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Stocks have typically seen rallies into year end as investors finished their tax-loss selling and looked forward optimistically to brighter prospects in the New Year. These rebounds are often strongest in otherwise ‘weak’ years. This seemed to set up this year even more for a bounce as stocks had their worst year since 2008 and bonds had their worst annual returns on record! However, the U.S. Federal Reserve threw cold water on that prospect following their December meeting, when they increased interest rates by another 50 basis points (bringing the 2022 total increase to 425 basis points) and indicating that they were not yet done with rate increases and would also be leaving those higher rates in place somewhat longer than the consensus expectations of investors and economists. On top of that, a few ‘industry bellwether’ companies, such as Micron Technology and Fedex, reported tepid earnings results and indicated that conditions continued to worsen such that further cost cutting would be the only way to meet even their reduced earnings targets. That prognosis put a damper on any expectations of continued strength in the employment numbers. The fact that the economic numbers have remained resilient so far in 2022 is testament to the residual impact of both the monetary and fiscal stimulus applied during the pandemic as well as the benefits of the full ‘re-opening’ of the economy. Those residual effects will wear off in 2023 and then the economy will be faced with the reality of a much higher interest rate backdrop. Stock market weakness is more reflective of that belief.
For the record, the final numbers for 2022 were returns that most investors will want to forget. U.S. stocks fell about 20% on average but those returns were not evenly distributed. The ‘value-centric’ Dow Industrials Index dropped by only 9% but the ‘growth oriented’ Nasdaq Index, which is much more sensitive to the move in interest rates, fell by over 33%. In Canada, the TSX Index limited its loss to under 9%, but this was almost solely due to the 32% gain for the Energy sector and only moderate losses in the Financial sector, which accounts for almost one third of the index value. On the other end, the Real Estate sector was down 21%, Technology dropped 48% and the Health Care sector collapsed over 54%. Overseas indices were also weak, but not quite to the same degree as the U.S. European stocks dropped about 12% on average, helped by strength in the U.S. dollar which made European exports more competitive on world markets. Asian stocks fell about 15% on average, with South Korean and (no surprise) Russian stocks leading to the downside. Non-U.S. equities outperformed U.S. equities thanks in large part to the implosion in growth stocks, which are more heavily represented in the S&P500 (there are no European or Asian FAANG stocks). Moreover, U.S. growth stocks (18.6x forward EPS) are still more expensive than their global counterparts (15.6x) despite the sell-off in 2022.
The bigger problem for most investors in 2022 was that the bond market, which is the typical ‘safe haven’ in times of economic turbulence, had its worst year on record. The Canadian FTSE Bond Index lost 11.4% in 2022, driven mostly by the 21.2% decline in the Long-Term index. A little over a year ago, central bankers in the U.S. were proclaiming that they were ‘not even thinking about’ raising interest rate anytime soon. To go from that to the most aggressive rate hiking cycle in history in such a short time was too much for investors to absorb. Investors had been conditioned to a climate of ongoing interest rate declines for much of the past four decades, with a particularly aggressive easing in the past decade as growth was slow and inflation non-existent. That era of zero interest rates has clearly ended with the 2022 rate surge. The only question that remains is whether this is just a cyclical response due to the inflationary response to the pandemic or a longer-term reversal in the disinflationary period of the past three decades. Our inclination is to believe that the inflation of the past 18 months will end up being more ‘transitory’ since expectations of inflation in general have not become as embedded in consumers as it had been in the late 1970’s when they had experienced a full decade of elevated inflation levels. Bottom line for investors in our view; we have created a very attractive entry point for bonds.
Moving on to the outlook for 2023, we believe that we will see the peak in interest rates in the first quarter of the year. While those rate levels may be sustained throughout the year, we believe that weaker economic numbers and receding inflation rates will move central banks towards a ‘neutral’ or even an ‘easing’ bias before the end of the year. We aren’t alone in those views to be sure. Big banks are predicting that an economic downturn is fast approaching. More than two-thirds of the economists at 23 large financial institutions that do business directly with the Federal Reserve are betting the U.S. will have a recession in 2023. Two others are predicting a recession in 2024. The main culprit is the Federal Reserve, economists said, which has been raising rates for months to try to slow the economy and curb inflation. Though the economy has held up relatively well during the 2022 rate increases—jobless claims remain low, for example—economists said the cooling effects of higher interest rates will filter through more noticeably in 2023. There are a number of indicators that have traditionally portended recessions: Banks have tightened lending standards, and demand has weakened to near levels typically associated with recessions. The Conference Board’s collection of leading economic indicators has fallen for nine months in a row, reaching levels that have historically preceded recessions. Gauges that track overall business activity and the services and manufacturing sectors have fallen to some of the lowest levels since the Covid-induced 2020 recession. Further, U.S. government bonds maturing between three months and two years hold higher yields than long term bonds. This so-called ‘inverted yield curve’ is a warning sign that has occurred before every U.S. recession since World War II. The impact of the higher interest rates will take hold, even if this has taken longer than expected, often known as the ‘monetary policy lag.’ But job growth has slowed and we expect it to turn negative as corporate sales slow and layoffs start to occur. We have already seen that in the technology sector, where a ‘hiring freeze’ has morphed into actual layoffs as the largest companies try to reduce costs to bring them back down into line with reduced revenue expectations. Given how conditioned the economy had become to extremely low interest rates and how exceptionally-levered we are, it seems almost impossible for the economy not to fall into at least a short term recession. The chart below shows the statistical probability of a recession in the next twelve months as forecast by the shape of the Yield Curve. Currently that probability is just under 40%. We have to go back to 1967 to see a time when the probability of recession rose over 40% but no recession occurred within the next twelve months. It did come following the inversion in 1967 but took a little over two years until the recession actually began.
From the point of view of stock investors, it would probably be better to see this inevitable recession come sooner rather than later so that markets can get back to looking forward to rising earnings and lower interest rates. In that regard, we are once again at a point where “bad news (for the economy) is good news (for stocks)” since weaker economic data could hasten the end to the aggressive interest rate action of the central banks and set the stage for the next recovery. The bigger risk in 2023, in our view, is that earnings estimates still remain too high. Consensus expectations still call for 5% earnings growth for S&P500 companies in 2023. Our view is that the expectation of US$230 in earnings for the index is too high and is more likely to come in the US$210-220 range. Higher interest rates also argue for a lower earnings multiple for the stock market than the 21 times multiple it traded up to at the peak in November 2021. Putting a more reasonable 16-17 multiple on our suggested earnings range gives us a ‘fair value’ on the S&P500 of 3360-3740. This is below the closing value for the index in 2022 of 3839.5 suggesting that we could still break below the 2022 lows (seen in June and October) but that the downside risk would only be about 12% from current levels, even in our more bearish scenario.
The potential good news for stock investors in 2023 is that most of this bad news is already being reflected in investment portfolios, meaning that we have already seen much of the selling pressure. The chart below outlines the relative position of investors from the Bank of American Global Fund Manager Survey. While not yet to levels seen at the 2009 lows, we have to point out that stocks had already fallen 45% at that time and that we were in a full-blown global recession and financial crisis. While we see economic risks to the downside in 2023, we don’t see economic or financial circumstances getting anywhere close to where we were in the wake of the 2008 Financial Crisis. More likely, at some point we will start to get a more positive outlook on interest rates, which would ignite a rally in stocks similar to what we saw in several failed rallies in 2022, but sustainable. As the old adage goes, ‘invest when others are fearful.’ The chart below suggests that fear has become the major narrative!
In terms of our investment strategy for 2023, we remain cautious about the economic outlook and believe that we will see at least a shallow recession. However, stocks and bonds suffered in 2022 as they adjusted to the unexpected and higher level of interest rates. Given the better valuations and our belief that interest rates are close to peaking, we are constructive on bond prices as well as many sectors of the stock market, including the telecom and pipeline sectors, autos, travel, leisure and energy. Auto favourites remain General Motors, Magna and Martinrea, although we are getting more tempted to take a look at Tesla as it trades down almost 75% from its peak with earnings expectations still in excess of $5 per share in 2023. Core energy names in Canada included Crescent Point Energy, Whitecap Resouces, Suncor, Enbridge and TC Energy. In the telecom stocks we still like Rogers and BCE on valuation, dividend yield and earnings growth. In the U.S., AT&T looks intersting on valuation and recovery. We also like the biotech sector, particularly if we are closer to a peak in interest rates. In that group, we hold the ETFs, both the IBB, which covers the major players as well as XBI, which holds some of the newer entrants, where we may see some corporate activity. We are slighlty underweight technology but still have ample exposure and would add on any weakness but would first like to see 4th quarter earnings reports and the impact of economic weakness on IT spending and if further adjustments to the cost structures need to be made. Semiconductors look particularly attractive as the ‘chip shortage’ has abated. Names such as Qualcomm, AMD and Broadcomm look attractive as do the big cloud players such as Microsoft and Alphabet. We are also looking at getting back into Apple after 18 months on the sidelines in that name. While there is earnings risk from iPhone sales in China, we continue to see strength in the services business (iOS) and ancillary devices while the earnings multiple on the stock has dropped into the low 20’s.
We are still carrying slightly higher than normal cash balances into year end, which is less of a drag on the overall portfolio with rates higher now. However, we have added to bonds recently with the U.S. 10-year treasury bond trading with a 3.8% yield and our expectation that we may have seen the peak in longer term rates for now. Preferred shares had a difficult year in 2022 and now face more competition from cash and bonds as well as heightened credit risks in an economic slowdown, so we are carrying a slightly lower weight in preferred shares but looking for opportunities on any weakness.