To use a technical musical term used by guitar players, equity markets have choked; global equities are negative YTD, and U.S. stocks fell 10% from their highs (correction territory) last week. I realize that the volatility is uncomfortable for many. I hope to alleviate your concerns by explaining what is behind this weakness and whether it changes our outlook for 2022. On that note, let's take a closer look.
After a long period of calm in the markets, it is easy to forget that market volatility is the price you pay when investing in equities and other risky assets. Historically, U.S. equities have experienced 5% correction on average every nine weeks and a 10% correction on average every 11 weeks. Although Covid is still front and center of our daily lives, the market correction of March 2020 is long gone from many an investor’s memory. The subsequent calm in the markets led us to 165-weeks without a 10% correction, nearly 15 times the normal duration. In other words, we have been long overdue for a market correction.
“Recent market weakness can be attributed to a combination of investor concerns about Central Bank rate increases/inflation, slowing economic growth, the composition of the U.S. equity market, and concerns about Russia's intentions towards Ukraine.”
As the saying goes, bull markets don’t die of old age, so what are the likely catalysts for the dissonant tone, and what do we think about them? Recent market weakness can be attributed to a combination of investor concerns about Central Bank rate increases/inflation, slowing economic growth, the composition of the U.S. equity market, and concerns about Russia's intentions towards Ukraine.
With respect to interest rates and inflation, throughout 2021, I have written extensively about our position on the matter. You can find the most recent two outlooks here and here. To summarize, we believe that investor concerns about interest rates and inflation are valid but perhaps inflated (pun intended). True, inflation is real, but current inflation levels largely reflect base effects, the rebound in demand, and frictions caused by reopening the global economy from a standing start, which should eventually ease. But this will take time, and supply-side strains will likely be a continuing theme for much of 2022.
“We expect headline inflation to fall, but we expect core inflation to remain elevated around the three to four percent level across the developed world as shortages persist and wage growth picks up.”
We expect headline inflation to fall, but we expect core inflation to remain elevated around the three to four percent level across the developed world as shortages persist and wage growth picks up. Accordingly, most central banks are set to raise interest rates. The bottom line is that central banks find themselves in a difficult situation: attempting to sustain economic recoveries in the face of this pandemic while at the same time maintaining their commitment to monetary and financial stability against a backdrop of elevated inflation and high and rising asset prices.
The recent Bank of Canada rate decision to hold rates at current levels, which surprised investors, reflects the difficulty that central banks find themselves. All forecasts are subject to uncertainty, and the dislocations caused by the pandemic mean that uncertainties are unusually high right now. The volatility in equity markets has understandably attracted a lot of headlines in recent weeks, but as we navigate the way ahead, it’s important to keep in mind that future developments in labour markets will ultimately determine the future path of inflation and interest rates. We will be watching these developments closely and adjusting our portfolios accordingly.
“We especially like other developed markets as they are further behind in their recoveries. Their growth rates are markedly higher than in the U.S and their valuations are more attractive.”
On global growth, we have stated that it will be slower this year than last, and we expect major economies, including the U.S. and China, to be slower than other developed markets, as they were the first to recover. That being said, we believe that 2022 economic growth will be higher than in 2019. Looking at global economic growth, the theme remains intact with global growth slowing versus 2021, but decidedly higher than in 2019. We especially like other developed markets as they are further behind in their recoveries. Their growth rates are markedly higher than in the U.S and their valuations are more attractive.
U.S. markets have fared worse than other markets YTD, and this partly reflects the “growth heavy” sectoral composition of the U.S. stock market, which has relatively large weights in sectors where expectations and valuations have been most excessive (i.e. high growth technology stocks). The valuations of technology stocks have, in general, already fallen sharply in recent weeks, and we suspect they may decline even further. All the other sectors of the U.S. market have fared much better over this period as they were not so richly valued, and/or their businesses are more resilient to inflation and/or they have more pricing power (i.e. they have the ability to pass along higher prices).
Like the current Russia-Ukraine situation, geopolitical risks are certainly top of mind when we think about the risks to our global growth and/or inflations forecasts in the short term. However, geopolitical risks tend not to have lasting impacts on the prices of risky assets.
Why Stay Invested
The tug of war that we see play out in financial markets is best characterized by two leading figures: Jeremy Grantham, co-founder of GMO, and Jeremy Siegel, Wharton Finance Professor and author of Stocks for the Long Run. Jeremy Grantham is often characterized as a market bear, and he stayed true to form last week when he predicted that we are at the end of a superbubble in stocks, bonds, real estate, and commodities. He asserts that the U.S. is facing the largest fall in wealth in history. Jeremy Siegel, on the other hand, is more moderate in his expectations, as you would expect as the author of a book called Stocks for the Long Run.
“For all risky assets to be in a bubble that will deflate like Jeremy Grantham predicts, the following will likely need to occur: An economic crash; or a very significant and surprising increase in interest rates. We don’t see either of these scenarios being likely.”
We won’t debate Jeremy Grantham’s conclusion that there has been bubble-type behavior in the markets since the pandemic. From our lens, we see them occurring more in select areas than across all risky assets. Areas such as Special Purpose Acquisition Companies, meme stocks, cryptocurrencies, and high growth technology stocks have inflated prices/valuations and then had some of their excesses deflated, with likely more to go. We don’t like to paint everything with broad strokes and take a more moderate view. The entire technology sector doesn’t appear to be in a bubble. For all risky assets to be in a bubble that will deflate like Jeremy Grantham predicts, the following will likely need to occur: An economic crash; or a very significant and surprising increase in interest rates. We don’t see either of these scenarios being likely. The return of valuations two-thirds of the way back to historical levels must assume a significant jump in interest rates. Keeping all else equal, it might take a rise in the 10-year TIPS yield from its current level of minus 0.72% to 6.79% for the CAPE (Robert Shiller’s Cyclically adjusted price to earnings ratio) of the S&P 500 to fall to two-thirds of its historical average. Knowing how high the Fed funds rate would have to go to be consistent with a 10-year TIPS yield of 6.79% is not totally clear cut, though clearly, the Fed would have to raise real rates to levels that we’ve not seen for several decades and be expected to keep them there for some time.
“…higher yields will limit the upside for risky assets like equities leading us to forecast only small gains in equities across both developed and emerging markets.”
As mentioned in our Q4 commentary, we expect to see long-term bond yields rising across most major economies, especially in the U.S., where we think inflationary pressures are particularly strong. As a result, higher yields will limit the upside for risky assets like equities leading us to forecast only small gains in equities across both developed and emerging markets. For fixed income, we expect corporate credit spreads to narrow only a little, if at all.
Despite our very moderate return expectations, we have repeatedly acknowledged that forecasting future returns is a tricky proposition, as valuation measurement is not a great timing indicator. As Jeremy Siegel’s and other researcher’s work has shown, market timing is extremely difficult, and the penalty for being wrong can be catastrophic to an investor’s long-term returns. In contrast, the benefits of staying fully invested in a well-designed portfolio that is aligned with your objectives, risk tolerance, and time horizon have proven itself over time.
Until next time, stay safe and be well.
Chief Investment Officer
Counsel Portfolio Services | IPC Private Wealth
 We use the S&P 500 price return in CAD as the broad market proxy for U.S. equities as the index goes back to 1928, further than almost all market proxies. We define a 5% correction as a market drawdown where the market has corrected by 5% but less than 10%, and we include the period of time in which it takes the market to recover to its previous high in the average number of weeks calculation. Special thanks to IPC Analyst Kody Knieriem for the analysis.
 The current level of CAPE at 36.06 implies a CAEY of 2.77%. If we take the current value of the 10-year TIPS yield, minus 0.72%, as our stand-in for the real yield, we have an implied “excess CAPE yield” of 3.49%. Let’s assume, for the sake of argument again, that this proxy for the equity risk premium remains unchanged. A CAPE of 9.73 would mean a CAEY of about 10.28%. If we keep the excess CAPE yield constant at 3.49% and subtract that, this implies a “real risk-free” component of 6.79%. Thanks to our friends at Capital Economics for the calculations.