Market volatility has persisted through the first five months of the year. Investors are clearly focused on the ongoing concerns around inflation, rising rates and the risk of recession. Stu Kedwell, Co-Head of North American Equities, recently shared his thoughts on the state of markets.

What can central banks do to combat inflation?

For much of the last decade, central banks haven’t had to worry about high inflation, so they’ve instead focused on easing financial conditions to drive economic activity, with a specific focus on lowering unemployment. Today, central banks are laser focused on reigning in inflation. They are trying to achieve this through tighter financial conditions (i.e. raising rates and less quantitative easing). As a result, interest rates are rising, credit spreads have widened and equity prices have fallen. They’ll need to see inflation cool off before returning to the stimulative effects of eased financial conditions.

How is recession risk reflected in company valuations?

Valuations have improved in North America from elevated levels to start the year, but we are carefully focusing on earnings. S&P 500 earnings are expected to reach US$230 this year and US$245 next year. While these numbers do take into account some margin pressure and moderation of economic growth, they are not reflective of the potential impact of a recession. While difficult to estimate, the decline in equity markets witnessed so far would suggest the likelihood of recession is around 50%, higher than what many economists are predicting. That said, in the event of recession, earnings could decline by 15%-20%, leading to further equity weakness.

When looking at the headlines, what they are saying about market performance and equity valuations don’t tell the whole story.

The valuations of some sectors are actually at or below their long-term averages. These sectors largely contain businesses expected to grow earnings and cash flow meaningfully in the future. Conversely, stocks with defensive qualities are trading at relatively high prices as investors apply a premium valuation in the near term, responding to worry about an economic slowdown.

TSX Valuation by Sector

Source: Bloomberg, closing prices as of May 31, 2022

What are your long-term return projections for the market?

As we all know well, but sometimes forget during these periods of heightened volatility, is that it is always important to maintain a long-term perspective. If we look at a 10-year time period, and assume  reasonable earnings growth in the 6.5%-7% range (in line with historical levels) and a reversion to a normal valuation of 15 times earnings (today we’re at 17 times), the total return potential for the market is around 7-8%. While lower than the traditional 8-9% the S&P 500 has delivered in the past, it’s still quite attractive.  In the context of a 10-year plan, it’s prudent to prepare for and incorporate at least one recessionary period.

What strategies can investors incorporate during these times of uncertainty?

It is a reality that as liquidity in the market declines, volatility increases. While stock market gyrations can be magnified by some market participants’ behaviour, the acknowledgement and navigation of volatility is key. When the market sells off, it adds return potential for a long-term investor. One of the ways investors can navigate the market ups and downs is through dollar cost averaging or DCA. DCA is when you invest an equal amount at regular intervals. It takes the guess work out of trying to time the market.

Although the trough of a falling stock market is hard to time, dollar cost averaging allows you to find your way down the market’s path, ensuring you put money to work at reasonable prices. It’s an effective way to manage the emotional aspect of volatility without derailing a long-term plan.

This is a particularly difficult time for investors. Yet, these are the times that it’s essential to have a good financial plan; one which incorporates drawdowns along the path of a long-term investment horizon.