No Recession on the Horizon, But Time to Start Looking at High Quality, Defensive Opportunities
Equity Strategy
After an extremely strong 2021, January presented investors with wild stock swings. No sector was harder hit than high- multiple, technology stocks as concerns about rising inflation and associated higher interest rates took center stage. We still think Omicron and tensions on the Ukrainian border are not the primary market movers at this point and that COVID-19 will soon morph into something more akin to a “bad flu.”
While global economic activity should continue to be robust, we do think the rate of growth in activity is bound to slow in 2022 from 2021’s impressive COVID rebound. This will have important implications for market and sector performance over the next number of quarters. Historically, the market can post small, positive returns in such an environment, but the leading sectors have tended to be defensive (think of Consumer Staples, Healthcare, and REITs) rather than cyclicals like Technology, Consumer Discretionary or auto stocks.
Our key messages are that: we are still positive on equities, especially vs. bonds, but that investors SHOULD NOT expect another 20%+ return year from stocks; and we think the S&P/TSX should continue outperforming, at least in the short term given huge valuation support and natural resource tailwinds (especially Energy).
Valuations Matter Again and That Should Continue
As we wrote at the beginning of December 2021: “Looking at valuations for stocks – or other asset classes for that matter – is a terrible timing tool”. However, financial history has proven time and time again that being disciplined about the price paid for assets (having a “margin of safety” as Warren Buffet famously put it) is the best way to ensure an appropriate return for long-term investors. The principal reason for this is that the stock market is inherently “mean reverting,” meaning that excesses to the upside or downside tend to be corrected with opposite reactions.
We do not believe that stocks are in an investment “bubble;” however, we do think crypto currencies (i.e., Bitcoin, Ethereum and friends) and related equities certainly fit the profile. We continue to think that investments should generate positive cash flow and solid returns on investment to have merit. Even with the nasty pullback we have seen recently, we would prefer avoiding these areas.
Investors need to be selective in their choices. In an inflationary environment, and especially when growth momentum is slowing, companies with pricing power (i.e., the ability to pass on price increases to their customers) will be better able to protect their profit margins, thereby offering a measure of protection to their share price.
Canada: Still Trading at an Unusually Steep Discount to the U.S. Based on Price to Earnings (lower) and Dividend Yield (higher)
We again turn to the relative value advantage of Canadian stocks vs. U.S. stocks. Canada has already outperformed the U.S. by 5% in one month, but we still consider the current discount to be excessive relative not only to history but also to the profit growth potential for several natural resource industries. While Energy is not a defensive sector, we want to reiterate our view that oil and natural gas stocks remain too cheap given their huge cash flow generation and ability to buy back shares and increase dividends. Looking at the commodities, our analysts think oil and natural gas prices will continue to be well supported by increased demand as lockdowns ease, while supply constraints should be exacerbated by the chronic lack of investment in production growth over the last five years.
From our perspective the odds of an actual recession in the next year are still very low (around 10%). Barring a new COVID variant against which vaccines are ineffective or some other serious exogenous shock, we do not see a fundamental reason for a bear market to develop in 2022.
U.S. Economic Momentum Has Likely Peaked – Important Sector Implications
BMO Economics notes that – while still strong – U.S. manufacturing continued to lose momentum at the start of the year, down 1.2 pts. to 57.6 in January, marking it the third straight monthly drop and the lowest level since November 2020. Production and new orders fell again as the sharp rise in Omicron cases capped activity. Meantime, prices paid for materials accelerated further as energy prices surged. The good news is that supplier delivery times improved for the third month in a row and order backlogs fell. The steady progress in these indicators suggest that supply constraints, though still elevated, are starting to ease.
Technical Analysis – Russ Visch
Since the pandemic recovery began in early 2020, the correct investment strategy has been “all gas, no brake,” as investors focused almost exclusively on pro-cyclical areas such as Industrials, Energy, Materials, and Technology stocks. While the run-up in those areas has been nothing short of spectacular, it’s standard fare for how groups tend to perform coming out of a recession. Over the past 4 to 8 weeks though, we’ve seen a more balanced market develop where traditionally defensive sectors such as Consumer Staples, Healthcare, and REITs have begun to outperform. This is also typical for where equities are in the cycle, as economic momentum reaches a peak and the recent long- term trendline reversals in relative performance suggest this trend is likely to persist throughout 2022.
Fixed Income Strategy
Rate hikes and Quantitative Easing: What’s Not Priced Yet in Fixed Income Markets
It has been another volatile and challenging start of the year for fixed income markets, as central banks close in on a major policy shift. Anxiety about the end of asset purchases, the impending rate hikes and balance sheet reduction have continued to apply pressure on rates including at the shorter end of the yield curve where many investors sought refuge. Even the star performers of 2021, inflation-protected securities and high yield bonds, could not avoid the turmoil, with high yield bonds recording one its worst starts in years.Most forecasters have increased their expectations for five rate hikes this year (from three last December), including BMO, and see Quantitative Tightening (“QT”), the term given to the shrinking of central bank balance sheets, as beginning mid-summer.
While the risk remains for higher interest rates, the implication of these expectations means that much may already be priced into the market. And, despite central banks’ tougher talk and increasing focus on inflation, which is sitting at a 40-year high (U.S. CPI at 7.0% and Canada CPI at 4.8%), long-term yields are hovering between 1.75% to 2.10%, failing to reflect the current economic environment.
That leads us to the question of whether market expectations – that most 2022 rate hikes are front loaded earlier in the year – could be a bit excessive. We admit that COVID-19 risks and uncertainty surrounding the delayed impact of rising rates make it difficult to forecast how aggressive central banks will be. But we wonder whether the current yield curve will provide enough flexibility in the near future to hike as much as 125 basis points in 2022, and likely another 50 to 75 basis points in 2023, without risking an inversion where short-term rates exceed long-term rates.
We think it may be early to say that long-term rates have peaked for this cycle, but we believe that even if they remain under pressure, the climb will be at a much slower pace than what has been experienced in the last 12 months.
Please contact your BMO financial professional if you have any questions or would like to discuss your investments.
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