Chief Investment Officer Dan Chornous discusses the key factors impacting his outlook for global growth, and fixed income and equity markets – with inflation top of mind.
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What is your outlook for the global economy?
Like most of you, I've been enjoying the return to office and time with my partners.
The exit from the worst of the pandemic, while also pleasant in so many ways, has been a challenge for the economy. The invasion of Ukraine by Russia, supply chain disruptions, changes in spending patterns, two years of excessive monetary stimulation, ultra-low interest rates have all combined to move inflation, as you know, to an unacceptably high level. About a year ago, 18 months ago, one of my partners said, if I could know one piece of data for the coming period, I want to know the level of inflation, because that's what's going to determine the outcome for the economy and for markets.
And boy, has that proven to be true. As a result of this high level of inflation, the need to bring it down closer to Fed targeted levels of, say, 2% over a reasonable period. We've got a spike in short and long term interest rates. That's now showing up in a slowing of the economy. And the chance of recession is perhaps higher now than it's been in several years.
It's not a certainty, but already, growth is moving down lower than any of us expected for 2022 and 2023.
Central banks are hiking interest rates to help ease inflation. Is it working?
Inflation is unacceptably high, spiking above eight and a half percent in North America. Even higher levels and sustaining higher levels in the United Kingdom and in Europe. They absolutely must be brought down to closer to prior targets of about 2% or even slightly above over a reasonable period of time.
It took 40 years for central banks to earn the credibility that they have, and they’re not going to put that at risk in the near term. To bring inflation down means higher rates. We've seen a round of what we call jumbo rate hikes, where they typically go up at 25 basis points. A hike spaced over several months as central banks watch to see their impact.
In fact, these have been 50 and 75 basis points of rapid succession. Inflation, at least in North America, may already have peaked. Some of the elements of those price pressures – energy prices have come off the boil as demand destruction. People just bought less energy than they would in the past at higher prices. That's not yet happening in Europe, the United Kingdom – they could be faced with a very stressful winter as a result.
But policy initiatives will have an effect and are already starting to show their strength in North America. If inflation continues to rise or even stays at its current level, the risk of higher interest rates, tighter fiscal conditions and a much more difficult end to 2022 and 2023 for the economy is a virtual certainty.
We believe that inflation will move towards a three and a half percent target by the fall of 2023. If we’re wrong, more difficulty lies ahead for the economy and markets.
What is your outlook for fixed income markets?
Fixed income markets have experienced a very, very difficult 2022 so far. In fact, by some measures, it’s the worst fixed income market in many decades. This, of course, is on the back of soaring inflation and probably more importantly, tightening monetary conditions and rising interest rates.
We expect that short-term interest rates will rise all the way to three and a half percent and more if inflation doesn't react to the higher levels of interest rates and monetary tightening. In our forecast, inflation peaked in the summer of 2022 and will gradually make its way closer to three and a half percent by the fall or year-end of 2023.
That would allow the Fed to stop raising interest rates at three and a half, three and three quarters percent, and the pressure will come off the bond market as that all moves into view. In that scenario, a year from now, you'd likely see bond yields at roughly their current level, somewhere between three and three and a quarter percent.
And you essentially get to keep your coupon as your total return over the year ahead.
What is your outlook for equity markets?
Well, the bull market ended with Fed rate hikes and inflation soaring the beginning of this year. At one point, the U.S. stock market was down over 23% before recovering half of those losses through the summer rally. There are challenges, though, ahead. Virtually all of the losses in stocks have come by falling valuations. They haven’t really looked at earnings all that closely.
In fact, analysts seem to be behind the curve at the impact of a slowing economy and corporate profits. P/E ratios came down as interest rates went up. If inflation doesn't moderate, there will be further downside on valuations. However, in our forecast, we think valuations should stop falling around where they are right now. On the other hand, the problem becomes as you move closer and closer to recession. Analyst forecasts where 8% earnings growth in 2022 and again in 2023 seem pretty aggressive. Using a bit more modest earnings expectations and assuming that valuations are likely to stay at current levels, you know, markets close to four thousand, forty-two, forty-three hundred seem to be reasonably valued.
However, as the economy moves to a lower glide path and those earnings results surprise to the downside, there is risk of further downside in the stock market as well. Our valuation models globally show that the correction so far has actually made stocks in many cases move down to attractive levels.
Europe, the United Kingdom, emerging markets are actually quite attractively valued, much more attractively valued than they were only six months ago. The United States, just above fair value, has corrected much of its prior excesses. It sets up the chance—the opportunity for stocks, as the outlook for the economy begins to clear, for a new rally to take hold.