Counsel Views – Episode 19: Stu Morrow
Special edition: Stu's views on the recent market volatility
Counsel Views, hosted by Stu Morrow, Chief Investment Strategist, RBC PH&N Investment Counsel, is an audio series aimed at bringing insights to clients from thought leaders and experts across Canada’s leading wealth management firm.
Episode guest: Stu Morrow: Chief Investment Strategist, RBC PH&N Investment Counsel
In this special episode of Counsel Views, Stu provides his perspective on and guidance around the recent surge in market volatility, as well as his insights into the key themes on investors’ minds today.
In this episode, I address the most recent surge in market volatility, after what has been an extraordinary period of market gains. While we always take a long-term and consistent approach to investing at RBC PH&N Investment Counsel, as a client-focused firm, we want to assure and inform our clients by providing appropriate perspective on this recent market action.
So let’s start with a few questions.
First one: What’s driving the most recent market volatility? I think in these moments of market stress, perspective is important. So let’s begin by mentioning that global equities extended their gains from 2020 to record gains in another strong year in 2021. In fact, in 2021, we saw inflows into global equities equal to all of the cumulative inflows over the previous 19 years.
Reflecting a lot of optimism surrounding the economy and corporate profits, the market has also been driven by the extraordinary monetary policies of central banks, which has made fixed-income returns less attractive than those of equities, and fuelled a surge in risk investing.
As a result, pockets of the markets such as the U.S. large-cap equities have seen their valuations pushed beyond their fair value, leaving them vulnerable to heightened volatility. This predicament has actually started to play out with stocks like Zoom, Netflix, Peloton, Lululemon, and others who have seen strong demand pulled forward as a result of the shift to work from home, while valuations have gotten ahead of themselves.
And we started the year off, actually, with a decline in the bond market as financial conditions started to tighten, though they do remain mostly accommodative. News from the U.S. Federal Reserve showed a propensity to accelerate the removal of accommodative monetary policy sooner that the market may have expected, and as a result of higher-than-expected inflation readings.
Furthermore, the supply of bonds in 2022 has been quite heavy, which has added new supply and created selling pressure on existing bond positions, thus putting upward pressure on bond yields.
More recently, the markets have grown concerned with respect to the uncertainty and escalating tensions between Russia and Ukraine, and with this, this period of risk-off in the market has taken hold. And as we know, equity markets and bond markets do not like uncertainty and they tend to try to overestimate perhaps the downside risk when it comes to future events. Any de-escalation on a geopolitical front would certainly play favour back to risk or back to stocks.
All told, with the markets beginning the year in this risk-off sort of attitude, we’ve certainly seen the brunt of selling pressure and less profitable high valuation in growth assets like the Nasdaq-100 and parts of the S&P 500. But meanwhile, Canadian equities have actually fared better so far relative to their U.S. counterparts.
A second question we often get asked is, is this something more serious or the start of something more serious? And I’d start by saying, first of all, nobody really knows for sure, but we don’t think so.
So, to start, when there’s heightened volatility and a sell-off in equity markets, we often look to the credit markets for signs of confirmation that there could be more to this, i.e., is there a heightened risk of a recession, for instance. And so far, while credit spreads—which is a key gauge of risk—are somewhat higher to start the year, they’re nowhere near previous levels, which may suggest a deeper pullback in equities is still to come.
We’ve been asked if this correction in the U.S. equity market was driven by an aggressive federal reserve, and then, so what’s the outlook for equities over the medium term. We’ve taken a look, actually, at the four previous monetary tightening cycles in the United States, where the average Fed funds rate or short-term interest rate went up 300 basis points or 3% from the lows. And across those four tightening cycles, which go back to 1985 and include the most recent period ending in 2020, the average S&P 500 total return during those periods averages over 90%, with a range of between positive 45% to 225%, which was seen during the 1993 to 2000 period.
On the inflation front, we continue to believe inflation will peak soon or has already peaked perhaps, which leads us to believe that this recent sell-off may not be the start of something more serious. While supply chain disruptions continue, we see signs of incremental improvement in throughput. Some key freight rates have declined, container backlogs appear to be coming down modestly, and auto production has started to pick up more recently.
Capital spending has been increasing and that should lead to further increases in productivity and dampen inflation readings. And more recently, actually, we’ve seen a slowing in demand of consumer goods in retail sales numbers, which will slow the rate of change in price increases or inflation. So all of this to say, as inflation slows, we expect a less aggressive removal of monetary stimulus as we enter into the summer months.
So, going back to the question I posed myself, I think it’s important to also point out that corrections in the equity market like we’ve seen or experienced so far in 2022 aren’t uncommon. Up until this month, the S&P 500 had gone 451 trading days without a 10% correction, which is about where we are now, which is about the historical time between corrections. And over the last decade, we’ve seen the S&P 500 index go through 10 corrections of 10% or more. So this episode hasn’t surprised us in that respect, nor does it leave us terribly concerned at this point.
In addition to 10% corrections being more common perhaps than people may have thought, it’s important to point out the opportunities that come with corrections, and sell-offs have been quite attractive. So, when you go back through the historical data, and you look back as far as we could, in 1929, the subsequent one-year forward returns on stocks following a 20% drawdown has been 21%. The historical data also shows us that forward one-year returns, they continue to increase, actually, as the sell-offs increase. So sell-offs of 55% or more have averaged a 63% return to stocks in the following year.
And all of this to say, of course, past performance doesn’t indicate future performance, but it does provide some important perspective. We don’t always want to view volatility as a risk per se but perhaps as an opportunity for longer-term investors to take advantage of those who may be forced to sell into weakness.
A third question is, has anything occurred year-to-date that’s changed our views on asset allocation? We’re not making any changes to our outlook at this time and I would say we have anticipated heightened volatility this year. We continue to recommend a modest overweight to stocks in traditional balanced portfolios following some profit taking late last year in stocks.
From a fundamental perspective, we continue to see underlying economic conditions improve and corporate profits are holding up, despite concerns about rising input costs eating into margins. It’s still early in this current fourth quarter earnings season, but we expect margins to remain firm, thanks to improving productivity and prices outpacing wage inflation.
We do expect volatility ahead continued as interest rates move away from zero interest rate-type of policies to something less accommodative.
As always, I think it’s important to note that we stand behind tried and true principles of portfolio diversification, not only across asset classes, but across regions, currencies, and investment strategies, staying invested. Important to remember, there’s always going to be reasons to sell, perhaps like this month, which we did talk about in our 2022 outlook piece. It included a great chart to this effect so, if you haven’t read it yet, please reach out for a copy of our outlook piece and we’ll be happy to get that to you and answer any questions you have.
The last point on asset allocation is that we believe timing the market has been extremely difficult to say the least and, as such, we advise a more systematic approach to rebalancing portfolios as a result of sell-offs.
We know adding to equities stocks following a decline is not an easy pill to swallow. However, as we talked about, forward-return prospects improve as markets decline, of course. And dollar-cost averaging into the market in this environment counters both a fear of getting in too early and a fear of missing the subsequent recovery rally.
The last question we get often is, what do you continue to watch as we go through this year or these events? And a couple of areas I’ll highlight.
One, we’ll be watching the narrative coming out of the Bank of Canada and the U.S. Federal Reserve, which had meetings this week.
For any colour on the path forward to tightening policies, it’s important to note that we do see the structural forces exerting downward pressure on bond yield to remain well in place. These include demographics, high government debt loads, wealth and income inequality, and significant number of buyers who are less price sensitive, such as central banks, pension and insurance companies, banks, and funds.
Over the coming weeks, we’ll continue to monitor the colour from businesses during this earnings season. This is an important gauge for the outlook for businesses on costs and, therefore, margins and free cash flow, which have implications for analysts’ growth expectations and, therefore, expected returns for stocks over the short term.
Over the coming weeks and months, as I’ve mentioned previously, credit spreads and the yield curve, both will be monitored for their impact on equities and bond markets.
And finally, on the geopolitical front, a lot has been written on the Russia-Ukraine escalating tensions, the real possibility of a conflict, which I wouldn’t downplay, but I won’t belabour that side of the issue.
On the optimistic side, there’s a case to be made against perhaps a Russian invasion at this time. Recall from the 2014 Winter Olympics, Putin didn’t invade Ukraine until after the Olympics were done. Beijing’s Winter Olympics begin in a week’s time and China’s foreign ministry has already asked for all countries to honour the UN Olympic Truce resolution, which states, from seven days before the start of the Olympic Games until seven days after the end of the Paralympic Games. And this resolution was passed in December 2021, with Russia’s agreement.
Clearly, China doesn’t want any distractions between now and March 20th, so not to distract from its showcase event. Russia can obviously change its mind. I wouldn’t say that, but I would openly question, why poke China in the eye when it’s easy to perhaps invade at a later date or next winter, as Putin can wait as a ruler for life per se. And the cost to Russia, of course, finally, on top of the price tag for Crimea, in addition to sanctions, may be quite unfavourable.
We’ll certainly keep an eye on the threat of a multiregional involvement, but we note that in the past, these episodes have often resolved themselves as quickly as they’ve appeared. But we’ll monitor for prolonged tensions, especially where the oil market is front and centre, which could pose a threat to growth in the future.
That’ll end it for this podcast. I just want to say thank you to you, our clients, for your trust and confidence in us as stewards of your wealth. I expect that, as events unfold over the coming weeks and months, we’ll continue to provide regular updates like this one. And in the meantime, please feel free to reach out to your Investment Counsellor with any questions or concerns. Take care.
This episode of Counsel Views was recorded on January 25, 2022.
Note on index references
S&P 500 Index
The S&P 500 Index includes 500 companies across many sectors of the U.S. economy. The index is weighted by market capitalization so bigger companies make up a larger proportion of the index than smaller companies. The index is designed to measure performance of the broad US economy through changes in the aggregate market value of the largest US companies
The Nasdaq-100 is a U.S.-based stock market index made up of equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock market. It is a capitalization-weighted index. The stocks' weights in the index are based on their market capitalizations, with certain rules capping the influence of the largest components.
Stuart Morrow is the Chief Investment Strategist of RBC Phillips, Hager & North Investment Counsel Inc. (RBC PH&N IC). All opinions of Stuart Morrow and his podcast guests are solely their own opinions and do not reflect the opinion of RBC PH&N IC nor of any of its affiliates.
This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. This podcast is not an offer to sell or a solicitation of an offer to buy any securities. The information provided in this podcast is not investment, tax or legal advice. Individuals should consult with qualified tax and legal advisors before taking any action based upon any information contained in this podcast. Neither RBC PH&N IC, nor any of its affiliates, nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this podcast. Clients of RBC PH&N IC may maintain positions in the securities discussed in this podcast.
RBC PH&N IC and Royal Bank of Canada are all separate corporate entities that are affiliated. RBC PH&N IC is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ® / ™ Trademark(s) of Royal Bank of Canada.