Moderating growth, the new Omicron virus variant and fading monetary stimulus have agitated financial markets.
Economy encounters a variety of headwinds
A new coronavirus variant, problematically high inflation, supply-chain challenges and China’s property-market slowdown are among the main headwinds facing the global economy. Moreover, policymakers are acknowledging that the recovery is well advanced, allowing for a gradual dialing back of monetary accommodation and less generous fiscal support. As the recovery progresses and economies reach their potential, it is natural for growth to become less buoyant. The recovery is still in good shape and we expect growth to persist into 2022, albeit at a slower pace relative to 2021. Among all of the headwinds, there are two key factors that could continue to support the expansion. The first is that consumers are flush with savings and they have low financial obligations, putting them in a solid position to boost their spending. The second is that businesses have also expressed their desire to rebuild inventories and boost capital expenditures. Weighing the positives and the negatives, we look for 3.5% growth for most developed nations in 2022. This projected growth rate is nearly twice the pre-pandemic norm and consistent with an extension of the economic recovery. However, our below-consensus GDP projection means that the expansion will slow, perhaps to a degree that ends up disappointing investors.
Where do we go from Here?
The coronavirus regains traction
The pandemic has become more challenging in recent months as infections are rising throughout the developed world. Colder weather, the reopening of schools and the relaxation of social restrictions have made it easier for the virus to spread. The deterioration is most obvious in Europe, but cases are also ramping up in North America. The bulk of the current wave is due to the Omicron variant and it is proving more contagious than previous versions (though perhaps less deadly), superior at resisting vaccines and better at re-infecting people. Vaccine makers can adapt their formulas to take on the new variant, but it might take a number of quarters before production ramps up and distribution gets to the point where large portions of the population are again protected. Our base case scenario looks for a moderate wave of infections to subtract up to one percentage point from global output over a few quarters. This hit would be worse than the one caused by the Delta variant, but not much different from the late-2020 wave, and far less damaging than the original wave.
Inflation continues to run hot
The rate of inflation has increased further over the past quarter and now stands at extraordinary levels not encountered in decades. Economic demand has snapped back faster than supply, causing higher commodity prices, an insufficient workforce and shortages in a variety of goods. Inflation expectations have consistently been above expectations and real-time measures remain hot. Although supply-chain constraints may ultimately fade and oil prices come down, other inflation pressures may persist or even intensify. Central banks have printed significant amounts of money and are broadly accepting of higher inflation. For these reasons, our inflation forecasts over the next year remain above consensus. Shifting to the longer term, however, we continue to believe that high inflation is cyclical rather than structural. After distortions from the pandemic settle, we should eventually see a return to normal inflation readings. It is even conceivable that inflation over the long term could be lower than normal as the deflationary effect of demographics outweighs structural inflationary forces from climate change and the rising bargaining power of workers to set wages.
Currency markets face increased volatility
Volatility is returning to the foreign-exchange markets, fueled in part by a new COVID variant and in part by diverging central-bank monetary policies. The U.S. dollar has benefited from market expectations that interest rates will be raised next year, but may soon reverse some of its gains as moderating U.S. inflation would suggest less upward pressure on rates. While we have reined in our optimism on the low-yielding euro and Japanese yen, we remain positive on cyclical currencies such as the Canadian dollar. The resilience of the Chinese renminbi amid otherwise negative Chinese developments has been a stabilizing factor for currency markets and is a theme worth monitoring in the year ahead.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 2.5% | 3.0% |
| Fixed income | 40% | 20-60% | 33.5% | 33.5% |
| total cash & fixed income | 45% | 30-60% | 36.0.% | 36.5% |
| canadian equities | 20% | 10-30% | 15.8% | 15.7% |
| U.s. equities | 20% | 10-30% | 26.1% | 25.9% |
| international equities | 15% | 5-25% | 22.1% | 21.9% |
| total equities | 55% | 40-70% | 64.0% | 63.5% |
Global Asset Mix:
Asset mix – a second modest trim to stocks
Our base case scenario is for the economy to continue growing at a rapid yet slowing rate as the recovery matures and much of the economic damage from the pandemic has been repaired. As the economy moves into its middling stage, central banks are starting to dial back monetary accommodation and, although conditions fully justify the need for tightening, we recognize that financial markets will be receiving less support. Prospective returns for fixed income are especially unappealing in this environment and any meaningful increase in yields would lead to low or negative returns in sovereign bonds. Stocks continue to offer better return potential relative to fixed income. However, we recognize that the cycle is advancing, valuations are elevated and the market is vulnerable to correction as is evident currently narrowing market breadth, slowing growth, a lack of leadership outside of U.S. large-cap equities and the Omicron variant have motivated us to reduce our equity weight this quarter, placing the proceeds into cash. For a balanced, global investor, we currently recommend an asset mix of 63.5 percent equities and 33.5 percent fixed income with the balance in cash.
Geographic allocations are as follows:
Canada 15.7%
United States 25.9%
International 21.9%
Risk / Reward to our Strategy
Sovereign-bond yields remain unsustainably low
Sovereign-bond yields began the year on a rapid upward trajectory amid the economic reopening, COVID vaccinations and firming inflation, but declined toward the end of the period as slowing growth and mounting concerns about the Omicron variant boosted the appetite for safe havens. Our models continue to suggest that yields are too low and that the key to higher yields lies in the eventual normalization of real interest rates to levels at or above the zero bound. Real rates are currently deeply negative and sovereign-bond investors are accepting an after-inflation loss in purchasing power over time. We don’t think this situation is sustainable and, as a result, we expect a gradual increase in yields paced by a gradual upward adjustment in real interest rates. Our own forecast is 1.80% for the U.S. 10-year yield over the next 12 months.
Stocks are fully valued, so profit growth will be critical to sustaining the bull market
Global equities extended gains from 2020 to record another strong year in 2021 and the rally has pushed our global composite of equity market valuations to 25% above fair value. At these levels, stocks are pricing in a favourable outlook for the economy and corporate profits, and the risk is that conditions deteriorate such that equities are left in a vulnerable position. Highly demanding valuations like those we see in the U.S. large[1]cap equity market are consistent with higher volatility as any doubts over profit growth will likely lead to heightened instability. Continued strong gains in corporate profits will be critical to supporting higher stock prices, and earnings have indeed been spectacular. Stocks are expensive, but an environment of still-low interest rates, and where inflation could transition back to normal levels alongside strong growth in corporate profits, the equity market could deliver mid-single-digit to low-double-digit gains over the next few years.
Conclusion:
Until well into 2023 we think the trajectory of the world’s major economies will be shaped by the normal progression of the business cycle and the remaining effects of policies put in place to contend with the pandemic.
Following the shortest recession on record – less than three months – the U.S. economy had regained all its ground by the end of the third quarter of 2021. Canada likely hit that milestone in the fourth quarter.
Our principal focus is always on the U.S. economy – the world’s largest which sets the rhythm and tone for much of the developed world. A U.S. recession has usually been bad news for other economies and for equity markets. Every bear market for U.S. stocks – and for most other equity markets – has been associated with a U.S. recession.
One direction
All six leading indicators of a U.S. recession that we follow are pointing in a direction consistent with this economic expansion having quite a bit further to run. Powerful tailwinds are driving the U.S. economy and most developed economies forward:
• Credit conditions are very “easy.” U.S. recessions, with few exceptions, have been triggered by the arrival of overly tight credit conditions featuring: (1) prohibitively high interest rates that discourage businesses and individuals from borrowing and (2) an unwillingness by banks to lend.
The opposite describes today’s credit conditions. Rates are so low they encourage borrowing, while banks everywhere are looking for credit-worthy individuals, businesses, and projects to which to lend.
• U.S. and Canadian households are sitting on excess savings built up over the pandemic of more than 10% of GDP. We expect about 20% of this saving pile will get spent in the coming year or two, and keep the consumer spending engine powering through 2023.
• Inventories of goods on hand are unusually depleted and need to be replenished for many businesses to meet current demand. Restocking should underpin industrial production and GDP growth through much of this year.
Business capital spending has been strong in the U.S. driven by low interest rates, strong corporate profits, as well as the need for more capacity and more resilient supply chains.
Could the Fed and other central banks spoil the party?
The answer is “Yes – eventually.” But before that happens, monetary conditions have to transition from “easy” – what we have now – all the way to “tight,” which looks far off. And once it finally arrives, “tight money” is typically around for six to 12 months before the U.S. economy tips into recession.
Usually the fed funds rate has had to climb above the nominal growth rate of GDP (i.e., the growth rate before subtracting the effect of price increases) before a recession gets under way. Looked at this way, at the end of last year’s third quarter, U.S. GDP was ahead by 9% over the previous year. The fed funds rate is currently close to zero. Assuming the Fed raises rates three times next year (as it has indicated) and then raises by 0.25% at each meeting thereafter (i.e., far faster than either the Fed or the market currently expect) that would leave the rate at 2.75% by the end of 2023. This is still well short of the nominal GDP run rate, which we expect by then to have slowed to 4%-5%.
In other words, we seem to be a long way from the kind of interest rate environment that would throw the U.S. into recession. It’s worth remembering the Fed doesn’t tighten with the intention of pushing the economy into recession. It is always trying to engineer a “soft landing” wherein the economy slows enough to reduce inflationary pressures but avoids an outright downturn. Of the 17 Fed tightening cycles since 1953, only eight ended in recession.
We expect inflation to ebb in the second half of 2022 and recede further in 2023 under the influence of:
• Resolution of factors that have artificially produced shortages;
• Return of more people to the labourforce as benefit programs end and personal safety issues fade; and
• A capital spending boom already under way yields productivity gains that somewhat offset higher employment costs.
If this proves to be the case, the Fed and other central banks may be able to end rate hikes before credit conditions pass the point of no return for the economy.
Either way, the economic tailwinds described earlier provide good reasons to expect above-trend GDP and corporate profit growth through 2022 and probably 2023 as well. It would be unusual for share prices not to maintain an upward trend for at least another 12-18 months in that case.
What could go wrong?
Our Recession Scorecard persuades us the business cycle is alive and well and has much further to run. It would take some powerful external event or circumstances to produce a sustained downturn from here. There is no shortage of media speculation about what might threaten to do this. For example, the threat of contagion from possible credit defaults within the large Chinese property sector, or a geopolitical flare-up. And the arrival of the Omicron variant reminds us that the pandemic remains capable of seriously disrupting economic momentum.
Such potential threats regularly come on and off the stage and it’s always worth considering what they might mean for the economy and financial markets. But structuring a portfolio as if one or more were likely to occur soon would have left a portfolio un-invested, or at least under-invested, for most of the past 15 years if not longer
In our view, an investment portfolio diversified across asset classes – where the equity component is diversified sensibly across industry sectors and owns the best, most resilient businesses in each sector – is the most appropriate stance in a world of unpredictable possibilities.