- Equity markets slumped this week, as the Federal Reserve remained hawkish, and a cooler CPI report wasn’t enough to trigger a sustained rally.
- The S&P 500 fell 2.1%, with all but the energy sector in the red. Consumer discretionary and technology lagged, as they have done for most of the year.
- Meantime, the TSX gave back 2.5% with declines spread across all sectors.
Inflation and Recession
Recently, we’ve observed a shift in markets’ risk focus from inflation to recession. But why is that? For most of 2022, the big question was what the U.S. Federal Reserve’s terminal rate would be—at what point would they stop hiking rates? Early in the year, estimates were exceptionally low. But as the year progressed and inflation became a bigger problem, those estimates increased. Now, we can confidently say that we’re past peak inflation, but we still don’t know how quickly numbers will decline and when we’ll reach central banks’ inflation target of 2%. In November, the Fed seemed to pivot, indicating that the end of rate hikes was in sight. But last week, in addition to raising rates by 50 basis points, the Fed returned to a more hawkish stance, reiterating that inflation may stay relatively high. Markets didn’t like that, and we’re seeing a selling pressure as a result. Our analysis is that most of the impact of inflation and higher interest rates is behind us, though there could still be some volatility moving forward. The remaining question is what will happen to corporate earnings given the emergence of some consumer weakness. That story will play out over the next couple of quarters, but we’ve already seen some big names reporting negative results and announcing layoffs. The earnings question is the main reason for markets’ shift in focus from inflation to recession—it remains to be seen what effect companies’ profits and margins will have on the wider economy.
Bottom Line: Going forward, it will be a balance between potentially disappointing earnings and positivity stemming from a likely pause in interest rate hikes.
Looking ahead to 2023, we expect U.S. markets to hold up fairly well. Some negativity is likely, given a less-positive earnings outlook and the likelihood of more job losses being announced. But the important thing to remember on the jobs front is that we’re starting from a place of strength—any decline would be from a great job market to merely a good one. That’s the key factor that will likely prevent a “hard landing,” or a deep and long-lasting recession. Our expectation is that we’re more likely to get a soft landing, but the onset of that downturn keeps getting deferred because of how slowly consumers have been weakening. At this point, we expect a shallow recession to begin some time around Q2 or Q3 of 2023, along with a commensurate downturn in markets. But in positive news, China’s reopening is a rising tide that will likely lift all boats, including U.S. and global markets. That’s another reason why a recession could be short, along with optimism around a potential pause in rate hikes and an eventual earnings rebound.
Bottom Line: Despite some negativity, U.S. markets will likely hold up well in 2023, and we still expect the looming recession to be short-lived.
We’ve been bullish on Canada for all of 2022, and it’s worked out exceptionally well for us. But as we head into 2023, we expect to see some of the positives for Canada coming off somewhat, especially in terms of the impact of inflation and higher interest rates on the Canadian consumer. The Canadian consumer hasn’t followed the U.S. consumer in deleveraging—reducing levels of household debt. As a result, they experience comparatively more pain when interest rates go up. This wasn’t a major issue in 2022 because only a portion of Canadians’ mortgages came up for renewal. But as we move into 2023 and eventually 2024, more people will be renewing their mortgages at a much higher rate, which will hit consumers in their pocketbooks. We’ve already seen housing prices come off, and both equity and bond markets were down in 2022—all of which directly affect Canadians’ net worth. Because of these challenges, we’ve brought our overweight to Canada back to neutral. We haven’t gone underweight yet because some of these problems aren’t exclusive to 2023. But it was the right time to crystallize some of our profits.
Bottom Line: Looking at the big picture, it’s bad news for the Canadian consumer—and the consumer is a bigger part of Canada’s economy than other comparable economies.
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