While a North American recession is not a sure thing, the odds of this outcome are not trivial either. To try to quantify the odds, the BMO Nesbitt Burns Portfolio Advisory Team’s seven-variable model1 now shows a 45% chance of a U.S. recession in the next 12 months, which is a good proxy for Canada as well, and is in line with BMO Economics’ forecast for a North American recession. We were at around 30% just a few months back, so the trend has clearly deteriorated given the much more hawkish stance from Central Banks and the growth slowdown which is becoming clearer based on real world manufacturing survey data.
With the exception of housing and automotives, which react quickly to higher interest rates, the impact on most of the real economy has a 12-month lag (or even longer) so it will take time to determine the effectiveness of tighter monetary policy on the inflation demon with which most economies are currently wrestling. However, market history has proven time and time again that when everybody becomes fearful, we could be getting close to an interesting buy point. The caveat of course is that getting the timing wrong can be very costly in a declining market, particularly since the final phase of liquidation can see asset prices “gap down” quickly. From our perspective, a lot of risk is already priced in the market but we continue to advise caution and to focus on high quality “oligopolistic” stocks that have great upside potential when the next upturn unavoidably happens.
Canadian Dollar Should Get Stronger (Eventually)
It is not that the Canadian dollar has been weak, it’s that the U.S. dollar has been so strong relative to all major currencies. The U.S. Federal Reserve’s (the “Fed”) broad nominal U.S. dollar index is up about 10% over the past 12 months, including 5% in the second quarter. If the U.S. dollar were to continue to spike at the present Q2 pace, the Fed’s real broad U.S. dollar index would reach a new 21st century high by the end of July. This year’s U.S. dollar rally began as a reasonably gentle Fed-on rally, but it has transitioned into more of a risk-off spike on the back of global recession fears. Those fears are unlikely to dissipate this summer, so we are projecting another 3% spike in the U.S. dollar before it peaks some time around September.
The BMO Currency Strategy team views the loonie’s combination of economic growth, monetary policy, fiscal policy, political stability, and external balance fundamentals as the best in the G10. In a calm foreign exchange market, the Canadian dollar would be king. In this year’s spiking U.S. dollar environment, the Canadian dollar has to settle for being the G10’s number two.
U.S. Corporate Earnings Growth Estimates Going the Wrong Way – No Big Surprise There
According to FactSet, more S&P 500 Index companies have issued negative earnings per share (“EPS”) guidance for the second quarter of 2022, compared to recent quarters. At this point in time, 69% of companies are issuing negative EPS guidance for Q2 2022, which is above the 5-year average of 60% and above the 10-year average of 67%.
Six of the eleven sectors are projected to report yearover- year earnings growth, led by the Energy, Industrials and Materials sectors. On the other hand, five sectors are predicted to report a year-over-year decline in earnings, led by the Financials sector.
Unfortunately, this negative trend in corporate earnings will likely last until the first half of 2023 (when economic momentum could rebound), which underlines the importance of focusing on stocks which are still able to deliver some earnings growth irrespective of the macro environment. The bond market is a great leading indicator for sector rotation and style performance. Generally, and notwithstanding short-term trading volatility, growth stocks outperform when interest rates are falling since these stocks are typically expensive “high duration” assets where much of the value comes from long-term expected cash flows – and when corporate bond spreads are widening (since these types of stocks generally have very little debt so they are not harmed nearly as much by higher borrowing costs).
Conversely, value stocks do better when yields are rising (since this is a sign of economic strength when more sectors and companies benefit from strong corporate earnings growth) and corporate bond spreads are falling.
The problem currently is that interest rates have been rising and corporate credit spreads have been widening, which means that pure growth (i.e., Technology) and pure value stocks could remain out of favour for some time.
According to our Technical Analyst, Russ Visch, over the past 80 years, cyclical bear markets of the S&P 500 within bigger secular bulls have lasted six months, on average, with a decline of just under 22%. As we start the third quarter the S&P 500 Index is nearly six months past, and 23% below its early 2022 peak, as measured to the mid-June low, so we are certainly in the “zone” where a major low could occur at any time now. More importantly, all of the indicators in our medium-term timing indicator are now essentially 100% of the way towards where they get to at the end of bear markets. Recall that the sell-off of the S&P 500 during the pandemic was the worst since the early 1940s and we are now more oversold than that. The same is true for breadth oscillators such as the percentage of stocks in the S&P 500 trading above their 50- and 200-day moving averages.
Fixed Income Update
While the pandemic and the war on Ukraine offered different challenges, we can still find many similarities to previous cycles, and at the risk of sounding too simplistic, the same important observations are made in each cycle.
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First, the yield curve remains a valuable forecasting tool, not necessarily just a reflection of current conditions;
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Second, as fiscal and monetary policies are used to influence the labour market, economic growth and inflation – with the objective of returning them to secular cycle averages – the greatest impact will be felt by bonds with longer terms to maturities; and
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Third, while central bankers believe they know where the neutral rate is, it is rare they find the proper level that will continuously support the labour market, price stability and reduce economic cycle volatility.
The first two stages of rising rate cycles normally produce the weakest performance for the bond market in general. Looking at the past 2 years, we can associate 2021 performance to the first stage, while this year’s surprisingly weak performance is associated to the second stage. The combination of the war and surprise shifts from the Fed in their inflation fight exacerbated the impact of that second stage and led to the worst start of the year on record for bonds.
Now, as we enter that third stage, with yields at the highest level in years and a potential yield curve inversion at our doors, what can be expected of bond portfolios? Short-term rates continue to focus on terminal rate expectations with the latest Fed projections calling for the policy rate to reach 3.75% in 2023. This leads the market to believe that the persistent high inflation will drive Central Banks to hike policy rates between 1.25% to 1.50% at the next two meetings ( July and September) in Canada and the US.
The longer part of the curve; however, has already shifted toward longer term expectations. While uncertainty remains as to the time it will take for inflation to decline again, we have seen longer-term inflation expectation moving lower.
The Canadian economy remains relatively strong, thanks to energy and commodities in general, but it is nonetheless slowing. As for the U.S. economy, it has slowed down more significantly this year and some strategists are even suggesting it may already be in a recession, hence the rising probabilities.
Based on previous tightening cycles, the current environment leads us to update our recommended strategy as we enter the second half of 2022. Our defensive portfolio bias during the first two stages supported our less interest rate sensitive portfolio positioning – a shorter duration – to mitigate the impact of rising rates. Now that longer-term rates are likely closer to peak levels, it will be time, in our opinion, to gradually move toward a more neutral duration. We are now becoming more defensive in our sector allocation and, in particular, our credit selections. As short- and long-term interest rates trajectory/returns may diverge during the third stage, so will likely the performance of government and corporate bonds. A growing risk of a recession means credit markets could remain vulnerable in the coming months, favouring a greater exposure to government bonds as investors gradually increase their portfolios’ interest rates sensitivity.
Fixed income investments are more attractive today than they have been for years. But risks exist with the possibility of more persistent inflation, more surprises from Central Banks and elevated volatility.
Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your investments.
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