Mid-Year Outlook

 

The first half of 2022 is one that most investors would like to forget.  As illustrated in the table below, there were few places to hide over the past six months, with both stock or bonds declining in the double digits, and cash returns being eroded by high levels of inflation.

 

(Source: Bloomberg.  Canada = S&P/TSX Composite, U.S. = S&P 500 C$, Developed International = MSCI EAFE C$, Emerging Markets = MSCI EM C$, Canadian Bonds = FTSE Canada Universe Bond Index, Cdn Corporate Bonds = FTSE Canada All Corporate Bond Index, Corporate High Yield Bonds = BofA Merrill Lynch U.S. High Yield Master II Index CAD$)

 

While sobering at first glance, even after this decline, most global stock markets have still compounded at 8-10% rates over the long term (10 years).  Bonds have delivered lower historical returns, but with current yields in the 4-6% range are in a position to deliver higher returns going forward.

 

With both stock and bond markets well into “bear market” territory (a decline of 20% or more), it is natural to ask:

• What caused this?
• Are we nearing a bottom?
• What will prompt a recovery?
• What are we doing?
   

What caused this?

 

While it is easy to blame the market declines on the tumultuous geopolitical backdrop (Putin’s invasion of Russia, the lockdowns in China, the rising tensions and gun violence in North America, etc.), the underpinnings of this correction are a lot more boring.  So bear with us.

 

After more than a decade of inflation averaging about 2% in most developed economies, the change in the Consumer Price Index (CPI) quadrupled in just over a year to its highest rate in over 40 years.  Central banks have two jobs: to ensure full employment and price stability.  With unemployment running at multi-decade lows, they turned their attention to ensuring price stability.  Nobody wants a repeat of the double-digit inflation of the 1970s, and the painful actions that central banks had to take to stop that cycle.  Paul Volcker, the President of the U.S. Federal Reserve, raised the benchmark borrowing rate from 11% to 18% from 1979 – 1980, triggering the painful recession of 1980, and then again from 9% to 20% in the fall of 1980, triggering the recession of 1981.  Central banks are taking incremental actions now to avoid painful actions later.

 

While the central banks are right to prioritize fighting inflation, investors are in the uncomfortable position of seeing increasing warning signals of a slowdown in growth without the comforting signals of a slowdown in inflation.  The hot housing market has cooled off, companies are starting to slow their hiring, and consumer and business confidence has plunged.  History tells us that 70% of rate hike cycles end in a recession, and when the yield curve inverts as it did in April and again in June, the odds of a recession are even higher.

 

As a result of the deteriorating economic backdrop (weaker growth, higher inflation and interest rates), investors have lowered the valuations they are willing to pay to own stocks.  The price to earnings multiple on the S&P 500 started the year at 21.5x and declined to 16.1x by mid-June, driving the bulk of the price declines in the stock market.  Global stocks followed suit.

 

 

Are we nearing a bottom?

 

This is difficult to answer, because each market cycle is different.  Our current view is that while most of the damage has been done, and many markets are already pricing in a slowdown that is by no means a foregone conclusion, it is still too early to have confidence that we are poised for a sustainable turnaround. 

 

First, the primary driver of the market correction has been valuations, while earnings estimates have remained firm. This does not strike us as sustainable given deteriorating economic conditions.

 

Second, while there are early indications that inflation is waning, central banks will need to see clear declines in inflation, and perhaps an increase in unemployment numbers before they pivot and start cutting rates.

 

 

What will prompt a recovery?

 

The stock and bond markets tend to “price in” economic downturns before they happen.  Likewise, these markets start to bottom and recover well before the economy does.  This is why the tempting strategy, given what we have written above, of “moving to the sidelines until the coast is clear” often backfires.  Stocks recover well before anyone feels “comfortable” wading into the market.  And avoiding the worst days also raises the odds that you miss the best days in the market.  From 1993 – 2021, if you missed the best 5 days in the market, you only achieved 61% of the total return you would have enjoyed if you remain fully invested (source: Fidelity, Refinitiv).  Sometimes the best course of action is to hold tight and ride out the storm.

 

With that said, we expect the following to underpin a sustainable recovery. 

 

First, we need to see clear evidence that inflation has peaked and is heading back down towards long term trends (2-3%). 

 

Second, we need clarity on how high central banks will raise interest rates.  Currently, the market is expecting the Fed funds rates (the benchmark borrowing rate) to peak at 3.8% in April 2023.  The market has already “priced in” an additional 1.25% in short term interest rate increases if the Fed proceeds with its 0.75% rate hike on July 27, as expected. If rate expectations start to fall, then we expect the market will begin to “price in” an eventual recovery.     

 

Third, we need earnings estimates to come down.  Right now, the market has, with a few notable exceptions, too rosy an outlook given the economic backdrop.

 

 

What are we doing?

 

As always, we are looking for the businesses, segments of the market and strategies that we expect to deliver attractive returns going forward in the recovery to come. We are also fine-tuning portfolios to deliver returns that meet your objectives without taking undue risks.  While uncomfortable at the time, market corrections like we are experiencing offer exceptional opportunities to achieve both of these tasks.  For example, we haven’t seen GIC yields in the 4-5% range, and a broad selection of stocks across industries with free cash flow yields in the 5-10% range in several years. 

 

Most importantly, we are touching base with you to address any concerns you may have, to see if anything has changed in your circumstances that would force us to alter you long-term plan, and to remind you that, while displeasing in the short term, corrections like this provide a set up for better returns going forward.

 

There are many reasons to avoid investing at this time, whether it’s in real estate, private equity or the public markets like stocks and bonds.  We are living through strange times.  The lockdowns of the past few years have all weighed on us to the point where a headline or drop in the markets can trigger an emotional response.  The 24 hours news cycle and social media barrage doesn’t help.  At our essence, we are human animals who want the best and fear the worse.  While we know that keeping our emotions in check is essential to achieving our goals, periods like this can test our fortitude.

 

With that in mind, it is important to keep perspective, so we wanted to leave you with these thoughts:

• We are fortunate to live in a safe part of the world with abundant resources at our disposal and a highly educated and skilled population. Many, many others are less fortunate, and are striving to do better with much less.  We should think about what we can do to help and be mindful that their aspirations to live lives like we do will drive the global economy for decades to come.
• As bad as things are, our parents and grandparents (and so on) have been through much, much worse.  We should all strive to be so resilient.
• Unlike in 2008 – 2009, the banking systems in North America are well regulated and should have ample liquidity and equity to absorb declines in big asset classes like real estate and stocks.
• After a decade of home price appreciation, U.S. and Canadian homeowners have lots of equity in their homes.  U.S. consumers have considerable amounts of excess cash to spend.
• The Fed has finally showed up to work and are having success in slowing demand and lowering asset prices through higher borrowing rates.  Most commodities have already seen substantial price declines and the supply chain is starting to normalize, but it could take some time.
• What we are going through is normal.  The market declines have been orderly and have been going on for a considerable period of time, which implies the worst may be behind us.  Below the surface, there has been bigger carnage (high valued tech, cryptocurrencies, speculative growth stocks) but well diversified portfolios like ours have been much more resilient.  Take comfort in the fact that you own quality companies and well thought out and time-tested strategies that should be resilient in various market conditions.
• In 2020, we experienced the biggest hit to global GDP in modern history, a 50% drop in output by some accounts.  We all should be able to handle a slightly higher mortgage rate and a 2-3% contraction in GDP like we used to have back in the day.  This is a normal resetting of market expectations that encourages rational decision making and dampens speculation.  Investing one’s life savings in Dogecoin is not a strategy for long term wealth generation.

 

As always, we thank you for choosing to work with our team and look forward to more cheerful conversations in the days ahead.