EQUITIES COMMENT: WHATEVER HAPPENED TO GOLDILOCKS?
Goldilocks was a term often used by economists in the last two decades to describe an economy that was not too hot and not too cold but just right. When an economy is too hot (growth is very strong), it can cause inflation to increase. When an economy is too cold (growth is weak), it can cause unemployment to rise. Central banks like the Bank of Canada and U.S. Federal Reserve use monetary policy such as interest rate moves to either cool a hot economy or warm up a cold one. In a Goldilocks economy, limited and/or gradual interest rate moves are the norm. Stocks benefit from a Goldilocks economy.
COVID-19 has put an end to the Goldilocks era. With shutdowns at the start of the pandemic, the economy became too cold—unemployment skyrocketed. Massive support from governments that boosted unemployment benefits and central banks that lowered interest rates heated up the economy. As vaccinations increased and the economy reopened, it started running too hot in 2021 (5.6% average quarterly GDP growth versus 2.5% prior to the pandemic) and inflation (Core PCE-Personal Consumption Expenditures Price Index) accelerated. Meanwhile, the unemployment rate dropped to pre-pandemic levels. Due to COVID related disruptions, many economists thought high inflation would be temporary. The central banks were, in hindsight, too slow to cool growth. The war in Ukraine and COVID shutdowns in China have further contributed to higher prices. Now central banks are raising rates at a much faster pace than was anticipated in order to cool economic growth and inflation. Rapidly rising interest rates put downward pressure on stocks, particularly valuations (price to earnings multiples).
The previous chart shows how quickly the U.S. has raised the Federal Funds interest rate this year. However, it is still well below the peak reached in 2019. Recent economic data indicates higher rates are having the desired effect on the economy. Growth is cooling however, inflation is stubbornly high so central banks have pledged to continue raising rates. The big worry for stock market investors is that central banks will raise rates so high they cause the economy to shrink. In a recession, corporate earnings decline and this has a negative effect on stocks.
Stocks Under Pressure in the Second Quarter The TSX Composite and the S&P 500 were both down 13% during the second quarter in Canadian dollar terms. Over the past twelve months, the TSX fell 4% while the S&P 500 is off 7%. The good news is the decline in stocks has brought valuations to attractive levels. The bad news is, if the economy does enter a recession, earnings are likely to fall and stocks would be vulnerable to further declines.
Energy Wins Again Energy is the only sector to have a positive return so far in 2022. Strength in oil prices has boosted the stocks. All other sectors are down with Technology and Health Care the hardest hit in Canada. In the U.S., Consumer Discretionary (includes Amazon and Tesla) and Communications (Facebook and Netflix) are the losers. These sectors contain stocks with high p/e multiples and therefore suffered the most with the increase in interest rates.
Earnings Risk on Investors’ Minds Shrinking p/e multiples were a big factor in the decline of Technology related stocks in the first five months of the year. In June, worries about a recession and falling corporate profits caused stocks of economically sensitive businesses like banks to also come down. So far, though, earnings are holding up well and forecasts for the TSX and S&P 500 have changed very little. Companies will be reporting their most recent quarterly earnings starting in mid-July. The results and management commentary will give key insight into the earnings outlook for the balance of 2022. If companies reduce their earnings forecasts for 2022 significantly, we would expect stocks to experience further losses.
Risks to 2022 Outlook The risks we identified last quarter have increased in some cases. As a result, we have reduced our forecast for stock returns this year from between 5%-10% to between -8% and +5%. Our targets are revised to 21,600 for the TSX and 4,300 for the S&P 500.
Inflation is too hot. It has shown few signs of cooling down and is being exacerbated by the impact of the war in Ukraine on commodity prices like energy and wheat. Although a moderation later in the year is still expected by many economists, inflation will most likely be well above the U.S. and Canadian central banks’ target of 2%. Inflation is still being affected by the pandemic so as the impact of COVID recedes, some price pressures should ease.
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. This has put downward pressure on stock p/e multiples. Rising interest rates are starting to cool economic activity (housing). It is possible that central banks will not have to raise rates as much as expected to bring inflation down. This would be positive for stocks.
The global economy is still being affected by the pandemic. An example is China’s recent lockdowns. Increased vaccinations are allowing greater movement of people and improved activity. There is still the possibility of a more lethal or vaccine resistant variant that would have a negative impact on economic growth.
World economic growth is cooling with hot energy prices a drag. Typically, increased oil prices act like a tax and reduce economic growth. This, along with higher interest rates, dampens activity. Reopening of China’s economy will have a positive effect. Low unemployment in many countries should cushion the blow of higher rates and inflation, Nevertheless, the risk of a more severe slowdown/recession has increased.
The invasion of Ukraine by Russia has increased the risk that stocks could have negative returns this year should energy supplies be cut off and/or the war spread to NATO countries.
The stock market is caught in the cross currents of too hot inflation (and rising interest rates to counteract it) and a cooling economy. Will a recession be required to restore a Goldilocks economy? We believe stocks are attractively valued assuming there is no recession (our most likely scenario). Should a recession occur, there is a risk of lower levels by the end of 2022.