Where are markets and the economy headed going into 2022?

2021 chartbook update

The first three quarters of 2021 have unfolded very similarly to what we outlined in our 2021 outlook. Our team believed we were heading into a period of accelerating economic growth and accelerating inflation and identified the asset classes that perform best in this environment, as shown in our Growth/Inflation Momentum Matrix. This phase is also characterized as the third phase of the post-recession recovery, when equities tend to enter the exhaustion phase. It’s usually marked by a peak in price-to-earnings (P/E) multiples and a shift in gains from valuation-led to earnings-growth driven. We also tend to see a steeper yield curve, with 10-year U.S. Treasury yields rising by an average of 50 basis points.

We now believe that we’re transitioning out of the accelerating economic growth and accelerating inflation environment, as the pace of economic growth and inflation has likely peaked. However, it’s likely that economic growth and inflation will remain above longer-term levels. This next phase of the post-recession recovery can be characterized as a normalization phase, where earnings growth will moderate but remain strong, valuation will decrease in an orderly fashion, and yields across the curve are likely to increase. During this phase, investors should temper return expectations, and portfolio construction will be paramount.

Our chartbook is a collection of charts we believe are relevant to helping explain the economic and market environment we believe we’re headed towards through the remainder of 2021 and into 2022. We continue to focus on the data that’s most relevant to the macro environment, equity and fixed-income markets, and portfolio positioning.

We’ve summarized a few of the more important charts/tables from our chartbook.

Our 12-month macro risk outlook (page 5)

Market risks

Risk

From current level

Outlook

Economy Neutral The U.S. economy and others around the world continue to recover, supported by consumer spending, accommodative central banks, and increased vaccination rates globally. Economic growth has likely peaked but will remain above pre-pandemic levels.
Valuation Risk to the downside Earnings recoveries tend to see a P/E contraction. Trailing S&P 500 12M P/E ratio falls 1‒3 multiples over the next 12 months on rising earnings. Our base case is for S&P 500 valuations to moderate as earnings continue to grow.
Earnings Neutral Earnings growth is anticipated to remain strong into 2022. However, it'll likely slow relative to 2021 on margin compression (rising input costs, wages, interest rates).
Yield curve Steeper The Federal Reserve and Bank of Canada maintain their accommodative policy through the first half of 2022. Short end of the yield curve is likely to shift modestly higher in anticipation of a potential rate increase in H2 2022. Longer end of the curve steepens as the recovery takes hold and inflation is sustained above central bank targets.
Credit Neutral Credit spreads remain range-bound near current levels. Returns are predominantly yield driven as bonds come under pressure from a rising yield environment. High yield is favoured over investment grade as a source of income. Risk of a credit event is very low.
Oil Prices Neutral Oil prices stabilize with West Texas Intermediate between US$65‒75/bbl over the next 12 months, with risk to the upside on near term price shock.
Currency
(CADUSD)
Risk to the upside CADUSD trends higher with a target range of US$0.81‒0.83 over the next 12 months, with risk to the upside based on oil prices and two-year rate differential.

Source: Capital Markets Strategy, as of September 30, 2021 

Global Purchasing Manager’s Indices (page 10)

What are they?

The Markit Purchasing Manager’s Indices (PMIs) are monthly economic surveys of carefully selected companies compiled by IHS Markit. They provide advance insight into the private-sector economy by tracking variables such as output, new orders, employment, and prices across key sectors. Economic analysts, business decision-makers, forecasters, and policymakers use the PMI surveys to better understand business conditions in any given economy. A reading above 50 indicates that the manufacturing output is growing while a reading less than 50 signals that it’s contracting.

What are they saying?

Although the output growth component accelerated for the first time in five months, it remained among the slowest during the current 15-month sequence of expansion. The pace of expansion in the new orders component also ticked higher from a recent low. Supply constraints fed through to prices, leading to marked inflation of both input costs and factory gate selling prices.

Of the 31 nations for which September data were available, 24 registered PMI readings above the 50.0 no-change mark that signals expansion. European manufacturing dominated the top of the growth rankings, with nine out of the 10 best readings. U.S. manufacturing also performed strongly (third place overall). The weaker performances were generally seen in Asia. Of the 12 lowest PMI readings in September, ten were from nations located wholly on the Asian continent, including four of the six countries to register sub-50.0 readings.

Bottom line

The global manufacturing upturn was subdued by supply chain disruptions and material shortages in September. Supply disruptions and material shortages also fed through to higher prices in September. The past six months have seen supplier lead times lengthen to the greatest extents in the survey’s history. Economic activity likely peaked in the summer and will face headwinds due to supply chain challenges over the coming months. But overall, the global manufacturing environment remains in a resilient position.

Purchasing Manager Indices (last two years)

Here’s a heatmap that show the positive and negative change in the Markit Purchasing Manager’s Indices from September 2019 to September 2021.

Source: Capital Markets Strategy, Markit, Bloomberg, as of September 30, 2021 

Outlook for the Canadian dollar (page 33)

What is it?

The Canadian/U.S. dollar exchange rate has typically been driven by two factors: the price of oil as measured by West Texas Intermediate (WTI) and the differential between the two-year yields for U.S. Treasuries and Canadian government bonds. The loonie has always been known as a petro-currency, but over the last decade, the two-year yield differential has also proven to be a highly correlated factor. The two-year government bond yields are seen as a proxy for central bank policies and, as such, the differential is indicative of the difference in the market’s perception of central bank rates. Our model uses a regression calculation on these two factors to try and predict the direction of the exchange rate going forward.

What is it saying?

The Canadian dollar has recently deviated from its historical correlation to oil prices and the two-year interest rate spread with the U.S. Rather, it has been the market’s view of the U.S. dollar globally that has created the recent depreciation in the loonie. As such, as at the end of the quarter, it’s trading significantly below its fair value.

Bottom line

Our fair value model would suggest the CADUSD exchange rate should trade near US$0.87; however, that’s perhaps a bit of an aggressive target, as external factors are limiting its upside. Our six- to 12-month target for the CADUSD is US$0.81‒0.83.

Modeled CAD/USD exchange rate vs actual CAD/USD exchange rate (last 10 years to current)

This chart compares the Capital Markets Strategy team’s fair value model of the Canadian-U.S. dollar exchange rate to the actual Canadian-U.S. exchange rate, from 2011 to 2021. There’s a positive correlation between the model and the actual rate.

Source: Capital Markets Strategy, Markit, Bloomberg, as of September 30, 2021 

During an earnings recovery, price-to-earnings ratios tend to fall (page 39)

What is it?

The trailing price-to-earnings ratio represents the relationship between the price of an index and the weighted value of the earnings growth per share of its underlying securities on a year-over-year (YOY) basis. When the P/E ratio is increasing, the index price level is growing faster than earnings growth, and when it’s falling, either the price is falling faster than earnings are growing or the price is growing at a slower pace than earnings. Both of these variables contribute to the index total return. The blue bars represent the monthly YOY change in earnings growth and the red line represents the change in the YoY P/E multiple (inversed).

What is it saying?

In this phase of the post-recession recovery, P/E multiples have peaked and are decreasing as earnings growth increases. Macro indicators would suggest that 2022 will continue to see a favourable earnings growth environment. During periods when earnings growth on the S&P 500 Index is between 10% and 20% on a year-over-year basis (as we believe it will be in 2022), the average P/E contraction is 1 multiple point and the average return is 9%.

Bottom line

We expect the P/E ratio to moderate in an orderly fashion as earnings growth continues to increase, but at a slower pace than this year. Given this outlook, investors should temper expectations for returns next year relative to this year and favour quality companies that have solid earnings growth with attractive valuations.

Year-over-year change in S&P 500 Index earnings per share vs change in trailing P/E multiple (last 50 years)

Here’s a chart that shows a positive correlation between the year-over-year change in S&P 500 Index earnings per share and the change in the trailing price-to-earnings multiple, from 1972 to 2021.

Source: Capital Markets Strategy, Bloomberg, as of September 30, 2021 

Seasonality (pages 49‒52)

What is it?

The charts below illustrate monthly performance and the odds of being positive for the S&P 500 and S&P/TSX Price Indices since 1950.

What is it saying?

September is historically the weakest month in terms of performance and in the odds of being positive for the S&P 500 and S&P/TSX Indices. However, the October-to-January period is historically a very strong period.

Bottom line

If we get a correction, it’s important to remember that the markets reward those investors who are eternal optimists and take advantage of the pullback.

S&P 500 – median monthly returns
(1950 ‒ 2020)

This chart shows the median monthly returns for the S&P 500 Index from 1950 to 2020. The month of September has the lowest average return (0.2%) and the month of November has the highest average return (1.9%).

S&P 500 – odds of a positive monthly return
(1950 ‒ 2020)

This chart shows odds of a positive monthly returns for the S&P 500 Index from 1950 to 2020. The month of September has the lowest odds (46%) and the month of December has the highest odds (75%), followed closely by April (72%).

S&P/TSX - median monthly returns
(1950 - 2020)

Here’s a chart shows the median monthly returns for the S&P/TSX Composite Index from 1950 to 2020. The month of September has the lowest average return (0.7%), with June also showing a negative average return (0.2%), and the month of November has the highest average return (2.0%).

S&P/TSX - odds of a positive monthly return
(1950 - 2020)

Here’s a chart shows the odds of a positive monthly return for the S&P/TSX Composite Index from 1950 to 2020. The month of June has the lowest odds (45%), followed very closely by September (44%), and the month of December has the highest odds (83%).

Source: Capital Markets Strategy, Bloomberg, as of December 31, 2020 

CMS inflation model (page 65)

What is it?

The CMS inflation model helps us forecast U.S. inflation measured by the Consumer Price Index (CPI). We use U.S. owner’s equivalent rent (OER), the U.S. Dollar Index (DXY), oil measured by West Texas Intermediate, and U.S. wages measured by the Atlanta Fed Wage Growth Tracker.

What is it saying?

For our forecasts, we used these assumptions:

  • owner’s equivalent rent – We used 3.3 (the three-year, pre-COVID-19 average).
  • US Dollar Index (DXY) – We used 97, whereas the current reading is 94. We see slight upside for the U.S. dollar vs its global peers on a less accommodative U.S. Federal Reserve.
  • West Texas Intermediate – We used an average of US$80/bbl for the next year.
  • wages – We used 4.2, whereas the three-year, pre-pandemic average was 3.4. We believe there are more upward wage pressures today due to a tighter labour market.

Bottom line

Our inflation model suggests CPI will remain above 2.5% into the third quarter of 2022. We believe higher inflation will put pressure on bond yields and remains one of the key risks worth watching into 2022.

CPI YOY vs CMS inflation model (1998 ‒ September 2022, including forecast)

This chart compares the year-over-year Consumer Price Index to the Capital Markets Strategy team’s inflation model from 1998 to 2021, with a projection into 2022. As of the date of writing, there’s a positive correlation between the CPI and the inflation model.

Source: Capital Markets Strategy, Bloomberg, as of September 30, 2021 

2.5% on the U.S. 10-Year Treasury yield is within reason for 2022 (page 67)

What is it?

The real yield on a bond is the yield an investor receives after adjusting for inflation. It’s important to know what the investor earns net of inflation to make sure it’s positive or else the investment will erode the purchasing power in the following year. There are multiple ways of calculating the real yield for U.S. Treasuries but a simple way of looking at it is to reduce the nominal yield by current inflation.

What is it saying?

Over the last 10 years, the real yield has averaged 26 bps. If we were to apply that to inflation between 2.0% ‒ 2.5%, which we believe is the level that inflation will settle at over the next 12 to 18 months, that would imply a U.S. 10-year yield of approximately 2.25% ‒ 2.75%.

Bottom line

The current nominal yield for the 10-year is around 1.5%. While we’re not expecting an immediate jump to the range above, should the market start to accept sustained inflation above 2%, then the 10-year should trend higher. This would put longer duration, fixed-income bonds at risk of a negative return. We continue to favour a shorter duration posture, credit over government bonds, and emerging market sovereign bonds over developed market.

U.S. 10-year treasury yield vs CPI (last 10 years through September 2021)

Here’s a chart that compares the U.S. 10-year treasury yield to the Consumer Price Index from October 2011 to September 2021.

Source: Capital Markets Strategy, Bloomberg, as of September 30, 2021 

CMS Model Portfolio (page 74)

In keeping with our process (and ignoring the short-term noise that we’re experiencing today) and based on reasonable valuations and a positive outlook for earnings into 2022, we’re maintaining our asset allocation the same. As of September 30, 2021, the CMS Model Portfolio remains overweight equities at 65% (+5% from benchmark) and 35% to fixed income (–5% from benchmark). The portfolio is well balanced across equity geographies.

Throughout the COVID-19 pandemic, we’ve been advocating rebalancing portfolios to target asset allocations and dollar-cost averaging into this market. We continue to emphasize that approach today. We don’t know what the market holds for us over the near term. A correction within that timeframe would be entirely consistent with normal market activity. If we get a correction, it’s important to remember that the markets reward those investors who are eternal optimists and take advantage of the pullback.

CMS Model Portfolio

This pie chart shows the breakdown of equity and fixed-income investments in the Capital Markets Strategy team’s model portfolio, as of September 30, 2021. The model portfolio is overweight in equities at 65% (+5% from the benchmark) and underweight in fixed income at 35% (5% from benchmark).

Source: Capital Markets Strategy, as of September 30, 2021 

Kevin Headland, CIM
Senior Investment Strategist
Manulife Investment Management

Macan Nia, CFA
Senior Investment Strategist
Manulife Investment Management

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

The opinions expressed are those of Manulife Investment Management, as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness, or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers, or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.

All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment, or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment, or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security, and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Unless otherwise specified, all data is sourced from Manulife Investment Management.

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Macan Nia, CFA

Macan Nia, CFA, 

Co-Chief Investment Strategist

Manulife Investment Management

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Kevin Headland, CIM

Kevin Headland, CIM, 

Co-Chief Investment Strategist

Manulife Investment Management

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