Meanwhile, the global economy is slowing, and the path forward for the economy and markets hinges largely on whether/when price stability will be restored.
Downgrading economic forecasts again, risk of recession is elevated
The global economy is grappling with a variety of challenges. Central banks are hiking interest rates aggressively, inflation is extremely high and geopolitical tensions have led to an energy crisis in Europe. Other risks include China’s troubled real-estate market, U.S. politics and the lingering effects of the pandemic. Extending the pattern of the past several quarters, the economy continues to slow and we have further downgraded our growth forecasts for the year ahead. We estimate the odds of recession at 70% in North America, with an even greater likelihood in the U.K and Eurozone. Should a recession materialize, we expect it to be of middling size and duration in the U.S. and for the economy to recover at a moderate pace thereafter. The situation is expected to be meaningfully worse in Europe and the U.K. as both regions face a spike in natural-gas prices due to Russia’s war on Ukraine. For the developed world, we now forecast moderate economic growth of 2.3% in 2022, followed by just 0.3% in 2023. In emerging markets, we look for 2.8% growth in 2022 followed by an improvement to 3.8% in 2023. These figures are relatively weak by emerging-market standards and the recovery in 2023 would occur because headwind to China’s growth are expected to fade somewhat by next year.
Unacceptably high inflation appears to have peaked
There are a variety of reasons to think that inflation may have peaked and be headed toward meaningfully lower readings. Over the past year, there have been four major contributors to inflation and all of these have begun to turn. Supply-chain challenges are being resolved, commodity prices have slipped, fiscal stimulus has faded and monetary policy has flipped from easing to aggressive tightening. Moreover, our inflation-peaking scorecard reveals that the majority of inputs and signals have now reversed, suggesting inflation probably crested in June. Although there are risks that inflation could reassert itself if the pandemic flares or geopolitical tensions intensify, we anticipate substantially lower inflation in 2023. We look for U.S. inflation to fall to 3.5% by the end of 2023, while readings in the U.K. could remain more problematic given particularly high natural-gas prices and surging wage demands that have led to a wave of strikes.
Where do we go from Here?
U.S. dollar is extremely expensive, temporarily supported by extraordinary factors
The U.S. dollar has rallied strongly this year, gaining broadly against both developed- and emerging-market currencies. A relatively hawkish (Hawks re policy makers and advisors who favor higher interest rates to keep inflation in check) U.S. central bank, the uncertain financial-market outlook and softening global economic growth have all played roles in driving both a stronger greenback and foreign-exchange markets in general. The greenback now stands above its March 2020 highs and is extremely overvalued by most measures. In our view, the currency should weaken over the medium term, but extraordinary factors may lend further support for the rest of this year. On a 12-month horizon, we remain more constructive on the Canadian dollar and Japanese yen than we are on the euro, pound or U.S. dollar.
Central banks are committed to fighting inflation, even at the expense of the economy
While there is good reason to think inflation is already headed lower, the unpredictable nature of inflation in the post-pandemic era suggests it may be difficult for the U.S. Federal Reserve (Fed) to claim victory until inflation actually starts falling decidedly toward the 2% target. With the labour market in solid shape, the Fed can afford to be aggressive with monetary tightening. Our models suggest that the fed funds rate could rise as high as 6% from the current 2.25%-2.50% given conditions for growth, inflation and the labour market. As a result, the pressure will likely remain to the upside on rates and pricing in the futures market suggests that short-term rates could rise to 4% sometime in the first half of 2023.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 1.5% | 1.0% |
| Fixed income | 40% | 20-60% | 36.0% | 37.5% |
| total cash & fixed income | 45% | 30-60% | 37.5.% | 38.5% |
| canadian equities | 20% | 10-30% | 15.6% | 15.3% |
| U.s. equities | 20% | 10-30% | 25.8% | 25.5% |
| international equities | 15% | 5-25% | 21.1% | 20.7% |
| total equities | 55% | 40-70% | 62.5% | 61.5% |
Global Asset Mix:
Asset mix – positioning closer to a neutral stance
The macroeconomic environment is highly uncertain and we believe that the range of potential outcomes for markets continues to be especially wide. There are pathways to positive outcomes and falling valuations in both stocks and bonds have improved the return potential over the longer term. However, we remain concerned about the short-term outlook as the risk of a recession is elevated and the future path for inflation remains uncertain. The last eight months were especially difficult for balanced investors as both stocks and bonds moved lower. We acknowledge that both asset classes could continue to be adversely affected in the near term by unacceptably high inflation, although this is not our base-case scenario. At today’s higher yield levels, bonds offer a much better ballast for stocks in the event of an economic downturn. Last quarter, we took advantage of the rise in U.S. 10-year yields above 3.0% to add 1.5% to our fixed-income position, sourced from both cash and stocks. Over the longer term, we continue to believe that stocks will outperform bonds, so we are maintaining a slight underweight in bonds and overweight in stocks. Reflecting our cautious stance, however, our positions are much closer to a strategic neutral setting than they’ve been in the past. For a balanced global investor, we currently recommend an asset mix of 61.5 percent equities (strategic neutral position: 60 percent) and 37.5 percent fixed income (strategic neutral position: 38 percent), with the balance in cash.
Geographic allocations are as follows:
- Canada 15.3%
- United States 25.5%
- International 20.7%
Risk / Reward to our Strategy
Bonds extend sell-off, valuation risk diminishes
While rapidly rising interest rates have caused declines in global government-bond prices, we believe that any further losses will likely be limited. The World Government Bond Index (WGBI) hedged to U.S. dollars lost 10.1% between January and August, or 13% from its peak in 2020, and has erased all of the gains generated since late 2018. With the massive increase in bond yields so far this year, the acute valuation risk that existed across major developed-world sovereign-bond markets has been greatly alleviated. Our model for 10-year Treasuries suggests that government bonds have likely priced in much, or even most, of what is needed to properly reflect current and expected inflation and real interest rates. Assuming that the inflation spike subsides as we forecast, our model suggests the U.S. 10-year yield should be positioned near 3.5% in five years, not far from where it is at the time of writing. We therefore think that bond investors are more likely to keep their coupons and that the risk of fixed-income capital losses has meaningfully diminished since the start of the year.
Equities dinged by falling valuations, earnings outlook faces headwinds
Stocks encountered significant volatility during the quarter as the fluctuating outlook for interest rates and inflation impacted valuations and a more challenging outlook for earnings came into view. The S&P 500 Index had fallen as much as 24% from its all-time high in June and almost all of this year’s decline in stocks has come from shrinking valuations due to rising inflation and bond yields. As a result of the worldwide drawdown in stocks, the entire excess valuation that existed in our composite of global equity markets has been erased. Within the composite, U.S. equities remain slightly above our estimate of fair value, but stocks in other regions look more appealing. Although stocks are more reasonably priced, the focus is shifting to corporate profits which remain well above their long-term trend and may soon encounter headwinds from slowing economic growth, especially if a recession were to materialize.
Conclusion:
Caution called for
Most developed-country markets rallied through July and into August. However, they have given back most of those gains over the past several weeks. Investor sentiment is once again lopsidedly negative.
The summer rally was fueled by a substantial retreat in bond yields as investors hoped softer inflation readings would allow the U.S. Federal Reserve (“Fed”) and other central banks to pivot away from a path of aggressive tightening. Fed actions and rhetoric subsequently scuppered that idea: bond yields have since moved up to the highest levels in 11 years while equities have once again slumped.
It is worth putting this market retreat of the last nine months into perspective. From the pandemic low in March of 2020 to the market peak in early January of this year – a stretch of 21 months – the S&P 500 gained about 2,600 points or 118%. Over the past nine months it has given back not quite half of that advance. The TSX over the same period first rose by a more subdued 99% (if one can call it that) but has given back less than a third of the points gained. So far, in both cases, leaving aside the strident headlines, it looks a lot like a very strong bull market up-leg followed by a pretty normal period of correction and consolidation of those gains.
While markets are deeply oversold they could become even more so in the coming days and weeks, in our opinion. A sustained equity rally, one with the potential to reach or exceed the old highs, would require a powerful catalyst from here. The one conceivably strong enough, in our view, would be a decisive weakening of inflation on a broad front, putting an early 2023 end to Fed tightening back on the table and pushing bond yields lower in the process.
Such a development is not entirely wishful thinking: U.S. gasoline futures have fallen from $4.50 per gallon back down to 2021 levels around $2.30, while some agricultural commodities, including wheat, soybeans and corn, have come off the boil – as have most metals including copper, zinc, nickel and gold. Port congestion and supply chain dislocations are rapidly clearing, and shipping rates have retreated markedly, as has the cost of containers. As new car production builds, used car prices – a source of much of the 2021 inflation ramp up – have weakened and should fall further. Airfares and hotel room rates have softened.
Looking for a sign
But the Fed and other central banks will need more than “softening.” They will need to see unequivocal signs the inflation tide has turned. Such evidence is unlikely to materialize definitively before the first half of next year.
Central banks in Europe, the U.K., Canada and the U.S. have indicated they are willing to risk recession if that’s what it takes to tame inflation. For the first two, this appears to be a moot point – recessions seem inevitable in both the U.K. and EU by way of the energy crisis rather than monetary policy.
For the U.S. and Canada, the probabilities of a broad-based economic contraction arriving in the coming months have risen sharply. Our Recession Scorecard shows that two of the longest lead-time, most consistently reliable predictors of U.S. recession – the Treasury yield curve and the Conference Board’s Leading Economic Index – have each crossed their respective warning thresholds. Their histories suggest the U.S. economy will enter recession around the second quarter of next year. A third, less important indicator – ISM New Orders minus Inventories – is also flashing red. Other indicators in the scorecard are heading in the same direction but have not yet given outright negative readings. They may well do so in coming months.
This is not good news for equities. U.S. recessions have always been accompanied by equity bear markets in most developed-country stock markets, including Canada’s. These typically get underway some months before the recession begins – on average about five to seven months before. If that average holds true, it would offer the intriguing possibility the cycle peak for the post-COVID-19 bull market still lies ahead before the coming recession and associated bear market get underway.
Of course, it could also be the case the timing averages won’t pertain in this case: both the recession and equity bear market could start earlier than usual – and conceivably may have already started. It’s equally possible that, against all the historical odds, the Fed will pull back from its aggressive tightening agenda soon enough to engineer a “soft landing” for the economy as it has done in nine of the past 17 tightening cycles.
This leaves investors to navigate through some challenging crosscurrents. On the one hand, equity returns are likely capped by the highs of late last year/early this year for as long as central banks, especially the Fed, are not finished with raising rates. On the other hand, as each month passes, leading indicators strongly suggest we are getting that much closer to the onset of recession and, even before that, the start of the associated equity bear market that could conceivably feature even greater market downside than we have experienced year to date.
For now, a “market weight” position in global equities balances the possibility of a market retest of the old highs in the coming months against the growing risks of market weakness next year associated with a recession that has become increasingly probable.
Capped upside (for the time being) – together with the rapidly growing probability of a recession and some additional associated market downside in 2023 – presents a risk/reward profile that argues for caution.