Rough Markets Ahead: Investors Should Take Advantage
Although there has been some good news for risky assets – equities, higher-yielding corporate bonds – over the past couple of months, we still think they will struggle before long as economic growth disappoints in major developed economies and a downgrading of expectations for corporate profits.
The global equity market rally that began at the back end of 2022 has continued strongly into the new year. The S&P 500 and the S&P/TSX, are now up ~12% and ~14% respectively from their late-2022 trough, while the EURO STOXX Index has risen by more than 25% - all in local currency terms.
Those gains reflect, in part, a slew of good economic news that has boosted the appetite for risk and the prospects for corporate earnings. In the euro zone, falling natural gas prices and significant government support for households have seen the economy hold up much better than was widely expected. In the U.S., Q4 2022 GDP data released last week showed, at face value, a surprisingly large expansion. Elsewhere, China’s re-opening has given a boost not only to that country but those that are exposed to it.
Too Fast, Too Soon?
This rally leaves markets priced, in our view, for very optimistic economic outcomes. Credit spreads, for example, are consistent with a continued robust economic expansion, at least in the U.S., even as inflation swap rates suggest that investors are very confident that inflation will return towards normal, allowing central banks to “pivot” later this year.
We agree that inflation is clearly falling but think growth expectations will be disappointing. This current tightening cycle has happened very quickly, and some of its effects on economic activity are still yet to be felt. As such, we still think the U.S. economy will slip into a recession, albeit a mild one. While Canada will contract more, relative to previous recessions, it will be fairly mild. Even if the euro zone ends up narrowly avoiding a recession of its own (although the Q4 contraction in Germany’s GDP has poured some cold water on this view), we suspect that Europe will likely stagnate, then rapidly expand in the near term.
All that underpins our expectation for risky asset prices to come under renewed pressure over the next few months.
We think the S&P 500, for example, will fall back approximately 10% to 15% – re-testing the lows it reached late last year – and then will recover on a more sustained basis in the back half of the year. There are four key points why we this is the path for equity markets:
1. While expectations for S&P 500 earnings have been pared back, they remain well above historical trends. The drop from the peak hasn’t been significant. Also, while there has been a significant fall in expectations for growth sectors, there have only been small changes in expectations for other sectors.
2. The overall drop in expectations doesn’t appear to be consistent with the expectations of a mild recession.
3. When earnings have fallen, markets typically don’t bottom out until three-to-six months before the end of the recession. If our expectations are correct, we don’t see the recession in the U.S. ending until around Q3 of this year, therefore markets should bottom out through the spring.
4. Markets tend to do well after they reach their low points when a recession has been reached. If the market low is behind us (October 2022), then that would mean that investors are uncharacteristically looking 11 months ahead, rather than the typical three-to-six months before a recession ends.
In summary, we believe there are some rough seas ahead, but investors should look at the coming months as investment opportunities rather than obstacles to avoid. We believe that markets will rebound by year-end and investors should position themselves to take advantage of the market volatility rather than avoid it.
Corrado Tiralongo
Chief Investment Officer
Counsel Portfolio Services | IPC Private Wealth
Counsel Portfolio Services | IPC Private Wealth
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