The global equity market’s mood shifted dramatically in the early weeks of 2022, as the S&P 500 and most other major indexes pulled back enough to break some well-established uptrends.
Many factors have been credited with causing the selloff: high and persistent inflation; the potential for more aggressive tightening by the U.S. Federal Reserve; and the possibility that both of these factors could have knock-on effects on economic and corporate earnings growth—not to mention the COVID-19 pandemic that has yet to be tamed, and escalating geopolitical tensions. After ignoring these issues through the end of 2021, investors finally took notice, ushering in a multi-week selloff.
Markets have pulled back, with the U.S. leading to the downside
Performance of select equity indexes since the peak in the U.S. market (Jan. 3 – Jan. 31, 2022)
Source - RBC Wealth Management, Bloomberg
Major equity markets have pulled back so far this year following the peak in the S&P 500 on January 3. Performance is as follows: S&P 500 -5.9%, STOXX Europe 600 -4.3%, MSCI World ex-U.S. -4.1%, Canada S&P/TSX -0.6%, UK FTSE All-Share -0.4%.
Despite the headwinds—which we evaluate below—we think the economic expansion is intact. In our view, the market can work through this period and eventually resume its uptrend, albeit following a more modestly sloped, bumpier path than investors had become accustomed to in 2021. Neither our leading economic indicators nor credit markets are signaling that U.S. recession risks have risen; in many important areas, the landscape is largely unchanged.
This pullback, however, is a reminder that corrections and volatility are normal occurrences in bull markets.
As the chart illustrates, the S&P 500 has pulled back 10 percent or more at some point during the year in over half of the years since 2000. It’s important to recognize that pullbacks and corrections are not uncommon even in good years: among the 13 years with above-average annual returns, 10 included periods where the market pulled back seven percent or more.
Every market disruption has different catalysts and unique contours. In our view, the outlook for inflation and Fed policy, together with the knock-on effects these could have on economic expansion and corporate earnings growth, are the primary considerations that should factor into equity portfolio positioning.
Reality check: Pullbacks happen even in good years
S&P 500 total returns and pullbacks each year since 2000
Source - RBC Wealth Management, Bloomberg; data through 12/31/21
Annual performance of the S&P 500 including dividends from 2000 to 2020. For each year, the maximum peak to trough declines are also shown. This illustrates that even when the market performs well for the full year, meaningful pullbacks and corrections can occur. For example, in 2003 the S&P 500 rose 29%, but the market pulled back 14% at some point during the year. In 2009 the market finished the year up 26%, but at one point it had been down 27%. In 2020 the S&P 500 rose 18%, but at one point during the height of the COVID-19 crisis the market was down 34%.
The challenge of taming inflation
Our economists’ near-term inflation outlook is for more of the same: uncomfortably high inflation rates for several months. They anticipate the situation will improve in the second half of the year. The rate of goods inflation seems set to recede as supply chains gradually get back in gear and COVID-19-related anomalies fade further.
Some improvement is baked into Wall Street’s expectations, if only because the surging inflation in the second half of 2021 will make for easy comparisons with the same period this year.
But even if U.S. inflation were to fall back from its current rate of 7.0 percent to an average of 4.0 percent in Q3 and 2.7 percent in Q4—a plausible scenario, according to RBC Capital Markets—it would still be advancing at an above-normal clip.
Consumer prices are already 8.3 percent in aggregate above where they were before the pandemic began in January 2020—this is what households and businesses experience; their reference point is not the year-over-year rate.
We think it will take some time for households and businesses to absorb the current inflation shock, not just in the U.S. but elsewhere, even if the year-over-year growth rate of inflation diminishes in the second half of 2022 and subsides further in 2023 as we expect. Some of the global inflation angst may be expressed at the ballot box, as 2022 will see U.S. midterm congressional elections in November, UK local elections (which are regarded as indications of approval or disapproval of parliamentary stewardship) in May, and the French presidential election in April.
No quick fix
Looking further out, our economists acknowledge inflation could remain above the Fed’s two percent target level for some time, possibly for a couple of years. Even after inflation rates start to recede, it could take a number of quarters for financial markets to become confident that elevated inflation is not going to be a long-term challenge. As this gets sorted out, more stock market volatility can’t be ruled out.
Highest inflation reading since 1982
U.S. Consumer Price Indexes (CPI) (year-over-year percentage change)
CPI Core (excludes food and energy)
Source - RBC Wealth Management, Bloomberg; monthly data through December 2021
U.S. wage inflation has perked up
Broad measures of U.S. wage inflation (year-over-year percentage change)
Atlanta Fed Wage Growth Tracker
Employment Cost Index
Source - RBC Wealth Management, Bloomberg; data through 12/31/21
Will corporate earnings prove resilient?
S&P 500 companies are not yet seeing inflation eat into their overall index profit margins, nor has it dented 2022 earnings estimates—key considerations for the market.
However, the early innings of the Q4 2021 earnings season have revealed inflation is weighing more heavily on some individual companies’ profit margins. More management teams (particularly those of large banks and investment firms) have stated that higher compensation and other costs could constrain margins in coming quarters. Wage pressures are not just impacting large firms; higher compensation costs are the single most important challenge cited in a recent survey by the National Federation of Independent Businesses, the largest small-business advocacy group in the U.S.
Even consumer staples companies, which usually are able to pass higher input costs on to consumers through price increases, have noted that it is becoming more difficult to manage expenses.
Thus far, all of this hasn’t signaled trouble for 2022 earnings; the S&P 500 consensus forecast of $224 per share is slightly higher than it was a month ago and RBC Capital Markets maintains its $223 per share forecast.
Earnings projected to grow moderately in 2022 and 2023
S&P 500 annual earnings per share and RBC Capital Markets forecasts*
*Actual results in dark blue; RBC Capital Markets 2021–2023 forecasts in yellow
Source - RBC Wealth Management, Bloomberg
After dipping to $140 per share in 2020, during the peak of the COVID-19 crisis, RBC Capital Markets estimates that 2021 S&P 500 earnings per share will rise to $205 for 2021, and then rise moderately to $223 in 2022 and $243 in 2023.
The Fed shakes things up
Since the Fed acknowledged the need to fight inflation more aggressively, rate hike expectations have shifted significantly, and this has shaken equity markets.
In the middle of last year, Fed indications led the market to expect the first interest rate increase wouldn’t arrive before late 2022 or early 2023. Fast-forward through a series of shifts in Fed communications, and today we find the market pricing in five hikes this year and one next year, with the first now expected in March. As a result, from the beginning of last December through the end of January, the 10-year Treasury yield jumped from 1.40 percent to 1.78 percent.
In search of a soft landing
As we’ve pointed out previously, the Fed doesn’t tighten monetary policy with the intent of pushing the economy into recession. It always attempts to engineer a “soft landing” wherein the economy slows enough to reduce inflationary pressures or other excesses but avoids an outright downturn. Historically, the results have been mixed: of the 17 Fed tightening cycles since 1953, eight ended in recession, while nine produced no recession.
We can’t remember a rate hike cycle where equity market participants didn’t worry and debate whether the Fed would be able to engineer a soft landing—this is par for the course. And these concerns typically flare around the beginning of every Fed tightening cycle, despite the fact that the U.S. equity market has historically performed very well in the 12 months preceding the first rate hike and has typically gone on to deliver positive gains in the 12 months following that initial increase.
Could the Fed spoil the party this time around? Yes, eventually. But before that could happen, monetary conditions would have to become much tighter; we think that would be a considerable distance down the road, and involve many more rate hikes than the Fed currently has planned for this year and next.
Financial markets will also have to contend with the Fed reducing the size of its balance sheet as a proportion of GDP—a process known as quantitative tightening or QT. Our Fixed Income Strategies team points out that the Fed’s balance sheet has ballooned to almost $9 trillion, a record 38 percent of GDP, since the Fed started pumping liquidity into the financial system during the height of the COVID-19 pandemic. The previous peak of 26 percent was reached in 2013, in the aftermath of the global financial crisis.
When the Fed moved to reduce its bloated balance sheet in the post-financial-crisis decade, both bonds and equities corrected. While our fixed income colleagues see the potential for similar, temporary volatility spikes as the Fed winds down the balance sheet this time around, they do not see a high risk of permanent impairment to asset prices. They point out that the Fed possesses several tools to keep the challenges associated with QT at bay, but market volatility is likely to emerge nonetheless.
A bull market in transition
Equity markets are grappling with these uncomfortable headwinds. This is the stage of the economic cycle when challenges typically arise, as economic and earnings growth transition from the ultra-strong initial expansion phase to something more normal.
When the U.S. economy is devoid of major recession risks, global equity bull markets typically endure, although they often include bumpy periods and normal corrections. It is when recession risks increase meaningfully that bull markets tend to run into real trouble. Currently, none of our seven leading economic indicators of U.S. recession are flashing red, or even yellow; their behavior suggests this economic expansion has farther to run. That should mean corporate earnings and business values will be able to move higher from here.
While the risks currently facing equity markets have the potential to generate further volatility or downside, we don’t think the economic backdrop has deteriorated in such a way that investors should reposition broad asset class exposure in portfolios. We remain moderately Overweight global equities, with the view that major developed equity markets have the potential to deliver worthwhile gains for the year ahead and probably beyond.
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