Consumers and investors are on edge as extremely high inflation leads to a rapid rise in the cost of living and more
aggressive central-bank tightening. Price increases have been larger and lasted longer than most experts had
predicted due in part to supply-chain challenges, rapidly changing consumer demands, the war in Ukraine and
lingering tailwinds from the massive monetary and fiscal-stimulus packages deployed during the pandemic. Central
banks are now in a precarious position where they need to tighten policy aggressively to rein in problematically
high inflation at the same time that the economy has already begun slowing. The combination of aggressive rate
hikes, a commodity-price shock and elevated inflation suggests that the risk of recession is higher than usual.
Consensus estimates for growth continue to be ratcheted lower and those for inflation revised higher (exhibits 1 and
2). Our own forecasts are below consensus for growth and above consensus for inflation. We do think, however, that
any recession that comes to pass would not be as severe or damaging as the ones following the global financial
crisis and the COVID-19 pandemic.
Exhibit 1: Weighted average consensus real GDP
Growth estimates for major developed nations
Exhibit 2: Weighted average consensus CPI
Inflation estimates for major OECD nations
Consumers and businesses lack confidence, but spending is holding up so far
With the economy facing a variety of headwinds and the outlook highly uncertain, consumers and businesses are feeling
quite pessimistic about their future. The University of Michigan Consumer Sentiment Index fell to its lowest reading
in nearly a half century and is at levels that have in the past been associated with recessions (Exhibit 3). But,
interestingly, consumer spending remains relatively robust and is still rising at a rapid pace (Exhibit 4). As for
the business community, small-business confidence has also waned but, here too, we have not seen a decline in actual
sales (Exhibit 5). It would be unusual for these survey-based confidence measures to be at such negative readings
without the actual sales data following suit, so we believe the surveys are foreshadowing economic weakness ahead.
Exhibit 3: University of Michigan
Consumer Sentiment Index
Exhibit 4: U.S. retail sales
Adjusted retail & food services sales y/y % change
Exhibit 5: U.S. small business
survey
Optimism index
Housing market is starting to feel the pinch from higher rates
One segment of the economy that is highly sensitive to interest rates is the real estate market, and it started
showing signs of softening as borrowing costs began rising rapidly. Home prices soared during the pandemic as people
sought bigger spaces to work at home and made other changes to their working and living arrangements. High housing
prices were supported by historically low interest rates, but the rate landscape shifted rapidly this year. U.S.
30-year fixed mortgage rates surged to 6% in June from 3% at the start of the year and housing affordability is now
the worst it’s been in 30 years (Exhibit 6). While house prices do not appear to have fallen much yet,
construction and home sales began shrinking in recent months (exhibits 7 and 8).
Exhibit 6: Housing affordability
index
Median family income
relative to mortgage qualifying income
Exhibit 7: U.S. housing – new
private housing units started
Total starts including farm housing
(SAAR)
Exhibit 8: U.S. housing - sales
of existing homes
Total existing
home sales
Inflation remains problematic, but could be peaking
There are signs that today’s extremely high inflation is peaking. While the U.S. Consumer Price Index (CPI) is
rising at its fastest pace in four decades, lifted by food and energy prices, the core CPI, which excludes them, has
been declining gradually from its March top (Exhibit 9). The headline CPI measure could be near its peak as well,
given that a variety of commodity prices are down significantly from their highs (Exhibit 10). Oil is down 15% from
its peak, copper has fallen 24% and lumber has lost 60%. Moreover, inflation expectations have also come off their
highs, indicating that investors believe the worst of the inflation spike may have already occurred (Exhibit 11).
While inflation could remain elevated in the next few months, all signs suggest we could start to see some
significant relief later this year and into 2023.
Exhibit 9: U.S. CPI and Core CPI (ex. food & energy)
Exhibit 10: Bloomberg Commodity Index
Exhibit 11: U.S. Treasuries inflation breakevens
Fed delivers substantial rate hike, vows commitment to fight inflation
Even if inflation tops out at current levels, the gap between where inflation is and where the Fed wants it to be is
unacceptably large. This discrepancy is leading to unusually large short-term interest-rate hikes such as the U.S.
Federal Reserve (Fed)’s 75-basis-point increase to 1.75% on June 15, when Fed Chair Jerome Powell reiterated
his commitment to getting inflation back to the 2% level. Powell mentioned that the Fed’s estimate of a
neutral policy rate is 2.5% which means that, technically the Fed is still engaging in a stimulative monetary policy
since the fed funds rate remains below that level. The question for investors is how far above neutral does the Fed
need to push for inflation to come down? Exhibit 12 plots the expected path for interest rates based on futures
pricing. The various lines on the chart show that this path has been adjusted meaningfully higher so far this year.
Currently, the market is pricing in a fed funds rate of around 3.6% by mid-2023 and is already expecting rate cuts
shortly after the peak in fed funds is reached. In our view, the aggressive rate-hiking path signaled by markets,
should it materialize, could lead to challenges with liquidity and jeopardize the financial well-being of highly
indebted businesses and individuals. There is a fair chance that tightening ultimately undershoots current lofty
expectations.
Exhibit 12: Implied fed funds rate
12-months futures contracts
Historic sell-off in bonds takes a pause
Bonds have extended their sell-off as inflation persists and the Fed accelerates the pace of rate increases. The ICE
BofA U.S. Broad Market Index has declined as much as 13% this year as the U.S. 10-year yield rose to a high of 3.47%
on June 14 (Exhibit 13). More recently, as investors began pricing in a greater probability of recession, safe-haven
government bonds have rallied and the U.S. 10-year yield has retraced closer to 3.0%. This bond rally is consistent
with our view that yields have reached a level where bonds offer more of a cushion against a downturn in the
economy. Our models suggest that valuation risk in the sovereign-bond market has been alleviated as a result of the
surge in yields so far this year (Exhibit 14). Yields could again move higher if the Fed fails to control inflation
and is forced to keep hiking aggressively, but our base case is that inflation will ultimately calm and that further
sustained increases in yields from here will likely be limited.
Exhibit 13: ICE BofA U.S. Broad Market Index
Total return index
Exhibit 14: U.S. 10-year T-Bond yield
Equilibrium range
Credit spreads widen, but they remain well below levels consistent with recession
The sell-off in corporate bonds is also due to concerns of an economic downturn that would hinder companies’
ability to repay their debts. Credit spreads for U.S. investment-grade and high-yield bonds have widened to their
largest in two years (Exhibit 15). Note, however, that even with the recent increase, spreads remain well below
levels that are consistent with recessions. During a recession, we could expect investment-grade spreads to rise to
250 basis points and high-yield spreads to rise to 900 basis points, but those spreads are currently at just 149
basis points and 543 basis points, respectively. Either the bond market is telling us that the risk of recession is
fairly low or that, in the event one materializes, corporate-bond prices could have much further to decline. That
said, the pandemic flushed out many of the troubled debts that existed pre-COVID-19, and there hasn’t been
sufficient time for excesses to build up again in credit markets. Another positive is the fact that balance sheets
are in relatively good shape, and it is therefore possible that corporate bonds could be more resilient to a
downturn.
Exhibit 15: U.S. corporate bond spreads
Difference with U.S. 10-year Treasury yield
Equities extend decline, valuation risk greatly reduced
Stocks encountered another leg down as central banks turned more hawkish and the economic outlook became increasingly
uncertain. Most major markets fell to new lows for the year and the S&P 500 Index officially fell into a bear
market of more than 20% below its peak (Exhibit 16). Since the start of 2021, the S&P/TSX Composite Index is the
only major market we track that is still sitting on a gain. The S&P 500 is flat over that period, while the MSCI
EAFE Index, the MSCI Emerging Markets Index and the NASDAQ Composite Index are all down by double digits. Valuation
risk has been significantly alleviated as a result of the intense sell-off. Our composite of global equity-market
valuations now sits at fair value after being as much as 37% above fair value in December 2021 (Exhibit 17). Stocks
are not necessarily cheap in aggregate, but there are large differences between regions. The S&P 500 remains at
the more expensive end of the spectrum (Exhibit 18) while other equity markets are at or below their fair values.
Exhibit 16: Major equity market indices
Cumulative price returns indices in USD
Exhibit 17: Global stock market composite
Equity market indexes relative to equilibrium
Exhibit 18: S&P 500 equilibrium
Normalized earnings & valuations
Optimistic earnings expectations are vulnerable to downgrades
While expectations for the economy have downshifted, analysts have been reluctant to cut their earnings estimates.
The outlook for corporate profits remains robust, with the consensus of analysts anticipating that S&P 500
earnings will rise 10.3% in 2022 and another 9.7% in 2023 (Exhibit 19). If these forecasts materialize, S&P 500
earnings per share would rise to US$252 by the end of next year, providing solid support for the equity market. That
said, companies are reporting increasing cost pressures and the economy is slowing. It would be unusual for earnings
to be immune to downgrades in this environment and we know that, historically, earnings have declined an average of
25% during past recessions. With profit margins at record highs, earnings above their long-term trend and the
economy slowing, it is likely in our view that reported earnings will come in below current consensus estimates.
Exhibit 19: S&P 500 Index
12-month trailing earnings per share
The style rotation out of growth and into value may be stalling
Growth stocks underperformed for the better part of 2022 but have started to hold their ground more recently. Rising
interest rates and inflation have put downward pressure on valuations, which hurt expensive growth stocks, in
particular, during the downturn. As a result, value stocks outperformed growth stocks by more than 25% from the
start of 2022 to late May (Exhibit 20). Since then, however, growth stocks have started to hold up relative to value
stocks and even outperformed slightly. This slight outperformance in growth stocks more recently has been coincident
with a slight decline in inflation expectations, increased expectations of recession and a 20% decline in energy
shares in just two weeks. Growth stocks tend to outperform during periods where the economy is slowing because they
have a proven ability to generate profit growth regardless of the economic backdrop. It is not yet clear whether
this shift to growth stocks will be sustained, as the market appears to be weighing the possibility of higher
inflation and interest rates, which would favour value stocks, versus the chance of recession, which would favour
growth stocks.
Exhibit 20: Value to growth relative performance
S&P 500 Value Index / S&P 500 Growth Index
Asset mix – positioning closer to neutral
The macroeconomic backdrop is highly uncertain, growth is slowing, inflation is elevated and central banks are hiking
interest rates aggressively to restore consumer-price stability at the risk of sending economies into recession.
Given our view that the range of potential outcomes is larger than usual, that recession risk is high and that bond
yields are at levels that would offer protection against a downturn in a balanced portfolio, we have made two
asset-mix changes so far this month. The first was to move 50 basis points out of cash into bonds as the U.S.
10-year Treasury yield climbed above 3.0%. Later, as yields rose even further, we moved another 100 basis points
into bonds, sourced from stocks. We are still maintaining a slight overweight in stocks, recognizing that the risk
premium in favour of stocks over bonds remains, although that the premium has narrowed as bond yields rose
(Exhibit 21). As a result, our asset mix is much closer to neutral than it has been at prior points in the cycle.
Our current recommended asset mix for a global balanced investor is 61.5% equities (strategic:
“neutral”: 60%), 37.5% bonds (strategic “neutral”: 38%) and 1.0% in cash.
Exhibit 21: S&P 500 earnings yield
12-month trailing earnings/index level
