Fed rattled markets, but stocks powered through
But with vaccinations underway and economies mostly reopened in some regions, the next phase of the pandemic will likely feature a bit less policy support. The winding down of government cheques to individuals could curb consumer spending and result in a deceleration in economic growth. One potential offset to fading stimulus could be that households are in solid financial shape, since limited opportunities to spend during lockdowns led to significant savings which could eventually be released into the economy. New government infrastructure spending programs could be another source of support.
COVID-19 remains a key risk to our outlook. Vaccines are being rolled out, but at a slowing pace and the Delta variant is spreading rapidly. Overall, the economic recovery remains in good shape, though the pace of improvement may be peaking. We continue to look for well-above average growth in 2021 and 2022, but we are no longer above the consensus mainly because economists’ estimates have risen significantly.
Where do we go from Here?
Risks to our positive outlook
A variety of risks may challenge our positive base case scenario. The extremely contagious Delta variant of the virus could prompt further waves of infection similar to how the emergence of the highly contagious British variant contributed to a surge in the spring. Moreover, there is a risk of a fiscal hangover in 2022 as some spending initiatives expire, and the possibility exists that investor confidence will wane if central banks contemplate withdrawing monetary stimulus. Another key risk is that inflation has spiked higher. While we believe much of the increase is temporary, a period of sustained higher inflation would erode purchasing power, increase borrowing costs and encourage central banks to be more hawkish.
Inflation accelerates as price pressures mount
Base effects, higher commodity prices and factors such as shortages of shipping containers and computer chips are contributing to rising inflation, which is now accelerating in a number of countries. We expect elevated inflation over the next several months, moving to moderately above the long-term average over the next few years, but ultimately average or even slightly below average inflation over the longer term. Stimulus cheques have prompted many Americans to splurge on big-ticket goods such as cars and houses, pushing prices higher. But demand preferences should revert at least partially to historical norms as the impact of the pandemic fades. There are, however, several scenarios that could lead to an unwelcome period of relatively high inflation. Rising inflation expectations could become a self-fulfilling prophecy, a wage-price spiral could unfold, and/or a commodity super-cycle could emerge. Inflation, an afterthought for the past decade, now requires some attention.
U.S. dollar bear market to persist
We think the U.S.-dollar bear market that began last year still has a few years to run. Currencies often move in cycles, from overvalued to undervalued, and the dollar remains rich even with the weakness of the past year. The stimulative fiscal and monetary policies pursued by the U.S. support the weakening trend. Cyclical periods of strength, like the one seen in the first quarter of this year, are good opportunities, we think, to position portfolios for a further U.S.-dollar decline. While the early stages of a bear market in the greenback will benefit all currencies, it is cyclical currencies, including the Canadian dollar, that have the most to gain from the global economic recovery underway. Broadly speaking, emerging-market currencies should also rally, although careful monitoring of country-specific risks is necessary to avoid individual currency underperformance.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 1.0% | 1.0% |
| Fixed income | 40% | 20-60% | 34.5% | 35.0% |
| total cash & fixed income | 45% | 30-60% | 35.5% | 36.0% |
| canadian equities | 20% | 10-30% | 15.5% | 15.6% |
| U.s. equities | 20% | 10-30% | 26.5% | 25.9% |
| international equities | 15% | 5-25% | 22.5% | 22.5% |
| total equities | 55% | 40-70% | 64.5% | 64.0% |
Global Asset Mix:
Asset Mix – maintaining overweight in stocks, underweight in bonds
The economic recovery is fanned by the cyclical tailwinds of massive monetary and fiscal stimulus, an easing of virus-related restrictions and low interest rates. We expect strong economic growth in 2021 and again next year as the economy accelerates at a rate that supports solid corporate-profit gains. In this environment, we think a significant overweight in equities is appropriate. Recall that ultra-low return expectations in fixed income motivated our decision over a year ago to boost the strategic neutral weight in stocks to 60% from 55%. Investors with long-term savings plans, in our view, would likely want to minimize exposure to low-returning sovereign bonds and boost equity allocations. That said, the powerful advance of U.S. equities over the past year prompts us to recognize that their valuations are full and that the risk premium between stocks and bonds has narrowed somewhat. We have therefore trimmed our overweight equity exposure by 50 basis points from last quarter, sourced entirely from U.S. equities, and moved the proceeds to bonds. For a balanced, global investor, we currently recommend an asset mix of 64 percent equities and 35 percent fixed income with the balance in cash.
Geographic allocations are as follows:
Canada 15.6%
United States 25.9%
International 22.5%
Risk / Reward to our Strategy
Bond yields pause after massive rise earlier in the year
Much of the good news related to vaccines, a reopening of economies and firming inflation was priced into the bond market in late 2020 and early 2021, and so there was little impetus for yields to rise further in the past quarter. Bond yields everywhere were range-bound over the past three months after having reclaimed their pre-pandemic levels earlier in the year. Our models indicate the acute valuation risk evident in the sovereign-bond market immediately following the pandemic’s declaration was greatly alleviated by the rapid rise in yields over the past year. Once the impact of the pandemic fades, we could be left with real (after-inflation) yields in the 0% to 1% range, with a 2% inflation premium for U.S. Treasury bonds. If these assumptions prove correct, it would be difficult for 10-year U.S. government bond yields to rise much above 2% to 3% over the medium to longer term. In the shorter term, we see yields peaking around 1.75% over the next year and, as a result, expect low returns in sovereign bonds.
Stocks rally to record levels on surging profits
Global equities extended their gains in the past quarter with most major indexes reaching record levels. The solid rally in stocks has pushed our global composite of equity-market valuations to its highest level since before the 2008/2009 financial crisis. We note that the extended valuation in stocks largely reflects the dominance of U.S. markets in our GDP-weighted model. While the S&P 500 Index may currently appear expensive, it could grow into those elevated valuations fairly quickly as a surging economy boosts volumes and pricing power, lifting revenues and earnings, and leading to a durable earnings expansion that could last several years. Analysts are quickly picking up on the fact that profits are rebounding quickly and earnings-per-share estimates for the S&P 500 have increased nearly 10% since the start of the year. Our conclusion is that U.S. stocks could offer decent returns in the mid to high single digits as long as investor confidence holds up and earnings come through. Return potential improves as we move outside of North America to regions such as Europe, Japan and emerging markets, all of which offer more attractive valuations.
Conclusion:
In our view nothing that has transpired in the past six months has fundamentally changed the outlook for the remainder of the year or for 2022. All of the developed economies, led by the U.S., will post above-average GDP growth compared to last year’s slump. Absent a vigorous return of the pandemic, the momentum provided by repeated applications of fiscal stimulus by governments – supported by entrenched accommodative monetary policies – should keep most economies powering on through next year and probably beyond. Robust growth this year followed by slower, but still above-average growth next year looks to be the odds-on favourite outcome.
For the all-important U.S. economy, this view is supported by our recession scorecard. All six of the leading indicators of recession we track are giving the economy a decisive green light. These indicators are strong enough to suggest that even an “early warning” phase lies a long way off.
In our view, the next recession, when it eventually arrives, will likely be triggered the good old-fashioned way: by a tightening of credit conditions sufficient to make interest rates prohibitively expensive and banks more cautious about lending. No such tightening appears nearby.
No recession on the horizon
Recessions are the enemy of the equity investor, as they have always formed the economic backdrop associated with bear markets. So seeing a recession coming ahead of time is extremely useful from a portfolio management perspective. As of yet and probably for some time there is no recession on the horizon.
While a bear market-inducing recession may not be in the offing any time soon, there is always the potential for worries to arise in response to a growth slowdown. In several bull markets over the past 70 years, such worries have led to a correction 12 to 18 months following the start of the new economic advance. However, these were always eventually superseded by another substantial up leg in the economy, corporate profits and the equity market.
History lessons
Another way to plot the path ahead is suggested by Eric Savoie, investment strategist at RBC Global Asset Management. He points out that in the U.S. there have been 17 Federal Reserve tightening cycles since 1954. Eight of these produced enough credit tightening to bring on a recession; nine others did not.
Looking at market performance over the 12 months leading up to the first Fed rate hike in each cycle, Savoie notes that the median return for the S&P 500 over that stretch was 16.8%.Switching to look at what the market does in the year after the first rate hike reveals the median return to be an above-average 9%.
So, the year before the first rate hike and the year after are both generally pretty good for the stock market. If the Fed tightening cycle is going to cause trouble for the stock market, then that trouble usually arrives a fair ways down the road from the first rate hike, if it arrives at all, keeping in mind that nine Fed tightening cycles produced no recession or bear market.
The Fed, while always reserving the right to change its mind, has told us there will be no rate hike before early 2023. Counting backward one year, the historical probabilities would suggest the stock market will deliver positive, probably above-average returns for two consecutive years starting early in 2022.
Correction always possible, but not a given
Of course, even years that feature above-average stock market returns can contain within them rocky periods of correction and consolidation. It’s always possible that one lies just around the corner. As usual, there is a long list of things that investors are worried about – inflation, the pandemic, geopolitics, severe weather. In one sense investors are right to expect a correction – they are not uncommon. But they rarely announce their arrival (or conclusion) in a timely enough fashion to allow even a nimble investor to wring much advantage out of that knowledge.
There are also plenty of factors that would argue against a correction occurring:
• Most economies are reopening as the vaccine rollout diminishes the impact of the pandemic;
• Earnings are very strong (GDP based U.S. corporate profits are already above their pre-pandemic peak) and forward earnings estimates have been revised sharply higher over the past six months (S&P 500 by 15% and TSX by 13%;
• CEO confidence as measured by The Conference Board is near 18-year highs;
• Corporate bond yields remain very low and access to credit plentiful;
• Capital spending is booming, which is good news for productivity and inflation.
It’s worth remembering that should a market correction occur without an accompanying downturn in economic activity and corporate profits, then even though share prices are falling or a few months, the intrinsic, underlying value of most businesses goes on compounding at a rate driven by earnings growth.
Global equities likely to Advance
We are left with a constructive outlook for global equities for the coming 12 months. We expect the impact of the pandemic will continue to subside over the remainder of this year and through 2022. The forecast rising tide of GDP and earnings should permit broad market indexes to advance further from today’s levels.