April 20, 2022
There’s no doubt that the first quarter of 2022 was monumental on many levels. From a surging omicron wave, a full-on war in Ukraine and inflation soaring to levels not seen in four decades, the global economy and markets continued to be battered by one major exogenous shock after another. All this comes on top of, and somewhat related to, the confusion surrounding a global economy trying to normalize following pandemic-related shutdowns, attempted economic reopening and the impact from unprecedented fiscal and monetary policy responses. It would be a significant stretch of the imagination to claim that this is a “normal” economic or market cycle. There is nothing normal about the current environment. This isn’t to imply that there are no lessons to be learned from past cycles, but rather that we must recognise the much greater uncertainty surrounding the current environment and, hence, a lower degree of confidence in any expected outcome.
In our 2022 outlook, “Into the Omi-verse: Wash Rinse Repeat,” we forecast a strong U.S.-led global economy, with U.S. economic growth expected to slow toward a still very robust 4% from the 5.5% pace of 2021. The key drivers for the U.S. economy would be the consumer, where strong household balance sheets, along with robust job and wage growth, would underpin the ongoing reopening boom on the back of pent-up demand for many service-oriented sectors of the economy. Corporate capital expenditures would also play an important supporting role. With strong GDP growth, unemployment below 4% and elevated inflation, it was clear that the U.S. Federal Reserve (Fed) would continue along its hawkish pivot to accelerating their exit from extremely accommodative monetary policy. Interest rates of zero made no sense given the robust economic backdrop entering 2022. We highlighted that we saw the two biggest risks being (1) the path of inflation and resulting Fed response; and (2) escalating geopolitical risks, including Russia.
Our decision to reposition portfolios to a more neutral equity weight, from overweight, was largely premised on the expectation that markets had yet to reprice the risks of a more aggressive Fed shifting policy rates from zero back toward a neutral setting as quickly as possible. With the S&P 500 Index entering the year at record highs, we saw only limited upside along with more volatility as policy normalized. As is usual at the start of a tightening cycle, equities were still expected to outperform other asset classes, but with more modest returns and higher volatility. Hence our message of “Curb Your Enthusiasm”.
Re-pricing the Fed
Now, three months later, much of that forecast, and then some, has already occurred. Leaving aside the Russia-Ukraine war for now, the more significant market driver has been the repricing of the Fed’s expected policy path. Entering 2022, bond markets were pricing an expected three interest rate increases in 2022. Today that number is eight or nine, along with a more aggressive path for quantitative tightening (QT), or the shrinking of the Fed’s balance sheet. As one of the Fed’s most aggressive policy-path repricing initiatives, it has driven up the entire yield curve, with two-year yields rising from 0.75% to 2.5%, and the 10-year going from 1.5% to 2.7%, well past immediate pre-pandemic levels. For now, the bond market has fully priced in a move in policy rates back to neutral. The market has already done the Fed’s job of raising rates and, to the extent that a return to a neutral Fed Funds rate of 2-2.5% is the appropriate level (very uncertain, and not a forecast), then the biggest shifts in the bond market may be behind us. While it was a negative quarter for most equity markets, including the U.S. (-4.6%), their ability to withstand the very aggressive bond market repricing has been pretty impressive so far. Although to be fair, there was considerably more damage to individual names and sectors beneath the surface, with many of the more speculative highflyers down 50-75% over the past year.
Three questions to consider
Looking forward to the remainder of 2022 and having priced a return to neutral, the rate shock is now behind us. The questions become whether persistent inflation will force the Fed to continue tightening significantly beyond neutral, whether the degree of tightening already in play will cause a more significant economic slowdown to a below-trend (2%) pace, and for equities, does the strong pace of nominal GDP growth translate into stronger-than-expected earnings growth to support current valuations and further upside gains from current levels? Let’s address each of these three questions in turn.
1: Fed policy
The Fed has made clear that with robust GDP growth, inflation far above target and unemployment below 4%, they want to get rates back to neutral as soon as possible. That path forward is now priced in and should not be problematic for markets. In effect, the Fed has a “free pass” for the rest of 2022 to get back toward a neutral range of 2-2.5%. Assuming the Fed reaches neutral towards year-end, we will have better clarity by then regarding whether their next steps will be further tightening relative to current pricing, or taking a pause to see how the economy and inflation are adapting to the shifts – bearing in mind that policy moves tend to work with long lead times. Since the Fed has also recommitted to doing what is necessary should inflation not roll over and start heading back toward their 2% target, the path of inflation remains the biggest risk for markets. Another unknown will be the Fed’s QT program as they attempt to run down the size of their balance sheet. This needs to be monitored mostly because we have very limited experience with QT as a policy lever and no one really knows how it may or may not impact markets. It’s likely not a massive concern, but given the undefinable nature we remain vigilant to potential unintended impacts.
As mentioned in the 2022 outlook, inflation is tricky. Inflation was already proving more resilient than expected coming into the year as supply-chain bottlenecks, policy-enhanced pent-up demand for many goods and curtailed labour supply were all straining the concept of “transitory” inflation. Nevertheless, given base effects and “un-bottlenecking” of supply chains, inflation was expected to peak and roll over right around now (April/May), and start trending down towards target. To the extent that inflation stops increasing and begins to subside, it would ease pressure on the Fed to continue escalating their hawkish rhetoric as well as easing broader inflationary fears. Then along comes the Russian invasion of Ukraine and spiking prices for energy and commodities (liquified natural gas, grains, etc.). With oil above US$100 and gas prices rising as well, headline Consumer Price Index figures are getting a big boost and the inflation outlook has become substantially more complicated. Inflation will now spike higher and last longer than was anticipated before the conflict in Ukraine. This dynamic has already played into increased hawkishness from the Fed and other central banks like the European Central Bank and Bank of Canada, so it is partially discounted in markets. However, it clearly has the potential to continue pushing inflationary pressures higher and would be a key driver of a Fed path for rates that ultimately heads well above neutral.
Many forecasts already expect the Fed to push rates above 3% in 2023, only to then reverse course as ensuing recessionary pressures would help bring inflation back down through the destruction of demand. Essentially, it’s an expectation of a mini 1970s Volker playbook. We are not there yet. While such a path is possible, there just isn’t enough clarity in our crystal ball to be so definitive on events that are still likely nine to 12 months out. There’s plenty of time for us, as well as for policymakers, to digest incoming data over the coming months before jumping to 1970s types of conclusions. Keep in mind that six months ago markets expected only one rate increase in 2022. With hindsight that was clearly way off base, now they expect nine increases. Believe me, in another six months the views will also have evolved significantly – hence, the need to remain humble and flexible in our outlooks.
2: Recession watch
With parts of the yield curve (2s-10s) recently inverting, the kneejerk cries of impending recession became deafening. But let’s all just take a deep breath and calm down. While there are strong correlations between inverted yield curves and subsequent recessions, there are a few big caveats to consider. First, there are many different yield curves that come into play and most are not inverted. Second, there is usually a significant lag between inversion and the onset of a recession that tends to be measured in years and not months. Even most of the voices calling a recession are looking at late 2023 or into 2024. As mentioned above, given the unprecedented levels of uncertainty related to repeated exogenous economic shocks, the ability to forecast 18+ months with any degree of certainty is a skill we just don’t have.
Rather than relying on a Pavlovian type of correlation reaction to the brief curve inversion, it’s better to try and assess what might be the underlying fundamental drivers of a potential slowdown or recession. The U.S. economy is still roaring ahead as the reopening trend continues to unfold, driving robust growth in jobs and wages. Household income remains strong, as do balance sheets owing to past savings, government transfers and wealth effects from buoyant housing and equity markets. It will take more than a headwind from elevated gas and food prices to stall that momentum. So, growth will slow more than previously anticipated, but is unlikely to drop below 3% in the coming year. The same holds true for a measured rise in interest rates. The risk of tipping into a recession would arise if interest rates continued to push well beyond the neutral rate, either because of a misreading of inflation drivers by the Fed (policy error) or if inflation does truly become entrenched to the extent that the Fed continues to tighten aggressively to deliberately curtail demand and slow the economy below potential.
Both paths are possible, but also remain very data dependent, with the key question being will inflation roll over sufficiently before the Fed is forced to tighten beyond the point of no return? Keep in mind that the economic impacts of policy tightening continue to unfold with a lag that could extend a couple of years. In that sense, the most interest-rate-sensitive aspect of the economy will be the housing market. With 30-year mortgage rates now up in the 5% range, new housing activity and refinancing activity will already be hit hard. How it plays out versus a still-strong supply/demand backdrop is an area we’ll be watching closely. Bear in mind that the U.S. mortgage market tends to be one of 30-year fixed rate, so existing mortgage holders do not face the same degree of refinancing shock to higher rates as in Canada, where we tend to rely on variable rates or five-year fixed. Accordingly, Canada faces a significantly higher risk of a shock from rising rates hitting households.
3: Earnings outlook
The third fundamental question for equity investors pertains to the outlook for corporate earnings. Will they continue to rise at the roughly 10% pace currently expected in 2022 and 2023, or will they disappoint? Based on expected earnings, global equity valuations appear reasonable. But that does require companies to deliver on earnings, and fortunately we will continue to get regular quarterly updates to track their progress! Since the start of the year, earnings forecasts for the S&P 500 have continued to trickle higher, despite all the headline angst. Underpinning the ongoing earnings growth is a still-robust economy, keeping in mind that one person’s inflation is another’s welcome price increase! The ability for a company to pass on price increases is very important from a stock selection perspective. In a more inflationary environment those price increases, coupled with the impact of operational leverage over fixed or historical cost components, tend to be supportive of corporate margins. Ultimately, earnings are a nominal and not a real number, and if the economy grows at 3.5% real with 3.5% inflation, that is 7% nominal economic growth – a very healthy backdrop for companies with any degree of pricing power. Overall earnings growth is returning to earth from last year’s inflated levels following the economic recovery as the pandemic began to wane. So long as companies can deliver even modest growth, it should be supportive of current market levels. It's when earnings roll over that markets tend to correct. That is not the current expectation, but earnings are an area we watch very closely.
Markets and Positioning
While most of the shocks in the first quarter could be characterised as negative shocks for the markets, we are now discounting a lot of negative news. We see two potential positive catalysts that could occur, relative to current hawkish expectations. One would be a rolling over of the inflation numbers in coming months as the weakness from base effects will still unfold and could be sufficient to offset the extra boosts from energy prices. The second catalyst would be an easing of hostilities in Ukraine. I’m not a war expert and the current conflict is a shocking geopolitical, social and humanitarian disaster of epic proportions. But an accurate read of battlefield and behind-the-scenes developments is never likely in wartime. Accordingly, surprises (both negative and positive) tend to be the base case. My sense today is that most people are more prepared for negative developments and, hence, a potentially favourable development (unfortunately not a base case, though) could be a positive catalyst.
For now, we continue to see 2022 as a “sideways grinding” year in equity markets as an improving and healthy economy shakes off the reliance on counter-cyclical economic policy support, both fiscal and monetary. It’s time to exit the economic ICU, so to speak, and stand on our own. But we have only just exited the ICU, which makes it too soon to call for a relapse into recession, even if markets may miss the policy “drug-induced” highs. Without the policy drugs, progress may be a little slower and a little more volatile, but we still expect both the economy and markets to adapt to the current policy stance and progress forward from current levels.
I stand by my January 2022 outlook, where I wrote:
“Overall, we expect 2022 to be a good, not great, year for equity markets supported by still favourable earnings growth while bonds continue to lag in the face of rising rates. In the U.S., with both GDP growth and inflation above trend, we see strong nominal GDP growth in the 7% range. This will be a very favourable backdrop for earnings, which are driven by nominal rather than real growth. As in 2021, I expect earnings to continue to beat current estimates and expect 10%+ growth in 2022. For the S&P 500, EPS should reach 230 in 2022, and 250+ for 2023. Last September I suggested 5,000 on the S&P made sense by end 2022, and with earnings continuing to beat expectations that target is achievable with even a little upside toward 5200. But with the S&P ending 2021 at 4766, that only leaves an expected 5-10% upside for 2022. Good, not great, but certainly the best expected return amongst major asset classes. Along with an expected modest return for equities we also expect a much bumpier ride as shifting monetary policy impacts market liquidity. 2022 is a year for cautious optimism and tactical opportunities. This is not the stage of the cycle for all-in optimism but nor is it time to be fearful.
Within our CI Global Income and Growth Fund we moved our equities exposure to neutral from overweight at the end of 2021, we remain underweight government bonds and overweight cash. The rise in cash in December came from taking equities down to a neutral 60% weight as uncertainties around the rise in Omicron, equities at record highs and the shifting Fed policy pivot were all cause for increased caution near term. We expect to have opportunities to selectively redeploy back into equities in coming months.”
As they say: “Plus ça change, plus c’est la même chose.”
For the CI Global Income & Growth Fund, with the selloff in both equity and bond markets during the first quarter, we increased our equity target back to a modest (62%) overweight, as well as increasing our high-yield credit exposure by two percentage points, to 15%.
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Published April 20, 2022