What a difficult year we just had! We are forced to admit that a perfect storm has hit our portfolios in 2022. While at the beginning of 2022, we were still experiencing a period of significant economic expansion and meteoric GDP growth, the changing economic context and the geopolitical events that took place in February disrupted the markets. Indeed, the combination of a consumer with purchasing power and a weakened supply chain created inflationary pressure that prompted central banks to raise interest rates at historic speed.
As firms and portfolio managers, we have always sought to evolve. After the disappointing results of last year, we had no choice but to learn from it, to seek to understand where our approach failed and what are our points of improvement to regain a performance like we enjoyed in the past. We learned that a single badly calibrated variable could amplify its impact and therefore, like many economists and investors, we underestimated the impact of inflation and especially the aggressive approach that central banks took with a series of rate hikes.
Since the pandemic, the changes in economic cycles are happening at an accelerated speed and the gap between the most optimistic and the most pessimistic economists is wide, while predicting and anticipating becomes increasingly complex. In this regard, we are working to find the necessary solutions to be able to better anticipate the future rebound.
2023
That being said, we enter 2023 with hope for a rebound and opportunity. Most of the macroeconomic frictions are known, the risk of recession seems to be already anticipated by investors. Central banks are expected to end interest rate hikes soon, and a rotation to a phase of the business cycle more favorable to risky assets may well begin this year.
How quickly this rotation begins, however, will depend on the path the economy takes, whether or not we succeed in avoiding a recession, whether or not the central banks have succeeded in their gamble.
Two main scenarios appear to be on the horizon for 2023, one where we fall into a recession and one where we avoid it. According to the latest census compiled by Bloomberg (see Table 1 below), we have a 65% chance, according to the median of economists, of falling into a recession in both the United States and Canada.
However, according to the data, the recession would be relatively mild and there is still a chance that central banks will succeed in preventing the economy from falling into a deep recession. We can see in Table 1 below that the projected GDP for Canada and the US would fall negative for 2 consecutive quarters (definition of a recession), but the depth of the downturn still seems limited.
Table 1: Probability of Recession in the United States and Canada
Source: Bloomberg, January 2023
In the scenario of a recession, the stock markets tend to rebound before the economy and therefore, contribute to the rotation towards the next phase of the economic cycle, like the recovery which has always been a period of much more favourable to equities.
In this scenario, it is possible to assume that the S&P 500 could revisit its lows of 2022 and the possibility of going slightly lower remains, because historically, no bear market has been concluded before the start of a recession. However, as the U.S. Federal Reserve (FED) is expected to halt its hikes in the first quarter or as soon as the recession is declared, we can expect these temporary lows not to last very long.
In the second scenario where recession is avoided, the lows of 2022 could remain intact, and the indexes would resume their normal courses and gradually readjust to the earnings per share of the companies. In this context, we can expect interest rate hikes to continue for some time, but this would be much less aggressive than in 2022. In fact, they should take place during the first half of the year and then adjust, according to the evolution of inflation.
Regardless of the scenario, historically, stock markets have tended to stabilize about four months after the last rate hike. Thus, in regards of what we have read previously, the two scenarios would suggest a volatile start to the year and a second half of the year that should rebound and head towards the next bull market.
Interest rates and inflation
Inflation and interest rate hikes have been the hot topic throughout 2022 and we must admit that it will still be the case at the beginning of 2023. Now well advanced in the cycle, the big question remains whether central banks will succeed in their gamble of slowing inflation through rate hikes without pushing the economy into recession.
If we want to answer this question, we must first dwell on projecting whether the rate hikes are coming to an end. Currently, still according to the latest surveys compiled by Bloomberg (see Chart 1 and 2 below), we would see two last rate hikes in the United States in the first quarter of 2023 and then take a break. In Canada, the data suggests a final rate hike in March and then stabilizes and possibly even begins to fall towards the end of 2023. This pivot would instead take place in early 2024 in the United States.
Chart 1: Projections for U.S. Policy Rate Increases
Source: Bloomberg, January 2023
Chart 2: Projections of Policy Rate Increases in Canada
Source: Bloomberg, January 2023
The main objectives of the FED are employment, price stability and long-term interest rates. With inflation spiralling out of control, the Fed had no choice but to raise interest rates to stabilize prices. The Fed has repeatedly mentioned being aware that inflation comes from sustained demand, but also from a weakened supply chain. We hope that the reopening of China will have an impact that will be felt quickly on the supply chain.
Finally, we can start to see the interest rate hikes and tightening measures taking hold and can say that the central bank strategy seems to be working as inflation is now on a downtrend and may have peaked in the second quarter of 2022. The economists’ inflation projection for 2023 would be 3.9% in Canada and 4% in the United States (see table 2 and table 3 below).
Table 2: U.S. consumer price index and its projection
Source: Bloomberg, January 2023
Chart 3: Projected change in the U.S. consumer price index by quarter
Source: Bloomberg, January 2023
Table 3: Evolution of the Consumer Price Index in Canada and its projection
Source: Bloomberg, January 2023
Chart 4: Projected change in the Canadian consumer price index by quarter
Source: Bloomberg, January 2023
Stock markets, earnings per share and analyst expectations
At the risk of repeating ourselves, stock markets tend to outperform the economy and could possibly rebound more quickly. Historically, markets have on average rebounded four months before the end of a recession (see chart 5 below). In the absence of a major crisis, the recession, if it occurs, should be quick and shallow.
Chart 5 below is particularly interesting: we find our 2 scenarios, the one where we fall into recession and the one where we avoid it. This is the 12-month average evolution of the bear markets we have seen since World War I, depending on whether or not we fall into a recession. This evolution takes into account that the recession would end in 9 months as well as the following 3 months. We see that regardless of the scenario, from the midyear, the market trend would be upwards.
Chart 5: 12-month average evolution of the S&P500 in a recession scenario and in a non-recession scenario since World War I
Source: NDR, January 2023
Another interesting statistic is that markets have historically tended to stabilize on average four months after the last interest rate hike. Given that we see this could happen in the first quarter, the possibility of a big rebound in the second midyear becomes very plausible.
Historically, corporate earnings per share (EPS) have tended to rebound a quarter or two after the recession has ended, so if we estimate the recession to end around September, we would tend to believe that a resumption of sustained EPS growth could return at the first quarter of 2024. However, the rebound in EPS could materialize slightly earlier this time around due to the fact that it peaked relatively quickly at the start of the second quarter of 2022. At present, expectations point to a return to EPS growth from the second quarter of 2023 (see Table 4 below).
Table 4: S&P 500 EPS Expectations
Source: Bloomberg, January 2023
The technology sector could be one of the leaders of the rebound, considering the weight it has in the indexes and its underperformance in 2022. This sector is generally a little more sensitive to rising interest rates. It is conceivable that it will outperform during the rebound and even more so when we begin to anticipate interest rate cuts. In this regard, we can see that EPS growth expectations for the technology sector will be among the strongest, at around 14.20% EPS growth in 2023.
When we look at the aggregate average target prices of the various indexes, the gap between the target price and the averages of the indexes currently offers us a portrait of the potential rebound. The gap between the S&P 500 price and the companies’ target price is 15.7%, the TSX is 16.3% and the NASDAQ is 27.5%, could offer interesting performance especially with the underperformance recorded in 2022 (according to Bloomberg censuses in January 2023).
High investor pessimism may well contribute to the eventual rebound as well. Indeed, the AAII Bear Index (an index that reflects investor sentiment over the next six months) seems to have peaked. When we compare it with the peak reached during the pandemic, we can see that 2022 was a year where investors were generally more negative than usual, and a swing of the pendulum could very well create a positive effect and contribute in supporting the rebound.
Chart 6: AAII Bear Index
Source: Bloomberg, January 2023
Bonds
Could this be the year of fixed income? With the series of interest rate hikes, bond values have also taken a beating in 2022. However, when we look at the odds of interest rate hikes now, the data suggests that we are near the end. This could be a good time for investors to start building positions ahead of the top of the hikes because it’s important to remember that markets are looking to time ahead and once the hikes officially end, interest rates could already have fallen sharply and thus, be less attractive.
The interest coupon of a 2-year US bond is currently higher than the 10-year bond. However, normally in a bull market, the coupon of long-term bonds is higher than the short-term bonds. We are therefore experiencing an inversion of the interest rate curve, and this has been going on for quite some time. The return to a norm would confirm the start of the new phase of the economic cycle and the solidity of the rebound of the next bull market. If we look at chart 7 below, a return above zero corresponds to a normalization of the curve.
Graph 7: 2-year / 10-year bond curve
2023: risks and dangers
As investors, we always remain vulnerable to surprises and uncontrollable events whether economic, geopolitical or even natural in nature. There will always be a series of risk factors and in this regard, here are the uncertain elements that we foresee for 2023:
- Will the Federal Reserve react too late and push the economy into recession?
- Could China's reopening create a short-term inflation spike before the impact of supply chain normalization is felt, pushing central banks to be even more potentially aggressive in their future rate hikes?
- Could a recession cause commodity prices to fall? Or, could they be counterbalanced by rising demand as China prepares to reopen its economy?
- Where are we going with the war in Ukraine? Could Russia resort to the use of weapons that would cause the world to react differently?
- Could China invade Taiwan and trigger a conflict in the Pacific region?
A series of risks and opportunities lie ahead for 2023, but for investors with a long-term view, the opportunities that lie ahead could be very enticing and a "buy the bottom of the market" approach should be beneficial in the long run.
What can we expect?
In conclusion, there are still several scenarios before us this year, but the two main ones remain: recession or not.
The first quarter should set the tone for rising interest rates, so we expect a volatile first and second quarter, with or without a recession. However, if we focus on taking a long-term view, great opportunities could present themselves in the first half of the year.
As for the second half of the year, we see the beginning of a return to some normalcy and a change in the phase of the economic cycle, gradually returning to an expansion.
Bonds offer opportunities that are becoming very attractive considering that interest rate increases should stabilize soon. As for term deposits, they could have reached their peak and become less and less interesting as the year progresses. The stock market will depend on the short-term recession scenario, but remains the most interesting long-term purchase.
Historically, in the context of a changing economic cycle, our strategies at Pratte have normally been very successful. Our EPS growth approach could very well be very favorable again this time around, especially in the second half of the year.
The return of a typical balanced portfolio of 60% stocks and 40% bonds, with the desynchronization of asset classes, could be very successful in 2023. Indeed, bonds and equities should start trading off balance again and with the short-term opportunity in bonds and the potential rebound in equities in the second half of the year, a balanced profile should regain its credentials.
PHILIPPE PRATTE
PRESIDENT | CHIEF INVESTMENT OFFICER | PORTFOLIO MANAGER
DANIEL CLEMENT, CFA, PL. FIN.
PORTFOLIO MANAGER
RAYMOND PRATTE, CFP, CIM
VICE PRESIDENT | CHIEF COMPLIANCE OFFICER | PORTFOLIO MANAGER
