Andrew Pyle
January 22, 2022
Gloom crew falling over each other to grab the sound bite
Full disclosure – I used to peddle my wares on Bay Street as a bank economist. A number of my friends are still doing it. A couple of years ago, I told someone that I had put my economist hat on the hook and became an advisor and portfolio manager. They reminded me I still wore the hat. That being said, the career was great at teaching humility. You could have the best models on the street, and you would still get forecasts wrong. Depending on where you worked, even if you knew the forecast was a good one, you might not be able to tell anyone about it. For example, how many times have you heard a mainstream bank economist say we are going into recession? Not many.
Market strategists are a different breed and, for some, it’s all about the sound bite and what is going to attract the most ears. That could be an aggressively bullish forecast or one that conjures up memories of big corrections. I touched on this on our Wednesday evening conference call (playback details can be found at the end of the newsletter). A year ago, analysts and economists believed that inflation would spike, come down and require only a modest amount of central bank tightening, if any. With CPI inflation at a 20-year high in the US and a 10-year high in Canada, with no sign of bending, that forecast has indeed been humbled. Today, more and more are ripping up the script and becoming extremely hawkish on inflation and hence the necessary dose of central bank tightening. Instead of delaying rate hikes, some are falling over themselves in terms of projecting fast and aggressive increases in rates, starting in March. This time last year, the market was pricing in no change in the fed funds target rate by the end of 2022 or 2023. Today, the implied forecast is for three rate hikes (to 1%) by the end of this year and another three increases to 1.75% by the end of 2023.
As rate forecasts climb, analysts have also talked themselves into a much weaker environment for growth stocks. This is why we are looking at a NASDAQ that is down more than 10% since the record highs in November – in other words, a technical correction. Listening to the news this morning, I have heard views that we are going to see an equity market correction similar to 2008. I will admit that economic and market forecasts will sometimes follow the path of least resistance, depending on which way the herd is moving. No surprise then that both the bond and equity markets have become unhinged in the first three weeks of the year.
At the time of writing, the S&P500 was down close to 4% since the end of December and the Dow Jones index was off just under 3%. The damage to the tech-heavy NASDAQ has been worse, with the index down almost 9%. In contrast, the TSX is still basically flat this month, thanks to a continued surge in energy prices. The extent to which Canadian stocks can outperform the US is unclear. Already, the ratio of the Dow to the TSX has fallen back to the 1.65 area, which we last hit in November. Before then, it was August 2020 when the TSX traded this well relative to the Dow.
The question is whether a case is really being made for a bearish turn to the equity market. To answer that we have to take a step back and figure out where we are relative to the gloom forecasts. First, there is no evidence to indicate that we are either in the middle of a recession or on the doorstep of one. That’s important because to create the corrections in stocks that some are talking about (like 50%), you need the economy to fold. Even in March of 2020, when we orchestrated the worst recession since the Depression, stocks fell ‘just’ 35%. There are anecdotal data points that suggest the first quarter will show a significant downshifting in real GDP growth from the fourth quarter, but the majority of reports point to there be no contraction. For example, the US leading indicator is still showing year-over-year growth of just under 10%, but still below the peak of 16% back in the summer. This rate of increase will likely decline, but I’m not sure we get to negative growth in the index – at least not this year. As the following chart illustrates, we have gone through multiple cycles where we get sharp gains in the leading indicator after a setback, followed by moderation; but it is only when annual growth falls below zero that we get the major declines in the S&P500.
The other issue is what central banks are going to do with the current market volatility? The short answer is nothing. The Federal Reserve does not target equity market valuations and, when it meets next week for the first time in 2022, its guidance will likely remain the same. In other words, the economy has strengthened, and inflation has risen to the extent that interest rates have to move higher. It will also probably guide towards an interest hike in March but talk that it will spike rates by half a percent at that March meeting will probably not be reinforced by the Fed’s rhetoric.
We are also seeing signs of supply shortages cooling down, which should ease the upward pressure on prices. A major steel firm this week warned that steel prices could plunge on over-supply, as demand cools off in 2022. I’m not sure about a “plunge”, especially as demand for things like automobiles and infrastructure plans should still be sold this year. At the same time, home construction has been robust, which should help alleviate housing inventory shortages and calm price gains in that sector.
The message that Ally and I have conveyed for weeks now is that, while no one knows the direction equities will take in 2022, it was pretty clear that volatility would rise as economies and economists transition. There will be a point in time where monetary policy tightening could become too excessive, such that we get an actual contraction in economic activity. Positioning into that development will be defensive. Today, we don’t see the need to be defensive based on fundamentals. Indeed, if the combination of data and central bank messaging/actions leads the bears back to hibernation, then these minor corrections could be opportunities to build equity exposure back to target.
Conference Call Playback details:
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