May 31, 2022
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June 2022 Market Update
CIBC WOOD GUNDY
June Market Update 2022
The markets have continued to deteriorate since my last market update. Many cyclical patterns had pointed to a market bottom in March of this year. Larry Williams, for example, the long-time Wall Street market trader and technical analyst had suggested we would see a bottoming around this same March timeframe. Clearly that has not happened.
In fact, the S&P500 index had dropped to 4173 by March 14th, then rallied to 4631 by March 29th, a rise of 11%. But worries about the pace of Fed rate hikes and raging inflation caused investors to sell and markets rolled over, declining to a low of 3810 by May 20th, a decline of 20% from the January high.
So how do we assess the state of affairs at this moment? Perhaps more than any year in recent history, the markets are clearly struggling with multiple major global economic and political issues. Lingering affects of Covid-19 in China have led to further shutdowns in major cities, exacerbating supply chain disruptions. On February 20th Russia invaded Ukraine, roiling global markets. But trumping all these concerns is the relentless rise of inflation, which continued to rise in March to new all-time highs in the US, Canada and many other countries around the world. The Fed responded with a heightened sense of urgency, declaring its intention to take a much more aggressive approach to tackling inflation, shaking investor confidence and prompting more selling.
It is now clear that the pace of inflation and central bankers response, in the US, Canada and globally, will dictate how the markets will perform the rest of this year. It is also clear that interest rates will be significantly higher by the end of the year, with the bond market signalling Fed funds rate in the 2.50% range by year end (currently at 1.0%). Whether this will be sufficient to cause inflation to moderate is still unknown, but increasingly it is becoming apparent that we will be living with significantly higher inflation in the near and medium term, than we have seen in many decades.
We also know that consumer spending is holding up well so far this year. Personal spending in the US increased 0.9% month-over-month in April of 2022, following an upwardly revised 1.4% rise in March and beating market forecasts of 0.7%, in a sign consumption remains robust despite rising prices. There was widespread spending across goods and services, led by motor vehicles and parts, food services and accommodations as well as housing and utilities while spending on gasoline and other energy goods decreased. Adjusted for changes in prices, purchases of goods and services increased 0.7%, higher than 0.5% in March.
However, once consumers have had their summer vacations and enjoyed spending time outside their homes, and their pandemic savings dwindle, the reality of higher costs for just about everything will start to bite, causing consumption to decline. Central bank rate hikes take six to nine months to be fully reflected in consumer behavior, so the rate hikes we are seeing now will be in full display by the fourth quarter, and future rate hikes will have their full impact into 2023. That’s why many economists and money managers are forecasting an increasing likelihood of a recession in 2023. With consumer spending responsible for two-thirds of US GDP, it’s easy to see why.
Some might argue that with US unemployment at all-time lows, and 11 million job openings right now, it will be difficult for a recession to take hold. Canada likewise has a record low unemployment rate and lots of unfilled jobs. But with inflation running at 5 to 6% annually, and wage increases unlikely to keep up, most consumers are facing income shrinkage in 2022 and again in 2023, with the middle and lower income earners facing the greatest challenges. Whether we actually see a recession or not may not really matter, because when consumers decrease their spending, it will impact the markets negatively, and that’s all that really matters to investors.
So how concerned should investors be about inflation in the medium or longer term? Firstly, we are clearly seeing wage pressure resulting from labour shortages. This is partly due to Covid-19 induced resignations, re-evaluation of work-life priorities, decades of families having fewer children, and a lack of sufficient immigration to compensate for our ageing population and increasing retirement rates of workers. There are no easy or quick fixes to this problem, so we can expect to continue to see employers having to compete more aggressively to get and keep workers, meaning wage inflation could continue. Secondly, energy and commodity prices are rising as demand continues to increase each year yet there has been little or no investment in new sources of commodities in a decade. It takes between 5 and 15 years to bring on a new mine or major energy project, and there seems to be little political will or investor interest in seeing capital deployed in such a manner. Rather, commodity miners are rewarded for reducing debt, raising dividends and buying back shares in response to ESG concerns from the investment community globally. So, we should expect higher commodity and energy prices to continue until there is the political will to change.
Thirdly, trade globalization has been a tremendous driver of lower costs since the 1980s, ensuring inflation rates for goods stayed low or even negative. But Covid-19 has shown just how fragile our global supply chains have become. Governments and businesses around the world now realize the importance of having multiple supply sources for manufactured goods, as protection against political instability and natural disruptions due to climate change and health pandemics, for example. This new trend towards on-shoring and redundancy of supply chains will create higher costs and will be inflationary long term.
Fourthly, the rise of China as an economic challenger to US dominance will have significant effects on trade in the future. China’s stance on human rights and economic freedom will put them on a divergent path from western nations, limiting further global trade efficiencies, and adding costs. The recent decision by the Canadian government to ban China’s Huawei network equipment in Canada is a good example. We are only now starting to come to grips with all these major changes and its negative impacts on inflation in the future. Once the inflation genie is out of the bottle, it may be much harder to put it back, as 1980’s Fed Chair Paul Volker so famously said.
So far, the markets do not seem to have priced in a recession. Goldman Sachs estimates the chances at 35%- Other US banks say 50%. Earning estimates for the S&P500, a good indicator of the strength of the US economy, started the year up 8% and have been revised up since the beginning of the year. But stock analyst estimates are a lagging indicator and more typically are revised lower as the year progresses and rosy forecasts face economic realities. Should the consumer begin to pull back their consumption as rate hikes take hold, it’s possible that this summer could bring a new round of earnings revisions lower. This would create higher stock market multiples, and prompt lower stock market prices.
So, will the Fed come to our rescue if the market starts to roll over, as they have so often in the past? This time it seems the answer is no. Given the record high levels of government and consumer debt in some geographies, there is a limit to how high rates can go to fight inflation. Conversely, the Fed can’t lower rates to save a faltering stock market or economy as it must keep rates higher to at least partially combat ongoing inflation. Essentially, the Fed and Bank of Canada are stuck with maintaining a higher rate environment. The “Fed Put” appears to be off the table, at least for the short term.
How should investors be positioned? With a future looking increasingly like it’s headed towards a “stagflationary” world, there are examples in the past that can provide insights into what investor portfolios should look like to best navigate a path forward. Both in the 1970s and early 2000s, commodities and energy stocks acted as a natural hedge against inflation. The energy sector in particular was the best performing during these periods, as it is again this year. Other commodities in an increasingly commodity-scarce world include copper, aluminium, nickel and lithium. These materials will be increasingly important in the new green economy as we transition to an electrified grid and more battery powered vehicles and clean energy sources. Dividend paying, high quality stocks with strong cash flows and the ability to pass on costs to their consumers also look attractive; the healthcare sector is an example. Financials will be a mixed bag for investors but will fair better than most sectors as long as we avoid recession. Value will out-perform growth.
The market is now trying to decide if we will have a recession in 2023. Some seem to think so, although economists are divided about this, as they are about most things. Larry Summers, former Treasury Secretary, economist, and Harvard President, correctly identified the risk of rising inflation a year ago. More recently he noted there has never been a instance when the US has had unemployment below 4% and inflation above 4%, that we did not have a recession within 2 years. No one can say with certainty. But investors are faced with a number of significant challenges in 2022, and the very real possibility of more bad news to come. The best course of action is to prepare for the possibility of a mild recession in 2023, rather than wait to see how it plays out, at which point it will be too late to react.
As always, if you would like to talk about anything mentioned in this letter, or would like to review your portfolio in light of the inflationary cycle we are now in, please call or email me. We would be happy to arrange an in-person meeting (or via telephone or virtual) to review your portfolio, or discuss any matter related to your financial well-being.
Gordon Forsey | Portfolio Manager, Senior Wealth Advisor | CIBC Private Wealth
1801-1969 Upper Water St., Halifax NS B3J 3R7 | Tel: 902-420-6203 | Toll Free: 1-800-565-0601
Email: gordon.forsey@cibc.ca
Gordon Forsey Advisory Group:
Gordon Forsey P.Eng., MBA, CIM, FCSI
Portfolio Manager, Sr. Wealth Advisor
Tel: 902-420-6203
Andreas Demone BBA
Client Associate
Tel: 902-420-9624
Terri MacPhail
Client Associate
Tel: 902-420-8263
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