May 2022 Special Commentary

Looking at the Big Picture

So far this year, the markets have proven to be turbulent, with multiple changes to the outlook. We started the year expecting growth in 2022 to remain healthy, albeit at a slower pace than 2021. Central banks were expected to begin raising interest rates and taper quantitative easing. With continued low rates, supply chain debottlenecking and economies opening up from COVID-19 impacts, these economic tailwinds would support earnings growth.

However, inflation statistics continued to rise (Figure 1), prompting higher expectations for rate increases by the US Federal Reserve and other central banks (Figure 2). Higher interest rates and higher inflation have led to an out-performance of value stocks such as energy, materials, and financials that benefit in this environment. Growth stocks underperformed given the higher valuation, weaker relative earnings growth outlook, and higher discount rates of future earnings.

Russia-Ukraine continues to affect global economies.

The Russia-Ukraine war has further exacerbated inflation concerns. Russia is a major global supplier of oil, natural gas, wheat, fertilizer, and other commodities. Ukraine is also a major supplier of grain. The war’s significant impact has come in the form of high energy, commodity and food price inflation. Companies that are beneficiaries of this pricing environment continued to perform well. Global growth expectations have come down as a result (Figure 3). Growth from Europe has come down the most as they are the most sensitive to the Russia-Ukraine war. Europe imports 40% of natural gas supplies from Russia.

COVID outbreaks in China impact global recovery.

Adding to global growth concerns is China’s zero COVID policy. This first prompted a lockdown of Shanghai but has since expanded to dozens of other cities. Over 25% of China’s population is at least in partial lockdown. There is an end in sight as Shanghai has not had any cases for a few days, and they look to lift some restrictions by June 1st. Lockdowns have harmed their economic growth and will have implications for the global supply chain, which has not recovered from previous pandemic effects in the first place. The combination of slower growth from China, Europe and North America has brought down future inflation expectations (Figure 4) and stabilized the level of interest rates expected by year-end (Figure 2). However, both are still at elevated levels.

The market has focused on potential recession and stagflation risks. We saw relatively solid performance of defensive sectors such as consumer staples, utilities and healthcare. However, the most defensive sectors have become relatively expensive compared to growth companies, making them vulnerable to disappointment. For example, disappointing results from both Walmart and Target due to rising costs have resulted in share price weakness in consumer staples. This narrows the sectors to hide in during market weakness. Markets have corrected materially. The S&P 500 is down over 18% from peak levels, the tech-heavy NASDAQ is down over 28% from the peak, and the MSCI EAFE index is 18% from peak levels. The TSX has faired relatively much better, down almost 9% from peak levels thanks to high exposure to energy, base metals, gold, and fertilizers.

Uncertainty can drive changes in investor behaviour.

Despite attractive valuation, investors often panic and sell with the concern that the macro environment will worsen. This environment poses a challenge for investors with weak sentiment and the fear that we will go into recession. Market psychology can get the best of the average investor. Dalbar’s Quantitative Analysis of Investor Behavior (QAIB) has identified many actions that lead to poor investment decision-making. For example, Loss Aversion is a natural behaviour that makes the average investor overly fearful of losses. Psychologically, investors hate to lose much more than they like to gain. This can prevent logical choices and keeps investors away from potential gains. Withdrawing after experiencing a loss is a natural reaction. However, historical data shows that it is unwise to withdraw in the event of a loss.

Another behaviour to be aware of is Recency Bias. This is a natural behaviour that makes investors biased towards recent events. Subconsciously, investors can overestimate the probability that recent events will happen again. The result is that the average equity investor has under performed for 14 of the past 20 years. From 2001 to 2020, annualized returns for the average US investor were 2.9%. This compares to the 6.4% return of a balanced portfolio with 60% in the S&P 500 and 40% in US high-quality fixed income, 7.5% annual return for the S&P 500 and 4.8% in fixed income, according to Dalbar QAIB.

Even though global equity markets have corrected significantly from peak levels, it has not been due to weaker earnings. It has all been from a de-rating to attractive levels. Actual earnings have been strong, and growth forecasts in company earnings have risen this year. Estimated 2022 EPS (earnings per share) for the S&P 500 was expected to grow 4.8% on January 1st. Today, EPS growth is expected to be 8.4%. For the TSX, expected 2022 EPS growth has risen from 4.8% to 20%, thanks to high energy and materials exposure. Within EAFE, expected 2022 EPS growth has increased more modestly from 3.4% to 4.4%.

With higher earnings estimates and equity market declines, the one-year forward Price-to-Earnings ratio of the S&P 500 has gone from a peak of 23x to 17x (Figure 5).

The TSX P/E has gone from 20x to 12.5x (Figure 6).

EAFE (Developed Europe, Asia and Australia) has gone from 19x to 12.5x (Figure 7).

The market is prudently concerned over earnings downgrades from higher interest rates and persistently high inflation. It is increasingly pricing in a recession scenario and discounting significant earnings weakness.

Looking at the big picture.

At JCIC, we take a three to five-year view and like to invest in high-quality companies. Our bottom-up stock selection is primarily driven by fundamental analysis. Stocks will mainly be mid to large capitalization dividend-paying companies. Our fundamental analysis of a company includes assessing the company’s business visibility, free cash flow generation, growth, management team track record, competitive positioning, industry fundamentals, return on equity (ROE), balance sheet strength, shareholder remuneration and ESG (environmental, social, governance). We also overlay valuation and potential risk/reward.

Global growth expectations have been coming down. Inflation has risen significantly and remains elevated. Central banks are raising rates more aggressively than initially expected to tame inflation. And China’s zero COVID-19 policy has induced lockdowns and put pressure on Chinese growth with supply chain impacts. With this backdrop, there is light at the end of the tunnel. Future expectations for inflation have come down, the expected rate increases from the US Fed have stabilized, Shanghai is expected to lift restrictions soon following no new COVID-19 cases, and sentiment and investor positioning is already very weak. In addition, market valuation has de-rated significantly with equities already pricing in recession risks. While we cannot determine the exact timing of the bottom, and valuation is rarely a catalyst, focusing on long-term returns will result in better performance.