Seeking a new path onward

By Jim Allworth

Several important shifts occurred on the global economic and financial landscape over the first half of the year. Here are the most important:

• First the Fed and the Bank of Canada swung from being tolerant of higher inflation to being decidedly intolerant. Rate hikes have not only begun they’ve become more aggressive in the past 60 days as has the rhetoric about future hikes.
• Central banks are no longer suppressing bond yields through quantitative easing, producing a pronounced upward shift in long bond rates.
• While most forecasters (ourselves included) expected last year’s gradual build up in inflation to turn into a price surge in the first half of this year, they underestimated the extent of that spike. The Ukraine/Russia conflict intensified the upward pressure on prices for oil, natural gas, and most agricultural commodities.
• Supply chain disruptions have resolved much more slowly than expected, exacerbated by renewed China shutdowns.
• As consumers shift spending from goods to services, inventories of unsold goods are building in the U.S. and new orders are weakening, suggesting manufacturing may be heading for a slowdown in the second half.
• Meanwhile, ongoing labour shortages are affecting the reopening of the services side of the economy.

Market impact

The surge in inflation and bond yields has pressured valuations lower in the stock market by lowering the discounted present value of future earnings. (Moving bond yields higher from two percent to three percent reduces the present value of a dollar of earnings earned 10 years down the road by 9 percent.)

This has had the largest impact on the high P/E, mega-cap growth stocks of which the six largest comprised more than 25 percent of the value of the S&P 500 at the peak of the market in early January. Their performance was not helped by the fact that three of the biggest – Amazon, Meta (Facebook), and Alphabet (Google) – reported declines in first quarter earnings.

This magnified downward effect of a handful of very large capitalization stocks helps to explain why Canada’s TSX (down 14 percent), which contain none of these six stocks, fared better than the U.S. index (down 22 percent).

In the U.S. continuing supply chain issues, together with bloated inventories and labour shortages, have driven corporate confidence down to much-reduced levels, taking investor confidence down at the same time. So far earnings estimates for 2022 and 2023 have not come down, however, if second quarter earnings guidance proves more cautious then some downward earnings estimate revisions are likely.

Is there a plausible path to new highs?

Measures of investor sentiment have been hugely negative of late. Such unanimous pessimism does not occur at market tops but frequently appears at or near tradable lows. However, even were markets to turn higher from here, views about how far they rally and for how long are decidedly downbeat. “Bear market rally” is the consensus interpretation among U.S. market observers.

Perhaps but not necessarily. It is useful to look at potential market outcomes through the lens of the two prevailing schools of thought on the likely trajectory of inflation over the coming year or two.

One view has inflation becoming a bigger and more intransigent problem than central banks or the market have yet recognized. The inflation expectations of U.S. consumers have recently jumped above the longstanding 2—4.5 percent range that has prevailed for more than two decades to 5.5 percent. Reining in those expectations, so this view argues, will require the Fed to raise rates markedly higher than currently envisioned and keep them there for longer.

This would greatly increase the odds that the fed funds rate eventually overshoots producing the kind of tight credit conditions that would make recession inevitable. A recession would undoubtedly be bad for corporate earnings and share prices, and has typically been associated with a bear market for equities.

However, under this scenario, before that painful economic/market retrenchment arrived, the U.S. economy would likely traverse an extended period during which the Fed chased an overheated economy higher for much longer-than-expected – perhaps through 2023 and into 2024.

That prolonged stretch might well see inflation-boosted sales and earnings grow faster than expected. It would be unusual for new highs in sales and earnings not to be accompanied by new highs in share prices.

But how much of a new high? A bit of history might be instructive. From the beginning of 1977 until the end of 1979, the Fed did just that – i.e., chase an overheating economy higher, raising the fed funds rate from five percent to 15 percent in the process. The economy was growing and S&P 500 earnings per share advanced by a very satisfactory 40 percent over the three years. But the index itself flatlined, starting and finishing at about 100. Bond yields rose from seven percent to almost 11 percent over the same interval, compressing P/E multiples and limiting index investors to no better than dividend returns.

In our view, the same dynamic would probably yield similar results if the Fed-hikes-faster-for-longer scenario were to play out over the next couple of years. So, it’s possible the averages could get back to old highs, perhaps even exceed them, but it seems likely the appreciation potential would be heavily dampened by rising bond yields.

As was the case in the 1977–1979 experience referred to above, the S&P/TSX should do better than its U.S. counterparts given its heavier commodity exposure. But forestry, metals and mining are all much smaller components of the economy and market than they were in 1977. Energy, despite enjoying higher prices, continues to be bedeviled by an inability to get product to market, which is unlikely to be materially improved for a year or more.

The other prevailing view out there – and one we subscribe to – has inflation subsiding somewhat over the second half and retreating further next year. As the stay-at-home spending boom on goods wanes, with household budgets squeezed by rising costs for food and fuel, the goods side of the economy will need to pare back bloated inventories of unsold goods. This should produce some price weakness for non-essential goods, allowing the core rate of inflation to recede somewhat, the headline rate to peak and inflation momentum to turn lower.

That, together with a continuing slowdown in the goods-producing side of the economy, might induce the Fed to rethink how far rates need to rise and how fast. Any sign the Fed was backing away from further tightening would bring back into play the possibility of a “soft landing” for the U.S. economy, which would support an outlook for stronger earnings growth and higher share prices.

However, turning the equity market. decisively higher, where an advance to new highs becomes plausible, usually requires the arrival of some catalyst that re-ignites investor optimism – perhaps a Fed rate cut, a marked downturn in energy prices, or a couple of much softer-than-expected inflation reports. None of these looks likely at the moment.

On the other hand, current readings of unusually deep investor pessimism suggest limited downside from here. We expect the most likely path for equity prices through the remainder of this year will be a mostly sideways one until some set of circumstances re-invigorates the case for sustained economic and corporate earnings growth or conversely reveals that that a recession is rapidly approaching.

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.