While the economy is slowing, growth remains robust and consumers are well positioned to support the expansion. Bond yields remain unsustainably low and we continue to prefer equities as surging corporate profits have pushed the bull market to new highs.
Growth downshifts as expansion progresses
The rapid spread of the delta variant is causing a rise in coronavirus infections throughout the world and challenging economies. Growth is moderating, though we should recognize that the economy was bound to slow following 16 months of extraordinary activity during which much of the slack made available from last year’s recession was absorbed. We have dialed down our growth forecasts for 2022 and are now slightly below the consensus, mostly because the consensus outlook implies an optimistic outcome with no room for error. Even with our slightly less cheerful view, the pace at which the economy is expected to expand is still quite good and countries that suffered deeper recessions have the potential for even stronger growth. We forecast real GDP growth in many developed countries at nearly 4%, which is at least double the pre-pandemic norm.
Where do we go from Here?
Virus and other risks
The virus remains a key risk to the economy, especially with the delta variant being twice as contagious as its original form and perhaps more resistant to vaccines. As a result, more stringent measures would be needed to contain the spread even as tolerance for further lockdowns has diminished. Most governments are now turning to vaccine mandates and vaccine passports rather than forcing the lockdowns that were successful in curbing past virus waves. While it’s not yet clear how effective these new measures will be at curtailing infections, they should be less harmful to the economy. Another critical risk for the economy is the eventual shift in policy now that the economy has revived. Tremendous fiscal and monetary stimulus was delivered during the pandemic but the need for this support is less obvious and a reversal would be a headwind for growth in 2022. One factor that could offset these risks is that consumers have accumulated trillions of dollars in excess savings from the pandemic and can boost the economy through increased spending.
Inflation remains elevated, but peak may be behind
Elevated demand and constrained supply chains caused sharp price increases in a narrow set of goods and services that were popular during the pandemic. Shipping costs soared, used-car prices jumped, housing prices boomed and computer chips became difficult to source. On a broad basis, however, prices are now increasing at a normal rate in most areas of the economy, suggesting that the underlying trend to inflation is not as extreme. As a result, once distortions from the pandemic fade, we should expect headline inflation to return to rates more in line with pre-pandemic levels. We are already starting to see some price pressures easing. Commodity prices have leveled out and shipping costs may be peaking. While we recognize a diminishing threat of too-high inflation, we do consider the possibility that inflation could run above normal for a few more years. Longer term, however, inflation could be lower than normal due to structural factors such as technological advancements and aging populations.
U.S. dollar wobbles within long-term downtrend
Support from a few short-term themes helped the U.S. dollar trade sideways this year within a tight 4% band. We believe, however, that the greenback remains in a longer-term downtrend and that further weakness will persist in the years ahead. The dollar’s decline should be most helpful for cyclical currencies that benefit from rising commodity prices and the global economic reopening, and we are particularly positive on currencies with central banks that will likely hike interest rates faster than the U.S. Federal Reserve (Fed). While our optimism on the euro has been tempered slightly, we remain positive on other G10 and emerging-market currencies.
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% | 2.5% |
| Fixed income | 40% | 20-60% | 35.0% | 33.5% |
| total cash & fixed income | 45% | 30-60% | 36.0.% | 36.0% |
| canadian equities | 20% | 10-30% | 15.6% | 15.8% |
| U.s. equities | 20% | 10-30% | 25.9% | 26.1% |
| international equities | 15% | 5-25% | 22.5% | 22..1% |
| total equities | 55% | 40-70% | 64.0% | 64.0% |
Global Asset Mix:
Asset Mix – trimming bond allocation in favour of cash
The economy has moderated but growth remains quite good and, in our view, the economic cycle is in its early to middle stages with several years of expansion ahead. In this environment, interest rates remain low, but central banks are contemplating reductions in their bond-buying programs before raising interest rates. As distortions from the pandemic fade, we think that bond yields are likely to gravitate higher at a gradual pace. From current levels, even a slight increase in yields would result in negative returns for sovereign bonds. We remain overweight stocks as they offer better upside potential. We recognize, however, that valuations are demanding and that continued strong growth in profits and heightened investor confidence will be needed to keep the bull market going. For these reasons we are keeping a modest cash position to cushion against any volatility and to provide funds for opportunities as they arise. For a balanced, global investor, we currently recommend an asset mix of 64 percent equities and 33.5 percent fixed income with the balance in cash.
Geographic allocations are as follows:
Canada 15.8%
United States 26.1%
International 22.1%
Risk / Reward to our Strategy
Meaningful valuation risk in fixed income
Global bond yields fell significantly in the past quarter amid slowing growth and the expectation that central banks would maintain accommodative monetary policies. But according to our models, significant valuation risk exists in the sovereign-bond market and the odds, in our view, are tilted in favour of yields moving higher. Real, or after-inflation, rates of interest are deeply negative, suggesting that savers are subsidizing spenders, a situation that we don’t think can persist. Although a variety of structural forces continue to depress real rates, our assessment is that real yields on U.S. 10-year Treasury bonds should be around zero or slightly above, which would represent a sizeable adjustment from current negative real rates. Further upward pressure on yields could result from the Fed and other central banks tapering their massive bond-buying programs in the coming quarters. We expect the U.S. 10-year yield to climb to 1.75% from 1.31% over our one-year forecast horizon, which would result in a slightly negative return.
Soaring corporate profits extend bull market in stocks
Global equities continued to march higher, rising to records on elevated investor confidence and surging profits. The S&P 500 Index climbed to an all-time high of 4500 in the past quarter, representing a doubling from its March 2020 low and a 20% gain so far this year. The rapid increase in stocks has pushed our composite of global valuations to its most expensive reading since the late 1990s technology bubble, although it remains considerably below the all-time peak. While the degree of overvaluation has been concentrated in U.S. equities for most of the latest bull market, many indexes outside the U.S. are now near or above fair value. At these valuation levels, profit gains will be critical to keeping the bull market alive and earnings have indeed been stellar so far. S&P 500 profits are on track for the most rapid recovery on record, already surpassing the pre-pandemic high, and are expected to grow at an above-average pace for the next several years. With profits having rebounded to their long-term trend, further gains may be more difficult to come by and we should not expect the pace of gains experienced so far this cycle to be repeated. Although valuations are elevated, we think stocks can still deliver modest returns given low interest rates, transitory inflation and sustained corporate-profit growth. We look for mid-single-digit gains in North American equities, with slightly better return potential elsewhere over the year ahead
Conclusion:
It’s been a very good run. All the major stock market indexes are up mightily from their spring 2020 pandemic lows. The S&P 500 stands out – up a startling 107% at its recent high from the deeply depressed, pandemic lows set 17 months earlier. Equally impressive is the 34% advance from the 10-year high-water mark set in February 2020 just before the COVID-19 rout got under way.
Over the same two timeframes the TSX Composite advanced by 87% and 16%. Most of the shortfall in the TSX’s performance compared to that of the S&P 500 is explained by the relatively large exposure of the U.S. index to the high-flying tech sector – 28% versus 11% for the TSX.
All of the other major global markets have followed the same direction but their gains have been much less remarkable.
Economy enters new phase
Looking out one year we expect equities will be able to deliver positive all-in returns but the path from here to there is likely to be much less upwardly dynamic and the returns much more subdued.
The economy and earnings will tell the tale. The relative performance of various stock markets, one to the other, has been mostly determined by how fast their respective economies reopened following pandemic lockdowns and GDP recovered. And equities delivered very strong gains not because investors chose to be unrealistically optimistic but rather because over that stretch corporate sales and earnings did so much better than anticipated.
Work by RBC Global Asset Management strategist Eric Savoie makes the point. According to Savoie, in the early summer of 2020 the S&P 500 was trading at 22X year ahead earnings, which at that time were expected to come in at $150 per share. That multiple was a long way above the S&P’s long-term “equilibrium” price-to-forward-earnings multiple, which RBC Global Asset Management estimated to be 17.6X. However, as it turned out, over the next year earnings grew much faster than estimated: 22% faster in fact, all the way to $183. So, back in July of 2020 investors were only paying 17.9X the earnings per share 12 months, a multiple not far off calculated “fair value.”
Market cycle shifts gears
Fast forward to today and the S&P 500 is trading at 21X estimated earnings one year out. But this time it’s highly unlikely that actual earnings achieved in the coming 12 months will turn out to be much higher than estimated. Peak growth for the cycle likely occurred back in the second quarter. The most dynamic part of the cycle is probably behind us. Nonetheless S&P earnings are forecast to grow by a very strong 18% in 2022, down from 33% this year.
Generating earnings growth close to that implied by today’s consensus forward estimates, while maintaining a somewhat above-average price-earnings multiple, will be critical to achieving worthwhile all-in returns from the S&P 500 over the coming 12 to 18 months.
P/E multiples in all the other developed equity markets, including Canada’s TSX, are much less demanding, sitting as they all do near their long-term average in the mid-teens. But here too, earnings growth will need to come through for expected returns to materialize.
Reasons to believe
We think the needed earnings growth will indeed materialize because it is based on solid, consensus estimates of GDP growth supported by:
• very “easy” monetary conditions
• the lagged effect of fiscal stimulus delivered by all governments over the past 18 months
• the pressing need to replenish inadequate inventories
• the prospect that at least some of the immense “excess savings” now residing in North American household and corporate bank accounts will get spent over the next two years
• the constructive outlook for capital spending driven by high profits, low interest rates and labour shortages
We look for U.S. GDP growth of slightly below 6% for this year and a still-above-trend pace of 3.8% next year. Canada’s economy should deliver very similar results.
All that said, it is very likely we have entered a period when all those expectations and assumptions will be hotly debated. The “worry list” is growing by the day and now ranges from prospects for Fed tapering, the U.S. debt ceiling and other Congressional logjams, the still growing impact of global supply chain disruptions, all the way to the prospect of defaults in the large Chinese property sector. A stretch of uncomfortable market volatility can’t be ruled out.
What we don’t see is an imminent U.S. or global recession. History shows the odds favour staying with equities until such an economic downturn becomes inevitable.