A durable equity rally faces strengthening headwinds


Stock markets have kept climbing off their 2022 lows for longer than expected. Is it time to consider repositioning equity portfolios?


August 2, 2023

Jim Allworth
Investment Strategist
RBC Dominion Securities

  • The stock market rally off the washed-out lows of early last fall has run further and for longer than most had expected. U.S. large-cap outperformance has been largely powered by a handful of surging Tech and tech-related stocks, whose outsized weight in the benchmark index has left many fund managers running to avoid being left behind.
  • The strong stock market and some better-than-forecast economic data have once again raised hopes that the U.S. economy could experience a “soft landing” without a recession. While such a benign outcome can’t be ruled out, several headwinds already suggest the going is about to get tougher as the full impact of the Fed’s historic series of rate increases is yet to be felt in the economy. Notwithstanding all the above, and though the compelling valuations of last autumn are long gone, we think this rally has some time left to run. But with recession still the most probable outcome, investors should adopt a focused approach to individual stock selections.
  • The equity rally from the lows of early autumn 2022 continued through July 2023 – that is to say, for much longer than most had thought likely until recently. Japan’s TOPIX and the U.S. S&P 500 have led the way. It has been a much more anaemic affair for U.S. small caps, as well as for Canada’s TSX and the UK FTSE All-Share. And the going has been downright soggy for the Korean KOSPI, which we mention here because it is viewed in some quarters as a leading indicator of the future direction of the U.S. economy and stock market due to South Korea’s role as a major exporter of computer chips, smart phones, industrial goods, and consumer durables into the U.S.

The comparatively energetic advance of the S&P 500 is largely attributable to the much-reported-upon performance leadership of a handful of mega-cap Technology and tech-related stocks, which together account for more than 25 percent of the index by weight; the unweighted index presents a less dynamic picture. None of those high-flying mega-cap stocks are included in the more sedately performing indexes outside the U.S.

Our position since this rally unfolded has been to leave equity portfolios invested up to the recommended levels for their long-term strategic asset allocation. Our view has been that the washed-out market momentum, significant P/E retrenchment (from 22x trailing-12-month earnings at the peak of the market in January 2022, to just 16x at the early autumn low), and intensely negative investor sentiment that prevailed back in September and October would give way to a stretch in which all those markers reversed direction. Whether any rally would be robust enough to set new market highs has been far from clear, but staying invested long enough to find out has seemed the right approach.

Many are now attributing the longevity and strength of the stock market advance to the growing belief that the U.S. economy will enjoy a soft landing and avoid recession. This view is supported by the fact that – so far – the economy is still growing, while the employment picture is almost unanimously characterised as “resilient” in light of a high (but declining) number of unfilled jobs and a very low unemployment rate. The view that “the stock market is moving higher because the U.S. economy is stronger than expected” often gets turned around by the same speaker to “the market’s rise is telling us the U.S. economy is about to improve further” – which sounds like circular reasoning to us.

Monthly hiring pace set to reach multiyear low

U.S. nonfarm payrolls and small business hiring plans

The chart shows the month-over-month change in total U.S. nonfarm payrolls and the percentage of small businesses reporting plans to hire workers monthly from January 2021 through June 2023, and the projected change in nonfarm payrolls in July 2023. Nonfarm payrolls increased by roughly 200,000 in June 2023, a multiyear low, and the projected increase in July 2023 is roughly the same. The percentage of small businesses with hiring plans decreased to roughly 15 percent in June after increasing in the two previous months. The high point for small business hiring intentions in this period was 32 percent in July 2021, and the number has been at or below 20 percent since October 2022

  • Nonfarm payrolls monthly change (thousands, LHS)
  • Small businesses reporting plans to hire (RHS)

Source – U.S. Bureau of Labor Statistics, National Federation of Independent Business; data through 7/31/23

Growing optimism about the U.S. economic trajectory is probably part of the story of why this rally has had legs. But we believe a less-welcome phenomenon is in play, in which investor rationality is being overtaken by FOMO (“fear of missing out”). Many individual investors aren’t exposed to the mega-cap stocks that have been driving the market higher, as they have been unwilling to pay valuation multiples that always look too high. With the seven biggest S&P 500 stocks by market capitalization totaling 27 percent of the index, even fund managers who do have exposure to this handful of high-flying stocks usually don’t have enough to let their portfolios keep pace with the index benchmark. Hedge fund reporting suggests many of these tactically driven funds were not positioned by late spring for a market that was going to keep on moving higher, let alone accelerate as it has done since mid-May.

We believe FOMO can feed on itself, driving markets to climb longer, and reach higher levels, than anyone thinks is reasonable. Investors who have been selling or planning to sell stocks they regarded as overvalued, only to see them move appreciably higher, stop selling. Fund managers, most of whom are losing ground against their benchmarks, are buying in desperation.

In our view, this dynamic could keep the U.S. large-cap market advancing further for some weeks or months yet. Beyond the small group of leaders, the rest of the market, including other developed-economy stock markets, are likely to be pulled higher too – for a while. In our view, though, it will take more than FOMO to put this market advance on a sustainable footing; at the very least, the U.S. will have to avoid recession and experience some reacceleration in economic growth.

Is a soft landing possible?

Of course it is. And there’s nothing wrong with hoping for the best. However, planning for it is another matter – especially when most of the reliable leading indicators of U.S. recession, which have been consistently right over many decades, are giving progressively more negative readings about where the U.S. economy is headed.

S&P 500 Index vs. P/E ratio

Gains since September 2022 are due entirely to the rising P/E ratio, with earnings flat to down

S&P 500 Index vs. P/E ratio

The chart shows the value of the S&P 500 Index and its price-to-earnings (P/E) ratio monthly from September 2022 through July 2023. Both the index and the P/E ratio have increased roughly in parallel over this period. In September 2022, the Index was at roughly 3600 and the P/E ratio was 17.1x. In July 2023, the index was at roughly 4600 and the P/E ratio was 22.0x.

  • S&P 500 Index (LHS)
  • S&P 500 P/E ratio (RHS)

Source – Thomson Reuters, Bloomberg; data through 7/31/23

In addition to the signals coming from macro indicators, there are identifiable headwinds to growth facing the U.S. economy. Chief among them is the increasing tightness of credit. Changes in monetary policy are generally thought to take about a year to show up in the economy; from that perspective, the first half of this year is only showing the effects of the first 125 basis points of Fed rate hiking that took place over the first six months of 2022, while the second half of this year will reflect the further 275 basis points piled on from July to December 2022. Assuming the Fed wraps up its tightening program with the policy interest rate at 5.50 percent, this means another 1.50 percent will be layered onto the accumulated cost-of-borrowing burden through the first six months of next year.

This mounting cost of borrowing will likely be visited on an economy that is decidedly less robust than it was last year. Here are a few of the factors in play:

  • Excess savings in the U.S. are gone, or soon will be. (They remain at elevated levels in most other developed economies including Canada, China, and Europe.) At the peak of the government’s pandemic assistance efforts in mid-2021, many recipients used assistance payments to bulk up household savings by an estimated $2.2 trillion over and above what would have been accumulated had the economy remained open. Those balances have declined rapidly. One study undertaken by the San Francisco Fed calculates that only $500 billion remained unspent by April of this year, and that the remainder would likely be gone by December. Another study, using a somewhat different methodology and commissioned by the Federal Reserve itself, argues that these excess savings had already been more than fully drawn down by the end of Q1.
  • Credit card balances are rising. Large banks’ credit card balances jumped by 32 percent in the two years ending in Q1. The payment delinquency rate recently started moving higher after a multiyear decline. Interest rates on credit card loans have risen from 14 percent to 21 percent in a year and a half. And auto loans have been declining since last fall, partly in response to sharply higher borrowing rates – up from 4.5 percent to almost 8 percent over the 15 months ended in May. Lender refusals of auto loan applications also jumped from 2 percent of all applications to 14 percent over the same period, the highest refusal rate in years.
  • Financial stress at the corporate level is unusually elevated. Our colleagues at RBC Brewin Dolphin in the UK recently highlighted a June Fed staff note that calculated the proportion of non-financial firms in financial distress, at 37 percent, had reached a level higher than during most previous Fed tightening episodes since the 1970s. The analysis reveals that, historically, there has been a bigger decline in business investment among distressed firms than among healthy firms in response to monetary tightening shocks. The same has been true with regards to employment. Putting the two together, the note’s authors conclude that with a high proportion of firms in financial distress, policy tightening is likely to have stronger negative effects on economic growth this cycle than in most tightening cycles since the early 1970s. And the financial sector is not immune from this stress, as shown by the recent failures of three U.S. domestic banks, the travails of the regional banking sector, and the forced sale of international giant Credit Suisse.
  • Mortgage refinancing has become much more problematic. A typical new U.S. 30-year mortgage now sports an interest rate of 6.78 percent – more than double the 3 percent that prevailed two years ago. Understandably, the number of households applying to refinance has plummeted over the same interval, from 27 percent of those with outstanding mortgages to just 5 percent. But of the much smaller number now seeking to refinance, fully 21 percent saw their applications rejected in June.
  • Profit margins are getting squeezed. Total revenues of all U.S. manufacturing and distribution businesses have declined by about 2.5 percent since last June, while Employment Cost Index data suggests worker compensation has risen by more than 5 percent. Recent high-profile wage settlements suggest that large corporate labour cost increases aren’t going away soon. With productivity declining, job cuts are likely to be one response.

Plan for it

The factors mentioned above do not, singly or collectively, preclude the possibility of a soft landing for the U.S. economy. Neither do the increasingly negative readings from our U.S. Recession Scorecard . However, historical probabilities inform our expectations that a U.S. recession should arrive later this year or possibly early next year, that actual S&P 500 earnings will come in below current estimates, and that share prices will go through a challenging period during which investors’ unrealistic optimism eventually gives way to unrealistic pessimism.

In the meantime, we continue to recommend Market Weight equity exposure for global balanced portfolios because we think the current advance from early fall of 2022 has further to run. However, we believe investors should limit individual stock selections to companies they would be content to own through a recession. For us, that means high-quality businesses with resilient balance sheets, sustainable dividends, and business models that are not intensely sensitive to the economic cycle.

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Jim Allworth

Investment Strategist
RBC Dominion Securities

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