- Omicron is still impacting economic activity across many countries, but the health situation is improving in most. From the market’s perspective, the main concerns have shifted over to the increasingly hawkish outlook of monetary policy, and, to a lesser extent, to the Ukraine-Russia tensions.
- Global and North American economic momentum into 2022 remains robust, which is giving comfort to central banks to embark on a tightening cycle. Monetary policy tightening is widely expected to proceed at a faster pace than the previous multi-year hiking cycle. March should see both the Fed and Bank of Canada (BoC) hike interest rates, with scope for serial 25 basis points (bps) hikes throughout the year until policy rates are approaching 2%.
- The fourth quarter earnings season delivered solid, better-than-expected results, especially for the energy sector. Looking ahead, we expect the strong revenue and earnings performance to more than offset the negative trend on equity valuation (i.e., lower multiples) and provide a tailwind to equity prices in 2022.
- We tactically began increasing our equity overweight late January as we see the fear over the Fed and economic outlook overdone. We remain biased toward U.S. and Canadian equities, nearing neutral on Emerging Markets (EM), and shifting to an underweight on Europe, Australasia, and the Far East (EAFE). On a sector basis, we remain overweight of U.S. financials, energy, and international travel.
The Fed’s Policy Outlook Shakes Investor’s Sentiment to Start 2022
Shortly after overcoming the Omicron scare, investors began the year facing a U.S Federal Reserve (the “Fed”) that is more eagerly signaling policy tightening. Policy interest rates are widely expected for liftoff in March, with scope for a quick pace to 2%. While we’re approaching policy tightening faster than the market expected a few months ago, our view has long been that the Fed and the BoC were running behind-the-curve and rate hikes were overdue given how quick the recovery has been. Canada’s January employment report, which showed that 200k jobs were lost, should not distract the BoC from hiking in March as the job losses were largely the result of temporary COVID-19 restrictions, which began to progressively phase out in early February.
Global Markets in January: Powell’s nimble outlook spooked the S&P 500
Global equities (MSCI ACWI, -4.9%) began 2022 on a soft note in January, pulled lower by U.S. equities. In the U.S., large-cap S&P 500 (-5.2%) stocks fell but performed relatively well compared to small-caps (Russell 2000, -9.6%) and the tech-heavy Nasdaq 100 (-8.5%) because of a combination of valuation concerns for tech and slowing economic growth for small-caps. EAFE (MSCI EAFE, -4.8%) were also weak, dragged down by Japanese equities (Topix, -4.8%) and a stronger U.S. Dollar. Canadian equities (S&P TSX, -0.4%) outperformed by benefiting from the positive performance of the commodity complex and banks, our two preferred sectors. EM equities (MSCI EM, -1.9%) outperformed slightly, although Chinese equities (MSCI China, -2.9%) underperformed the EM complex again in January.
The bond market kicked off 2022 with echoes of 2021 with a sharp rise in long-term yields, causing fixed-income assets to register a negative performance in January. The yield on Canada’s 10yr bond spiked 34bps during the month as investors realized that rate hikes are not only fast approaching but could also be delivered at a quick pace for both Canada and the U.S. Oil prices benefited from the fading of Omicron and rising geopolitical tensions between Ukraine and Russia, which allowed Western Texas Intermediate (WTI) oil prices to surge 17.3%, to end the month at highest level since 2014 ($88.15/bbl). The U.S. Dollar added to its 2021 gains by climbing (DXY Dollar Index, +0.9%) against most other major currencies. Surging oil prices helped the loonie limit losses to only 0.5% for the month. Finally, the VIX volatility index spiked above 32% as the S&P 500 fell in January. But with equities partially retracing earlier monthly losses, managed to ease down to 25%, a level which still reflects a healthy degree of risk aversion for equities. We think that rising investor risk aversion whilst the macro backdrop remains solid offers opportunistic tactical upside as a re-entry point for equities.
Equity Outlook: Excessive fear over the Fed and the economic outlook?
For investors, we think the recent concerns over the Fed are threefold. First, can higher rates be detrimental to equity valuation, which is higher than history, and can higher rates end the “there-is-no-a-alternative” (TINA) thesis. Second, can too-much-too-fast Fed tightening send the U.S. economy into a recession rather than achieving the proverbial soft-landing? Third and last, recent Fed communications (Source: Bloomberg) have left investors wondering about the “Fed put”, asking “is it lower”?
Earnings and valuation
Although rising rates and discount factor naturally weighs on asset valuation, we think earnings growth is generally the most powerful force influencing equity prices, particularly over longer time horizons (+6 months), whereas price-to-earnings (P/E) fluctuations tend to be related to noisier short-term (1 to 3 months) price fluctuations. The most commonly used valuation metric, the forward P/E ratio, has broadly declined since 2021 as earnings growth outpaced the price appreciation. Looking back further to 2018, it’s notable that earnings (Chart 1) have grown as much as they did whilst global economic activity suffered a major recession from COVID-19.
Chart 1: Strong Earnings Growth Since 2018 Despite the Deep COVID-Induced Recession
The chart shows the growth of earnings across key regions since 2018, with the U.S. and Canada leading other regions by a wide margins. Source: Bloomberg, BMO Global Asset Management, data from December 31 2018 until February 2, 2022. Calculations based on trailing 12-month earnings. Index returns do not reflect transactions costs or the deduction of other fees and expenses and it is not possible to invest directly in an Index. Past performance is not indicative of future results.
Although U.S. equities are more richly valued relative to other regions, their earnings performance has been superior to other markets, which we think has helped support its higher multiples. Relative to EAFE or EM equities, U.S. equities have an attractive quality bias. Some important quality metrics are for instance lower revenues and earnings volatility, higher return on equity (Chart 2), or lower financial leverage. Quality stocks tend to perform well during the mid-phase of the market cycle, while lagging in the early phase of the cycle where investors tend to seek exposure to the most beaten segments of the market.
Chart 2: Higher and Less Volatile Return on Equity is Found in the U.S.
The chart shows the return on common equity across key regions. We see that U.S. equities have been exhibiting the strong return on common equity during the past decade, with a strong improvement in recent quarters. Source: Bloomberg, BMO Global Asset Management as of February 2, 2022. Index returns do not reflect transactions costs or the deduction of other fees and expenses and it is not possible to invest directly in an Index. Past performance is not indicative of future results.
Ongoing rates normalization won’t end TINA
Although we expect long-term interest rates to continue drifting higher, we don’t think that a hypothetical yield of 2.5% for 10yr U.S. treasury bonds in 2022 would be materially detrimental to the attractiveness of equities versus fixed income. With inflation expected to run well above 2% for 2022, we don’t think rising yields would tighten financial conditions in ways to pose risks to the economic outlook. It would instead reflect a normalization of interest rates back to their 2019 levels (Chart 3). For fixed-income assets, however, we think headwinds from rising rates have room to run given that monetary policy is barely in the initial stages of normalization. While yields are now well off their 2020 lows, bonds remain unattractive vs equities and we think this remains an environment for putting “capital to work” in equities, not to play defense.
Chart 3: 10-year Yields Have Room to Normalize to 2016-2019 Level
The chart shows the yield on Canada and U.S. 10-year yields since 2015, back when yields were often well above 2%. Source: Bloomberg, BMO Global Asset Management as of February 2, 2022.
Strike of the “Fed put”: all about the strength of the economy
Oil Outlook: Geopolitical premium and improving demand
Between a demand outlook that’s improving along the fast pace of global economic growth, and rising geopolitical tensions regarding the risks of a Russian invasion of Ukraine, oil prices have broken above the $90/bbl level (Chart 4). Our core thesis for oil remains about demand outpacing production and falling inventories, worsened by the resolve of OPEC+ countries to restrain oil supply. Regarding tensions between Ukraine and Russia, our central scenario is for a drawn-out diplomatic process with tit-for-tat economic sanctions and increasing risks of energy-supply disruptions in Europe. For oil prices, this means some lingering upward pressure, whereas we think it’s a more manageable risk for equities unless the conflict escalates to a large military intervention.
Chart 4: Western Texas Oil Prices Rising on Improving Demand Outlook and Geopolitical Tensions
The chart shows the price of WTI oil since 2013. We see that oil prices are now are their highest since 2014 having suffering decreases for many years. Source: Bloomberg, BMO Global Asset Management as of February 4, 2022.
Outlook and Positioning: Tactically rebuilding our equity overweight
Above trend growth remains our core theme for 2022, along with rising rates. Because we think the fear around a potential policy mistake by the Fed is exaggerated, we tactically began increasing our equity expose in late January, from a modest stance to a bullish stance. While the recent earnings season delivered choppy outcomes for some big-tech names like Netflix and Meta, U.S. and European earnings have not only beaten expectations, but the earnings outlook has also improved, most notably for the energy sector, on which we have a tactical overweight. We continue to prefer U.S. and Canadian equities. Elsewhere, we have been working toward closing our underweight of EM while we recently reduced our exposure to EAFE equities to bring them to a small underweight. Finally, our overweight to U.S. financials, U.S. energy, and international travel sectors, remains unchanged from last month.
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