By Rob Edel, Chief Investment Officer | Written as of November 14, 2022
Highlights this Month
- A change in trend or another bear market rally?
- Higher rates have largely been the major headwind for equity markets in 2022, but this has not been the case recently.
- Earnings are relevant, but the Federal Reserve and monetary policy are still the focus for traders.
- For inflation in general, there are mounting signs that inflationary pressures have started to roll over.
- The Canadian economy is unlikely to escape the global tightening cycle and subsequent economic slowdown.
- Key issues for voters have been the economy and inflation.
As we head into the last three months of 2022, news headlines and overall market returns paint a concerning picture. With stocks and bonds losing ground in the first three quarters of 2022, investors face some of the harshest return environments since World War II. Wild swings in the markets show evidence of trader uncertainty, with the S&P 500 on track for the highest number of one percent reversal days since 2008. As of early November, large-cap U.S. stocks erased a gain or loss of at least a percentage point in a single trading session 26 times in 2022. Equity returns in October, however, were generally strong, with the S&P 500 up 8.1% (total return in U.S. dollar terms) and the S&P/TSX +5.6% (total return in Canadian dollar terms). The venerable Dow Jones Industrial Average even had its best month since January 1976. In fact, excluding China, Scotiabank reported that all global markets ended the month solidly in the black. A change in trend or another bear market rally? Below we dive in a little deeper to see what was driving markets last month and what it might mean for the rest of the year.
A change in trend or another bear market rally?
From a sentiment perspective, there were some positive signs. According to Bank of America, its sell side indicator is the closest to a buy signal since early 2017, with Wall Street’s consensus equity allocations near extremely low levels. From a contrarian perspective, this is bullish, with Bank of America pointing out that subsequent 12-month returns have been positive 94% of the time when the indicator reached current levels, with median gains of 22%. Backing up the sell side equity indicator’s bullish call were inflows into cash, which, so far in the fourth quarter of 2022, are tracking at their fastest pace since the pandemic lows in 2020. For equities themselves, Strategas underlines the recent outperformance of the equal weight S&P 500 versus the top 50 market capitalization weighted S&P 500 stocks. A broader market rally is considered more durable and healthier, especially as improvement in the ‘average’ stock has included strength from both the industrial and financial sectors. Along with continued leadership from energy, the stocks driving the market higher have tended to be more economically sensitive.
As Rosenberg Research points out, however, the rally in October is the seventh in 2022, with each subsequently failing as the primary trend in stocks continues to move lower. While some contrarian indicators may signal that a market bottom is within reach, others are less optimistic. This bear market is now over nine months long, which according to Strategas, has historically translated to average maximum drawdowns of nearly 40%. At the end of October, the S&P 500 is down just over 18%, so there is much more room to fall. Strategas recently listed several criteria they deem necessary to become more constructive on equities. We will delve a little more into some of them below but suffice it to say that they have yet to be evident. According to Bridgewater, while inflation tends to be a lagging indicator, meaning it can still be high when equities bottom, other factors matter more in calling a bottom. As with Strategas, Bridgewater finds these factors have yet to signal a bottom. Economic growth is still too strong, the Fed is still tightening, and excess equity returns are still expected to be low, mainly because valuations are still too high.
The increase in interest rates last month and a flow out of stocks and into cash could be seen by some as a sign that the market is nearing a bottom. Last month, US 10-year treasury yields increased over 20 basis points, ending October at 4.05%, while 3-month T-Bill yields increased nearly 50 basis points to yield 4.15%. With the 3-month versus 10-year yield curve inverting, almost the entire yield curve is now inverted, a signal that has historically screamed recession. Historically, rates peak before recessions, but as Strategas points out, this is not the case when inflation is strong. During inflationary years, it is more common for yields to peak during or after recessions. In other words, rates may continue to move higher even though the yield curve is flashing warning signs. It is hard to call a market bottom when rates are still moving higher.
On the other hand, how they move higher is also significant. So far in 2022, the bond market and bond prices have been much more volatile than equity markets. This volatility, and more specifically, the speed at which rates have moved higher, has been detrimental to equity valuations. According to Morgan Stanley, a decline in bond price volatility could support equity valuations in the future.
Higher rates have largely been the major headwind for equity markets in 2022, but this has not been the case recently.
With stocks rallying in the face of higher bond yields, BCA Research recently asked the question of whether the current rally is a bear market rally or something more durable. Sadly, they conclude the former. Bridgewater tends to agree. In dissecting the anatomy of a bear market, Bridgewater differentiates a correction from a bear market by the degree of earnings correction. A milder correction in equity prices is typically due to a move lower in valuations while a more severe bear market starts with a rate-driven correction in valuations but is followed by a further price decline due to a decrease in earnings. Bridgewater believes the current market is close to a handoff regarding what is driving stocks down, with lower earnings leading the next leg down in stocks, likely due to a recession. According to Bridgewater, margins will be vital in determining earnings’ fate, given that top-line revenue can remain robust in an inflationary economic environment.
Raymond James tends to agree, believing market bottoms coincide with lows in forward earning per share expectations. While equity markets can continue to decline two or more years after a Fed pause, the investment banking company believes market lows occur within one to two months of the lows in earnings. Unfortunately for investors, earnings are only starting to come down. Since the start of October, third-quarter earnings have fallen a mere 1.5%, and while 2023 estimates have been falling, they remain higher than they were at the beginning of the year. In fact, better-than-expected earnings were one of the reasons the market was strong last month.
Earnings are relevant, but the Federal Reserve and monetary policy are still the focus for traders.
Bad news is considered good news as it brings forward the prospects of a pivot, which Strategas says has become what “transitory” was to markets in 2021. It is all that traders and market pundits want to talk about; when is the Fed going to shift from raising to cutting rates? Based on signs of growing economic weakness and slowing inflation, expectations that the Fed would start to slow the tightening pace brought more rhetoric regarding a potential pivot. However, financial markets continued to price in a terminal fed funds rate near 5%, with little rate relief for the rest of 2023. If anything, financial markets have been pricing in a rate environment that looks like it will be higher for longer.
The Fed needs financial conditions to remain tight to calm inflationary conditions. As of early November, however, financial conditions have started to ease as stocks rally, which presents a problem for the Fed, especially as five-year inflation expectations have begun to move higher. Unanchored inflationary expectations are the Fed’s worst nightmare.
The Fed’s goal is to slow economic growth and inflation without causing too much damage to the economy and the job market. Without being too optimistic, there are some early signs they could be having some success. The ISM services index fell to its lowest level since May 2020 in September, and labour demand has started to slow. According to the Bureau of Labor Statistics, hourly earnings on a three-month basis slipped to their slowest pace since April 2021. Reducing job openings and slowing wage growth without a material increase in unemployment is the narrow landing strip the Fed is trying to manufacture.
For inflation in general, there are mounting signs that inflationary pressures have started to roll over.
According to a recent Bloomberg article, the New York Federal Reserve’s underlying inflation measure – which Core CPI tends to follow with a lag of about 6-months or so – has turned lower. Also turning lower is ISM manufacturing prices and commodity prices; AlphaSense documented a rising number of management teams citing lower input, commodity and raw material costs during U.S. earning conference calls.
However, it is premature for the Fed to announce that it accomplished its mission in combatting inflation. The economy remains reasonably strong, with low unemployment and high consumer spending. While some inflation indicators have started to recede, others, like the Dallas Fed Trimmed Mean Core PCE, both year over year and month over month, remain relatively high, as does the Atlanta Fed Sticky CPI index.
While the Fed’s primary mission is to manage domestic economic growth and inflation, its impact extends well beyond the borders of the U.S. As the world’s reserve currency, American monetary policy essentially becomes the world’s monetary policy. As the Fed raises rates, other central banks are forced to either follow suit or risk seeing their currency depreciate, as is evident by the tight correlation between the rise in U.S. overnight rates and the increase in the trade-weighted U.S. dollar index.
According to JP Morgan, the Fed’s terminal policy rate is expected to exceed that of other developed nations, which could support an even stronger U.S. dollar. Higher global terminal policy rates are slowing global economic growth, with the International Monetary Fund forecasting that a third of the global economy is already in a recession or soon will be.
The Canadian economy is unlikely to escape the global tightening cycle and subsequent economic slowdown.
A Nanos Research survey found that 47% of Canadians feel their finances have weakened over the past year, with 64% saying they expect the economy to deteriorate over the next six months. Given this backdrop, it should have been no surprise that the Bank of Canada became one of the first central banks to show signs of pivoting in late October when they increased the Bank Rate by only 50 basis points (to 4.0%) instead of the market’s expectation of a 75 basis point increase. JP Morgan includes Canada in the list of Central Banks with forecasted terminal rates lower than the US, which is why Canadian 10-year bond yields recently deviated from the more hawkish path of US 10-year rates. According to the derivatives market, the terminal rate forecast for Canada at the end of October had fallen to 4.28%, implying the Bank of Canada is nearly finished with its hiking cycle.
High household debt and an overheated housing market put Canada at particular risk from higher interest rates. A recent Economist article listed Canada’s housing market as the most exposed out of 17 selected countries due to its increase in policy rates, high household debt, and house prices. According to Macquarie Macro Strategy, residential investment as a share of GDP in Canada is very stretched relative to the U.S., and housing-related employment, which comprises about 20% of the private sector, puts the Canadian economy at higher relative risk. Even if inflation remains strong, there is a limit to how high the Bank of Canada can raise rates, given the debt burden that Canadians are carrying. Consequently, the Canadian dollar could remain under pressure as yields in Canada continue to disconnect versus those south of the border.
Apart from the Fed and inflation, investors need to keep an eye on some other issues and events that could impact markets over the next few months. First, Americans went to the polls on November 8th. Markets have historically been weak in the months leading up to the U.S. Midterm elections. After the election, however, Strategas found markets have traditionally been more friendly. Of course, seasonality also helps, but November and December returns have been even more substantial during Midterm election years.
Also favouring investors as we advance is the presidential cycle, which according to Carson Investment Research, is entering the strongest period in the 16-quarter cycle. As for the election results, the S&P 500 does better with a split Congress and Republican President, though a split Congress and Democratic President is not far behind. The worst-case scenario for markets, according to Strategas, is a Republican President and Democratic Congress, which thankfully cannot happen for at least another two years. As for bond investors, a Bloomberg MLIV Pulse Survey found that professional investors would like to see Republicans take both chambers of Congress, while retail investors would rather see a split congress.
Key issues for voters have been the economy and inflation.
While President Biden has successfully passed significant economic legislation with positive ramifications on climate change and inequality, voter focus has been on inflation and the cost of living. According to a New York Times poll, 78% of Republicans and 47% of Independents blame President Biden’s policies for rapid inflation. Moreover, important social issues like democracy, abortion, and gun policies lost voter focus between July and October, which hurt Democrats and their hopes of maintaining their control over congress. An August 31st Quinnipiac University poll found that 67% of Americans think democracy is in danger. However, Republican voters still appear willing to support a slate of candidates who claim President Biden did not win the 2020 election. The New York Times reported that the vast majority of Republicans running for the U.S. Senate, House, or State office, have expressed doubt about the legitimacy of the 2020 election. More on the election results next month, but we do not know if the impact on markets will be material.
Perhaps a more considerable influence on markets will be China and the future status of their zero-Covid policy. Previously considered a standout in handling the pandemic, the Financial Times reports that this policy has changed the Chinese economy to one of the worst at coping with Covid disruption.
In October, Scotiabank’s forecast for real Chinese GDP growth in 2022 fell to only 3.3% versus forecasts of 5.25%. At the same time, the Financial Times reports that China is becoming less transparent about its economic performance, quietly discontinuing thousands of economic indicators and statistical series. Most economists remain perplexed at China’s continued commitment to its zero-Covid policy at the expense of its economy and global economic growth in general.
The most logical explanation is political, given that China held its 20th Communist Party Congress in mid-October, with President Xi vying for his third term as leader. As highlighted by Gavekal, the President has shifted policies away from economic growth and reform toward security. And the lockdowns provide greater security. As President Xi consolidates power, China has become more insular, as evidenced by the International Trade Centre’s recent observation that China’s importation of books and periodicals fell to a four-year low in 2021.
Also falling has been foreign investor interest in Chinese stocks, with Bloomberg reporting record selling of Chinese A-shares for foreign investors in October. While these trends are negative for global markets long term, any hint at a change in China’s zero-Covid policy would result in a healthy jump in global growth in the short term, which would be positive for markets. Weighing against this is that stronger Chinese economic growth could also put upside pressure on commodity prices and inflation, which would be negative. Finally, we would also point out that any hint of a resolution to the war in Ukraine would also prompt a nice rally in risk assets.
One bullet that markets did manage to dodge in early December was Philadelphia winning the World Series. Be it the presently-named Phillies or the old Athletics, a recession or financial crisis has followed each time Philadelphia has won the World Series. Fortunately, the Houston Astros prevailed in this year’s baseball finale. The markets also dodged what was looking to be a very messy mid-term election, and inflation and job growth look to be trending in the right direction. Throw in the potential for good news from China or even some kind of cease-fire in Ukraine, and this current rally could have legs. Key, however, will remain the Fed and how much and how long they continue to raise rates. In addition, the impact on the economy and corporate earnings will determine the fate of markets in the coming months. Consequently, we remain committed to keeping a close eye on inflation and wage growth. Signs of weaker corporate earnings could signal the next leg down in risk asset prices, though fixed income returns would appear less at risk at these levels than equities.
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.