Uncertainty is elevated and financial markets have been extremely volatile, but the significant adjustment in asset prices this year has diminished valuation risk and boosted return potential for investors as we enter 2023.
Economic growth continues to slow, and a recession seems likely. A year ago, the impressive recovery from the pandemic-induced recession pushed the economy into a position of excess demand. But the backdrop is changing and headwinds have intensified as a result of tighter monetary policy and reduced fiscal stimulus. We continue to look for a deceleration in growth in 2023, with economies likely slipping into recession in the developed world. While emerging-market economies rarely contract, we expect most of them to slow in 2023. Taken together, our growth forecasts are mostly below consensus. We anticipate that global GDP will expand by 2.1% in 2023, which is less than a third of the figure in 2021, and about half the expected 2022 rate. That said, economic indicators have shown more resilience in the past few months, suggesting that the probability and expected depth of recession might be lower than initially feared. Should a recession materialize, we expect it to be of middling depth in most regions. A 1.75% peak-to-trough decline in output persisting no more than three quarters is our presumption, with a moderate recovery likely taking hold toward the end of 2023.
Inflation has started to calm from extremely high levels
The four main drivers that pushed inflation to multi-decade highs are all reversing course. Supply-chain problems have faded, commodity prices have declined, monetary stimulus has turned to tightening and fiscal stimulus has been reduced. For these reasons, we expect inflation to continue to soften and have below-consensus inflation forecasts for 2023. We recognize, however, that other factors may slow its descent. Labour markets remain especially tight, the breadth of the inflation shock may make high prices stickier, and the shelter component of CPI changes with long lags. It could take even longer for inflation in the eurozone and U.K. to come down given the region’s unique challenges, mainly weaker currencies and energy shortages.
Where do we go from Here?
U.S. dollar may have peaked
The U.S. dollar extended its 12-year-old bull market through October as the allure of higher U.S. bond yields and economic challenges abroad continued to overshadow longer-term issues facing the greenback. However, the rise in the ever buoyant dollar came to an abrupt halt in early November, leading investors to question whether the greenback’s period of dominance is finally coming to an end. With valuations stretched, it’s clear to us that the currency’s bull market is mature and that a major turning point is near. Such peaks are tough to call, but we have greater conviction that a softening in the greenback is in store and that it will herald the start of a multi-year decline.
Central banks approach tightening finish line
The quantity of monetary tightening delivered to tame extremely high inflation has been massive across the world. North American policy rates are already around 4 percentage points higher after less than a year of increases. But the rate-hiking cycle is starting to slow outside North America and Europe as inflation begins to ease. Some emerging-market countries have ended their rate hikes and the pace of tightening is mostly decelerating elsewhere. The U.S. fed funds rate is expected to peak near 5%, compared with a starting point of about 0% at the start of this year, and double the neutral policy rate – that which neither stimulates nor restricts growth. But most of the hard work has been done and there is a possibility that policy rates in developed markets start to decline over the second half of 2023 if inflation cooperates and growth slows.
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% | 37.5% | 37.0% |
| total cash & fixed income | 45% | 30-60% | 38.5.% | 38.0% |
| canadian equities | 20% | 10-30% | 15.3% | 15.6% |
| U.s. equities | 20% | 10-30% | 25.5% | 25.8% |
| international equities | 15% | 5-25% | 20.7% | 20.6% |
| total equities | 55% | 40-70% | 61.5% | 62.0% |
Global Asset Mix:
Asset mix – maintaining overweight stocks, underweight bonds
We recognize that uncertainty is elevated and that there is a wide range of potential outcomes for the economy and financial markets. That said, the 2022 bear market in both fixed income and equities has meaningfully improved return expectations across all asset classes. We note that bonds, at today’s higher yields, offer more ballast in a balanced portfolio should the economy enter a downturn. We believe a cautious approach to risk taking remains appropriate in this environment. Our asset mix is positioned with a small overweight in stocks and slight underweight in fixed income given our view that stocks offer superior return potential over the longer term. But these allocations are closer to our strategic neutral position than they have been at previous points in the cycle, allowing us to take advantage of volatility and opportunities should they present themselves. For a balanced global investor, we currently recommend an asset mix of 62 percent equities with the balance in cash.
Geographic allocations are as follows:
- Canada 15.6%
- United States 25.8%
- International 20.6%
Risk / Reward to our Strategy
Bond market finds support
As investors warm to the idea that inflation may have peaked and that the pace of tightening is slowing, yields on 10-year government bonds have fallen 50 to 130 basis points from their September/October highs. This rally in bonds started from a point where technical indicators signaled that the bond market had been oversold and our own valuation models suggested that yields had reached relatively appealing levels. Although real, or after-inflation, interest rates have room to move a little higher, we continue to expect that they will be anchored at levels between 0.5% and 1.0%. Structural forces such as aging populations and an increased preference for saving versus spending should ultimately limit how high real interest rates can go. Over the near term, however, inflation will likely be the factor dominating the trajectory for bond yields. If inflation falls as we expect, our modelled estimate for the U.S. 10-year Treasury yield today of 5.3% falls to 4.5% a year from now and to 3.4% in five years’ time.
Equity-market valuation risk diminished, but earnings remain vulnerable
Equity markets stabilized in the past quarter but, even with the recent bounce, are still sitting on significant losses for the year. The good news for investors is that stocks are now much more reasonably priced than they were at the start of the year. Our global composite of equity valuations peaked around 40% above fair value at the end of 2021, but the recent bear market pulled the composite slightly below fair value in September/October for the first time since March 2020. While valuation risk has diminished and return potential has increased, stock prices could fall in the event that we enter a recession and earnings decline. Analysts have already begun downgrading their profit forecasts for S&P 500 Index companies ahead of a potential recession, but the downward revisions have been small so far. We think these estimates are vulnerable to further downside given that earnings are still above their long-term trend and companies are facing headwinds from rising costs and slowing economic activity. In this environment, stock gains could be limited in the near term absent evidence that the economy is headed for a soft landing.
Conclusion:
U.S. recessions have always been associated with equity bear markets – not just for U.S. markets but for Canadian and other developed economy stock markets as well. But it’s worth pointing out the U.S. is not yet in recession. The official arbiter, National Bureau of Economic Research (NBER), needs to see “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.” While no such decline has appeared yet, several factors suggest it may arrive in 2023:
- History says so. The most historically reliable leading recession indicator – the position of short-term interest rates compared with that of long-term rates, also known as the “shape of the yield curve” – signaled back in July that a U.S. recession was on the way when the one-year Treasury yield rose above the yield on the 10-year note. Whenever such an “inversion” has occurred in the past a recession has eventually followed, usually about a year later.
The Conference Board’s Leading Economic Index – also sporting a “perfect” track record – fell below where it had been a year ago back in September. A recession has always followed such a signal, on average some two to three quarters later.
Most of the other leading indicators of recession we follow are still in positive territory but are sliding toward giving a negative signal for the U.S. economy in the coming months.
- “Tight money” has arrived. With just two exceptions (the post-WWII downturn and the two-monthlong 2020 pandemic recession) U.S. recessions have always been preceded by the arrival of tight money – i.e., prohibitively high interest rates accompanied by a growing reluctance of banks to lend.
The inversion of the yield curve in July, noted above, indicated credit conditions were heading in that restrictive direction. Certainly, interest rates have become prohibitively high for many borrowers as a result of the accelerated pace of tightening by central banks including the U.S. Federal Reserve (Fed) and Bank of Canada.
And loans are becoming harder to get too. The last three Senior Loan Officer Opinion Surveys (published every three months by the Fed) have shown that more and more U.S. banks are becoming choosier about who they lend to.
- Consumer spending is waning. At some 70% of GDP the direction of U.S. consumer spending is all important. While there are still excess savings and wages are rising, high inflation has pushed real incomes below where they were a year ago. Despite that, real personal spending has continued to climb, although it appears to have weakened somewhat through the important holiday season.
A lot of future demand for goods was pulled forward into 2020 and 2021 as many services were not available due to pandemic shutdowns while consumer incomes remained high, boosted by government support programs, which have now mostly ended. Meanwhile, much of the pent-up demand for services such as travel and dining out was fulfilled in 2022, with spending on such services likely ease in 2023.
What it means for investors
Interest rates: We expect 2023 will be a year of trend transition with rates rising somewhat further in the first half before falling in the second.
Over the past 70 years, the Fed has usually stopped raising interest rates and begun cutting even before the recession started. Given today’s inflation concerns, both the Fed and the Bank of Canada have made a point of emphasizing the dangers of cutting rates too soon. Rate cutting is unlikely to begin, in our view, until there is some marked worsening in the economic data, most likely around midyear.
Stock markets: U.S. recessions have typically been associated with global equity bear markets. Media commentary over the past nine months has assumed that a bear market has already begun. That may or may not be the case. However, wherever the stock market is headed over the next several quarters it’s unlikely to go there in a straight line, in our opinion.
Starting a couple of weeks before the U.S. midterm elections, most major equity markets began a rally that appeared to have better underpinnings than any prior countertrend upswing in 2022.
So far, this move has been almost universally labeled as no more than a “bear market rally.” It may prove to be just that. However, several factors suggest that this advance could have legs into 2023. These include moderating inflation data, which could raise the possibility of an end to Fed rate hikes, and the fact that the S&P 500 has almost always delivered strong, positive returns for months following the U.S. midterms.
Whether any unfolding equity rally is something more than simply an upside interlude in a longer-term downtrend remains to be seen.
That said, our most reliable leading indicators indicate a recession arriving around midyear. Every U.S. recession has been associated with an equity bear market (not just in the U.S. but in every major equity market). As a result, we expect that any rally in equity prices in the coming weeks will, at some point, give way to another period of challenging share price performance (reflecting declining expectations for earnings and eroding confidence in the future that typically comes with a recession).
Putting it into perspective
A longer-term view reveals that the economy and businesses are constantly adapting to changing conditions. Sometimes that adaptation is painful. But if recessions are the painful periods, then they are typically very short. Over the 77 years since the end of WWII, the economy was in recession for a total of 12 years or about 15% of the time.
Making big portfolio asset allocation decisions based on the premise that the economy and already successful businesses are going to lose their ability to adapt, or that the challenging periods are going to last much longer than they have in the past, seems out of proportion to the historical record, in our opinion.
On the other hand leaning more heavily toward quality and sustainable dividends and away from specific individual company risks that may come home to roost in a recession looks to us like a good approach as we enter 2023.