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analysis

Not long ago it seemed like policy makers had figured out how to fix bear markets.

When financial assets were in free fall in early 2020, central banks and governments stepped in to orchestrate the fastest rebound on record. For the S&P/TSX Composite Index, the pandemic-induced sell-off was over in just 22 trading days, compared with a postwar average of about a year it typically takes bear markets to unfold.

But the torrent of money creation, asset purchases, emergency spending programs and direct transfers to households came with a cost. And the bill has now come due, at least for the stock market.

All that stimulus fuelled runaway inflation and excess demand that must now be obliterated, setting the stage for a bear market more in line with historical precedents.

The market’s recovery in 2020 “had everything to do with the concept that central banks will always be there to save the day,” said Frances Donald, chief economist and strategist at Manulife Investment Management.

“This time, not only do central banks have zero desire to step in, they’re likely to continue tightening into that weakness.”

The stock market has yet to price in anything resembling a prolonged economic downturn, despite the bloodletting over the past two weeks of trading.

Over that stretch, the selloff in stocks quickened dramatically, as investors grappled with the largest rate hike by the U.S. Federal Reserve since 1994 amid inflation that continues to spiral out of control.

The S&P 500 index is now down by 23 per cent since its January peak, wiping away the entirety of the index’s gains in 2021. The S&P/TSX Composite Index has held up better – its losses sitting at 13 per cent by virtue of high commodity prices.

Investors naturally want to know the chances of the market bottoming out soon. The problem is that the market slide to date has been almost entirely driven by a mass re-evaluation of stock prices in the face of higher interest rates.

Corporate earnings estimates, on the other hand, have barely budged. And in a recession, S&P 500 profits tend to fall by roughly 30 per cent.

Many companies are already coming to the conclusion that they grew too aggressively while attempting to keep up with frenzied consumer demand over the course of the pandemic, said Bryden Teich, a partner and portfolio manager at Avenue Investment Management.

Amazon.com Inc. AMZN-Q, for example, recently said it has too much space and too many employees after doubling its fulfillment network and hiring 800,000 workers over the past couple of years.

“I think we’re in the very early innings of a pretty significant belt tightening from companies,” Mr. Teich said.

Across the corporate sector, costs are inflated at the same time as central banks are committed to suppressing consumer demand in the fight against rising prices.

“We’re in one heck of a storm here. I don’t see how earnings don’t collapse over the next six months, unless central banks pivot,” Mr. Teich said.

There’s little chance of that happening. Last week, Fed chair Jerome Powell said he sees “no sign of a broader slowdown” in the economy, despite the sharp rise in interest rates and bond yields.

A few days prior to Mr. Powell’s comment, U.S. monthly inflation figures topped expectations once again, with prices rising by a new 40-year high of 8.6 per cent in May.

For its part, the Bank of Canada has promised to “act more forcefully if needed,” after announcing three consecutive rate hikes.

That process could take policy makers some time, after injecting far more stimulus than was necessary through the pandemic.

“All this inflation came from printing 20 or 30 per cent more money than there were goods available for sale,” said Michael Decter, chief executive officer of Toronto-based investment firm LDIC Inc.

“It’s Economics 101.”

His hope is that after a quarter or two, higher interest rates will slow down the economy enough to bring inflation under control.

“I’d hate to see central banks overcorrect and crush the economy like they did in the early eighties,” Mr. Decter said.

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