Thinking through macro transitions

Happy new year. The market narrative hasn’t changed much to start the year, with inflation, interest rates, and recession risks still very much front and centre. Nevertheless, there have been some developments over the past month that are worth discussing as they have potential implications for investors in the year ahead.

Overseas, Europe has had a relatively mild start to the winter and it has resulted in reduced demand for heating. Consequently, natural gas prices in the region have fallen significantly, and now sit at levels last seen before Russia invaded Ukraine. That has lowered the odds, for now, of a rather extreme scenario in which Europe would consider the rationing of energy usage, something that investors were quite concerned about just a few months ago. Should trends continue over the months to come, the lower energy prices could provide some disinflationary tailwinds in the region.

Meanwhile, in China, there has been a stark reversal of the country’s “zero-Covid” policy, with a complete abandonment of the measures the country had been taking for the past few years. Rather than enforcing strict lockdowns, the country is now in the process of reopening despite the reported increase in infections and strain on its healthcare system. This may result in some temporary disruption from worker absenteeism and supply chain challenges, similar to what was witnessed in North America upon its reopening. Nevertheless, it should prove temporary, and markets are understandably more focused on the prospects for a recovery in Chinese economic growth that could be on the horizon in the not too distant future.

Closer to home, Canada’s economy added 104,000 jobs in December, more than expected, and its unemployment rate fell to 5.0%. Meanwhile, in the U.S., the employment report showed 223,000 jobs were added in the month, also higher than expected, with the unemployment rate falling to 3.5%. Despite some pockets of weakness and an overall slowing in employment trends relative to a year ago, the rate of job creation remains relatively healthy and normal. Offsetting this positive news was the weakness seen in some leading economic indicators that tend to foreshadow future economic activity. More specifically, readings for the manufacturing and services sides of the U.S. economy declined in December, with the latter being a particular surprise as it had been holding up well through most of the fall. In recent days, the U.S. inflation reading for December was released and suggested an ongoing moderation in pricing pressures. Overall, the data suggests the Canadian and American economies are losing momentum but also demonstrating resilience in the face of tightening financial conditions.

We view recent developments as being incrementally positive at the margin as there are some new potential tailwinds relating to global growth and inflation that could provide a lift to investor sentiment, which remains relatively subdued. Nevertheless, the overall outlook for the year ahead hasn’t materially changed. Simply put, tighter financial conditions should eventually weigh on global activity. It may simply take time for this to come to fruition. We expect to pivot our focus to what companies are having to say about the operating environment given the fourth quarter earnings season has now begun.

Late Cycle Vibes

Turning to the economy, global growth has slowed sharply over the past year under the strain of tightening financial conditions as a result of higher borrowing costs, more stringent lending standards, and a stronger U.S. dollar. Setting the tone for the rest of the world, the U.S. economy is likely to confront a downturn this year, with a range of economic and financial indicators monitored by RBC Global Asset Management conveying that the U.S. is most likely at the late or end stage of the business cycle. To be clear, recent economic releases continue to point towards resiliency in consumer spending and the labour market, and broadly remain consistent with an economy in an expansion phase.

However, as we pointed out in previous articles , a U.S. recession will likely arrive in the year ahead. This view is mainly predicated on the cautionary signals issued by two of the most historically reliable leading recession indicators, namely the position of short-term interest rates compared with that of long-term rates (also known as the “shape of the yield curve”) and the Conference Board’s Leading Economic Index. These two indicators—with historical average lead times of six to 12 months—signaled back in July and September that a U.S. recession is likely on the way, potentially arriving as soon as this summer.

Consequently, we believe corporate fundamentals will be challenged by worsening macro conditions. Given notably slower economic growth and higher cost structures, our sense is that consensus earnings expectations may need to be revised lower to reflect the reality of a meaningfully less favourable operating environment for revenues and margins. We are also mindful that recessions have usually been accompanied by substantial declines in corporate profits, a key reason why every U.S. recession has been associated with an equity bear market.

Investment Implications

Navigating a late-cycle environment against a backdrop of elevated uncertainty around recession risk, inflation, and monetary policy is a formidable task. The lagged growth-dampening effects of synchronized monetary tightening around the world will continue to percolate through major economies in the quarters ahead, in our view. Although we take some comfort in the fact that most asset markets are entering 2023 on improved valuation grounds (see exhibit), we believe that nagging headwinds emanating from increasingly restrictive borrowing costs, shrinking liquidity, and corporate earnings vulnerability means this is not an environment particularly conducive for assertive risk-taking.

From a cross-asset perspective, we believe it is sensible to take a relatively more constructive stance on fixed income securities, where the opportunity set across corporate credit markets has expanded considerably. With many segments offering attractive all-in yield (return) profiles, we believe corporate bonds are reasonably well cushioned against further spread widening and rate increases before returns turn negative. We see the balance of risks as favouring higher-quality bonds in the short-to-intermediate term that lock in improved yields today, but without taking on excessive interest rate risk should inflation prove to be more stubborn than expected. While valuation risk in equities has diminished following the selloff last year, the heightened likelihood of a U.S. recession leads us to maintain a defensive posture and we believe equity portfolios should lean more heavily towards quality and sustainable dividends and away from individual company risks that may come home to roost in an economic downturn.?

Risk premiums look more attractive across major asset classes

Relative value has shifted in favour of fixed income

Should you have any questions or concerns about your own wealth management strategy (investments, financial planning, estate planning, tax strategies, etc.),?please feel free to reach out to me personally,?at?[email protected] , or to?Ahsen Ansari, CIM ?at [email protected]

Trevor Hodgins,?CPA,?CFP?, CIM??|?Portfolio Manager, Investment & Wealth Advisor Ansari & Hodgins Group?- Private Wealth Management?of?RBC Dominion Securities