May 25, 2023

Quarterly Newsletter - Spring 2023

A break from interest rate hikes?

While the performance of the markets exceeded most expectations in the beginning of the year, the rest of 2023 could see more erratic movements, but also some opportunities. Turbulence in the banking sector in March may have given central banks a reason to pause monetary tightening in the short term. However, they remain fully committed to finishing their fight against inflation. In addition, tightening financial conditions could facilitate the task of monetary authorities and considerably reduce the number of additional key rate hikes.

US regional banks

Warren Buffett once said, "only when the tide goes out do you discover who's been swimming naked!" The tide finally went out in March. The failures of Silicon Valley Bank and Signature Bank, followed by the forced merger of UBS and Credit Suisse, brought back memories of 2008. However, the global economy probably isn't on the brink of a new major financial crisis. Not only are banks in the United States (and Canada) much better capitalized than in 2008, the quality of loans is higher and the monetary authorities have more tools at their disposal.

A disconnect between stock markets and the economy?

Are we seeing a disconnect between the markets and economic reality? Corporate profitability outlooks have weakened due to the direction of the economy and monetary policy. Historically, economic contractions have been followed by falling corporate earnings. It's important to keep in mind that a new investment cycle starts after, not before, the economy dips into recession.

In view of recent positive economic data, we anticipate the recession to start later than previously expected, but that doesn't mean it's not happening at all. The longer the economic data stays resilient, the longer interest rates should remain high. Sooner or later, they'll cut further into consumer spending. For stocks to keep climbing, economic growth must continue to surprise while inflation must fall rapidly on its own, even if the labour market stays strong. That's a lot of stars that need to align. Is it possible? Perhaps. But is it likely?

We continue to view a recession as the most probable scenario. Therefore, it's hard to see how earnings could go up. If they were to decline by around 10% (compared to an average drop of 19% during a recession), earnings per share on the S&P 500 would fall, leaving the US flagship index with a multiple of more than 20. That's hardly a bargain. Even without a decline, the S&P 500 is trading at over 18 times anticipated earnings, which is at the upper end of the range seen before the pandemic, when interest rates were also much lower than today.

While we might opt for a slightly cautious stance in the short term, it shouldn't be excessive. Pessimists might look like they're making the smart move right now, but optimists will make the most money in the long run.