I had the opportunity to attend our annual Portfolio Management Conference earlier this month. It is an excellent chance to hear macro views from internal and external strategists. We also get to hear directly from our analysts and their top picks as well as some of our third party providers like Veritas.
For our macro outlook, we are maintaining a defensive tilt.
2022 was a uniquely challenging year. In one of the most difficult years for financial markets, 2022 brought persistently high inflation, synchronized central bank tightening and geopolitical conflict, forces that coalesced into a powerful headwind for the world economy and left investors with few places to hide as both stocks and bonds generated negative returns. While we expect these headwinds to linger into 2023, we also believe this year will likely be characterized by trend transitions and, in some cases, constructive reversals.
Inflation and monetary policy remain the predominant macro factors. Much of the deceleration in global growth over the past year can be primarily attributed to tightening financial conditions as the Fed and other major central banks increased interest rates at a historically rapid pace to rein in elevated inflation (see Exhibit 1). Encouragingly, there is mounting evidence that a period of disinflation is coming, with lower crude oil prices, easing supply chain bottlenecks and slowing consumer/business demand all pointing in that direction. With the Fed and the Bank of Canada having recently adopted a more “data dependent” approach in adjusting monetary policy going forward, a meaningful retreat in inflation on a sustained basis could allow policymakers to scale back the pace of rate hikes followed by an eventual pause, potentially in the first half of this year.
Ex 1: Business activity slowdown has deepened amid restrictive financial conditions
The risk of more persistent than expected inflation remains a wildcard. While recent inflation reports in the U.S. and Canada bolster the notion that price pressures probably have peaked in the near term, other aspects of those reports arguably underscore a potentially underestimated risk of inflation persisting longer than expected. Signs that the drivers of core inflation is transitioning from goods to services (see Exhibit 2), together with still uncomfortably high wage growth, raise the prospect that inflation could prove “stickier” at a higher level than current market expectations. Such an outcome could compel central banks to maintain a restrictive monetary policy stance for longer than anticipated, perhaps even in the face of a broadening economic slowdown.
Ex 2: Core inflation driver may be shifting to stickier services components
U.S. economy moved further into the late stage of the business cycle. To be clear, recent data releases continue to point towards resilience in consumer spending and the labour market and broadly remain consistent with a U.S. economy in expansion phase. However, as we cautioned in our Global Insight 2023 Outlook, a U.S. recession will likely arrive in the coming year. This view is in part predicated on the caution signals issued by two of the most historically reliable leading recession indicators, namely the position of short-term interest rates compared with that of long-term rates (also known as the “shape of the yield curve”) and the Conference Board’s Leading Economic Index (LEI). The yield curve signaled back in July that a U.S. recession was on the way when the one-year Treasury yield rose above the yield on the 10-year note. Whenever such an “inversion” has occurred in the past a recession has eventually followed, usually about a year later. Meanwhile, the LEI fell below where it had been a year ago back in September. A recession has always followed such a signal, on average some two to three quarters later.
Worsening macro conditions will test the resilience of corporate fundamentals. Despite the notable deceleration in global growth over the past year, consensus earnings projections have held up remarkably well (see Exhibit 3). Against the backdrop of a slowing economy and higher cost pressures, however, our sense is that earnings expectations will need to be revised lower to reflect the reality of a less favourable operating environment for revenues and margins. Meanwhile, recessions have typically been accompanied by substantial declines in corporate profits, a key reason why every U.S. recession has been associated with an equity bear market.
Ex 3: Profit estimates could come under downward pressure
Consensus forward 12-month EPS estimate (Jan. 1, 2022 = 100)
Equities: How much economic downside is reflected?
Valuations have cheapened but not cheap. Because consensus earnings estimates have largely defied a slowing economy, the vast majority of the losses suffered by global equities were attributable to a compression in valuation multiples, reflecting the impact from higher interest (discount) rates (which reduce the present value of future profit streams) and heightened macro uncertainty (which raises risk premiums demanded by investors). Given the forward price-to-earnings (P/E) multiple for major equity indexes declined by 8%–22% in 2022 (see Exhibit 4), it may be tempting to conclude that stocks have priced in most of the negative economic news. We certainly view stocks as more reasonably priced today after the selloff last year, but we also think the focus here could shift to less constructive fundamentals, where limited downward revisions to profit forecasts despite notably slower economic growth and elevated recession risk suggest expectations are still too optimistic.
Ex 4: Equities may not be adequately accounting for a recession scenario
Forward P/E ratio
Fixed income: Income returns to bonds
Central bank look set to moderate the pace of rate hikes. After delivering a series of outsized rate hikes in 2022, both of the BoC and Fed have hinted at the possibility of downsizing rate moves at future policy meetings, provided that policymakers perceive inflation to be on a durable path towards their targets. For the most part, this is already reflected in market expectations which now foresee benchmark rates in Canada and the U.S. to rise by a more modest 25-50 bps over the next two quarters to reach a peak of around 4.5%–5% by June (see Exhibit 5). Further improvement on the inflation front over the coming months could eventually allow central banks to pause their tightening campaign, which in turn could alleviate upward pressure on bond yields.
Ex 5: Interest rate expectations
Better return expectations ahead. Bonds that do not default must eventually reach par value on maturity, so poor trailing performance has led to improved return expectations going forward. For investors whose investment horizon is longer than the average term of their bond portfolio, this past year’s price declines are likely to result in higher total-return figures over that investment period. The sharp repricing of Canadian bonds is particularly apparent when looking at corporate bond yields. The yield on the average IG-rated Canadian bond doubled in 2022 (see Exhibit 6), and now pays investors more than at any point since the global financial crisis. This surge in yields has returned the Canadian bond market to an environment where investors can achieve reasonable levels of income, in our view, even from historically lower-risk investments.
Ex 6: Relative value has shifted in favour of fixed income
Note: Earnings yield is the inverse of the forward P/E ratio. Bond yield refers to YTW for the Bloomberg Canada Corporate Index, Bloomberg U.S.
Corporate Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index.
Portfolio positioning: Selectively add credit and duration. While we are mindful of ongoing economic headwinds, the higher all-in yields and improved compensation for credit risk reinforce our view that it remains a timely opportunity to rotate the portfolio risk budget towards bonds and maintain an Overweight stance in fixed income.