Q4 2022 – OCTOBER
Looking at long-term historical charts of most major equity indices, bear markets appear to be brief in nature; a short-lived, but violent disruption in an otherwise gradually ascending line chart. But living through them is a completely different experience. Bear markets tend to be volatile, grinding affairs, which test the patience and resolve of professional and retail investors alike. After an initial sharp sell-off phase, prices tend to oscillate wildly, as financial markets attempt to find a new equilibrium. Market bottoms generally require a catalyst to rejuvenate investor sentiment. Per our most recent Ask Forstrong publication, the most likely catalyst in this cycle will come when investors “sniff out” a pivot in the US Federal Reserve’s monetary tightening campaign.
So how close are we to the bottom? We would venture to say that the bear market is much closer to the end than the beginning, but some challenges still remain. Perhaps the most notable hurdle is also the most ironic: the US economy (particularly the household sector) remains resilient. Per the chart below, consumer confidence has taken a hit, but remains elevated in part due to very strong labour market conditions. This is both good and bad for financial markets. On the plus side, the strong starting point for US households should translate to a less severe economic downturn. But from a negative perspective, household resilience may delay a meaningful downshift in aggregate demand, which is a key driver of inflationary pressure.
US inflationary pressure is now concentrated in a few components including food, transportation and rent. Here again there are both pros and cons. Food and transportation prices have felt an acute shock from higher energy prices. The European energy crisis (please see our take on Europe in the August Strategy Dashboard), OPEC+ actions and global demand projections all continue to contribute to volatility. The good news however, is that energy has already gone through a massive repricing following Russia’s invasion of Ukraine, prices have retreated from their highs, and the outlook is much more balanced than it was in early-2022.
Rental inflation is likely to remain sticky. The rapid increase in US mortgage rates has pushed potential homebuyers into the rental market en masse. As home prices rolled over, rent prices spiked. But this imbalance cannot persist indefinitely. The rent-versus-buy equation is shifting towards buying, while broad household formation is likely to decelerate amidst tight financial conditions and a slowing economy. Leading indicators have already pointed to peaking rent prices in major US cities, but it will likely take a few more quarters to meaningfully show up in the headline data.
Some recent encouragement has been drawn from moves by the Reserve Bank of Australia and the Bank of Canada to slow the pace of interest rate hikes. However, both economies have much higher household indebtedness (and thus interest rate sensitivity) than the US, so one should not overestimate the likelihood of the Federal Reserve quickly following suit. Regardless, with many of the key drivers of US inflation stalling or already in reverse, the worst of the de-risking is very likely behind us. The year-to-date carnage in global equity markets has produced a significant value restoration, as evidenced by much lower valuation multiples and much higher dividend yields. Investors should not lose sight that this means longer-term return forecasts are now far higher than they were only six months ago.
CASH AND CURRENCIES
European currencies, particularly the euro and British pound, have undergone a significant depreciation this year, due in part to monetary policy divergence and fears of a continental energy crisis. While these currencies could remain at depressed levels for an extended period of time, risks are now asymmetrically skewed to the upside, as financial markets have already digested a plethora of bad news. European currency exposures have been unhedged in client portfolios this quarter.
Rising interest rates have made fixed income a much more serviceable asset class within the context of a balanced portfolio. However, with flat (and in some cases inverted) yield curves, developed market investment grade debt fails to offer meaningful compensation for the inherent interest rate risk at most maturities and credit quality ratings. Fixed income exposure has been modestly decreased and remains below neutral levels in client portfolios.
Despite our view that inflation is currently in the process of receding, we do not expect a return to the disinflationary environment of the 2010s any time soon. A period of above average inflation would not play to the advantage of growth stocks, whose higher valuation multiples and long-term growth projections make them relatively more interest rate sensitive than value stocks. We have decreased exposure to market capitalization-weighted US equities and initiated an overweight position in US value stocks.
We view the recent weakness in lithium and biotechnology equities as an attractive entry point into asset classes that are supported by well-entrenched super trends. Lithium demand should continue to boom as electric vehicle adoption proliferates, while biotechnology aligns with aging demographic profiles in major economies worldwide and new opportunities arising from the advent of mRNA technology. Exposure to lithium and biotechnology equities have been initiated in growth-oriented strategies this quarter.