Caution called for

By Jim Allworth

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.

Recession Scorecard

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.

For a more detailed discussion of our outlook for financial markets, ask your advisor for a copy of our current issue of Global Insight.

Jim Allworth is co-chair of the RBC Global Portfolio Advisory Committee.