Moderating stock market trends and inflation catalysts suggest better days ahead
While the past year has been replete with challenges for the stock market, a moderating picture of economic risks suggests that for the long-term investor, cautious optimism might be in order.
“Last September, the S&P was down about 25% for the year,” said Don Stuart, executive vice president at Dixon Mitchell, at a recent webinar. “Since that time, markets are up a fair amount.”
The lion’s share of declines in 2022, he estimated, could be chalked up to the sharp increase in interest rates which compressed stock valuations. But as of February 17, Stuart noted, the TSX and S&P 500 had posted total returns of 12.5% and 14.5%, respectively, from their respective bottoms reached last fall.
Looking at the U.S. 10-year Treasury yield, he said it peaked last year above 4% – modest by historical standards, but a steep increase compared to the level at which it began 2022. While longer-term yields turned down in the fourth quarter, short term rates continued to rise, leading to the inverted yield curve that is currently in place.
“The recovery in the market that we saw in the fourth quarter can be largely attributed to those longer-term rates levelling out and putting less pressure on the present value of corporate earnings” Stuart said.
From early 2022 to its summer peak, he said inflation showed a “rate of change that we probably haven’t seen in a generation.” Though he noted that CPI in the U.S. peaked in the summer at 9.1%, its most recent print came out at about 6.4%. Things have played out similarly in Canada, where inflation reached a zenith of 8% and has since descended to 5.9% in January.
“There's no guarantee that inflation won’t turn back up again, but several inputs have eased significantly of late and should support a moderating backdrop going forward. If we continue on this path, we made not revisit the market lows posted last fall” he said.
Among the wide array of elements that underlie the Consumer Price Index, he said the three biggest contributors – energy, food, and shelter – are showing signs of easing. A lot of the “doom and gloom worries” over energy price inflation, for example, have failed to play out, due in large part to a warmer-than-expected winter in Europe, as well as the continent’s commitment to consumption austerity and its rapid adoption of LNG as a substitute to gas piped from Russia.
While food prices haven’t yet come down to 2016-2020 levels, Stuart observed that they have declined considerably from mid-2022 levels. That’s come on the back of lower costs of fuel, fertilizer, and shipping.
The pattern of food prices also provides a good example of the “base effect” phenomenon which could play out with several items in the very near future. Even though prices remain higher than they were two years ago, Stuart said, comparisons with the 2022 peak will become more favourable as we approach summer and could cause posted inflation to decline sharply or even turn negative. “As our point of reference for one year inflation becomes the lofty heights of last summer, we could find that CPI is declining more quickly than most currently expect.
“Beginning in the third quarter of 2021, there were a lot of mentions on earnings calls about labour shortages,” he added. “Today, however, things seem to be straightening out a little bit … in management comments accompanying Q4-2023 earnings, for example, labour shortages came up far less frequently than in the recent past.”
Shelter costs are also showing signs of softening. For the past five consecutive months, rents in the US have declined, causing the yearly increase to plunge by about 80% from its peak in 2022 to a more normal 3.3% clip today. The pace of U.S. home price increases has also eased significantly, from as much as 25% annualized during the 2020-2021 pandemic housing fever to a current rate of about 1.3%.
The consensus forecast for recession, meanwhile, seems as strong as it’s ever been. Indicators such as surveys of money managers’ opinions, their allocations to bonds and equities, and margin balances in investment accounts all point to a deeply bearish sentiment and tilt toward risk aversion. But for long-term investors, Stuart said, that fearful attitude supports the view that much of the selling might already be behind us.
“We’ve got sentiment really on one side of the boat, which is calling for a recession … Over time, you’re generally better off moving to the other side and getting away from the crowd,” he said. “The most important thing is to identify the purpose of your portfolio, and especially how long you plan to be invested for. The biggest mistakes tend to happen when long-term plans are short-circuited by short-term emotions.”
