By Joseph Wu, CFA
Incoming data continue to support the view of ongoing economic expansion, but growth momentum remains on a decelerating path, buffeted by the fluid Russia-Ukraine war, listless Chinese and European economies, and the Fed and other central banks pivoting assertively to tighten monetary policy and, in turn, financial conditions in the face of persistently high inflation.
We think the key question for investors is whether the current slowdown, particularly in the U.S., is an intra-cycle soft patch to be followed by renewed expansion – fairly common episodes in expansion cycles – or a precursor to a recession.
With healthy corporate balance sheets, ongoing strength in employment and wage growth, and households in solid financial shape with a sizable amount of excess savings that can tapped into to smooth spending, we believe the outlook for the largest components of the U.S. economy – personal consumption and business investment – is likely to remain adequately robust to sustain the expansion over the coming quarters. This, together with a relatively benign message from our recession scorecard, underpins our current assessment that U.S. recession risk, while present and rising, remains reasonably moderate on a 12-month horizon.
Nevertheless, we are cognisant that the risks to this sanguine view stemming from the headwinds mentioned above are building, which suggests to us that “end-of-cycle” worries are likely to persist until markets gain greater visibility on the path of inflation, Fed policy and the durability of the current U.S. expansion.
More “income” in bonds
Bond markets have endured a bruising stretch over the past 12 months amid a rising rate environment, which has broadly pressured bond prices lower. Despite the understandable frustration associated with negative returns in bonds, we believe the recent rout in bonds comes with some potential positive aspects that investors should take into consideration.
First, as bond prices fall, their yields rise, so the recent selloff in bonds has meaningfully bolstered their expected returns. Thanks to the downward repricing, the yields on most major segments of the bond market have not only improved substantially compared to a year ago, but also climbed near or above their respective averages since 2002. Moreover, credit spreads – a measure of the additional yield compensation for credit risk over government bonds – have widened, pointing to enhanced excess return potential for corporate bonds.
Yield profiles look increasingly reasonable
Index yield to maturity
Column chart showing index yield to majority metrics for the following Bloomberg indexes: U.S. Treasury Bond, U.S. Corporate Bond, U.S. High Yield Bond, and EM USD Aggregate Bond for May 31, 2021; May 31, 2022; and the average since 2002. U.S. Treasury Bond: May 31, 2021 = 0.9%; May 31, 2022 = 2.8%; Avg. = 2.4% U.S. Corp. Bond: May 31, 2021 = 2.2%; May 31, 2022 = 4.2%; Avg. = 4.2% U.S. Corp High Yield Bond: May 31, 2021 = 4.8%; May 31, 2022 = 7.2%; Avg. = 8.2% EM USD Aggregate Bond: May 31, 2021 = 3.9%; May 31, 2022 = 6.3%; Avg. = 6.3%
Average since 2002
Source - RBC Wealth Management, Bloomberg; data through 5/31/22
Second, now that bond yields have moved off historically low levels, relatively higher starting yields today can offer more of a cushion to weather further rises in rates, as well as help augment the ability for fixed income to act like a shock-absorbing diversifier in multi-asset portfolios during periods of equity market turbulence.
While the rising rate backdrop has resulted in short-term capital losses in bonds, the combination of considerably higher all-in yields and improved diversification capacity suggests to us that some value is starting to emerge in fixed income assets.
An equities markdown
Aside from emerging markets, forward 12-month earnings estimates for major markets have displayed impressive resilience, particularly for Canada’s resource-heavy S&P/TSX Composite (see table). In stark contrast, the forward price-to-earnings (P/E) multiples investors are willing to pay for these expected earnings streams have declined sharply, as the backdrop of a global economy undergoing a slowdown and higher interest (discount) rates – which reduce the present value of future profit streams – have prompted investors to demand a higher risk premium to own equities.
When in doubt, focus on earnings
|Consensus forward 12-month EPS estimate||Forward P/E|
|Index||Current||Jan. 1, 2022||Current||Jan. 1, 2022||Long-term average|
Table showing current and, Jan. 1, 2022, consensus forward 12-month EPS estimates and current, Jan. 1, 2022, and long-term average forward P/E for the S&P 500, S&P/TSX Composite, MSCI EAFE, and MSCI EM. S&P 500 EPS: Current: $238, Jan. 1, 2022: $223; P/E: Current: 17.4x, Jan. 1, 2022: 21.4x, LT avg: 16.2x S&P TSX Composite EPS: Current: $1,642, Jan. 1, 2022: $1,418; P/E: Current: 12.6x, Jan. 1, 2022: 15.0x, LT avg: 14.8x MSCI EAFE EPS: Current: $161, Jan. 1, 2022: $155; P/E: Current: 12.7x, Jan. 1, 2022: 15.1x, LT avg: 13.4x MSCI EM EPS: Current: $84, Jan. 1, 2022: $99; P/E: Current: 11.4x, Jan. 1, 2022: 12.4x, LT avg: 11.3x
Source - RBC Wealth Management, Bloomberg; data through 5/31/22
In an environment of heightened macro uncertainty, we think earnings delivery will be taking on added importance for equities. Our expectation for slower, but still positive, economic growth suggests that, despite a moderating growth rate, earnings are likely to be higher 12 months from now. Because the direction of stock markets typically aligns with profit trends (beyond the near term), a further expansion in earnings in coming quarters should provide some degree of fundamental support for share prices.
Market corrections, while always unnerving, occur with regularity as a normal part of the investing cycle. Importantly, these phases of the cycle often provide opportunities for long-term investors to deploy capital at relatively more compelling prices that are beneficial to long-run outcomes.
While we believe investors should remain nimble in light of a wider range of outcomes for the economy and corporate earnings over the next 12 months, if our view that the current slowdown will likely unfold as a “growth scare” is correct, then valuations across a number of asset markets are starting to look quite appealing.
We think the bottom line is that risk-reward for equities and bonds look considerably more attractive than even a few months ago. This is markedly the case for riskier corporate credit such as high-yield bonds, whose volatility-adjusted expected return potential is arguably competitive with equities.
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