Chapter 32: Re-calibrated Market Outlook
Dear Clients,
We hope the summer finds you in good spirits. In summer outdoor barbecues, there is a saying that “everything goes on the grill.” This saying may aptly describe today’s heated investment climate, in which the convergence of multiple macro- level dynamics has given rise to a highly sensitive and reactive investor psyche. One of these developments was this morning’s 75 basis point Federal Funds Rate increase, which signals a more forceful stance on the part of the Federal Reserve to quell inflation regardless of the economic implications (as of June 15, 2022). Indeed, growth revisions came down a full percentage point (GDP from 2.8% to 1.7%), there were upward revisions for 2024 unemployment from 3.6% to 4.1%, and expected headline inflation for 2022 was revised upward once again from 4.3% to 5.2%.
Markets initially reacted favourably to the Federal Reserve's resolve to tame inflation, indicating the markets are recalibrating expectations for financial conditions. Over a longer timeframe, the implication of a Federal Reserve policy that has shifted from neutral into restrictive is its influence on the market multiple, which represents investors’ perceptions of the fair value they are willing to ascribe to the average S&P500 company. The last time we wrote, we had predicated our S&P500 intrinsic value target of 3500 on past corresponding periods in the market cycle where the 10 year treasury yield had exceeded 3%. With the Federal Funds Rate expected to move close to 4% by the end of the year and the 10-year treasury yield already at 3.4% as of this morning’s decision, it is likely the S&P will experience further valuation multiple compression, reflecting less accommodative monetary conditions. Indeed, 100% of the price movement this year can be explained by multiple compression, and not earnings results.
As a result, the associated volatility in the financial markets that we are witnessing, stemming from these more restrictive conditions, is completely reflected in the trajectory of the valuation multiple (i.e. the price-earnings ratio), and has little to do with company specific developments influencing the earnings outlook, which for the most part, have been constructive but remain unacknowledged by the markets. We wish to explain a number of these influences on the market psyche. First, the duration and severity of a recession scenario will depend on the persistency of inflation, and how quickly headline readings recede so that the Federal Reserve can modify its stance to a less restrictive one. A critical distinction between this recession (if we do have one) and prior economic cycles is that in prior cycles, there were fundamental issues embedded in the economy that became systemic and required more time to heal. This time around, however, the economy is on sounder footing, with strong private consumption, fixed business investment, and expanded household net worth as a result of the extraordinary measures implemented during the pandemic. Second, the conflict in Ukraine, which has disrupted supply chains and led to elevated food and energy prices, has created pricing pressures. While this supply driven inflation will take time to abate, one year forward inflation expectations are still lower than where they are today, signaling an expectation for some supply-side improvement. Third, the COVID lockdowns in China have caused supply distortions, which are just starting to recede as China re-opens again. Any further positive developments in this area will allow supply chains to thaw further. From a markets perspective, valuation multiples of select areas in the market during the pandemic became overextended, and as demand normalized, so did earnings, leading to valuation multiple compression. We did not own companies in any of these “boom-bust” areas during the pandemic, as we believe a focus on the long-term fundamentals within quality business models will always prevail through a full market cycle.
Cash generative companies with strong economic moats will likely lead the next bull market cycle, in an environment in which growth is becoming more scarce. Given that markets typically price in economic events (i.e. recessions) 6 to 9 months in advance, we anticipate a re-start to the cycle in the second half of this year or the first half of next year, which is when we believe markets will trough on the expectation of an early to mid-2023 recession. In terms of portfolio activity, we have been employing relative value strategies to identify high quality positions with discounted growth profiles to migrate into during this downturn. With this framework in mind, we improved the quality attributes of the broader portfolio construction by pairing selling opportunities with purchases of high quality, large cap growth companies that are now attractively valued. For example, using the sales proceeds from a few small-cap companies, we augmented our positions in large-cap semiconductors, which we believe will lead in the next bull market cycle. This re-allocation has also created an offsetting taxable benefit to our clients’ capital gains positions in 2023. We also raised cash in clients’ portfolios, in anticipation of deploying funds into high quality investment opportunities should our base case materialize.
We also want to illustrate how markets have typically reacted to “growth scares” over the last full market cycle. Typically, an average 17.3% drawdown is followed by a 6-month return of 22.3% and a 12-month return of 29.6%. While recessions have a steeper drawdown (31.8% on average), markets have demonstrated their resilience in rebounding, then climbing a wall of worry over a long timeframe, with 5-year, 10-year and 15-year compounded annual returns on the S&P500 being 13.1%, 14%, and 9% respectively. We have conviction that this time will be no different, and that quality companies with attractive valuation profiles will continue to lead the new cycle. The market is close to reaching peak pessimism, and on the cusp of a new market cycle later this year or early the following year.
Source: RBC Portfolio Advisory Group
We are investors in high quality, cash generative companies, regardless of the short-term direction of the market. While the intermediate timeframe may present some volatility, as the market digests more restrictive financial conditions, the genesis of a new market cycle typically precedes the economy with a lead time of 6-9 months. In being patient for the next bull market cycle, investors can reap the benefits of investing in high quality companies with a track record of outperformance over a full market cycle.
Warmest regards,
Grace Wang, CIM, PFP | Senior Portfolio Manager
Samuel Jang, CFA | Investment Associate | samuel.jang@rbc.com
Leslie Mah | Associate Advisor | leslie.mah@rbc.com | 604-257-7059
Jennifer Hamilton | Associate | jennifer.hamilton@rbc.com | 604-257-2537
Kim Choi | Administrative Assistant | kim.choi@rbc.com | 604-257-3273
RBC Dominion Securities
Phone: (604) 678-5794
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Vancouver, BC V6E 0C5
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