In the article “Our outlook for 2022,” we drew comparisons between the path for market returns and a family road trip. The journey would have both expected and unexpected pit stops along the way, but the end destination can likely be positive.
What had been expected was the start of the pivot in global central banks’ monetary policies from ultra-accommodative to tightening. What was unexpected was that the pivot and market expectations would be toward an ultra-restrictive monetary policy in the form of above-average interest rate increases. Further, the conflict in Ukraine and its impact on energy and food prices, along with the implementation of a zero-COVID policy in China and its added impact on supply chain disruptions, have also been unexpected but material pit stops.
What has changed in our view? Higher than usual volatility will likely be with us for some time. A lumpy return profile is likely ahead of us as investors price in flat to negative earnings growth. Current earnings expectations are for 8%–10%.
However, as country music star Brad Paisley once said, “If you make the mistake of looking back too much, you aren’t focused enough on the road ahead of you.” As investors, it’s easy to focus on the past, given the volatility across nearly all asset classes, but it’s important to keep focusing on the road ahead, as that’s what’ll likely lead us to our desired destination.
The slowing economy
There’s little doubt that we’re seeing a slowdown in economic growth around the world. The “R-word,” recession, is being used more frequently to describe the risks in Europe, Asia, and North America.
From a global perspective, the Markit Purchasing Manager Index (PMI) gives a 30,000-foot view of the economy. It provides advance insight into the private sector economy by tracking variables such as output, new orders, employment, and prices across key sectors within individual countries. A reading above 50 indicates that the manufacturing output is growing, while a reading less than 50 signals that it’s contracting. Said differently, green is good, yellow is neutral, and red is bad. The PMI tends to be a strong indicator of the overall health of the specific economy.
Recent readings indicate support the thesis of economic weakness, as many countries have moved into the neutral area, with some falling into red. The pace of the slowdown could continue if expectations of higher interest rates and runaway inflation remain for the rest of the year and into next. Further complicating the issues are the extreme weather conditions in certain areas of the world, such as low water levels on the Rhine and the Yangtze rivers, two extremely important waterways for the local economies and major exporting arteries.
The U.S. has already experienced two consecutive quarters of negative GDP prints, the common definition of a recession. However, given the positive underlying data, such as employment and consumption, it’s unlikely that a material recession is at hand. This doesn’t change the fact that a recession may be forthcoming though.
Historically, there are warning signals prior to falling into a traditional economic recession. We characterize traditional economic recession as one where unemployment surges and is the major cause of the recession. Some of the signals that we look at are highlighted in the table below. Once again, we use the green, yellow, and red colour coding to illustrate our views of each indicator.
While there’s no specific rule as to how many of the signals need to be red before a recession is a foregone conclusion, the more important element is the number that are moving from green to yellow to red. The inflection points are what matter most. Our lone red signal is inflationary pressure, which was already pointing to a higher risk of recession late last year. Last quarter, we moved two indicators from green to yellow—the yield curve (measured by the difference between the 10-2-year U.S. government bond yields) and tighter financial conditions—as they began to signal an economic slowdown. Most recently, we’ve moved U.S. housing starts and leading economic indicators to yellow, as they too are pointing to a weaker economic environment in the U.S.
Given the expectation of continued weakness in many of these indicators, our base case is that we’re likely to experience a shallow recession in the United States in the first half of 2023. In addition, we could see a more severe recession in Europe as a result of the looming energy crisis.
Although the U.S. Federal Reserve and Bank of Canada are likely nearing the end of their respective tightening cycles, it’s unlikely that they can achieve the soft landing they desire. Certain aspects of inflation are outside of their immediate control and a recession-led reduction in demand may be required to achieve their goal of price stability.
For the first nine months of 2022, we‘ve experienced the consequences of policies put into place at the depth of the pandemic. While low rates were important at the time, central banks were perhaps slow in removing the stimulus they put in place during the pandemic, which ultimately led to “too much money in the system.” Inflation was also driven higher as a result of the conflict in Ukraine, which led to further energy and food inflation and continued supply chain disruptions with China’s shutting down of Shanghai and Beijing due to strict policies regarding the re-emergence of COVID-19.
These factors drove inflation to multi-decade highs globally. Inflation in Canada and the United States at current peaks reached 7.6% and 8.5% respectively. A slowing global economy will likely reduce demand and prices for global commodities. We’re already seeing material weakness in prices across commodities. Inflation appears to be peaking and we believe it’ll decelerate going into 2023. For our inflation model, if you assume current levels for owner’s equivalent rent (OER) at 6%, the US Dollar Index (DXY) at $106, oil prices measured by West Texas Intermediate (WTI) at $100, and wage growth at 7%, our expectation is that the Consumer Price Index (CPI) will trend between 4%–5% by year end and 3%–4% by the summer of 2023.
Other measures of inflation are also trending lower, including commodity prices measured by the Goldman Sachs Commodity Price Index (down 16% since last summer), the ISM Prices Paid Index (60 vs 90 on June 2021), and the NFIB Small Business Raising Price Index (56 vs 66 on March 2022). The year 2022 will be remembered for the increase in inflation and its impact on monetary policy and the global economy. In the short term, inflation remains a headwind for markets, but we believe there are catalysts throughout the year that will put downward pressure on inflation, and we’re likely to be discussing inflation a lot less next year.
Despite multiple challenges including supply chain disruptions, higher wages, and higher inflation, corporate earnings have remained resilient. For companies that have reported Q2 earnings, S&P 500 Price Index and S&P/TSX Composite Price Index earnings grew by 7% and 17% respectively; sales grew by 14% and 6% respectively. Within the sectors, there was wider variability in their results, a theme that’s likely to continue. The global economy is slowing, and the impacts of higher interest rates have yet to be absorbed, which provides a challenging backdrop for earnings moving forward.
The market hasn’t priced in a material earnings slowdown. Estimate for S&P 500 12-month earnings growth is 8%, and earnings estimates have just begun to roll over. We believe we’re likely to see flat to slightly negative earnings in the early part of 2023. Our proprietary Nuts & Bolts Index indicates flat earnings growth in Q1 2023. Other macro models confirm this theme of flat to slightly negative earnings growth, including the ISM US Manufacturing New Orders Index. New orders have dropped as inventory levels have risen; new orders will likely remain low as we work through excess inventory.
We believe that volatility will remain with us throughout the year as the market digests a weaker earnings environment. This environment favours “quality” businesses with high recurring cash flows and flexible business models. Earnings are likely to recover in the second half of next year, but there’ll be more uncertainty before that. We think the path for returns will be bumpy for the next few quarters but the return profile over the next year remains favourable. On a positive note, when earnings growth is negative on a monthly basis year-over-year, the S&P 500 is positive one year forward nearly 70% of the time, with an average return of 10.7%.
The biggest question for investors remains whether the upcoming volatility will cause equity markets to retest or even break the recent lows. Despite the risk of revaluing the earnings growth environment, we don’t believe the market is going to drop more than it did during first leg down, driven by a re-pricing off of higher interest rates.
Central banks around the world have been on an interest rate tightening path, with some of the most aggressive policies being those closest to home—the U.S. Federal Reserve and the Bank of Canada both raising their target rates by 2.25% so far this year. Although, they’re likely nearing the end of their respective tightening cycles, Fed chairman Jerome Powell seemed to dispel any thoughts of a pivot to an easing posture anytime soon. As we get closer to the end of the rate tightening, there’s more clarity to how high interest rates will get, which means that much of the downside risk to investing in bonds is in the rear-view mirror. Investors need to remember that interest rates or yields move in the opposite direction to price.
If we believe that the economy is slowing but a recession isn’t imminent, there may be pockets of opportunity in fixed income. New investments in bonds are now providing yield levels not seen in quite some time.
As we move through the rest of this year and into next, the risk of recession in the U.S. could increase. If we’re in the latter stages of this cycle, longer-duration, higher-quality bonds tend to outperform as their prices tend to rise and their yields fall. While rising yields was a headwind for performance earlier this year, falling yields will likely be a tailwind. Since June 1976 (the furthest date back that we have data for), in periods of a recession, the U.S. 10-year yield has fallen by a third on average.
The combination of higher yields to begin with and the potential for price appreciation increases the overall attractiveness of longer-duration bonds within a fixed-income portfolio. However, flexibility remains key to take advantage of the ever-changing landscape ahead.
What lies ahead?
There’s no denying that market volatility is likely to continue through the rest of the year, but history has shown that trying to time the peaks and valleys of the equity markets is near impossible. Like the family road trip, investors need to remain focused on their destination and not let pit stops derail them from getting there. Throughout the past couple of years, we’ve been advocating rebalancing portfolios to target asset allocations and dollar-cost averaging into this market. We continue to emphasize that approach today.
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