Is it safe to look yet?

What a year 2022 turned out to be. A year ago, when we forecast a year of above average volatility, we had no idea the extent of the surprises that would take a strike at financial markets over the next 12 months. The war in Ukraine is in many ways the most shocking, but financial markets were more rattled by the aggressive shift in interest rates engineered by the central banks across most developed countries. Last December as we wrote this report, it was expected that rates would rise by 1.25% in 2022 – give or take a bit. It would be hard to find anyone who was forecasting an increase of over 4.0% or with the expectations that interest rates will end up at close to 5.0% in early 2023.

Bank of Canada Rate – Past 18 months

Source: https://www.bankofcanada.ca/core-functions/monetary-policy/key-interest-rate/

While the U.S. Central Bank continues to forecast more rate hikes, the Bank of Canada appears closer to moving to the sidelines, with only one more hike expected early in 2023. The reason for the difference is twofold. First, the Bank of Canada began raising interest rates earlier and was more aggressive. The second key fact is that the Canadian economy is more sensitive to shifts in interest rates. Not only do Canadians hold notably more household debt than their American counterparts, but a larger portion of that debt is affected by shifts in interest rates. This is primarily due to the difference in mortgage structures between the two countries. The result being a Canadian economy that should feel the pain of higher interest rates earlier than its southern neighbour.

Perhaps in line with that thought, inflation pressures seem to be ebbing in Canada. (Remember, the point of raising interest rates is to increase the cost of debt, which reduces consumption and therefore brings supply and demand back into line, reducing inflation pressures). Although the headline numbers that are published in the media are still shockingly high, those numbers are mostly a reflection of a surge of inflation early in 2022, which will continue to impact the annual inflation numbers until around the end of the first quarter of 2023. However, if you only look at the period since then, inflation has been trending back towards a relatively tame level, although still somewhat above the Bank of Canada’s 2% target.

The U.S. is a somewhat different story, as the overall inflation number remains high. Goods inflation has collapsed back towards the target level as supply chain problems have eased. Services inflation, if the housing component is excluded, is now easing. The housing related component remains high but there is a significant lagging effect in how housing prices translate into the inflation numbers. Concurrent measures of housing inflation have rolled over, suggesting this element will also ease later in 2023.

We are not prepared to say inflation is defeated, but it seems this round is slowly coming back under control. That is to say that inflation may not disappear as it has for much of the last two decades. Some fundamental shifts occurred in 2022 that could make inflation a topic of ongoing conversation over the coming years.

First, the war in Ukraine and the heightening of geo-political tensions elsewhere (Iran for example) mean oil supplies cannot be deemed as secure as in the past. This could result in periodic oil price shocks. Secondly, food supplies could be disrupted as Ukraine and Russia are both major suppliers of many staple products. The war is also expected to result in pressure on western democracies to re-arm, potentially straining the capacity of the industrial complex.

The same geo-political tensions mentioned above may change the dynamics of trading relationships. Rhetoric from the likes of Chrystia Freeland and Janet Yellen suggesting that trade should be with trustworthy friends and allies rather than unreliable dictators may also be playing out in practice. From August to November, the volume of imports from China to the U.S. declined by 21%, sinking back to pre-Covid levels. Between March and November, the volume of imports from Europe rose by 20%, well above its pre-Covid levels. It is difficult to tell on such a narrow piece of data whether this is truly a strategic shift, or simply a practical but temporary adjustment made due to the continuing Covid lockdowns in China.

Shifting trade to other democratic nations may make supplies more secure, but it is important to remember the reason that trade in goods migrated to China and that Europe sought access to Russian gas. These countries provided us with what we needed at lower prices. Reversing this seems likely to lead to higher prices.

Finally, the attempts to slow climate change do not come without a cost (despite what politicians try to convince the electorate). Let’s just be honest about it. If switching to green energy saved consumers and businesses money, they wouldn’t need incentives to make the shift. That isn’t to say that it isn’t the right thing to do or that it may be less costly than the long-term cost of doing nothing, but it is not a free ride.

Will these elements keep inflation a factor for years to come? We think it is a distinct possibility.

However, going back to our previous point in that it seems likely that in the near term, inflation will drift back to more manageable levels. For investors, that means that the carnage in the bond market should come to an end. (Note: 2022 may have been the worst bond market for investors in 100 years.) We will even be bold enough to predict that 2023 will be a relatively good year for the bond market.

Our prediction assumes that the central banks will pause raising interest rates early in the year. We are not anticipating a cut in interest rates, merely a pause. So, how does this add up to a good year in the bond market? It’s simple (or perhaps not so simple) math. That math is outlined below, but we would consider it optional reading – there won’t be a quiz after.

If any of you remember our lesson on bond pricing from our first quarter report (found here if you would like to re-visit it), our optimism comes from the simple passage of time. Here is a summary of how it works:

For the sake of continuity, let’s go back to that example from the first quarter. Ilsa bought a 2-year government bond on January 3rd, 2022 with a yield of 2.3%. A year has passed since she purchased that bond. A one-year bond now has a yield of 4.6%. That means that Ilsa’s bond is valued at $97.70 (4.6% return required by the market less the 2.3% interest payment she receives = discount of 2.3% from its maturity value.) That means that last year Ilsa received $2.30 in interest, but the bond declined in value by $2.30, leaving her with $0 overall return. In 2023 she will receive her $2.30 cash payment plus the price will appreciate back to its maturity value, gaining $2.30. So, this year she will earn $4.60.

Assuming we are correct in our belief that interest rates will now stabilize for a period, price appreciation should occur across the bond portfolio. If Ilsa’s bond had been a 5-year bond, the price would have dropped more (the differential between her interest rate and the market rate would be multiplied by 4 years remaining resulting in a price decline of $9.20). But in the coming year, it should still increase by $2.30 as the number of years the price must account for in the spread in the bond’s interest payment and current market rates shrinks.

Shifting to Equity Valuations

We have used a lot of space to discuss inflation and interest rates, and probably now need to turn our attention to equity markets. The picture for equity markets is far from clear as we enter 2023. If it seems like we are about as consistent as a squirrel on LSD, we apologize, but there are many factors both pushing and pulling equity prices over the next year.

When we look at equity markets, the simple answer is that we would expect one more leg lower in 2023, particularly in U.S. equity markets. But that is far from a certainty. Equity returns are made up of two basic components – the earnings of a company and the valuation investors are willing to assign to those earnings.

Let’s start with valuations as that may be the simpler piece of the puzzle. Higher interest rates are associated with lower valuations. Higher perceived risk is also associated with lower valuations. Over the last 15 years U.S. equity markets have traded at an average valuation of just under 16 times earnings. Canadian equity markets have been closer to 14.5 times earnings.

Although the decline in U.S. equity markets last year has primarily been a valuation reset (with valuations coming down from 2021 highs in the mid-20’s range), valuations remain above the long-term average. In contrast, Canada and Europe are both valued below the long-term averages. Bear markets rarely end with above average valuation levels. In this context, it is important to recall two of the rationalizations for the higher valuations that equity markets have traded at in recent years: low interest rates, and a peace dividend (i.e. low geo-political risk to business). Neither of these still hold. Therefore, we would expect valuations to hover closer to the long-term averages than in the past several years.

Forward Price Earnings Ratio for S&P500

Source: Refinitiv

The Final Piece of the Puzzle – Corporate Earnings

Now let’s try to tackle the earnings story. This gets a bit messier. So far, the North American (and even the European) economies have been surprisingly resilient to higher interest rates and spiking energy prices. Will this continue? It is hard to be certain. Data suggests that the “covid savings” that households were using to protect their lifestyle from price increases are running thin. But data also suggests that mortgagors are also dodging some of the pain of higher interest rates by extending the amortizations of their mortgages and thereby keeping payments lower than they would be otherwise. Employment remains strong and many employers are reluctant to reduce staff as it has been so difficult to hire good people. Therefore, if people aren’t seeing their debt costs spike and remain employed, the economic impact of higher interest rates may be lesser than would be expected.

But let’s go back to the data (this is where the squirrel might come in). Historically, when the economy has gone into a recession, corporate earnings have tended to decline by roughly 5% to 20%. Currently, markets are expecting a 5% increase in corporate earnings this year. Therefore, even if the economic slowdown is only mild, there is still likely a need to readjust earnings expectations by about 10%.

We are now going to go full squirrely. When you look at the breakdown of earnings amongst the different sectors of the economy, the main sector holding earnings up is energy, as you can see in the chart below showing the breakdown of third quarter earnings by sector. If the energy sector were excluded, the earnings situation would look decidedly more dismal. Which leads to the question as to how much of the expected economic slowdown is already being priced into the non-energy stocks? There is no clear answer to this question, and it is near impossible to make sweeping statements across the broad market. It is something that needs to be assessed on a company-by-company basis. That is our job to try to sort out.

Third Quarter Earnings Growth By Sector (S&P500)

Source: Factset

We recently heard a well-known commentator on equity markets state that if anyone tells you they know how 2023 will play out they are full of……. Well, we will leave that thought, even though we tend to agree. Our best guess is that the year starts out with more bouts of volatility but gets better as the year progresses. Equity markets tend to bottom out before the economy and to be on their way to recovery before the economic slowdown is complete. With the full weight of interest rate increases anticipated to hit the economy by the middle of the year, we expect markets will start to look beyond the slowdown and towards the recovery.

Can we ‘carry’ on?

We have just a few more comments to make on the possibility of an outlier event. Whenever there is a dramatic shift in any economic factor, the risk of something “breaking” in the system rises. In our opinion, the magnitude of interest rate hikes, after a prolonged period where rates were held artificially low, qualifies as such a dramatic shift.

One of the areas we have been watching is Japan. For decades Japan has been an active participant in what is commonly known as the ‘carry trade’. Hedge funds, pension funds and other investors could borrow in Japanese yen, at interest rates of zero (or lower) and invest that money in U.S. treasury bonds or other investments. It is unclear how much money is invested using this strategy of taking ‘free’ money from Japan and investing it elsewhere. It is likely at least in the many billions. (The best estimate we were able to find was about $500 billion, but it is difficult to know if that is a reliable number.) One of the pre-conditions of this working is that Japanese interest rates need to stay at zero or lower.

The Japanese central bank has been adamant that short-term rates will not rise, even as the yen falls. Or at least, the central bank had been adamant. But as the Bank of Japan gets ready for a leadership change this spring, the current head of the central bank has begun to prepare the market for higher short-term interest rates. If this triggers an unwinding of the carry trade, that could impact broader financial markets as assets in other regions are sold to pay back the money borrowed in yen.

This unwinding would take place in a market already experiencing reduced liquidity as Central Banks withdraw the stimulus provided in 2020 and 2021. Reduced liquidity is associated with higher volatility. This is already being felt in financial markets as it has become more difficult to execute large bond trades and even some governments have been challenged to have new debt issues absorbed into the market.

Needless to say, in our mind markets remain vulnerable in the near term. Could we be wrong? Absolutely! It is often said that markets must climb a wall of worry. There are always things that could go wrong, sometimes they are just less obvious. (In fact, those less obvious risks are often the more dangerous ones.)

There is nothing that we have discussed here today that is not being broadly debated by money managers around the world, which also means investors are adjusting their portfolios to reflect their assessment of these risks. That reduces the risk of a shock.

There are no easy answers to navigating the next few months of uncertainty. However, during periods when the crystal ball seems to be caught in a snowstorm, our belief is to shift the focus away from the noise of the overall environment and focus on the fundamental value of each company that we invest in for our clients. Our core belief is that if you own good companies that can consistently grow earnings (no matter the economic conditions) and buy them at good valuations, that you will be a successful investor over time.

Logan Wealth Management

December 30, 2022