Andrew Pyle
May 06, 2022
Looking for opportunities in a week of churn
If retail investors ever wake up thinking that institutional traders are a tad irrational, they are to be forgiven. If they feel confused, they are to be equally forgiven. In the equity market, we are conditioned on the principle of long-term investing; yet market sentiment can and has swung on mirages as much as fact. This year is a good example, but this week is an even better one. A fully-anticipated half a percent rate hike by the US Federal Reserve was delivered and US stocks went from exuberance, fueled by suggestions the central bank wasn’t going to drive the economy into recession, to an inflation relapse on Thursday. A famous investor from Omaha has said that “you leave a room when the party is in full tilt and go back in when people are fleeing on talk of a fire.” We believe we are in that situation now.
Ally and I have talked about how both bond and equity markets have been dealt blows since the start of the year and how some segments have been disproportionately stressed relative to fundamentals. Inflation has definitely risen to levels not believed possible over the past three decades, even though the factors have been known for some time. What has changed, in part because of the Russian invasion of Ukraine, is that the worries over its persistence have escalated. Those worries have permeated the Federal Reserve and Bank of Canada, which is why we have seen the first half-point rate hikes in over twenty years.
Understandably so, investors believe the risks of a sizable slowdown or recession have increased. The way we have explained this to clients is that, back in 2020, we knew that interest rates would eventually have to rise. Growth was exceeding potential; labour markets were getting overly tight and inflation expectations were feeding into the behaviours of economic and market participants. A gradual and steady pace of rate hikes by central banks would get us to neutral (or terminal) rates by around 2024 and at that point there would be a significant chance of economic contraction. Well, as we know now, the Bank of Canada and Federal Reserve have hastened the pace of tightening to the extent that, if they were to continue, neutral rates will be reached by the end of this year. That has compressed the forecasted time horizon to the point where the chance of economic contraction has been brought forward from 2024 to possibly the second half of this year.
The perceived negative impact of substantially higher borrowing costs on everything from housing to consumer spending is at the core of the market’s concerns overgrowth. Global factors, however, are also contributing to this. China has been in a state of lockdown during its latest COVID-19 wave, leading to massive disruptions to supply lines and output. It was hoped that Chinese leaders would realize that shutting down the economy 2020 style would be detrimental and the goal of eventually moving out of the pandemic in a sustainable fashion.
Based on the headlines out of this week’s Politburo standing committee, that is not the case. Leaders said they will “exhaust all means and efforts” to eradicate Covid-19 and that criticisms of President Xi’s policy would not be tolerated. Sound familiar? Yet, the committee did not mention anything about how the government would act to contain the economic fallout from this failed policy. On top of that, we had reports that China’s government and central bank are swapping out all of their foreign-made computers for domestic ones (about 50 million units or so) over the next two years. This has reinforced concerns about China’s decoupling from the western world’s economy. As a result, China’s stock market continues its stumble through the bear forest. After a temporary bounce at the start of the week, the CSI 300 Index fell back sharply this morning and is down about 33% from its peak in February 2021.
Against this backdrop, economists are quickly marking down their economic projections for not only Asia and Europe, but the US as well. Bloomberg gathers predictions for the major indicators, like real GDP and inflation, and calculates the consensus forecast for the current year and years into the future. Back in September of last year, the average prediction for US growth in 2022 was 4.3%. As of this week, the consensus forecast is for barely 3%. The outlook for 2023 has also shifted lower from 2.4% last September to only 2.1%. If we look out to 2024, there has been only a small decline in the consensus from 2.1% to 2.0%. This underscores what Ally and I have been talking about. A normal rate hike cycle would likely take growth to 2% in two years anyway. The compression in risk is really taking place this year.
Some analysts believe a North America bear market for stocks is upon us. While it is foolish to rule anything out these days, we believe headline-making forecasts are premature. In the case of the S&P500, a 30% decline from the highs seen at the start of this year, would take the index below 3400, from its current level just above 4100. This would effectively reverse all the gains made since November 2020. Keep in mind though that 3400 was also where we got to just before the COVID-19 lockdown in the spring of 2020.
If the TSX were to experience a 30% drop from its January highs, this would take the index down to just below 15,500 versus its current perch of around 20,700. That, however, would be about 2500 points below where we got to in February 2020. On a relative value basis, we do believe there is more downside risk to Canadian stocks versus the US, which is why we have been tilting the equity portfolio towards US in recent weeks. There is a market that is even closer to bear territory and that is the tech sector.
The NASDAQ 100 index, which is dominated by large tech names, is down by more than 20% from its January peak after tumbling almost 700 points to 12,850 on Thursday. A 30% slide would get us down to the 11,600 area. Trying to figure out exact tops and bottoms for any market is an extremely difficult and fruitless thing to do. Estimating where the relative probabilities are of a further slump or rebound, based on how far a market has deviated from other markets is useful. This is why we have started to move back into the NASDAQ 100 this week. If there is to be an economic slowdown or correction, then investors are going to be looking for growth and not cyclical stocks, which suggests money could go back to tech.
The same analysis can be applied to the bond market. After half-point hikes by the Bank of Canada and the Fed, bond yields have reached levels that are more consistent with where analysts think terminal rates will get to, rather than where official rates are today. The 10yr Government of Canada bond yield crossed 3% this week and the 2yr yield is only 0.3% below it. These levels improved the attractiveness of the government market relative to credit and stocks. As such, we have started to shift the fixed income portfolio towards government debt. Clients will recall that Ally and I did the opposite back in 2020, given that a tightening cycle would do more damage to low-risk government paper than corporates or floating rate notes. Again, it’s not about picking the top in yields but assessing the relative strength of one market versus another.
The one thing I will say, and it echoes comments we made back when the pandemic started, is that investors are going to have to be nimble in this fluid environment. What looks cheap today might look expensive in a few months. It is important to maintain a long-term focus in terms of strategy but be more tactical than normal.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew
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These are the personal opinions of Andrew Pyle and may not necessarily reflect those of CIBC World Markets Inc.