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Valuations Starting to Matter Again
Another South African COVID variant has been uncovered with over fifty mutations. This changes nothing to our relative preference for stocks vs. bonds with the caveat that investors need to be selective given inflated expectations for a number of sectors and stocks (especially in the technology area). Financial history has proven time and time again that being disciplined about the price paid for assets is the best way to ensure an appropriate return for long-term investors. Excesses to the upside or downside tend to be corrected with opposite reactions, with a catalyst usually needed for this process to begin to unfold. We believe higher inflation is the best candidate at this point. Higher inflation erodes purchasing power and pushes interest rates higher. This, in turn, lowers the present value of future corporate free cash flows (which is the fair value of stocks).
The current consensus is that inflation is set to come down significantly in the U.S. and Canada, although we believe that view is too optimistic. A recent Canadian Federation of Independent Business survey showed that companies continue to anticipate a worsening inflation picture. Firms expect they will raise their prices by an average 3.8 per cent over the next year. That’s the highest in records going back to 2009 and more than double the historical average. The Bank of Canada and the U.S. Federal Reserve (the “Fed”) may well have to start raising rates sooner rather than later to contain this pressure. While rising inflation is bad news for most consumers, well positioned companies with pricing power can actually expand their profit margins in such an environment.
Still Bullish on Stocks But be Selective
Last month we increased our fair value estimates for the S&P/TSX and S&P 500 to 26,000 (from 24,000) and 5,000 (from 4,600) respectively. These higher targets were purely driven by higher corporate profits rather than a higher valuation multiple. We also noted that, “we believe some bearish analysts may be underestimating the potential length of this economic cycle. The key reason for this is that there remains considerable pent up demand for leisure products, cars, electronics, technology solutions, etc., which should extend through 2022 and into 2023”.
The Drivers of Stock Returns
While multiple expansion was the key driver of market returns up to the middle of 2020, the baton has been passed on to earnings growth. Since then, corporate earnings have exploded upward at a historical pace. Insatiable demand for a number of goods has provided pricing power to a host of well positioned companies and has driven up profit margins. The market P/E expanded significantly up to the middle of 2020 and started to compress since then. Stock returns after this time have been purely earnings driven and we expect this trend to continue. It will become a foot race between earnings per share growth and P/E multiple compression. The silver lining is that it would take very severe multiple compression to offset the current double-digit EPS growth pace. This is especially true in Canada where valuations are back to historical levels which means our market has rarely been this cheap versus the U.S.
Inflation Fears and Long-Term Interest Rates
The changing inflation and interest rate landscape provides some interesting geographic allocation opportunities. In Canada specifically, the market has posted far better median gains when interest rates were rising, likely because these periods coincided with inflationary pressure and associated strong commodity price cycles. Approximately a third of the S&P/TSX market capitalization is in the Energy and Materials sectors versus less than 10% in the U.S.
It is well understood that rising interest rates have a nefarious impact on the performance of defensive, lower growth sectors such as Utilities, Telecoms and REITs since: 1) these sectors are typically very capital intensive so as interest rates rise, their costs of funds go up; and 2) it makes the typical dividend yield advantage of these sectors less attractive relative to bond alternatives.
From High Duration Bonds to High Duration Stocks
Perhaps less well understood however, is the impact to “high duration stocks”. In simple terms, these are typically very high multiple stocks, where the bulk of the value comes from expected future growth in cash flows. Even if these companies continue to meet expectations, if the market predicts long-term bond rates will increase, this will increase the discount factor and REDUCE the fair value of the shares. This will happen through no fault of the company’s, just a reassessment of inflation/interest rate macro variables.
While we do not believe that stocks are in an investment “bubble” in general, we do think Crypto currencies (i.e., Bitcoin, Ethereum and friends) and related equities certainly fit the profile. We accept that we will likely sound like dinosaurs for expressing such a view but continue to think that investments should generate positive cash flow and solid returns on investment (preferably paying growing dividends) to have merit.
Technical Analysis – Russ Visch
A long-term chart of the Dow Industrials highlights a cycle that’s been playing out for more than one hundred years where the Index alternates between 16-year sideways trading ranges (secular bear markets) and 16-year steady uptrends (or secular bull markets). The most recent secular bull market began in 2014, when indexes broke out of their sideways trading ranges. This means we’re only about halfway through this secular bull if this cycle continues to play out as expected. The second half of next year could be quite volatile. Historically, an average cyclical bull market for the S&P 500 within those bigger 16-year secular bulls tends to last about 30 months on average with gains of 85-90 per cent. The gauges we will be paying close attention to in the first half of 2022 are credit spreads, CDS indexes, market-based measures of economic activity, and other risk on/risk off metrics such as the performance of discretionary stocks versus staples, banks versus utilities, etc.
The S&P/TSX Energy Index broke out of a massive year long base pattern earlier this year when it closed above resistance near 1,675. That breakout shifted the long-term trend to bullish and opened an initial upside target that measures to 2,375. The next target/resistance level above that is the 2018 peak near 2,475.
Like the Bank of Canada, The Fed is Becoming More Concerned about Inflation
There is the prospect for a more aggressive Bank of Canada (“BOC”) as inflation reached multi-year highs, ended quantitative easing earlier, pulling forward the tightening timetable. This contrasted with a more patient U.S. Federal Reserve, which only announced in November the start of tapering and, more importantly, maintaining its inflation narrative as “transitory”. In spite of diverging opinions on the inflation trajectory, the tone around the Fed has changed lately. Chairman Powell was reappointed over a perceived more dovish candidate and U.S. President Biden, the White House, and a chorus of current and former Federal Open Market Committee members have been more vocal about the need for the Fed to address the rise in inflation. Fed Chair Powell caught the markets further off-guard during his Senate hearings in late November, when he confirmed that the Fed may indeed increase the speed of tapering and admitted that the higher-than-target inflation should no longer be described as transitory. For investors, higher inflation and thus higher policy rates may not necessarily translate into higher long-term rates and not all tenors of the yield curve may be affected similarly going forward. In fact, before the recent news of the COVID variant Omicron, interest rates were already factoring in more aggressive monetary policies. These opportunities may no longer be as attractive with market uncertainty leading to a flight to safety into government bonds, driving both yields lower and corporate credit spreads wider. In the near term, the risk is that Omicron could further exacerbate supply chain issues and potentially slow the recovery in labor markets and growth. But it also risks causing inflation to remain elevated for a bit longer than originally anticipated. Until then, the demand for safe assets should remain strong, which should help this year’s performance of struggling fixed income portfolios. We also expect more attractive opportunities to re-emerge, including better entry levels in credit markets.
Please contact your BMO financial professional if you have any questions or would like to discuss your investments.
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