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December 1, 2022

Kelly Bogdanova
Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.

With 11 months of the year under our belt, developed equity markets are looking better than they were than just over a month ago. The S&P 500 has rallied 14.1 percent since mid-October, and the MSCI World ex-U.S. Index has jumped 17.6 percent in dollar terms over the same period, while the UK’s FTSE All-Share Index and Canada’s S&P/TSX have bounced 11.5 percent and 12.3 percent, respectively.

As a result, the S&P 500 is down “only” 14.4 percent year to date compared to being down 25 percent at its worst point. This is not a phantom move, in our assessment, as the four key factors behind the rally are notable.

Markets have rallied nicely off of the mid-October lows

Path of select developed market equity indexes (year-to-date % change)

Path of select developed market equity indexes

Line chart showing the path so far in 2022 of four major developed equity market indexes: The UK FTSE All-Share, Canada's S&P/TSX, the S&P 500, and the MSCI World ex-U.S. Each of them began to move lower early in the year, and then drifted further down in the spring and the first part of the summer. They all bounced in July and part of August, only to retreat again to new lows in September and into mid-October. But since mid-October, they have all bounced nicely. The FTSE All-Share and Canada's TSX are now down only 1.6% and 3.6%, respectively, year to date. The S&P 500 and MSCI World Index are now down 14.4% and 16.1% year to date, after having been down about 25% and 29%, respectively, as of mid-October.

  • S&P 500
  • UK FTSE All-Share
  • Canada's S&P/TSX
  • MSCI World ex-U.S.

Source - RBC Wealth Management, Bloomberg; data through 11/30/22. FTSE All-Share and S&P/TSX in local currencies; S&P 500 and MSCI World ex-US in U.S. dollars

The softening in U.S. inflation: The rally gained steam with better-than-expected October consumer inflation data. The headline Consumer Price Index (CPI) pulled back to 7.7 percent year over year, which was below the consensus forecast, and lower than the peak 9.1 percent reading last June.

There has been a meaningful shift in the month-over-month CPI trend. After spiking in 2021 and earlier this year, the headline and core rates have come down closer to their longer-term ranges since 2010, clearly illustrating that inflation is no longer accelerating at a swift pace like it was months ago.

U.S. consumer inflation has come off the boil

Consumer Price Indexes (% change month-over-month)

Consumer Price Indexes

Line chart showing that since 2010 the Consumer Price Index (CPI) and the Core CPI (excludes food and energy) have been somewhat subdued in terms of the percentage change from month to month. The CPI generally recorded increases of 0.2% to 0.5%, the CPI Core usually rose between 0.1% and 0.2%. However, in mid-2021, the pattern changed notably as both indexes began to significantly rise. In 2022, the CPI rose further, peaking out with a month-over-month gain of 1.3% in June. Since then, both of the indexes have moved lower, closer to their long-term trend ranges. In October 2022, the CPI rose 0.4% and the Core CPI rose 0.3% month-over-month.

  • Consumer Price Index m/m
  • Core CPI (ex food & energy) m/m

Source - RBC Wealth Management, Bloomberg; data through 10/31/22, the most recent CPI report

We think it’s reasonable to expect inflation to come down further in 2023, perhaps notably.

  • Commodity prices have receded, and have historically been positively correlated with inflation.
  • Supply chains have improved.
  • Households have become price-sensitive and are more often “trading down” to off-brand items as indicated by the earnings results of major retailers.
  • The math points to decelerating inflation. The so-called “base effect” should play a role here as inflation comparisons from year-ago periods are much tougher in coming months. It would take strong month-over-month readings to push the year-over-year inflation rates higher. Barring unexpected supply chain disruptions or significant changes on the geopolitical front, we don’t see this happening.

The end of the Fed tightening cycle seems in sight: We think sentiment about the Fed’s rate hike cycle has been a major catalyst for the equity market. Even before Fed Chair Jerome Powell signaled on Wednesday that the Fed would likely downshift the size of rate hikes from 75 to 50 basis points at the December 13–14 meeting, equity market participants had been expecting this. However, markets strengthened further on Powell’s comments. Beyond the December meeting, we expect any subsequent hikes to be in 25 basis point increments, and only if justified by the incoming data, with the fed funds rate reaching no higher than 5.00 percent by Q1 2023 compared to the current 4.00 percent level, in our view.

Better-than-feared corporate earnings trends: Among S&P 500 companies, Q3 reports showed some deterioration in earnings and revenue growth, especially when Energy sector results are excluded. There were also high-profile misses and estimate cuts for Q4. However, on balance, the reporting season was better than feared, and we think the results were relatively good compared to previous periods when economic headwinds were blowing.

A typical boost surrounding the U.S. midterm elections: We think the rally was helped along by sentiment about the midterms, especially given the results gave way to gridlock in Washington with House of Representatives control shifting to Republicans. Thus far, the move has been textbook. Since 1934, there has typically been a big selloff in the 12-month period before the midterm elections, and then the S&P 500 tended to rally off of the midterm election-year low sometime around the election date. The S&P 500 has historically performed best when power in Washington was shared between a Democratic president and a split Congress, as we’ve pointed out in two recent reports about historical election returns and the results of this election .

Lingering risks

Is the rally just another bear market bounce that should be ignored? We don’t think so given the above developments, especially on inflation and Fed policy. These are legitimate reasons for investors to reallocate capital to U.S. equities, in our view.

But let’s not kid ourselves, economic risks linger which can impact corporate earnings and generate more volatility in 2023:

  • The U.S. could succumb to a recession, possibly in the middle of the year. The leading indicators in our Recession Scorecard continue to flash warning signs. We doubt recessionary conditions have been fully factored into the consensus earnings forecast for 2023. In a recession, we think S&P 500 earnings could end up at US$220 per share in 2023 – at most – rather than at the current consensus forecast of US$231 per share.
  • It’s unclear the degree and pace by which inflation could retreat. The jury is still out about whether the Fed’s two percent inflation target will be achieved in 2023, or whether the likely retreat in inflation will stall out around three percent to four percent – not to mention whether there will be another inflation wave thereafter. How this ultimately gets resolved can impact the market’s valuation. Generally, elevated inflation and interest rates over the medium term result in lower equity market valuations, and vice versa.

Avoid the timing temptation

Regardless of how 2023 plays out, we think developed equity markets’ swift moves off the mid-October bottoms, which came amid very negative headlines and bearish investor sentiment, are prime examples of why attempting to time the market is such a precarious exercise for long-term investors. There is no bell that rings when a new bull market cycle begins, and missing the biggest rally days can have detrimental long-term performance consequences. We think now is a good time to review portfolios with the goal of bringing allocations back to the long-term strategic recommended levels.



Kelly Bogdanova

Vice President, Portfolio Analyst
Portfolio Advisory Group – U.S.