By Joseph Wu, CFA
Despite a growing drumbeat of pessimism, the outlook for the world economy and corporate earnings has remained reasonably resilient. The Bloomberg consensus global real GDP growth rate for 2022 was recently revised lower to four percent (from 4.3 percent in Feb.), but this expected pace of growth is still above the average growth rate of 3.7 percent between 2010 and 2019 and, in our view, should continue to provide a fundamentally supportive economic backdrop for earnings to stay in expansion mode.
The weakness in equities so far in 2022 has been driven in large part by a downward adjustment in valuations. The Bloomberg consensus forward 12-month earnings estimate for the MSCI All Country World Index is slightly higher today than it was at the start of the year, but the pricing multiple that market participants are willing to pay for those profits has declined as investors have demanded a higher risk premium to compensate for the mounting downside risks to growth. However, with earnings expected to maintain their upward trajectory, the upshot of the correction has been a considerable improvement in valuations, as shown in the first chart.
Valuations have priced in some near-term headwinds
Forward price-to-earnings multiples vs. long-term averages
The line chart shows the forward price-to-earnings valuation multiples for the S&P 500 Index, the TSX Composite Index, the MSCI Europe Index, and the MSCI Emerging Markets Index relative to their respective long-term averages since 2015. Valuation multiples have decreased significantly since the beginning of 2022. At present, the S&P 500 still trades at a premium relative to its long-term average, but the other indices are now valued either below or roughly in line with their long-term averages.
MSCI Emerging Markets
Source - RBC Wealth Management, Bloomberg; data through 3/23/22
The S&P 500, at 19.2x forward consensus 12-month earnings, still appears expensive relative to history, but not nearly as stretched as it was a few months ago. Meanwhile, equity market valuations in Canada, Europe, and the emerging markets are now below or roughly in line with their long-term averages. Thus, even if earnings estimates are trimmed modestly in the coming months, there now appears to be a relatively larger buffer against heightened near-term risks.
Conflict, commodities, and a history lesson
The range of possible outcomes in the conflict between Russia and Ukraine remains uncomfortably wide, stretching from a near-term ceasefire to a protracted multiyear war. But the recent optimism projected by negotiators about a diplomatic pathway to halt hostilities is encouraging, and has helped markets rebound from near-term lows.
Commodity prices, an important economic spillover channel, are a key area to monitor—and the Bloomberg Commodity Index has rallied nearly 30 percent since the start of the year. Until markets see definite signs that geopolitical tensions are easing, we think strength and volatility are likely to persist in commodity prices, particularly in energy products.
Geopolitical shocks are always disruptive in the short term, but a key lesson from history is that the impact of major military conflicts on markets has typically been brief. Even so, we think the road to a resolution that could allow attention to shift back to fundamental drivers will likely be potholed by unsettling developments that create more episodes of volatility.
Monetary policy faces supply-side challenges
Coming into this year, the biggest question facing major central banks—particularly the U.S. Federal Reserve—was how to tighten monetary policy in order to tame inflation without materially undercutting growth. Since then, the possibility that spiking commodity prices and geopolitical turmoil could dampen economic activity has made this delicate balancing act even trickier. It is nevertheless worth reiterating that markets have already priced in a very steep tightening path by the Fed, with seven more interest rate increases expected before the end of 2022.
But whether the Fed will need all the rate hikes that are currently anticipated is still an open question. Many of the inflationary pressures we are witnessing today are coming from the supply side, and there appears to be little that monetary policy can do to influence factors such as oil supply, resource shortages, and logistical gridlocks. Recent signs of easing supply chain constraints also suggest the possibility that inflation could fade to some degree over the coming quarters, relieving pressure on the Fed. And with financial conditions having already tightened meaningfully in recent months, as the second chart shows, central bankers can arguably breathe a little easier now.
Financial conditions have done some tightening work for the Fed
Goldman Sachs U.S. Financial Conditions Index
The line chart shows the Goldman Sachs U.S. Financial Conditions Index since 2015. The index is a broad measure of U.S. financial conditions that encompasses riskless interest rates, the exchange rate, equity valuations, and credit spreads. A rising index indicates tightening financial conditions. The most recent trend is an increase to a current value of 98, from 96.9 in early November 2021.
Downward movement indicates easing financial conditions; rising movement indicates tightening financial conditions.
Source - RBC Wealth Management, Bloomberg; data through 3/23/22
Meanwhile, we believe the U.S. economy remains on a sturdy footing. The outlook for consumer spending appears resilient, underpinned by healthy household balance sheets thanks to pandemic savings, gains in net wealth, and a buoyant labor market. Business investment demand is also likely to remain supportive, in our view, as firms seek to boost capital spending and replenish inventories to satisfy consumer demand.
There are certainly risks that warrant close monitoring, most notably the rapid flattening seen in key U.S. Treasury yield curves and the recent uptick in long-term inflation expectations, but we continue to see a relatively low probability of a U.S. recession on a 12-month horizon.
Stay the course with a defensive bias
We maintain a constructive stance towards equities and corporate credit, based on our view that the economic expansion remains intact and corporate earnings will likely rise further in coming quarters. Although valuations have priced in some near-term risks, we caution that further episodes of volatility are likely until investors gain greater confidence about the outlook for inflation, monetary policy, and the Russia-Ukraine war. For portfolios, this overall backdrop of solid fundamentals confronted by mounting risks suggests it may be sensible to moderately bolster defensive positioning.
In an environment where capital appreciation will likely be harder to come by, we believe dividend-paying and high-quality companies—characterized by the ability to raise payouts, above-average earnings stability, and lower debt levels—may help mitigate the effects of market volatility. Given limited visibility on the duration and severity of the war in Ukraine, both commodities and resource equities could prove to be useful portfolio diversifiers in the near term.
Within fixed income, upgrading quality by taking advantage of the substantial move higher in government bond yields, which now embed aggressive rate hike expectations, may also bolster portfolio resilience.
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