Facing the growing wall of worry

CIO Office National Bank Investments

National Bank Investments

Market Update │ May 2022

Highlights

• After some respite in March, market headwinds picked up again in April. The news flow hasn't been very bright for investors lately – Russia’s invasion in Ukraine, lockdowns in China, mounting inflation, rapidly rising interest rates. No wonder recession fears are ramping up, but is it justified?

• For now, the economic situation is more akin to overheating than a recession in the making. There is little doubt that the Fed and BoC will bring their benchmark rates to 2% in a series of 50-bp hikes by the end of July. However, they are likely to be more parsimonious thereafter, especially if inflation initiates a landing, as we can reasonably expect. Moreover, the strength of the North American economies indicates they can weather this monetary tightening, which is critical to long-term price stability.

• Several risks underlie this scenario. The situation is deteriorating in the euro zone and in China, grappling with significant rises in energy prices and lockdowns, respectively. In addition, the path of rate hikes currently expected by the markets suggests that we may find ourselves at the edge of restrictive territory in less than a year, which would increase the likelihood of a recession.

• That said, valuations and the most recent investor sentiment surveys suggest that a significant amount of uncertainty is already discounted in equity prices. Bonds still face some downside risk, but the outlook is now much more balanced, which should allow the asset class to play its important defensive role in the event of a more-pronounced economic downturn.

Market Review

Fixed Income

• April was another losing month for fixed-income securities as interest rates continued their historic climb. This is the fourth consecutive month of losses for the Canadian bond universe, down 9.7% year-to-date.

• Long-term bonds underperformed again, as their longer duration makes them more sensitive to interest rate moves.

Equities

• After soaring at the end of March, global equities retreated in April. Extreme lockdown measures in China weighed on market sentiment, as did the lack of positive developments on the Ukraine front. Defensive sectors (healthcare, utilities, consumer staples) and energy outperformed in the U.S., a sign of growing risk aversion.

• Although the Canadian stock market has once again outperformed the rest of the world, its losses in April now place it in negative territory year-to-date.

FX & Commodities

• Oil prices continued to rise supported by strong global demand and elevated geopolitical risks. WTI Oil price increased 4.4% in the month of April to USD$104.69/barrel.

• The U.S. dollar had phenomenal performance in April, with the DXY Index appreciating by 4.7%. The euro depreciated significantly against the Greenback as the Ukrainian conflict stalled and the economic outlook deteriorated in the Old Continent. The strength in the U.S. dollar would have had a positive contribution to unhedged US equity positions in client’s portfolios this month.

Facing the Growing Wall of Worry

After some respite in March, market headwinds picked up again in April, dragging bonds and, even more so, equities lower. As a result, even the resilient Canadian stock market now finds itself in negative territory from the start of this tumultuous year (Chart 1).

For the S&P 500, this marks the third dip into correction territory in as many months (including intraday movements) while both the technology heavyweights index (more sensitive to interest rates) and the small cap index (more sensitive to the recent strength of the USD) are back in bear market territory (Chart 2).

Admittedly, the news flow hasn't been very positive for investors lately. In addition to the conflict in Ukraine and all the associated instability, a surge in COVID-19 cases in China has prompted the country to adopt its most stringent containment measures in two years (Chart 3). Specifically, the near-total shutdown of economic activity in Shanghai, as well as at its major port, has added to concerns about global growth on top of supply chain disruptions.

Fortunately, the vast majority of developed countries remain on a path toward pre-pandemic normalcy. However, we can' t say the same about the inflationary backdrop, which has now surpassed labour challenges as the #1 problem for U.S. small businesses according to the latest NFIB survey – a first in 10 years (Chart 4).

Under these circumstances, it is no surprise that central banks have also become increasingly concerned about mounting inflation. Specifically, this change in tone has led markets to expect a much faster rate hike path for both the Fed and the Bank of Canada (BoC), thereby sparking fears of a sharp economic slowdown (Chart 5).

Case in point: recent Google search data related to recession illustrate the rise in economic anxiety that typically culminates in a bear market when founded (Chart 6). So, is it reasonable or premature to envision a recession at this stage? Let's take stock of the situation.

Overheating Economies…

For now, the economic situation is more akin to overheating than anything else. While the latest U.S. GDP figures showed a slight contraction in the first quarter, this was mainly the result of a sharp increase in imports, while domestic demand remained strong. Thus, after almost two years of a pandemic in which monetary and fiscal authorities preferred to risk overstimulating than the inverse, they are now faced with a red-hot labour market. These circumstances, coupled with severe supply-side disruptions, have pushed inflation to levels not seen in several decades (Chart 7).

Now, while major central banks spent most of 2021 counting on the "transitory" nature of inflation, they are now showing much more combative attitudes toward rising prices. Why the change of heart? In short, monetary policy has little impact on the so-called "flexible" components of inflation (e.g., used car prices), and it is these elements which were primarily behind the Consumer Price Index (CPI) rise in the Spring of 2021. This remains the case today, unlike the 1970s when inflation problems were much more chronic. But, in recent months, so-called "persistent" inflation (e.g., shelter costs), which is much more sensitive to monetary policy, has also started to accelerate rapidly (Chart 8).

Looking ahead, all indications are that upward pressure on flexible inflation should finally begin to ease. Despite the war in Ukraine and lockdowns in China, most key input price indices such as shipping costs and global commodities are still showing signs of stabilization (Chart 9).

On the other hand, the unprecedented strength of the labour market and the resulting pressure on wages (Chart 10) are likely to continue to lead to price increases for the more persistent components of the consumer basket – primarily services – in the coming months.

What will be the combined effect of all these dynamics on headline CPI? It’s impossible to predict with any degree of precision. However, base effects imply that year-over-year price growth is very likely to slow down during the quarter, even if the frantic pace of the last 6 months were to continue. And, beyond the simple arithmetic effects, a scenario close to one standard deviation above the historical average appears to be most likely at this stage (Chart 11).

… Overtightening Central Banks?

The big question is whether central banks will be able to raise their policy rates quickly and cool down the overheating economy without triggering a recession. This is a major challenge. Since the 1970s, every time the Fed's target rate rose materially above the market's estimate of the neutral rate, a recession followed soon after. If nothing changes and the Fed follows the path of increases currently expected by the markets, we will find ourselves on the edge of restrictive territory in early 2023 (Chart 12).

While this calls for some caution as investors, it still seems premature to refer to an imminent recession. There is little doubt that the Fed and BoC will bring their benchmark rates to 2% – near the lower bound of the neutral range – in a series of 50-bp hikes by the end of July. However, they are likely to be more parsimonious thereafter, especially if inflation initiates a landing. Moreover, the strength of the North American economies indicates they can weather this monetary tightening, which is critical to long-term price stability. For instance, the impressive excess savings accumulated by households since the start of the pandemic (about $2.7 trillion or 12% of GDP in the United States, Chart 13) should ensure a more than-acceptable level of consumer spending.

Of course, higher interest rates will mean higher debt servicing costs for many households. But recall that, in aggregate, debt-servicing costs in the U.S. are close to a historical low. Debt is a greater source of vulnerability on our side of the border, but its cost as a percentage of disposable income is still starting from a lower level than prior to the pandemic (Chart 14).

At the corporate level, the outlook also generally remains positive. When questioned, a majority of businesses mention inflation as their main problem (as outlined earlier), but they also indicate their inventories are too low and that they intend to invest in capital over the coming months (Chart 15). These trends bode well for the manufacturing sector and overall economic growth.

The Bottom Line

Given the altitude of inflation, the process of getting back to more sustainable levels is bound to be turbulent, and the volatility observed in markets since the start of the year reflects this. However, the intrinsic strength of the economy should allow the business cycle – still relatively young on a historical basis (Chart 16) – to proceed over the next 12 months. By extension, the same applies to the equity market cycle (Chart 17), closely linked to the direction of the economy.

For now, earnings expectations are in line with the historical average, and most recent corporate results suggest this is achievable (Chart 18). That said, there are several risks to this scenario. While the picture remains quite positive in North America, the situation is deteriorating in the euro zone and in China, grappling with significant rises in energy prices and lockdowns, respectively. This divergence has resulted in a sharp appreciation of the U.S. dollar and is adding downward pressure on global growth (Chart 19).

Now, as investors, we must ask ourselves to what extent this uncertainty is already discounted by markets. Everyone has their own opinion, but it is worth noting that the price-earnings ratios of the major stock market indices are now all below their pre-pandemic levels and, for the majority, also below their historical averages. In Canada, despite strong outperformance year-to-date, valuations are even in the bottom quintile of their ranges over the past 10 years (Chart 20) – a sign that a significant amount of risk is already reflected in stock prices.

A similar picture emerges from the most recent surveys of investor sentiment which show the highest level of bearishness in over a decade. Far from being bad news, such conditions are in fact usually a sign that a rebound is on the horizon, provided that the economy holds up (Chart 21).

For bond markets, it all depends on the evolution of inflation and the Fed's intentions. But, for now, U.S. 10-year yields seem destined to cross the 3% threshold and probably even test the 2018 peak near 3.25% at some point this year (Chart 22).

As a result, bonds still face some downside risk, but nothing comparable to the last few months which has been one of the most challenging periods in their history (Chart 23). Indeed, given the sharp rise in long-term yields, the return prospects for bonds are now much more balanced, which should allow the asset class to play its important defensive role in the event of a more pronounced economic slowdown (Chart 24).