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Traders gather at a post on the floor, on Wall Street, on Jan. 21. Stocks wobbled between gains and losses as major indexes head for another weekly loss.Courtney Crow/New York Stock Exchange via AP

Financial markets are in a foul mood and for two good reasons – interest rates are rocketing higher and corporate profit growth is careening lower.

The tech-focused Nasdaq index has already fallen more than 14 per cent from its recent highs in November, putting the benchmark into what commentators love to call “correction territory.” Canada’s S&P/TSX Composite (down 3.5 per cent this week), and the U.S.-based S&P 500 (down 5.7 per cent) are sliding, too.

Some veteran observers are ringing alarm bells. “What do markets look like when they are freaking out?” Jim Bianco of Bianco Research tweeted. “Answer, like they look this week.”

Mr. Bianco’s thesis is that investors are finally waking up to the realization that “the stock market is going to get thrown through the windshield” as the Federal Reserve stamps on the brakes and hikes interest rates at a frantic pace to tamp down inflation before midterm elections later this year in the United States.

You can argue with his logic – does the Fed really have a political agenda? Does any competent central bank really want to crater the stock market? – but it is difficult to dispute his diagnosis of the prevailing mood. Surveys of market sentiment, such as the one conducted by the American Association of Individual Investors, show small stock buyers stampeding toward the gloomy end of the spectrum.

Predictability is in short supply in today’s market

Investors must be ready to change their minds in 2022

They aren’t the only ones. The highest inflation readings in decades in both Canada and the U.S. have put everyone on edge about what comes next.

Most likely it will involve significantly higher interest rates and significantly lower levels of government support – the mirror image, in other words, of what happened when the pandemic struck two years ago.

Back in 2020, Ottawa and Washington shocked markets with the scale and speed of their economic aid. Policy-makers in both capitals slashed interest rates and doused workers with gushers of free cash. All that easy money helped propel stock markets to record heights.

It also helped fuel inflation. Now authorities are jerking their previous policy moves into reverse to bring price pressures under control. Central banks are poised to raise interest rates at the same time as governments reduce their free-spending ways.

Earnings slowdown

Forecast year-over-year (Y/Y) growth in earnings

per share (EPS) for the S&P 500

Estimated EPS growth

Actual EPS growth

90.3%

51.6%

48.6%

39.2%

22.4%

13.8%

9.3%

8.4%

6.5%

4.8%

-16.3%

Q1

Q2

Q4

Q1

Q2

Q4

2020

2021

2022

Q3

Q3

2021 Y/Y

quarter growth

2022 Y/Y

quarter growth

Annual Y/Y

growth

THE GLOBE AND MAIL, Source: FactSet

and CIBC World Markets

Earnings slowdown

Forecast year-over-year (Y/Y) growth in earnings

per share for S&P 500

Estimated EPS growth

Actual EPS growth

90.3%

51.6%

48.6%

39.2%

22.4%

13.8%

9.3%

8.4%

6.5%

4.8%

-16.3%

Q1

Q2

Q4

Q1

Q2

Q4

2020

2021

2022

Q3

Q3

2021 Y/Y

quarter growth

2022 Y/Y

quarter growth

Annual Y/Y

growth

THE GLOBE AND MAIL, Source: FactSet

and CIBC World Markets

Earnings slowdown

Forecast year-over-year (Y/Y) growth in earnings per share for S&P 500

Estimated EPS growth

Actual EPS growth

90.3%

51.6%

48.6%

39.2%

22.4%

13.8%

9.3%

8.4%

6.5%

4.8%

-16.3%

Q1

Q2

Q4

Q1

Q2

Q4

2020

2021

2022

Q3

Q3

2021 Y/Y

quarter growth

2022 Y/Y

quarter growth

Annual Y/Y

growth

THE GLOBE AND MAIL, Source: FactSet and CIBC World Markets

In more proof that markets aren’t omniscient, investors seem just as shocked by the sudden removal of support as they were surprised by its sudden appearance two years ago. Case in point: interest rates. Only a few months back, analysts were still debating whether central banks in Canada and the U.S. would dare to raise rates in 2022. Most predicted a nudge of only one or two quarter-percentage-point hikes toward the end of the year.

Those cozy assumptions have shifted with neck-snapping speed. Many economists now expect the Bank of Canada to start raising rates next week. Three hikes this year are considered the bare minimum. Four or five are considered probable. The team at Scotiabank Economics, which takes a particularly grim view of the inflation threat, wants the Bank of Canada’s policy rate – the rate it charges on overnight loans – to rocket to 2 per cent by year-end from its current level of 0.25 per cent.

Yields on many longer-maturity bonds have already taken flight. The 10-year Government of Canada bond, for instance, saw its yield soar from 1.20 per cent six months ago to 1.79 per cent on Friday, a major move by bond market standards. The yield is now higher than it was in the months leading up to the pandemic.

Rising bond yields drag on stock prices because higher yields make bonds more attractive relative to stocks. What makes the recent rise even more concerning is that it is happening at the same time as corporate earnings are grinding into lower gear.

Profit growth at S&P 500 companies will tumble from 51.6 per cent in 2021 to about 9.3 per cent this year, according to analysts. To be sure, the huge jump in 2021 was mostly an illusion – it was basically a bounce off the miserable lows set in 2020 – but the forecast for this year is nonetheless a striking contrast to what investors have experienced in recent months. That is especially true since analysts tend to err on the side of optimism. In all probability, their 9.3-per-cent forecast for the year ahead will be the ceiling for earnings growth, not the floor.

The tougher outlook for earnings helps to explain why the share prices of pandemic darlings such as Peloton Interactive Inc. and Netflix Inc. plummeted this week. Nobody wants to be invested in growth stories if growth isn’t going to materialize.

So should investors in other companies start running for the hills as well? In a word, no. Holding more cash than usual and tilting away from unprofitable businesses makes perfect sense, but corporate earnings are still growing – if more slowly than before – and the real economy is still humming along. Canada’s gross domestic product will surge an impressive 4.4 per cent this year, while its U.S. counterpart will grow an equally imposing 4.1 per cent, according to TD Economics.

Given the low levels of investor optimism, it would not take much to brighten the mood. A few positive earnings surprises would help. So would a few months of falling inflation readings. But until such glad tidings emerge, investors will continue to fret. And for understandable reasons.

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