically offer less-volatile total returns than the rest of the market and can be an excellent source of income. Right now, specifically, we like high-quality dividend stocks and we’re focused on companies that meet these four criteria: a higher-than-average dividend yield, higher return on equity, lower earnings variability, and low debt to equity. When I look at client portfolios at a high level, I see that most people are overallocated to cash and underallocated to fixed income. 

How would you invest for younger clients today? This might be the first true bear market they have been through, since the Covid bear market was over with a blink of the eye. I think the biggest risk is likely not even the losses they’ve seen, but rather the shaken confidence. So my first piece of advice for younger clients or an advisor managing younger clients’ money is to avoid making costly mistakes like coming out of this bear market with a portfolio that is way too conservative. 

We want clients to realize this is actually a great time to be opportunistic. Getting exposure to some of our favorite secular growth themes is now much cheaper than it was nine months ago. One example is the growing circular economy, focused on themes of recycle, reduce, and reuse of materials, which we think will play a major role in addressing issues around regulation, shifting consumer preferences, resource scarcity, and cost pressure.

Finally, it’s really important that young investors put certain best practices in place to set themselves up for success. For example, they should come up with a systematic plan around investing capital, so that it’s easier to stick with it during stressful times. 

What’s the lesson to be drawn from the meltdown of digital assets? I think we’ve seen two things: They’re not a hedge against inflation, and they’re not portfolio diversifiers. Those were some of the bigger arguments around getting into these assets. But they’re just like speculative stocks. So understanding the risk profile is really important.

Thanks, Solita.

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