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November 10, 2022

By Joseph Wu, CFA

Amidst mounting economic pessimism, it is worthwhile to take a step back and consider potential areas that could produce constructive surprises. To begin with, we think the prospects of inflation cooling over the coming months appear reasonably good, a view underpinned by the recent pullback in commodity prices, which have historically exhibited a close relationship with price pressures (see chart). Other indicators that typically lead inflation – global supply chain pressures, prices paid components of Purchasing Managers’ Indexes (PMIs), and shipping costs – also point towards moderating goods inflation in the near term.

Softening resource prices should filter through to lower inflation

Consumer Price Index (CPI) for the U.S. and major developed economies

Line chart showing Consumer Price Index (CPI) for the U.S. and major developed economies on a year-over-year basis since 2010 alongside the year-over-year change in commodity prices. While inflation remains elevated, the sharp deceleration in the year-over-year change in commodity prices suggest CPI is likely to begin trending lower over the coming month.

  • U.S. Consumer Price Index (y/y, LHS)
  • Major Developed Economies Consumer Price Index (y/y, LHS)
  • Bloomberg Commodity Index (y/y, RHS)

Source - RBC Wealth Management, Bloomberg; monthly data through 10/31/22

Meanwhile, despite persistently elevated inflation and higher borrowing costs, household expenditures have held up quite well. Sustained strength in the labour market is underscored by solid wage gains and ample job openings. This, coupled with a still-sizeable amount of savings that households can tap into, suggests to us that consumer spending – a crucial pillar of the U.S. economy that makes up nearly 70 percent of GDP – could remain well supported in the quarters ahead.

Lastly, now that the U.S. midterm elections are in the rearview mirror, this likely resolves one of the overhangs that may have hindered risk appetite in recent months. As of this writing, the election outcome remains unclear. Depending on recounts and runoffs, the balance of power in Congress may take days or weeks to determine. But based on initial results, the “gridlock” outcome, featuring a Democrat president alongside at least a split Congress, remains likely. As we outlined in September, equities have historically fared well in the year following the midterms since 1932, with the S&P 500 generating an average return of 16.3 percent. While the historical returns data around midterm elections paint a relatively sanguine picture, we believe investors should focus more on fundamental factors, including economic conditions, corporate earnings, and monetary policy, which together typically have much greater explanatory power for equity market trends over the medium and long term.

Profit estimates will need to “catch down” to worsening business conditions

Consensus forward 12-month EPS estimate (Jan. 1, 2022 = 100)

Evolution of consensus forward 12-month EPS estimates

Line chart showing the evolution of consensus forward 12-month EPS estimates for the MSCI All Country World Index, the S&P 500, the STOXX Europe 500 Index and the TSX Composite. The corporate earnings outlook has exhibited resilience this year despite a slowing world economy, with forward EPS estimates currently either in line or above levels at the start of the year. Given significant downgrades to 2023 and 2024 GDP growth estimates for major economies in recent quarters, consensus estimates will likely need to adjust lower to reflect economic realities.

  • MSCI All Country World Index
  • S&P 500
  • STOXX Europe 600 Index
  • S&P/TSX Composite

Source - RBC Wealth Management, Bloomberg; weekly data through 11/4/22

But outlook still murky

We believe the outlook for the world economy and, by extension, corporate profits, remains challenging with risks broadly skewed to the downside. Part of the reasoning for this downbeat assessment derives from thinking about whether the main macro forces that have hampered the economy and financial markets, namely inflation and hawkish central banks, have faded or stabilised to a degree that would inspire sufficient confidence that the worst is behind us.

Although we may be getting closer to that inflection point, the main concern is that we have not yet seen concrete signs of an inflation peak. Goods inflation may be in the process of coming back down from very elevated levels seen over the last two years, but we believe more persistent price increases in services and shelter (housing) could prove to be more difficult to control, which may necessitate further monetary tightening beyond what’s currently anticipated by markets.

While the Fed and other central banks must balance the risk of inflation becoming entrenched with the prospect of a severe economic slowdown, their mandates are currently focused on taming inflation. The Fed ostensibly opened the door to slowing the pace of rate hikes “as soon as the next meeting” in December, but policymakers also reiterated that the path of interest rates will remain higher over the coming quarters.

Unless inflation declines faster than expected over the months ahead, additional rate hikes by the Fed will keep tightening pressure on financial conditions, which should continue to dampen economic activity. Against this backdrop, consensus corporate earnings forecasts still seem too optimistic, in our view, and will likely need to be recalibrated lower to reflect the significant downgrades to 2024 GDP growth projections across major economies and the sharp deceleration in global PMIs.

Risks and opportunities

When considering the full picture of this economic uncertainty, we believe investors should maintain a modestly defensive stance in portfolio positioning. Given coordinated global monetary tightening and ongoing geopolitical turbulence, many of the global leading indicators we monitor continue to trend unfavourably.

For equities, uncertainties about the economy, interest rates, and inflation indicate the range of potential outcomes in the near term is unusually wide. And even though we believe stocks are more reasonably priced today following the selloff year to date, the focus here could shift to weakening fundamentals, where limited downward revisions to consensus earnings estimates this year despite a decelerating economy point to downside risks.

Meanwhile, we believe the risk-reward profile in fixed income has improved considerably. Virtually every segment of the bond market has suffered negative returns in 2022 as a result of the historically rapid rise in rates this year. But the silver lining, in our view, is that substantially higher yields have greatly improved return expectations going forward. In addition to boosting return potential, we believe higher starting yields also provide bonds with a relatively greater cushion to absorb further increases in rates.

While we are cognizant of intensifying economic headwinds, the higher all-in yields in fixed income, which appears to have undergone a more pronounced risk-adjusted repricing than equities, suggest to us that it is still a timely opportunity to rotate portfolio risk budgets towards bonds.

Relative value has shifted in favour of fixed income

Current forward earnings yields

Column chart showing the current forward earnings yield for the MSCI All-Country World Index and the S&P 500 and the yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index and the Bloomberg Global Corporate High Yield Index, compared to a year ago and the average since 2002. On a relative basis, the yield advantage that equities commanded over corporate bonds has sharply diminished over the past year.

  • A year ago
  • Current
  • Average since 2002

Note: Earnings yield is the inverse of the forward price-to-earnings ratio. Bond yield refers to yield to worst for the Bloomberg U.S. Corporate Index, the Bloomberg Global Agg Credit Index, the Bloomberg U.S. Corporate High Yield Index, and the Bloomberg Global Corporate High Yield Index

Source - RBC Wealth Management, Bloomberg; weekly data through 11/4/22


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