An unholy trinity of negative influences has shaken markets over the past couple of weeks.
First and foremost are rising interest rates. Second is a darkening outlook for corporate profits. Third is a global economy facing severe stresses.
Markets are unlikely to stage a major rebound until at least two of this ugly trio begin to fade or reverse. The question that investors may want to ponder is just how likely that is, at least in the short term.
Start with interest rates. They seem set to continue rising, at least for the next few months, if for no other reason than central bankers saying they must.
Policy makers, including those at the Bank of Canada and the Federal Reserve, have been pounding the table since mid-August to emphasize their No. 1 priority is taming runaway prices. If bringing inflation to heel means inflicting pain on their economies with higher interest rates, so be it.
The Bank of Canada, the Reserve Bank of Australia and the European Central Bank all delivered supersized rate increases this week. More hikes seem preordained. “We are in this for as long as it takes to get inflation down,” Lael Brainard, vice-chair of the Federal Reserve, warned on Wednesday. And she’s usually considered one of the less militant central bankers in the world.
Higher interest rates take a toll on stock prices in multiple ways. They hurt profits by raising the cost of borrowing for companies. They also raise personal borrowing costs and therefore put a damper on house buying and other types of consumer spending.
On top of all that, higher interest rates reduce the present value of future profits and dividends. A promise of $100 in dividends a year from now is worth a hair over $98 today if interest rates are 2 per cent. But if interest rates go to 5 per cent, the same promise of $100 a year from now is worth just a bit more than $95 in the here and now.
Put all of that together and it seems unlikely that stock markets will mount a sustained rally until central banks signal a definite end to rising interest rates. The only way that will happen over the next few months is if inflation fades more sharply than expected. The catch there is that the most likely reason why inflation might take a tumble is the onset of a painful recession – not exactly good news for equity investors.
This brings us to the second reason why markets have been in a sour mood: the darkening outlook for corporate profits.
As economies slow, analysts are beginning to pull back on their profit projections. In recent weeks, they have pared back their earnings expectations for both 2022 and 2023.
One strong reason to expect more bad news on the earnings front is that governments are slashing spending. In both Canada and the U.S., government deficits are falling sharply as pandemic spending ebbs.
A time-honoured piece of economic theorizing known as the Kalecki profit equation tries to tie all this together. While the Kalecki formula needs a bit of explaining, one of its key insights is simple: If the private sector is accumulating an economic surplus, then someone else must be taking on a corresponding deficit. That someone else is usually the government.
This implies that belt-tightening by government is not usually good for corporate profits, and so it proves in practice. In a paper published at the end of August, Jeremy Grantham, the reliably dour co-founder of asset manager GMO LLC in Boston, looked at all episodes since 1960 when the federal budget balance shifted abruptly over the course of a year. In each case when Washington cut its deficits by a large amount over a 12-month span, U.S. corporate profits took it on the chin.
If a similar relationship holds true this time, corporate profits in both Canada and the United States face a headwind as governments in both countries reduce their deficit spending. This would not come as a surprise to anyone who followed the epic increase in corporate profits during the pandemic. For profits to fall back to trend implies a painful shrinkage in bottom lines.
But here is where things get truly murky. Much of what happens next depends on the third factor in the ugly trio we discussed earlier: the radically uncertain global economy. War in Ukraine and Russian fuel embargoes have upended European energy markets. Meanwhile, China’s mass COVID-19 lockdowns, deflating property bubble and drought have cast a pall over the Asian giant. On top of all that, U.S. congressional elections loom in November.
It’s impossible to say how all these factors will interact, but one takeaway seems clear. Unless you anticipate a sudden outbreak of normalcy, global markets are likely to remain at the mercy of unpredictable politics for several more months at least. That could mean more tumult, but also the chance of positive surprises – a wave of Chinese stimulus, for example.
Only a very brave person would pretend to know exactly how to navigate these uncertainties, but it seems reasonable to err on the side of caution. Staying close to home, at least until central banks stop raising rates and global energy markets find a new equilibrium, seems like a decent idea.
In a report this week, analysts at CIBC World Markets argued that the impact of the European crisis is likely to be slightly positive for Canadian stocks, although the exact impact will vary widely by sector. Canadian energy producers and fertilizer companies should “continue to generate bumper levels of profitability,” according to CIBC, as soaring energy prices and food shortages create demand for their output.
Among the stocks that CIBC expects to do well are renewable energy suppliers with European exposure such as Northland Power Inc. NPI-T, Boralex Inc. BLX-T and Brookfield Renewable Partners LP BEP-UN-T, as well as natural gas producers such as Tourmaline Oil Corp. TOU-Tand Arc Resources Ltd. ARX-T, and fertilizer giant Nutrien Ltd. NTR-T. Many of these stocks have already enjoyed a boom, but they still seem like solid bets in a market struggling with a nasty trinity of malign influences.
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Ian McGugan