January was a very difficult month for global stocks and bonds alike, as both asset classes fell in response to the prospect of higher borrowing costs; as central banks turn their attention to battling inflation now that full employment has been achieved.  

 

While this likely produced a few attention-grabbing headlines like “stocks post worst month since the pandemic began,” the impact to diversified portfolios has been relatively limited and this process has really been underway for several months. The strong performance of large index weights in North America like Apple, Microsoft and the Canadian Banks have masked what has been a very difficult period for stocks generally. Over the past 6 months, the average U.S. stock has witnessed a peak to trough draw down of -18.7%, including sharp declines by household names like Facebook (now Meta Platforms), Tesla, Netflix and Shopify.  The average stock in the tech-heavy Nasdaq has declined by a staggering -46.6% (Source: JP Morgan, US Equity Strategy, January 26, 2022).  And more speculative areas of the market like SPACs, IPOs and Bitcoin entered formal correction territory (a 20% peak to trough decline) much earlier in the year (March – May of 2021).

 

In short, while unpleasant, the past few months have highlighted once again that diversification does indeed work, and that quality earnings growth and valuation does indeed matter. 

 

The good news is that many stocks are already in territory we would normally experience during a recession, though this is happening when economic conditions are improving and a recession is not an immediate threat.  And while bonds have fallen modestly in value in response to rising rates, they have maintained their role as key portfolio diversifiers while offering an opportunity to lock in higher rates of return for the lower risk component of portfolios.

 

Admittedly, the next few months won’t be a cake walk.  A conflict in the Ukraine would push energy prices higher at a time when consumers are already feeling pressure from rising food and energy prices.  This could force central banks to tighten whether they wanted to or not. The show of unity at the Olympics between Russia’s Putin and China’s Xi where they called on NATO to halt further expansion has ominous implications for China’s aspirations towards Taiwan and beyond.  Omicron’s impact is being felt in supply chains and corporations are feeling the pinch from a tight labour market, pressuring margins and dampening the outlook.  And higher short rates usually dampen the pace of global growth. 

 

However, we would argue that a lot of this bad news is already “priced in,” creating a better set up going forward.  Valuations have returned back to long term averages after spending most of the past two years well above average, and in some cases have become much cheaper than their long term averages, which increases the odds of better returns going forward.

 

It’s easy to become discouraged by market corrections, but we remind you that they are a normal part of investing and the reason an “equity risk premium” (the additional compensation received for investing in stocks) exists in the first place.  If you’re tempted to throw in the towel, consider this:

• Valuations have normalized. The MSCI World Index, the recognized benchmark for global stocks, currently trades for 20.9x trailing earnings, well below its peak of 33.2x earnings at the end of 2020, and right in line with its average valuation since 1995 of 21x. (Source: Bloomberg)

 

• Some markets are outright cheap for the first time in decades.  While U.S. small cap stocks were trading well below their long term average of 19.9x earnings for most of 2021, the U.S. small cap S&P 600 Index is now trading for 14.2x earnings, a level not seen since 2003. 
   
• Corporate earnings remain robust.  We’re about halfway through U.S. earnings for the quarter, and 76% of reporting companies have beaten estimates by 7%. Meanwhile, analysts’ estimates for 2022 earnings have actually increased since the beginning of this earnings season, reflecting generally upbeat guidance from the corporations they cover  (source: JP Morgan Global Data Watch, Feb 4, 2022)
   
• Speculation has beat a hasty retreat.  Broad measures of investor sentiment such as the AAII survey and the put/call ratio are at levels last seen during the depths of the market in March 2020.  Meanwhile, institutional investors are positioned defensively, which usually skews risks to the upside.
   
• Tighter central banks do not (always) lead to bear markets for stocks.  Balance sheet tightening by central banks does not necessarily lead to negative stock market returns.  JP Morgan put together the graphic below highlighting how U.S. stocks reacted to various tightening and loosening cycles over the past 15 years.  The best market performance occurred during periods of “quantitative easing,” followed by a tapering of this easing, and then followed by “quantitative tightening.”  Admittedly, there were short periods of volatility like the one we just witnessed, but they too passed. 

 

• Not every central bank is tightening.  Of note, the central banks of China and India, two key Emerging Market economies and large drivers of global growth, are both loosening policy or holding at current levels in efforts to stimulate their economies.
   

The bottom line is that, while risks to the outlook remain, we are coming off of one of the best years of economic growth since the early 1980s at a time when the biggest headwind to that growth, Covid, is most likely receding into the rearview mirror.  While unpleasant, the market has quickly recalibrated their growth expectations in light of rising borrowing costs.   There are no signs of distress that we would normally see at the beginning of a more profound downturn (eg. Wider credit spreads, inverted yield curve, etc).  We expect the market will pick itself up, dust itself off, and get back to doing what it has done for decades: making money into more money.    

 

 

 

 

 

 

 

 

This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2022.

Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.