Written as of January 13, 2023.
View the Nicola Wealth Investment Returns: December 2022
Highlights this Month
- Positive equity returns in 2023 would provide a welcome relief.
- Recession fears and what lies ahead.
- Concerns of inflation spiralling out of control have greatly diminished.
- The current environment is more constructive for fixed income.
- The investment case for stocks is less clear-cut.
December in Review
After back-to-back solid months for equity markets, stocks lost ground in December, with the S&P/TSX down -4.9% (total return in Canadian dollar terms) and the S&P 500 down -5.8% (total return in U.S. dollar terms). Despite weakness in December, returns for the fourth quarter still managed what we feel are impressive gains, where the S&P/TSX and S&P 500 generated returns of +6.0% and +7.6%, respectively. However, overall returns for 2022 still ended the year solidly in the red, with the S&P/TSX and the S&P 500 generating returns of -5.8% and -18.1%, respectively. While traditionally, the holiday season has rewarded investors with positive returns through a so-called Santa Claus rally, December returns were a disappointment. And though U.S. markets did deliver a positive Santa Claus rally for the seventh consecutive year, it took a strong push in early January's final trading session to keep the streak alive, with the S&P 500 gaining a cumulative +0.8% over the seven trading sessions to January 2023.
According to Carson Investment research, a good start to the year can foreshadow strong returns for the rest of the year. For example, since 1950, when the S&P 500 has increased more than 1% during the first five days of the year, annual returns have averaged +15.4%.
Positive equity returns in 2023 would provide a welcome relief for investor portfolios with few places to hide in 2022.
Normally when stocks go down, bond returns offer investors at least a partial offset as yields decline. In 2022, however, both U.S. stocks and bonds delivered double-digit losses, with Morgan Stanley reporting that a traditional portfolio of 60% stocks and 40% bonds in 2022 delivered the fourth worst annual return since at least 1926. Correlations between asset classes were a mess, as high inflation resulted in negative returns for fixed yield investments while equity valuations simultaneously contracted.
Forecasting is challenging, and it is rare for strategists to get it all right. Last year, most were close by forecasting positive corporate earnings, but few could predict the magnitude of decline in valuations and returns. Not surprisingly, when asked to defend their forecasts, many remember being less bullish than they were at the time or are at present. It is a humble reminder as we look forward to 2023.
According to two December investor surveys by Bloomberg and Bank of America, stubbornly high inflation is the most significant risk that fund managers see in 2023, followed by recession. Persistent inflation would compel central banks to continue tightening monetary policy, which we think would essentially result in a similar investment environment we saw in 2022, with lower equity valuations and rising bond yields. According to these surveys, investors were less concerned with the negative impact the aggressive monetary tightening in 2022 will have on the economy. Markets in December were less convinced that 2023 will play out accordingly, with economically sensitive equity sectors suffering worse relative returns, while longer term bond yields declined and yield curves became more inverted.
Strategas highlights that it is exceptionally rare for the S&P 500 to experience back-to-back negative annual returns, and markets have averaged 14.9% returns in years following large drawdowns. It is common to have another significant drawdown the following year, however. Strategas reports an average drawdown of 14.3% has occurred in years after a substantial drawdown. As mentioned above, forecasting returns is always challenging, but 2023 is shaping up to be particularly tough. While Wall Street strategists forecast negative returns for the S&P 500 for the first time in a decade, fund managers believe the market will deliver 10% returns in 2023.
Corporate earnings will be key in determining who is correct, the strategists or the fund managers. According to Raymond James, every equity bottom over the past 25 years has coincided with a bottom in earnings expectations within one to two months. Bloomberg states that earnings estimates in both the U.S. and Europe have only just begun to decline, with Refinitiv I/B/E/S estimating that 2023 S&P 500 earnings are still forecasted to increase by 4% versus 2022 earnings. According to Ned Davis Research, earnings have historically fallen 24% during an average recession.
Recession fears and what lies ahead.
The consensus is that the global economy is headed for recession: a mild one, but a recession nonetheless. In an early December Bloomberg MLIV Pulse survey, 81% of respondents indicated they see the U.S. economy in a recession in 2023, and a Wall Street Journal poll found that over 50% of respondents believe the economy will get worse in 2023. Professional investors agree, with a survey by the Philadelphia finding that over two-thirds of large Wall Street Financial Institutions are betting on a recession in 2023, putting an average 45% probability on shrinking growth over the next four quarters.
Maybe the issue is not whether the U.S. economy goes into recession but how severe the recession will be. With a soft landing or mild recession, corporate earnings might not fall that much, and perhaps estimates have already discounted the worst. Strategas is highlighting this as the most anticipated recession in history, and given that earnings estimates are still basically flat, this would appear to be the only plausible explanation.
A December Bank of America Fund Manager survey showed signs global growth expectations may have bottomed, and based on the forecasted change in unemployment, TS Lombard believes the recession is expected to be the mildest in history.
The labour market is one of the keys to determining whether an upcoming recession—if there is one—will be mild or more severe. The Federal Reserve would like to slow wage growth without increasing the unemployment rate, and to do this it hopes to decrease the number of job openings and make it harder for job switchers and seekers to bargain for higher wages. So far, job growth in December remained strong, with the unemployment rate falling to 3.5%. At the same time, while still elevated, wage growth came in lower than expected and, as pointed out by Raymond James, remains below levels in the 1970s. Growth may have increased during the pandemic due to a shift in mix towards higher-paid jobs, but the labour participation rate has still not returned to pre-Covid levels, and while job openings have started to recede, they remain historically high.
The goal is to bring inflation under control. The Federal Reserve needs to control wages but, in turn, risks slowing economic growth. According to Strategas, the central bank tightening cycles end once the Fed Funds rate is above CPI inflation, which means either inflation needs to fall a lot more or the Fed Funds rate has further to rise. Both will likely be required, but the mix between the two is what is being heavily debated by investors.
Focusing on the Fed Funds rate, the market does not believe the Fed will keep raising rates in early 2023, then pause until 2024 before starting a new easing cycle. According to the Federal Open Market Committee (FOMC) dot plot forecast—where each dot represents a rate forecast by a member of the Federal Reserve—the futures market is pricing in a lower Fed Funds rate than the average Fed member right through 2025. The Fed appears more worried about inflation than the market, or at least that's what they want the market to believe.
Concerns of inflation spiralling out of control have greatly diminished.
The market is less concerned about inflation as there are signs it has not only rolled over but is moving sharply lower. As Stategas recently commented, it is not mission accomplished as inflation appears to have peaked, and the concerns of inflation spiralling out of control have greatly diminished. Services inflation remains high, and wage growth remains a concern for the Fed. Still, goods inflation is proving to be truly transitory, and one-year consumer inflation expectations have fallen to their lowest level in 18 months.
It is not a question of whether inflation will fall but by how much and how fast. Forecasters were too optimistic last year, predicting inflation would fall sooner and quicker than it did, and while overall inflation is indeed falling now, sticky inflation remains stuck. Research Affiliates recently remarked that the higher inflation rises, the longer it takes to decline to a normal level. For example, when inflation hits 8%, it can take a median of 8 years before receding back to 3%, which is the top of the Fed's inflation range.
As for Canada, higher consumer debt loads make the economy more sensitive to higher rates. While a similarly robust job market and sticky inflation would appear to require the Bank of Canada to keep pace with the Federal Reserve in maintaining rates higher for longer, the Bank of Canada is likely to pause sooner as the nation's economic growth starts to roll over more quickly than the U.S. This rollover could put pressure on the Canadian dollar, though, as stronger commodity prices could provide support to the loonie.
From an investment perspective, we find that the current environment is more constructive for fixed income.
Investors were pricing in a continued decline in inflation and a Fed pivot but a very modest decline in corporate earnings. This opinion appears overly optimistic, given that slower economic growth or even a mild to moderate recession will be needed to lower inflation and cause the Fed to pivot towards a new easing cycle. The risk to bonds is that inflation does not continue to trend lower, and the Fed needs to keep hiking rates. According to Strategas, 10-year bond yields normally exceed inflation, and if the market is wrong and inflation does not continue to fall, bond yields may need to move higher, further depressing bond prices and returns. However, this environment would likely be short-lived, as central banks appear resolute in moving inflation lower and, to quote Fed Chairman Jerome Powell, the central banking system will "do whatever it takes" to get inflation under control. Alternatively, a recession would see the Fed eventually pivoting to an easier monetary policy, resulting in lower yields and higher bond prices. In either scenario, for the first time in years, bond investors are able to clip a 3 to 4% coupon in government bonds while waiting to see which direction inflation and economic growth take.
The investment case for stocks is less clear-cut.
Stocks tend to follow the trend in earnings expectations over the long term, with valuations being a poor short-term predictor of returns, making short-term forecasting challenging at the best of times. 2023 is particularly tricky given the many unknowns facing investors. A Fed pause or pivot could be good for valuations and returns in the short term, but not if it comes with a recession and lower corporate earnings. Only a soft landing, where the Fed can lower inflation while limiting damage to the labour market and economy, would make stocks appear attractive in the short term. More likely is a scenario where analysts are compelled to keep trimming corporate earnings estimates lower, likely in the first half of 2023, putting pressure on the broader market indices.
In this environment, stock selection will be essential, and we believe an emphasis on quality dividend-paying companies will continue to outperform non-dividend-paying growth stocks. As a result, we feel this is a market that should favour managers searching for value versus investors investing in large-cap equity indices.
One small consolation for the poor returns in equities last year is that it helped increase future expectations. In 2022, the decline in the S&P 500 was entirely attributed to a lower valuation, more than offsetting an increase in earnings of about 5%. While valuations are still expensive relative to historical averages, they are lower than at the start of 2022. According to Morningstar, 30-year return expectations for big-cap U.S. growth stocks increased from 6.25% to 9.65% at the end of last year, primarily due to lower valuations. Yet, Stifel recently pointed out valuations can contract more than usual during cyclical bear markets, even if GDP is trending higher. In this environment, Stifel postulates that we are only halfway through the current correction in equity valuations. Another reason why bonds are worth considering in 2023.
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.
