EQUITIES COMMENT - -2022 Highlights and 2023 Outlook
2022 was the worst year for U.S. stocks since the 2008 Financial Crisis with a decline of 18% (12% in Canadian dollar terms). Canadian stocks were less battered due to strength in commodity prices like oil. The TSX was “only” down 6%. Rapid increases in interest rates by central banks coupled with inflation shocks from the Ukraine conflict and the pandemic put downward pressure on stock valuations. During the fourth quarter, stocks rebounded. The TSX gained 6% and the S&P 500 rose 6.1% in Canadian dollars. Stocks were supported by lower bond yields amid signs of slower inflation and the move away from zero-COVID in China.
There was only one sector with positive returns in Canada and the U.S. last year—Energy. Oil and gas producers generated massive cash flows that were used to pay down debt, boost dividends, buy back shares, consolidate holdings and improve efficiency. What about spending some of that windfall on the transition to greener energy? Companies are waiting for more clarity on government support before undertaking billions of dollars of projects to clean up emissions.“ Canada faces intense competition for global capital for CCS projects from the U.S., Norway and the Netherlands, which all provide significant investment in CCS technology in cooperation with industry.” (Cenovus Energy, November 2, 2022, Third Quarter Financial Report) Note: CCS stands for Carbon Capture and Storage.
The hardest hit sector on both sides of the border was the high priced Technology group. This group suffered from a devaluation caused by rising interest rates. In the U.S., Communications and Discretionary also had large losses due to the fall of high p/e Tech-like stocks such as Amazon, Tesla and Google. Real Estate was another casualty of higher interest rates in both countries. In Canada, the Health Care sector was hurt by low cannabis sales and loss of a patent on a key drug for Bausch Health.
During 2022, TSX earnings likely grew by 16% and S&P 500 earnings 6%. (Fourth quarter profits have not yet been reported.) Very strong earnings from the Energy sector boosted overall results. Profits were actually down for some sectors.
Federal Reserve and Bank of Canada interest rate hikes are expected to cause an economic slowdown or mild recession in Canada and the U.S. during 2023. As a result, earnings for the TSX and S&P 500 are forecast to decline. Already, manufacturing and housing activity have moderated. Consumers are still benefitting from low unemployment however, higher debt servicing costs, declining incomes (after factoring in inflation) and lower savings could cause spending by this critical sector of the economy to soften. Our earnings forecasts could be too optimistic if there is a deeper recession or more protracted period of slow economic growth.
Central banks are expected to increase rates at least once more this year before their “tightening” cycle is complete. The next important question for investors is how long will rates stay at these levels. While inflation is coming down, it still remains well above central banks’ 2% targets. This higher interest rate structure will limit how much stock valuations (p/e multiples) increase however, should rate cuts occur later next year, stocks would most likely gain.
In this uncertain environment of recession/earnings risk, still high inflation and central banks’ determination to reduce it, we are maintaining our targets of 21,600 for the TSX and 4,300 for the S&P 500 at year end 2023. By that time inflation should be lower, monetary tightening ought to be behind us and markets will be anticipating faster economic growth in 2024.