EQUITIES COMMENT - How Do You Spell Relief?
There was a little relief for investors from declining stock prices during the third quarter due to a fall in our currency. US stocks rose 1.3% in Canadian dollars. However, for the second quarter in a row, the TSX posted a decline (1.4%); for the S&P 500, it was the third quarter in a row (-4.9%) in US dollars. It looked like the quarter was going to be positive until mid-September when two things happened: 1. The August inflation data in the U.S. was released and the rate was higher than expected. 2. The U.S. Federal Reserve announced that they would be raising interest rates more than previously forecast in June. Stocks sold off on this news as recession fears increased.
No relief from losses among sectors except for TSX Materials where chemicals, fertilizer and packaging stocks rose; all other sectors were down during the quarter. The graph below shows the returns year to date. Only Energy has a positive return. The hardest hit groups in the TSX are Technology and Health Care. Technology is dominated by Shopify which has experienced a slowdown in growth of online shopping. Health Care has been hurt by disappointing results from cannabis stocks and a negative patent decision that imperils the future of Bausch Health. In the U.S., Communication Services and Technology were down the most. Meta (formerly Facebook) and Netflix are part of the Communications sector and both have experienced slower sales growth. Higher interest rates have put downward pressure on Technology stock valuations.
There is some relief in sight now for valuations. The p/e multiple (the ratio of a stock price to profits per share) is an important driver of stock prices. Below we have highlighted the p/e multiple for two stocks – TD Bank and Microsoft. You can see the p/e multiple for both stocks has come down this year. Earnings have been stable so it has been the “p” declining that has caused the p/e to fall. Higher interest rates put downward pressure on p/e multiples. We think much of the decline in p/e multiples is a result of higher interest rates. However, if earnings remain stable, stock prices should stabilize.
Are falling earnings the next source of heartburn for investors? This is one of the biggest risks facing investors now. With the central banks determined to raise interest rates enough to cool demand in the economy and slow inflation, the risk of a recession has increased. In a recession, corporate earnings normally decline by at least 10% and often much more. So far, earnings are continuing to rise buoyed by strength in Energy and other commodity related businesses. As well, some pandemic “losers” are benefitting from a return to “normal” although some pandemic “winners” are experiencing reduced profits. Overall, earnings forecasts for the TSX in 2023 continue to increase while earnings for the S&P 500 have come down but modest growth is still projected.
How do you spell relief from the stock market downtrend?
LOWER INFLATION In our opinion, this is the key factor influencing stocks. So far, there has been some progress in reducing inflation however, it remains well above central banks’ 2% target. Inflation statistics are still being impacted by the pandemic; so, as the impact of COVID recedes, some price pressures should ease—the faster, the better for stocks.
INTEREST RATES ARE HIGH ENOUGH Central banks are now expected to increase rates at a faster pace and to a higher level than previously forecast due to stubbornly high inflation. Rising interest rates are starting to cool economic activity (housing) and slow manufacturing. If inflation starts to ease significantly, it is possible that central banks will not raise interest rates as much as expected.
NO RECESSION The U.S. and Canadian economies continue to expand due to support from the consumer. Low unemployment and above average savings should help consumers weather the storm of higher inflation and interest rates. If there is no recession, corporate earnings are unlikely to fall materially.
RELAX COVID ZERO POLICY China’s approach to managing COVID has contributed to inflationary pressures. The shutdown of ports and factories has led to shortages of goods and much higher shipping costs. As well, China’s growth has been hard hit by the shutdowns and this has weighed on the global economy.
END OF CONFLICT IN UKRAINE This would boost confidence among consumers and businesses, especially in Europe. It would also help to allow freer flow of trade in critical agricultural and industrial products that have contributed to inflation.
Given the increased risk of a recession, stubbornly high inflation and central banks’ determination to reduce it, we are lowering our targets for 2022 to18,500 for the TSX and 3,600 for the S&P 500. We believe our previous targets of 21,600 for the TSX and 4,300 for the S&P 500 are likely to be achieved by year end 2023. By that time stock market investors will be getting some relief as inflation should be lower, monetary tightening should be behind us and markets will be anticipating faster economic growth in 2024.