By Rob Edel, Chief Investment Officer | Written as of December 12, 2022
View the Nicola Wealth Investment Returns: November 2022.
Highlights this Month
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- There may still be some fight in this bear market.
- There are certainly enough elements left to cause concern for investors.
- China’s zero-Covid policy and its rippling effect on the economy.
- Considering the state of democracy.
- The biggest dilemma facing central banks in 2023.
- The key will be how higher rates impact the job market and consumer spending.
- What does all of this mean for 2023?
November 2022
November was a good month for equity markets. Apart from Brazil and Latin America, all global indices ended the month higher than October, with many seeing double-digit gains for the month. Closer to home, the S&P/TSX was up 5.5% (total return in Canadian dollar terms), while the S&P 500 gained 6.4% (total return in U.S. dollar terms). Also performing well was fixed income and credit, particularly emerging market bonds. On the other hand, the U.S. dollar and crude oil were lower in November.
There may still be some fight in this bear market.
Positive results might have brought a smile to Fed Chairman Powell’s face in the short term, but there may still be some fight left in this bear market. However, December may find some respite, as the last month of the year has historically been generous to investors. According to Carson Investment Research, only in 2018 was December the worst month of the year for stocks. Also favouring the bulls short term is the S&P 500. The index has increased two months in a row for the first time since the summer of 2021. Historically, after two back-to-back 5% gains, Carson notes that the S&P 500 added an average of 1.4% the next month and 5.5% in the following three months.
As we look towards next year, however, it is still being determined whether we are looking at the sunrise of a new bull, or the continued sunset of the previous bull market, with the recent increases just another bear market rally. According to Bloomberg, bear market rallies can be robust but ultimately succumb to the downward bear trend. While we have now had five rallies in 2022, the 2007-2009 bear market also experienced five, while the 2000-2002 bear market experienced six. The last two months aside, investors have voted with their feet, with Bank of America Research’s Fund Manager Survey finding institutional managers are most overweight cash and underweight equities.
There are certainly enough elements left to cause concern for investors.
As pointed out by a recent issue of Bloomberg Businessweek, the global economy is in a fragile state. The Federal Reserve Bank of New York (FRBNY) has listed fourteen risks, with geopolitical risks, persistent inflation and monetary tightening topping the list. We will not go over all ten this month, but we will explore a few crucial points below.
China’s zero-Covid policy and its rippling effect on the economy.
In our eyes, the first risk is China, not its potential conflict with Taiwan as highlighted by the FRBNY, but its zero-Covid policy and its negative impact on its economy and ensuing social unrest. According to China’s National Bureau of Statistics, the country’s purchasing manager’s index fell to 48 in November, below 50, thus indicating manufacturing activity is contracting. A similar services sector survey reported an even more significant decline to 46.7. While China’s zero-Covid policy is not the only reason, Morgan Stanley recently highlighted that Covid lockdowns have impacted 25% of China’s GDP. More concerning for leadership, protests have recently begun breaking out across mainland China. With restrictions mostly a thing of the past for the rest of the world, China is being left behind economically and socially. This seclusion has become very apparent for the Chinese watching the recent Football World Cup. While China did not qualify for the tournament, many housebound Chinese did tune in to watch, only to see crowds of unmasked fans cheering on their teams.
President Xi is in a tough spot. While easing restrictions would help the economy and reduce social unrest, the hospital system could become overwhelmed. Cases have recently spiked higher, and while severe cases and deaths remain manageable, Jefferies Financial Group Inc. reports that 8.4 million Chinese over 80 years old are entirely unvaccinated. Furthermore, the Financial Times found that China risks one million Covid deaths over winter, with daily hospitalizations peaking near 70,000 under a swift reopening scenario. Eventually, the country will have to open up, but the question remains when and how quickly. It matters because China is a significant driver of the global economy, and a reopening could help drive global growth higher. Markets appear to understand this, and with Chinese credit spreads narrowing and Chinese stock indices recently inflecting higher, the market is sensing an upcoming easing in China’s strict Covid controls.
The ramifications of the Russia-Ukraine war.
We want to be as optimistic about the war in Ukraine and its potential positive impact on energy prices, but there appears to be no near-term resolution. Financial Times reports that Russian oil output has managed to bounce back as countries like India, Turkey and China have stepped in to buy discounted Russian oil, but the U.S. and their NATO allies will likely put further pressure on governments and transporters to either stop buying Russian energy or at least only pay a capped price. The U.S. will also need to start replenishing its depleted strategic oil reserve at some point, and increased demand from post-lockdown China could also drive demand and prices higher once the Covid restrictions lift. As a result, high energy prices remain a risk for markets.
Considering the state of democracy.
Less of a risk in our opinion, is the demise of democracy, with the Democrats outperforming the polls in the U.S. midterm elections last month. While Democrats did lose the House of Representatives, they lost only nine seats, far fewer seats than expected by historical standards. Democrats could have expected to lose upwards of 50 seats based on President Biden’s popularity, according to Strategas. Democrats also kept control of the Senate, even picking up a seat to gain an outright majority.
If Democrats and democracy were the winners, former President Trump had to be the loser last month. According to the New York Times, rather than help candidates win their midterm election races, Trump’s endorsements cost candidates about 5% of the vote. The AP VoteCast survey found inflation was the most crucial issue for voters, followed by the future of democracy. Republicans should have picked up votes given that most voters, right or wrong, have more confidence in the Republican party’s ability to run the economy. Trump is not doing the Republican party any favours, however, and more and more people are starting to notice. While Trump has indicated he plans to run for President again in 2024, support has been cooling off, and many republicans would rather he ride off into the sunset. As for Biden, despite the midterm success, his popularity remains low. After celebrating his 80th birthday, many Democrats wish he would ride off into the sunset. With democracy saved, for now, and a split Congress keeping both parties in check, many expected lots of rhetoric but not much action. Gridlock is good for markets.
The biggest dilemma facing central banks in 2023.
While politics is likely not a risk for 2023, we believe that inflation, monetary policy, and the threat of recession are. According to a November Bank of America Fund Manager Survey, 80% believe a recession is likely within the next 12 months, with below-trend growth and above-trend inflation (stagflation) as the consensus view. An MLIV Pulse survey from November 21-25 also found stagflation as the most likely path for the global economy in 2023.
Rates have increased, and central banks are beginning to slow the increases, but inflation remains stubbornly high in places. How high are central banks willing to increase rates in order to tame inflation? The Fed has already undertaken one of its most aggressive tightening cycles in over 50 years, with Scotiabank calculating it has averaged 40 basis points in tightening per month over the first 12 months of tightening. Only the 1980 tightening cycle at 50 basis points per month was higher.
Everyone is waiting for the pivot, where the tightening cycle ends, and the easing cycle starts. According to the futures market in late November, the Fed is expected to raise rates by 50 basis points in December, followed by three 25 basis point hikes in February, March, and May. In July, the futures market has the Fed finally pivoting with a 25-basis point cut. These rate expectations have remained unchanged since both the terminal rate and the speed and magnitude of the pivot fell marginally on November 10th. But not everyone sees a pivot in 2023. While most fund managers polled see inflation moving lower, a report by Bank of America shows that only 30% see lower short-term rates in 2023.
Not everyone believes the terminal rate should be capped at around 5%. FHN Financial’s Executive Vice President & Manager, Interest Rate Strategies Group, Jim Vogel, believes that rates will need to rise to 6% to satisfy the Fed’s quest to lower inflation, a level the President of the St. Louis Federal Reserve, Jim Bullard could get behind. Bullard believes rate hikes have had a limited effect on inflation and thinks a range of between 5% to 7% for the terminal Fed Funds rate is needed. Former Treasury Secretary Larry Summers also recently voiced the risk that Fed Funds will need to get to 6% or higher to bring inflation under control. A higher terminal rate for Fed Funds is one of two significant risks we see for 2023, given it is not discounted in the market, and rates this high would almost certainly lead to a hard economic landing (recession).
The key will be how higher rates impact the job market and consumer spending.
The Fed hopes to reduce wage inflation by lowering job demand but not dramatically increasing unemployment. So far, the plan is working in as much as job openings are falling, but more work needs to be done. The Job Openings and Labor Turnover Survey (JOLTS) shows that the job openings to unemployed workers gap has rolled over, as have quit rates, but BCA Research highlights that more progress is needed if the U.S. economy is to avoid a recession. Goldman Sachs believes there are still about four million more jobs than workers, down from a peak of about six million, but the investment bank thinks this number needs to get down to only two million by the end of 2023 to engineer a soft landing. Also, while announced layoffs have inflected materially higher, most can be attributed to the technology sector. Finally, many parts of the U.S. labour market remain very tight, particularly the service sector; these are the areas where wage inflation is most problematic and cause the Fed the most headaches.
Even with higher wage growth, inflation and higher interest rates are starting to deflate the average U.S. consumer and the cash cushion they accumulated during Covid. According to Bloomberg, U.S. consumers experienced seven quarters of above-trend disposable income growth, but disposable income is now back to its 30-year trend line. JP Morgan sees excess household savings being depleted by mid-2023. Backing up both their claims, credit card balances are on the upswing, indicating consumers have to borrow more to meet their spending needs.
The second considerable risk we see in 2023 is corporate earnings. Earnings estimates for 2023 have come down, but more is needed. The average 2023 S&P 500 EPS estimate is $217 per share, down only about 5% from September’s estimate, while Strategas sees $200 per share as more likely. Rosenberg Research claims 2023 EPS estimates are tracking the average recessionary trajectory, which Morgan Stanley points out are slow to play out. In other words, expect more forecast cuts over the coming months, particularly earlier in the year. In bad years for earnings, RBC shows that cuts typically happen by April. If this turns out to be the case, Q1 2023 could be volatile for markets.
The reason we view a Fed Funds terminal rate of 6%—or anything materially above the 5% presently being priced in the futures market—and a lower S&P 500 2023 EPS per share ($200?) as the two most significant risks for the market is that neither is being discounted by traders, meaning the market does not believe this will happen and is priced accordingly. The market thinks the Fed will pivot to lowering rates in 2023, and this, along with a flush consumer, will result in a soft landing.
BMO Capital Markets highlights that other than in the year 2000, the end of a Fed tightening cycle has historically been good for stocks. This point was confirmed by Bank of America Research, with the S&P 500 historically up 14% on average once the Fed has stopped hiking rates. However, we must be careful in interpreting the data. As Strategas points out, the average number of trading days from the first Fed rate cut to the S&P market low has historically been 195 days and the S&P 500 has fallen an additional 23.5%. A proper pivot is not when the Fed stops raising rates but when it starts to cut. The Fed typically begins an easing cycle because of weakness in the economy, which is bad for corporate earnings, and equity returns. A pivot may be positive for valuations, given that it lowers the discount rate for earnings, but it is the lower earnings themselves that could lead the market in the next leg lower. From a pure contrarian point of view, the magnitude of investment flows into bond mutual funds and ETFs relative to equity mutual funds and ETFs recently makes one question whether stocks look attractive here. They will look appealing at some point, but from a risk-return perspective, investors may prefer bonds in 2023.
First of all, the odds favour a rebound in bond prices. According to Edward McQuarrie of Santa Clara University, long term bonds are on track for their worst loss since 1793. Long term bonds deliver positive returns 85% of the time, however, and have risen 79% of the time when declining in the prior year. In addition, according to Bloomberg, 10-year yields tend to fall well before the Fed cuts rates, favouring a rise in bond prices. Also, the increase in yields means bond duration has fallen, so even if yields rise in 2023, the price impact will be less than experienced this year.
Longer term bond yields have already started to fall, as evidenced by the deep inversion of the yield curve in both the U.S. and globally. The U.S. 2-year versus 10-year yield is the most inverted in 40 years, Strategas found, mainly due to the 44-basis point decline in 10-year yields last month. According to Jefferies’s yield curve cycle, we are likely somewhere between a bear-flattening and bull-flattening part of the cycle.
Bond investors will want to be careful about credit if this is the case. While investment grade and junk-rated credit have experienced strong returns over the past month, the current yield curve cycle would favour investment grade credit or government bonds. A recent Bloomberg MLIV Pulse survey agrees, with most investors preferring the safety of investment grade over junk bonds in 2023. Of most concern are levered loans, which investors see as a likely canary in the coal mine.
As for stocks, Morgan Stanley points out that high dividend stocks outperform during above-trend and falling inflation regimes. In addition, the investment bank believes defensive and value-oriented dividend-paying stocks tend to provide investors with the best returns. According to Strategas, dividends have historically been a large contributor to investment returns, with the 2010s being the outlier. Since the 1930s, dividends have historically accounted for 60% of the overall S&P 500 return; it was only during the quantitative easing era in the 2010s that dividends accounted for only 26% of total returns.
While traditional 60% equities and 40% bonds portfolios have had a terrible year—with bonds on track to lose slightly more than stocks—we feel that next year might work out better for the typical investor. Of course, a lot will depend on inflation and where the terminal Fed Funds rate ends up. As pointed out by Charles Schwab, the correlation between bond and stock prices tends to increase during times of high inflation.
What does all of this mean for 2023?
In summation, both government and investment grade bonds look to have more attractive risk/return attributes than stocks in 2023. Additionally, we see two significant risks to markets next year: terminal policy rates in the U.S. ending up higher than expected and not pivoting lower in 2023, and corporate earnings coming up short. Markets are currently discounting a terminal rate of around 5%, with the Fed shifting to rate cuts by July. At the very least, we believe the Fed would keep rates higher for longer and not pivot until 2024. While this would be bad for bonds, the risk is limited given that bond yields have already adjusted in 2022 and carry a larger coupon return, which should offset any losses (lower duration).
More problematic, higher rates would provide a headwind to equity valuations and also contribute to our second considerable risk: lower corporate earnings. According to a recent MLIV Pulse Survey, most investors believe the return for the S&P 500 in 2023 will be between -10% and +10%, but Wall Street strategists see a decline for stocks next year for the first time in decades. However, this belief is far from unanimous, as Bloomberg reports the highest spread between the highest and lowest price target for the S&P 500 since 2009. But, as they say on Wall Street, that makes a market.
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.
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