No Easy Way

CIO Office National Bank Investments

National Bank Investments

Market Update │ June 2022

Highlights

• The market picture remains bleak in 2022, with the vast majority of asset classes in negative territory year-to-date. The correction in U.S. equities recently approached bear market territory, a phenomenon typically observed in times of recession. Is such a level of pessimism justified?

• First, it should be noted that while economic growth is definitely slowing down in the U.S., the momentum of the economy remains strong, with a robust labour market and high-frequency indicators firmly above their historical average. Leading indicators, which tend to weaken first in times of economic contraction, also suggest that current recession fears are somewhat premature.

• On the inflation front, there are some early signs that a peak may have been reached. The Inflationary Surprise Index has been falling for several months, while market expectations of inflation are now comfortably below their peak of last March. Finally, a certain return to balance is being observed between spending on durable goods versus services, a necessary condition for inflation to normalize.

• That said, there are several key risks that will need to be closely monitored in the upcoming months. First, a sharp slowdown in the housing sector is in sight, following the significant increase in mortgage rates. Strict containment measures in China and soaring energy prices in Europe also represent threats to global growth.

Market Review

Fixed Income

• Following a rough start to the year, May provided some relief for the bond market, with the Canadian universe ending the month just slightly lower (-0.4%). This was still a fifth consecutive month of losses, and Canadian bonds are now down 10% year-to-date.

• Due to their greater sensitivity to interest rates, long-term securities once again underperformed in May, a recurring theme in 2022.

Equities

• The monthly performance of the major North American stock indices (S&P/TSX +0.1%; S&P 500 +0.2%) might lead one to believe that equity markets were relatively quiet in May. The reality was quite different; stocks started out sharply lower, with the S&P 500 even approaching bear market territory intra-day on May 20. Market sentiment then improved significantly and stocks finished strong, bringing May’s total returns back into slightly positive territory.

• In both Canada and the U.S., the energy sector outperformed significantly, supported by rising oil prices. In the U.S., the consumer (both staples and discretionary) and real estate sectors suffered losses on mounting fears of an economic slowdown caused by rising interest rates.

FX & Commodities

• Oil prices continued their significant rise as the European Union approved a gradual embargo on Russian oil.

• After a spectacular start to the year, the U.S. dollar fell slightly in May, pulled down at the end of the month by improving market sentiment (the USD being a safe-haven currency).

No Easy Way

The market picture remains bleak in 2022, with the vast majority of asset classes in negative territory year-to-date (Chart 1).

The past few weeks have been particularly volatile for equities, as evidenced by the S&P 500, which recorded both its best day (+3.0%) and worst day (-4.0%) in two years during the month of May (Chart 2).

Such fluctuations are symptomatic of the significant uncertainty about the future path of the economy in a context of aggressive monetary tightening. The correction in U.S. equities recently came close1 to bear market territory (-20%), a phenomenon typically observed in times of recession (Chart 3).

There is every reason to believe that the tough battle opposing central banks and inflation will continue for quite some time. However, while the possibility of a recession cannot be completely ruled out over the next two years, the sharp decline in equities has prompted us to tactically deploy our excess cash into stocks over the past month. We'll come back to this in the conclusion but, for now, let's review the economic situation and the inherent risks.

A Recession In the Near Future?

First, it should be noted that although economic growth is slowing down in the U.S. - which is essential for inflation to subside - the momentum of the economy remains strong. For example, the New York Fed's Weekly Economic Index, which translates a series of high-frequency measures into an annual GDP growth rate, remains above its historical average (Chart 4).

This reflects, among other things, the strength of the U.S. labour market, where the unemployment rate is near its pre-pandemic low. In the short term, a rise in the participation rate could momentarily push the unemployment rate higher, potentially good news insofar as it would alleviate fears of economic overheating. It would be surprising, however, if this led to an increase of more than 0.33% in the 3-month average of the unemployment rate, a condition that has signaled the start of each of the last nine recessions, without fail (Chart 5).

Of course, we cannot rely on GDP and the unemployment rate to "predict" a recession, as these are coincidental indicators. However, the diagnosis remains much the same for the Conference Board's Leading Economic Indicator (LEI), whose objective is to aggregate all measures that tend to decline first (leading indicators). Historically, a 2% decline in the LEI has translated into a marked increase in the probability of recession over a 1-year horizon, but we are not there at all (Chart 6).

Finally, the yield curve inversion – arguably the most advanced indicator of recession risk of all – is not in the danger zone either (Chart 7).

In this regard, we favour a measure that aggregates all possible inversions instead of looking at just one (e.g., the inversion of 10-year and 2-year rates). This allows us to follow the evolution of recession probabilities, which had actually increased in April when several inversions were observed between the 3-year and 10-year maturities, without ever exceeding the critical threshold. The yield curve then steepened in May, leading to the disappearance of the vast majority of inversions, suggesting a low risk of recession in the near future.

That said, a word of caution is in order. Although traditional recession indicators are not in the red, the situation could quickly change, especially if the Federal Reserve openly seeks to move its monetary policy into restrictive territory. Recall that over the past 50 years, a recession has always followed the Fed's effective rate moving above the neutral rate. For the moment, the bond market does not seem convinced this is necessary, but the margin is very thin (Chart 8).

Nonetheless, there are some early signs that inflation could slow in the upcoming months, suggesting that the peak may have been reached. If this scenario were to materialize, fears that the Fed would eventually have to adopt a restrictive monetary policy would certainly subside.

Inflation…

As expected, after seven consecutive months of rising annual inflation, the U.S. Consumer Price Index (CPI) finally recorded its first decline last month. While base effects should favour a decline for another two months, the details of the report show that the return to lower inflation levels will not happen overnight, with monthly price growth remaining about one standard deviation above its historical average (Chart 9).

Fortunately, more and more indicators suggest we may have seen the peak in this regard. For example, the Inflation Surprise Index continues to distance itself from its August 2021 height, signifying that the numbers, while still very high in absolute terms, are not as elevated when compared to forecasters' expectations (Chart 10).

A similar trend can be seen in market inflation expectations. Over the medium term (next five years), expectations are down sharply from the highs reached during the worst of last March's commodity price hike. Over the longer term (the subsequent five years), inflation is also projected to be on the decline but, more importantly, remains consistent with the Fed's target (Chart 11).

Going forward, a key element to watch will be wage growth, as wages are an important source of upward pressure on prices, particularly within the services sector. The latest NFIB survey results on labour shortages among small businesses, while very tentative, suggest that a peak in wage growth may be in sight in the upcoming months (Chart 12).

At the same time, it will be important to monitor household consumption trends. Recall that one of the many side effects of the pandemic and lockdown measures was to cause demand (and therefore prices) for durable goods to explode at the expense of services, a phenomenon that is partly responsible for the current inflation problem.

Therefore, normalizing inflation will necessarily require a return to balance between spending on goods versus services. This does indeed seem to be happening, quietly but surely, according to the latest personal consumption expenditure figures (Chart 13) and the latest results from major U.S. retailers such as Target:

Target CEO Brian Cornell said customers were buying fewer big items such as bicycles, TVs and kitchen items than in the past two years. Shoppers are “moving from buying small kitchen appliances and maybe replacing that with gift cards to restaurants and entertainment as they return to a more normalized lifestyle,” he said. Wall Street Journal 3

… and Other Inherent Risks

Beyond the inflation issue, there are three other key risk factors meriting particular attention in the upcoming months. First, the real estate sector is about to undergo an important test of resilience given the magnitude of interest rate hikes observed in the past months. For example, in the U.S., 30-year mortgage rates (the main barometer for mortgage financing south of the border) have risen more than 200 bps in just one year, the highest annual increase in 25 years. However, as discussed last month, U.S. household finances are in excellent shape, which is a fairly significant mitigating factor. Still, the real estate sector, which is highly sensitive to interest rate movements, is bound to slow down eventually (Chart 14).

Next, the strict lockdown measures in China – particularly in Shanghai – also pose a threat to global growth, as well as to the normalization of supply chains. Fortunately, the stringency of the restrictions finally appears to be easing (Chart 15), while Beijing continues to announce fiscal support measures.

Nevertheless, the risk of further closures will remain as long as policymakers maintain their zero-COVID approach. In addition, the negative impact of the shutdowns on the Chinese economy (second only to the U.S. in size) is becoming increasingly evident (Chart 16).

Finally, recession risk remains significantly higher in Europe, where rising energy prices could reach a critical threshold in the event of a disparate cut-off of energy flows with Russia. Moreover, the gradual embargo on Russian oil recently agreed to by European Union leaders will do nothing to help with the current bout of runaway inflation on the Old Continent (Chart 17).

The Bottom Line

Fundamentally, the economic and geopolitical situations remain tense and the risks of a pronounced economic slowdown are not negligible. However, based on the strength of the labour market and a host of leading indicators, it still seems a bit early to be talking about a U.S. recession. In any case, a significant portion of the bad news already seems to be discounted in current stock prices, so the risk/reward ratio of major stock markets are now much more attractive.

It is important to put into perspective the magnitude of the relative outperformance of cash in recent months. Against equities, only the financial crisis of 2008-2009 saw cash continue to generate value for several months after such outperformance. Against bonds, the last six months have been the best for cash since 1994, when its outperformance stopped at levels similar to those seen today, as well as back in 1990, 1987, 1984, and 1982 (Chart 18).

The latter finding is consistent with what we said last month: the outlook for bond returns is much more balanced now that 10-year yields are near their 2018 highs, provided the Fed does not adopt an even more combative tone against inflation (Chart 19).

In terms of valuations, the price-to-earnings (P/E) ratios of the main indices are all well below their pre-pandemic levels (Chart 20). In Canada, the P/E ratio of the S&P/TSX is even one standard deviation below its 30-year average (Chart 21).

From a fundamental perspective, it is likely that earnings expectations will eventually be revised downward in light of the severe pressure on profit margins. Nonetheless, the downturn in stock prices seems relatively disproportionate to what is ahead (Chart 22).

Moreover, despite all the current uncertainty, the earnings growth outlook for North American equities for 2022 and 2023 has actually been revised upward since the beginning of the present year (Chart 23).

Finally, on a technical basis, our Market Sentiment Indicator reached the extreme pessimism threshold in the middle of the month, a first since the March 2020 panic episode at the start of the pandemic (Chart 24).

Over the past 15 years, 1-month S&P 500 returns following such a signal were positive 80% of the time, and 4.2% on average. Over three months, it was positive 85% of the time, with an average gain of 8.5% (Chart 25).

Of course, there is no guarantee that history will repeat itself in our current unique economic environment. Nevertheless, beyond high volatility that is likely to continue for quite a stretch, the balance of risks suggests this is not the time to panic – quite the contrary.