By Rob Edel, Chief Investment Officer | Written as of October 14, 2022
Highlights this Month
- Tough times in September have historically been followed by a turnaround month in October.
- While many investors have been disappointed with stocks so far this year, it’s the rout in bonds that has been one for the record books.
- Wall Street is debating the Fed’s next move.
- Can the battle against inflation be won without creating a recession?
- The Fed continues to push the boundaries.
September in Review
As has been the norm so far in 2022, equity markets were weak in September, with the S&P 500 down 9.2% (U.S. dollar terms) for the month, while the S&P/TSX declined 4.3% (Canadian dollar terms). The poor showing for stocks last month also resulted in U.S. stocks losing ground for the third consecutive quarter — the first time this has happened since the financial crisis. For Q3, the S&P 500 declined 4.9% (U.S. dollar terms), while the S&P/TSX lost 1.4% (Canadian dollar terms). Year to date, the S&P 500 is down nearly 24% (U.S. dollar terms), the third worst first-nine-month start to a year since 1931.
The third quarter started on a strong note, with hopes the bear market had seen its lows. After bottoming in mid-June, the S&P 500 managed to recover more than 50% of its losses, according to Rosenberg Research, a near perfect historical indicator a bottom had been reached, and the bear market was over. Alas, this was not the case. The market turned lower again in August and ended September at a new bear market low. Given sentiment is still so bearish, it may be tempting to be a contrarian and buy stocks at these discounted levels, but this market appears to want to go lower. Not only did the S&P 500 drop to a new low after its 50% bear market rally, but it also pierced both the pre-Covid and 2018 highs.
Tough times in September have historically been followed by a turnaround month in October.
According to Carson Investment Research, however, October is often a much kinder month for investors. Known as the “Bear Market Killer”, Carson notes six out of the last 17 bear markets ended in the month of October and that the last three months of the year are some of the best months, historically, for the market. Perhaps so — but as Morgan Stanley recently pointed out, returns are also very dependent on the fed funds rate regime that we are in. If rates are falling or flat, stocks can do quite well. However, stocks have had a much tougher time in regimes where the Fed is raising rates, or even worse, raising rates and shrinking its balance sheet. Guess which one we’re in.
An additional problem for investors during a regime of a rising fed funds rate and a declining Fed balance sheet is that bond yields typically move higher, driving bond prices and returns lower. Bonds historically have acted as a risk diversifier for equities, with yields declining and prices increasing in times of economic stress and equity drawdowns. When the economic stress is caused by inflation and Fed tightening, however, bond prices become positively correlated with equity prices, as has been the case for much of this year. According to Ned Davis Research, this perfect storm has resulted in a 60/40 portfolio of stocks and bonds (60% stocks and 40% bonds) declining 20% in the first nine months of the year — the third worst start to any year since 1926, with only 1974 and 1931 handing investors larger losses.
While many investors have been disappointed with stocks so far this year, it’s the rout in bonds that has been one for the record books.
According to Rosenberg Research, 10-year U.S. Treasury yields have risen more in 2022 so far than in any prior year. Bank of America Global Research believes global bonds are on track for their worst annual loss since 1949 and fourth worst year since 1721 (no, this is not a typo). According to Deutsche Bank, global bonds, as a whole, have lost all their gains on a 10-year rolling basis, the worst return period since the 1950s.
After such turmoil, it’s natural to speculate on whether we have seen peak yields and should start to look for opportunities to put money back to work in the bond market. Bond yields have been very low for so long investors have been left wondering if a buying opportunity has presented itself or whether rates will continue to move higher, driving bond returns even lower. The recent increase in yields certainly looks different, with a recent Bloomberg article highlighting how the U.S. 10-year Treasury yield appears to have broken a 35-year downward trend. Globally, the story is much the same, with a benchmark comprised of the average G-7 bond yields recently rising above their 20-year average. According to JP Morgan Asset Management’s Arjun Vij, DoubleLine Capital’s Jefferey Gundlach, and Citigroup’s Steven Wieting, longer-term bonds are starting to look attractive.
We tend to agree. While there is still room for yields to move higher, especially shorter-term bond yields, most of the damage in the bond market has likely already been done. In terms of relative magnitude, the bear market in stocks has been just average. For bonds, it has been historic. According to Jefferies, the U.S. 10-Year Plus Treasury Bond index has underperformed even the Nasdaq, while Strategas points out that price volatility in the bond market has reached extreme levels. Perhaps the key lies with the divergence between bond price volatility and credit spreads. A JP Morgan graph recently highlighted the tight historical relationship between bond market volatility and credit spreads, highlighting the fact the relationship has broken down recently, with bond price volatility spiking higher while credit spread widening has lagged. The bond market volatility is correctly reflecting the impact of the sharp increase in interest rates, but credit markets have not yet fully discounted the negative impact higher rates could have on economic growth and corporate earnings.
The same could be said for stocks. Most of the decline in stocks so far this year has been due to the impact on valuation of higher rates, not earnings. This may make sense in a soft-landing scenario, and markets have already discounted the worst. But if rates keep going higher and financial conditions continue tightening, a hard economic landing becomes the more likely scenario, which is bad for stock earnings and credit spreads but potentially good for bonds. Below we discuss both scenarios in more detail.
Most discussion regarding the economy and markets currently starts and ends with the Federal Reserve and its plans for monetary policy. In just over six months, the Fed has increased overnight rates by 3% and is in the midst of one of the most aggressive tightening cycles in modern history. The fed funds rate year-end projections have increased after each Federal Reserve policy meeting. The post-September meeting yielded a projected level of 4.5% by the end of this year and a terminal rate of 4.75% in early 2023 before levelling off for the rest of the year. The easing cycle is not expected to start until 2024, with rates falling to 4% by the end of 2024 and 3% by December 2025.
The market sees it a little differently, however, with Fed Fund futures currently pricing a start to the easing cycle beginning shortly after fed funds peak in Q1 2023. The Fed says they are going to raise rates to around 4.75% and then pause. The market thinks the Fed will raise rates to maybe 4.5% but then quickly turn around and start cutting them. If the Fed does pivot and starts cutting rates, markets will likely experience a nice rally. Forget about the reason behind why the Fed might pivot (which might not actually be very market-friendly); instead, look at how traders will take the pivot as a cue that the Fed has the markets back again. Alternatively, if the Fed is right and there is no pivot, traders are likely to be disappointed as this is not what is discounted in the market.
Wall Street is debating the Fed’s next move.
Predicting the direction Chairman Jerome Powell and the Federal Reserve take with monetary policy in the future is a highly debated preoccupation on Wall Street right now. On the one hand, Powell could follow the lessons of previous Fed Chairmen, like Ben Bernanke, and ease monetary policy at the first sign of danger in the economy and job market. On the other hand, Powell could opt to emulate Paul Volcker and his 1980s playbook by “keeping at it until the job is done,” with “it” being controlling inflation by tightening financial conditions.
A recent Bank of America Global Fund Manager Survey noted that investors overwhelmingly believe inflation would need to fall below 4% before the Fed should either pause or pivot. Along with this, according to some interpretations, financial conditions are still too easy. As highlighted recently by Bloomberg, real long- and short-term U.S. rates (adjusted for inflation) are still at their lowest level since 1975. According to Jim Bianco, annual core PCE inflation remains well above the U.S. Treasury Bill, and Treasury Note yields from 3-months to 30-years, meaning real rates across the entire yield curve are still negative.
So far, Powell and his colleagues appear intent on following their inner Volcker, sacrificing the economy in order to ensure inflation remains anchored at their 2% target level. Using data from the Federal Reserve Bank of St. Louis, a recent Wall Street Journal article highlighted the Fed’s mixed record in fighting inflation while avoiding a hard landing over the past 60 years. Eleven games were played, with five wins (soft landing) and six losses (hard landing). Based on the performance of U.S. stocks this year, JP Morgan believes there is a good chance the Fed’s record falls to 5 and 7, as price action in the S&P 500 is currently discounting a 92% probability of recession. It hasn’t paid for investors to fight the Fed, with the past six bear markets requiring a pivot to Fed rate cuts before bottoming. Remember, according to the Fed, that won’t be until sometime in 2024.
Can the battle against inflation be won without creating a recession?
So if the Fed is willing to risk a recession in order to fight inflation, how is the battle going, and how likely is it the battle can be won without creating a recession first? According to financial markets, the battle is largely won, with break-even rates on inflation-protected Treasury bonds at, or near, the Fed’s 2% target. One-year breakeven rates spent some time in September below 2% but moved back above 2% in early October. However, this is more of a motivator for the Fed than an end goal. Breakeven rates at 2% indicate inflation remains well anchored, and investors have confidence in the Fed’s ability to get it back down to target. This is seen by the Fed as a window of opportunity not to be squandered, as it’s a lot easier to control inflation when expectations are anchored than if they are not.
As for what’s happening in the real economy, however, inflation remains more problematic. While Strategas recently showed evidence that the supply chain is improving, it’s the service sector where price increases remain sticky. As Jefferies Economics highlights, core goods prices are forecasted to fall dramatically over the next year, but they only represent 20% of consumer price index (CPI). Inflation in core services, which comprise 60% of CPI, is forecast to remain around the 6% level.
The area of most concern when it comes to services inflation is wage growth. According to Bridgewater, stubbornly high wage growth anchored inflation in the 1970s and Bridgewater believes it will take a recession to slow wage growth now. The Fed thinks otherwise and has targeted job openings as the answer to lowering wage growth without materially increasing the unemployment rate and triggering a recession. With nearly two job openings for every unemployed worker looking for a job, workers have ample leverage to negotiate higher wages. The Fed hopes to reduce this ratio closer to the pre-pandemic level of 1.2 job openings per unemployed individual so they can take away some worker bargaining power without taking away their jobs. So far, job openings have been moving in the right direction, declining to 1.7 openings per unemployed individual in September, but the Fed has a long way to go. Many believe the issue is the mismatch between workers’ skills and the skills required for the jobs offered. Goldman Sachs believes the real problem is unemployed workers are not even applying for jobs.
While there are likely many reasons why some workers choose to stay on the sidelines, the accumulation of excess savings during Covid has given them the financial means to delay or avoid re-entry. According to BCA Research, many U.S. consumers accumulated a mountain of excess savings during 2020 and 2021. Raymond James believes added savings during the Covid shutdowns totalled around $2.3 trillion USD or $18,000 per household. Further, they estimate about 10% of these savings have been spent through July and that spending should stay high through the end of 2022 before normalizing. According to Moody’s, however, the riches weren’t spread evenly, with cash levels for the lowest earnings quintile of Americans now actually lower than Q4 2019, while the top 1% have seen sizable gains. While this cash cushion is good for consumers and can help soften the blow of any brewing economic slowdown or recession, it makes the Federal Reserve’s job harder in that it delays the impact of monetary tightening on the economy and thus helps keep inflation high. The Fed is trying to slow things down, but the U.S. consumer keeps thwarting that.
The Fed continues to push the boundaries.
With many investors resigned to the fact the Fed plans to keep raising rates until something breaks, what if something actually does break? According to Bank of America data, stress is building in the global financial system as the Fed continues to raise rates and the U.S. dollar soars to new highs. While the official party line is that the Federal Reserve’s mandate is confined to the domestic economy, it’s hard to argue instability in the global financial system won’t impact the domestic U.S. economy. It’s certainly evident U.S. policies have a material impact on global markets. Historically, many market “events” have occurred and been associated with sharp rises in the Fed Funds rates, including the financial crisis, the Long Term Capital Management demise, the Russian debt default, and the Asian debt crisis, to name a few. Similar “accidents” can be seen after large spikes in the U.S. dollar, leading many to expect the current rally in the U.S. dollar to start exposing cracks from which the next crisis might emerge. If — or when — a crisis occurs, the Fed and its resolve to fight inflation will again be tested.
Traders continue to doubt the Fed’s resolve to continue raising rates. Either because of a domestic U.S. economic crisis or some other financial crisis, traders don’t think the Fed will be able to resist cutting rates next year. It’s one of two disconnects we see being priced in the market today. The second disconnect is the market’s expectations in regard to corporate earnings. While U.S. stocks have fallen into a bear market in 2022, most of the decline can be attributed to a higher discount rate or earnings multiple (due to higher interest rates) rather than lower corporate earnings. According to FactSet data going back to 1957, median S&P 500 earnings per share have historically fallen 18% during a recession, though we would point out a recent Bloomberg article was more pessimistic, pegging the historical decline closer to 31%. Regardless, average analyst forecasts are still predicting S&P 500 EPS to be up 3% in 2023. Estimates have been coming down, but they are still wildly optimistic if the U.S. economy falls into recession. According to Rosenberg Research, there is a strong correlation between leading indicators, which measure general business activity, and S&P 500 earnings. As highlighted by Rosenberg recently, leading indicators have turned sharply lower, with earnings threatening to follow suit. The key here will be profit margins. Inflation can help keep nominal revenue growth healthy if companies are able to maintain positive unit sales growth and pricing power. Higher costs, such as interest expenses, wages, and input costs, also get inflated, however, driving down profit margins. And don’t forget the strong dollar, which will pressure U.S. corporations with international sales as foreign profits translated back into dollars come under pressure, as will the competitive position of U.S. companies competing against foreign competitors and their discounted currencies.
A series of charts presented recently by Bridgewater (below) lay out a more pessimistic longer-term scenario for U.S. corporate earnings. As a percentage of GDP, corporate earnings have been on an upward trajectory since the early 1990s due to several favourable trends. A steady decline in both tax and interest rates has helped increase profits, as has labour’s shrinking share of the profit pie. As a percentage of GDP, labour’s share has declined over the decades as both union membership, and organized labour have declined, and globalization has increased. Wall Street has done very well at the expense of Main Street, but perhaps the tide has started to turn.
In trying to determine what all of this might mean for the market and what (or when) a bottom in stocks might look like, Strategas recently put together a useful matrix enabling investors to game out different scenarios based on their views. According to Strategas, the current PE multiple for the S&P 500 is 15.1 times earnings, down from its peak earlier in the year but considerably higher than the historical average bear market low of 11.7 times. The current PE multiple would also appear reasonable if inflation declines to a 4-6% range, but 11.6 times multiple is more appropriate if inflation remains in the 6-8% range. As for earnings, Strategas believes the S&P 500 EPS for 2023 will decline to around $200 per share versus the consensus of around $240 per share. This is about a 10% decline from this year’s $224 per share consensus forecast, so still reasonably conservative. With that in mind, pick your view. If you believe Strategas is right on earnings and inflation falls to the 4-6% range, the S&P 500 could fall to around 3,000, which would be down another 17% or so from where it closed at the end of September. Assume inflation stays high, however, and the PE multiple falls from 15.1 times to 11.6 times, and the bottom for the S&P 500 might be closer to 2,300, or down another 36%. More optimistically, if you believe the consensus and earnings don’t fall, like in a soft landing scenario, and you also believe inflation declines all the way back to the 2-4% range, the target level for the S&P 500 could increase to 4,200, up about 16%.
It’s a big dispersion in forecasted returns, depending on your view on inflation and earnings. It’s also why markets have been so volatile. As of early October, the S&P 500 has averaged a daily swing above 1% for 40 straight weeks. According to Bloomberg, the S&P 500 has witnessed 2% reversal days, both up or down, six times since January — the wildest ride for the market since the 2008 financial crisis. On October 13, in fact, U.S. stocks more than erased intra-day losses of more than 2% by rallying 5%, leaving traders wondering what happened. According to Bloomberg, the current bear market is tracking lower than the median bear market dating back to 1929. Whether this below-trend performance continues will largely depend on the trade-off between inflation and recession and the path the Federal Reserve and other central banks choose to follow.
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.