Economic headwinds continue to mount, inflation remains problematically high and financial conditions are tightening. Asset prices have experienced a sharp decline in the face of rapidly rising interest rates, slowing growth and greater uncertainty in the macro outlook than usual.
Downgrading growth forecasts as headwinds intensify
Our GDP forecasts have been below consensus for several quarters as we anticipated deceleration in economic growth for 2022. This quarter we have further reduced our forecast and now expect growth to be particularly weak in 2023. The key headwinds to the economy include unacceptably high inflation, aggressive central-bank tightening, a global commodity shock, the continuation of supply-chain challenges and damage from China’s zero[1]tolerance COVID-19 policy. Because of this combination of headwinds, we gauge that the risk of recession is heightened over the next two years. For the developed world, this outlook translates to a forecast of 2.5% GDP growth in 2022, less than half the 5.2% rate achieved in 2021, followed by just 1.2% growth in 2023. With the exception of 2020’s pandemic shock, the 2023 forecast would represent the weakest annual performance in more than a decade. We have also downgraded our emerging-market growth outlook and are now anticipating overall growth of just 3.3% in 2022 and 3.7% in 2023 for developing nations. The acceleration from one year to the next in large part reflects Russia’s economic collapse in 2022. These growth rates remain well below historical levels for emerging markets.
Unacceptably high inflation persists
Inflation sitting at multi-decade highs is the dominant challenge for this economic cycle. Our own inflation forecasts are above the consensus and we expect pricing pressures to remain elevated in the short to medium term before eventually falling back toward longer-term norms. In the short term, high commodity prices, supply-chain challenges, a housing boom and lingering tailwinds from monetary and fiscal stimulus are likely to keep inflation hot. We look for inflation of 6% to 8% in 2022 across most of the developed world and expect it to remain above normal in 2023, albeit meaningfully lower. Inflation pressures are broadly based but we expect them to calm as monetary and fiscal stimulus are being dialed back, commodity prices are unlikely to continue rising at the pace that they have over the past year and as housing prices feel the weight of higher interest rates. Over the longer term, we expect inflation to continue falling as long-term structural factors such as demographics limit consumer price pressures. But we also recognize that forces such as climate change, a partial reversal of globalization and a rebalancing of powers between employers and employees may provide offsets. As a result, we expect that inflation may ultimately settle a bit higher than 2% over the long term, versus slightly below 2% over the decade prior to the pandemic.
Where do we go from Here?
U.S. dollar has benefited from risk aversion, weakness likely to materialize
The greenback has benefited from risk aversion amid Russia’s invasion of Ukraine, as well as from expectations that the U.S. Federal Reserve (Fed) will hike interest rates faster than its peers. Although we have pushed back the timing for when we think U.S.-dollar weakness might return, we still expect the greenback to decline in the medium to longer term given that the dollar is meaningfully above its purchasing power parity with other world currencies and that much of the Fed hawkishness and expected economic weakness abroad are already priced in. Key markers that would strengthen our conviction that the U.S. dollar may have peaked include a slowdown in U.S. economic activity, a hawkish shift in tone from the European Central Bank, signs that Asian policymakers may step in to support their currencies and/ or a de-escalation of the war in Ukraine. Our forecasts are for the U.S. dollar to depreciate against a basket of major developed-world currencies over the year ahead.
Interest rates are on the rise, quickly
With inflation elevated and economic conditions tight, central banks have been forced to act urgently. They started tightening earlier than initially planned and are raising rates in 50-75 basis-point increments instead of the usual 25. Market expectations and central-bank guidance point to significantly more monetary tightening ahead, with policy rates in North America reaching neutral levels and potentially a bit beyond. With central banks highly focused on taming inflation, they will be reluctant to turn to monetary easing even if the economy encounters a downturn. Other central-bank priorities such as creating conditions for full employment, ensuring financial-market stability, reducing inequality and limiting climate change do not appear to be a focus at this time. Pricing in futures markets suggests investors expect the fed funds rate to rise to 2.80% one year from now, which would require at least two more 50-basis-point hikes followed by several 25-point hikes. Our own forecast is in line with market pricing as we look for a 2.75% fed funds rate one year from now.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 2.0% | 1.5% |
| Fixed income | 40% | 20-60% | 34.0% | 36.0% |
| total cash & fixed income | 45% | 30-60% | 36.0.% | 37.5% |
| canadian equities | 20% | 10-30% | 16.0% | 15.6% |
| U.s. equities | 20% | 10-30% | 26.6% | 25.8% |
| international equities | 15% | 5-25% | 21.4% | 21.1% |
| total equities | 55% | 40-70% | 64.0% |
62.5% |
Global Asset Mix:
Asset mix – shifting allocation closer to neutral given elevated uncertainty, higher yields
Taking into account the risks and opportunities, and balancing the long-term outlook against near-term challenges, we took steps to de-risk the portfolios during the past quarter. We added two percentage points to our fixed-income allocation as yields rose, which boosted return potential for bonds while also providing more cushion to a balanced portfolio in the event of a downturn in risk assets. We also reduced our equity allocation by 1.5 percentage points, recognizing that the risk/reward has diminished in an environment where corporate profits could be vulnerable to a slowdown. These shifts leave our recommended asset mix with a slight overweight in stocks and slight underweight in bonds. Our positioning is much closer to neutral than it had been at earlier points in the cycle, reflecting a higher degree of uncertainty in the outlook and wider range of potential outcomes than usual. For a balanced, global investor, we currently recommend an asset mix of 62.5 percent equities and 36.0 percent fixed income with the balance in cash.
Geographic allocations are as follows:
Canada 15.6%
United States 25.8%
International 21.1%
Risk / Reward to our Strategy
Bond yields surge, valuation risk has been greatly alleviated
The rapid and significant re-alignment of interest-rate expectations caused a fixed-income sell-off of historic proportions over the past year. As the U.S. 10-year yield soared above 3.0% from 1.5%, broad U.S. bond benchmarks lost more than 10% for the largest decline since the early 1980s. The speed and depth of the decline was highly unusual and we do not expect a similar experience to be repeated going forward. Valuation risk has been significantly reduced and yields are now at much more reasonable levels, according to our models, which suggests that once the near-term distortions related to inflation pass, there is little need for yields to rise much beyond current levels. We have also noted that in past tightening cycles the U.S. 10-year yield has peaked around the same level as the fed funds rate. Investors are currently anticipating that the fed funds rate will peak around 3%, which matches recent levels in the 10-year Treasury. For this reason, we have been increasingly comfortable adding to sovereign fixed[1]income positions and especially as 10-year Treasury bond yields trade above 3%. Although yields could continue to rise if extremely high inflation persists, our base case that inflation ultimately moderates means that the bulk of the needed adjustment in yields has already occurred. We forecast 2.75% for the 10-year Treasury yield 12 months from now, which would mean no further sustained capital losses for bond holders over the year ahead.
Equity rout deepens and profit outlook is vulnerable amid slowing growth
Fear of inflation, aggressive monetary tightening and the increased risk of recession sent stocks lower in the past quarter, dragging several major indexes into bear markets. The Nasdaq Composite Index, heavily concentrated in technology stocks, fell as much as 36% from its peak and the S&P 500 Index reached 20% below its peak on an intraday basis. Emerging markets were also down nearly 30% from their prior highs. The outperformer has been Canadian equities, helped by heavy weightings in energy and other resource companies that are benefiting from the high[1]inflation environment. So far, the decline in stocks has been mostly due to a fall in equity valuations that had approached extremes, especially in high-priced technology stocks that were most sensitive to interest rates. With valuation levels having adjusted meaningfully, the focus now is on whether earnings expectations need to be lowered. Consensus estimates are for low double digit profit gains over the year ahead. In an environment where those profits come through, inflation pressures subside and investor confidence rebounds from extreme pessimism, stocks could be set up to deliver double digit gains over the year ahead. But should a downturn or recession play out, history suggests that earnings could be vulnerable to declines of more than 20%, sending stocks lower still.
Conclusion:
Seeking a new path onward
Several important shifts occurred on the global economic and financial landscape over the first half of the year. Here are the most important.
First the U.S. Federal Reserve and the Bank of Canada swung from being tolerant of higher inflation to being decidedly intolerant. Rate hikes have not only begun they’ve become more aggressive in the past 60 days as has the rhetoric about future hikes.
Central banks are no longer suppressing bond yields through quantitative easing, producing a pronounced upward shift in long bond rates.
While most forecasters (ourselves included) expected last year’s gradual build up in inflation to turn into a price surge in the first half of this year, they underestimated the extent of that spike. The Ukraine/Russia conflict intensified the upward pressure on prices for oil, natural gas, and most agricultural commodities.
Supply chain disruptions have resolved much more slowly than expected, exacerbated by renewed China shutdowns.
As consumers shift spending from goods to services, inventories of unsold goods are building in the U.S. and new orders are weakening, suggesting manufacturing may be heading for a slowdown in the second half.
Meanwhile, ongoing labour shortages are affecting the reopening of the services side of the economy.
Market impact
The surge in inflation and bond yields has pressured valuations lower in the stock market by lowering the discounted present value of future earnings. (Moving bond yields higher from 2% to 3% reduces the present value of a dollar of earnings earned 10 years down the road by 9%)
This has had the largest impact on the high P/E, mega-cap growth stocks of which the six largest comprised more than 25% of the value of the S&P 500 at the peak of the market in early January. Their performance was not helped by the fact that three of the biggest – Amazon, Meta (Facebook), and Alphabet (Google) – reported declines in first quarter earnings. This magnified downward effect of a handful of very large capitalisation stocks helps to explain why Canada’s TSX (down 14%), which contain none of these six stocks, fared better than the U.S. index (down 22%).
In the U.S. continuing supply chain issues, together with bloated inventories and labour shortages, have driven corporate confidence down to much-reduced levels, taking investor confidence down at the same time. So far earnings estimates for 2022 and 2023 have not come down, however, if second quarter earnings guidance proves more cautious then some downward earnings estimate revisions are likely.
Is there a plausible path to new highs?
Measures of investor sentiment have been hugely negative of late. Such unanimous pessimism does not occur at market tops but frequently appears at or near tradable lows. However, even were markets to turn higher from here, views about how far they rally and for how long are decidedly downbeat. “Bear market rally” is the consensus interpretation among U.S. market observers.
Perhaps but not necessarily. It is useful to look at potential market outcomes through the lens of the two prevailing schools of thought on the likely trajectory of inflation over the coming year or two.
One view has inflation becoming a bigger and more intransigent problem than central banks or the market have yet recognised. The inflation expectations of U.S. consumers have recently jumped above the longstanding 2%-4.5% range that has prevailed for more than two decades to 5.5%. Reining in those expectations, so this view argues, will require the Fed to raise rates markedly higher than currently envisioned and keep them there for longer.
This would greatly increase the odds that the fed funds rate eventually overshoots producing the kind of tight credit conditions that would make recession inevitable. A recession would undoubtedly be bad for corporate earnings and share prices, and has typically been associated with a bear market for equities.
However, under this scenario, before that painful economic/ market retrenchment arrived, the U.S. economy would likely traverse an extended period during which the Fed chased an overheated economy higher for much longer-than-expected – perhaps through 2023 and into 2024. That prolonged stretch might well see inflation-boosted sales and earnings grow faster than expected. It would be unusual for new highs in sales and earnings not to be accompanied by new highs in share prices.
But how much of a new high? A bit of history might be instructive. From the beginning of 1977 until the end of 1979, the Fed did just that – i.e., chase an overheating economy higher, raising the fed funds rate from 5% to 15% in the process. The economy was growing and S&P 500 earnings per share advanced by a very satisfactory 40% over the three years. But the index itself flatlined, starting and finishing at about 100. Bond yields rose from 7% to almost 11% over the same interval, compressing P/E multiples and limiting index investors to no better than dividend returns.
In our view, the same dynamic would probably yield similar results if the Fed[1]hikes-faster-for-longer scenario were to play out over the next couple of years. So, it’s possible the averages could get back to old highs, perhaps even exceed them, but it seems likely the appreciation potential would be heavily dampened by rising bond yields.
As was the case in the 1977-1979 experience referred to above, the S&P/TSX should do better than its U.S. counterparts given its heavier commodity exposure. But forestry, metals and mining are all much smaller components of the economy and market than they were in 1977. Energy, meanwhile, despite enjoying higher prices, continues to be bedeviled by an inability to get product to market, which is unlikely to be materially improved for a year or more.
The other prevailing view out there (and one we subscribe to) has inflation subsiding somewhat over the second half and retreating further next year. As the stay-at-home spending boom on goods wanes, with household budgets squeezed by rising costs for food and fuel, the goods side of the economy will need to pare back bloated inventories of unsold goods. This should produce some price weakness for non-essential goods, allowing the core rate of inflation to recede somewhat, the headline rate to peak & inflation momentum to turn lower.
That, together with a continuing slowdown in the goods-producing side of the economy, might induce the Fed to rethink how far rates need to rise and how fast. Any sign the Fed was backing away from further tightening would bring back into play the possibility of a “soft landing” for the U.S. economy, which would support an outlook for stronger earnings growth and higher share prices.
However, turning the equity market decisively higher, where an advance to new highs becomes plausible, usually requires the arrival of some catalyst that re-ignites investor optimism – perhaps a Fed rate cut, a marked downturn in energy prices, or a couple of much softer-than-expected inflation reports. None of these looks likely at the moment.
On the other hand, current readings of unusually deep investor pessimism suggest limited downside from here. We expect the most likely path for equity prices through the remainder of this year will be a mostly sideways one until some set of circumstances re-invigorates the case for sustained economic and corporate earnings growth or conversely reveals that that a recession is rapidly approaching.