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2022 was an unsettled year for markets. But what about 2023? Today we bring you a conversation from the Scotiabank Perspectives podcast with Hugo Ste-Marie, Director, Portfolio and Quantitative Strategy, Global Equity Research at Scotiabank. His role is to give investment advice to large, institutional investors. In this conversation with him and Perspectives host, Stephen Meurice, he gives us a glimpse into his outlook for 2023. He’ll tell us what trends, potential pitfalls, and opportunities may lie ahead.
Hugo, thanks so much for joining us today.
Hugo Ste-Marie (HSM): Thanks for having me.
Stephen Meurice (SM): So today is all about looking ahead to 2023. But before we do that, maybe you could give us a quick recap? What did 2022 look like from a stock market or investor perspective? It seemed like it was a bit of a wild ride.
HSM: Yeah, 2022 was marked by, I would say, extremely elevated inflation. And to fight inflation, Central Banks around the world, not just the Bank of Canada, the Fed in the U.S., but most central banks around the world adopted very aggressive monetary policy to cool down price pressure or inflation, in other words. But when, let's say, interest rates are going up very fast, it tends to put pressure on stock markets, on equity valuations. So, when we looked around the world, most global equity markets are down on a year-to-date basis. The U.S. is down, Canada is down more so. What has been challenging, I would say, for investors is that usually when equities are going down, the bond market tends to do better. And that provides some caution on the overall performance of portfolios. That has not been the case this year. Last time both bonds and equities were down on a full calendar year in the U.S., we have to go back to 1969. So from that perspective, no safe haven from bonds, very negative performance from stocks. Only cash has performed better and some commodities, namely oil.
SM: Wow. So, a challenging year for sure for investors of all kinds. If we start maybe with the big picture of looking at 2023, you recently put out a report titled ten Themes for 2023, Balancing Risk Versus Reward. I'm sure we'll get into some of the details, but can you give us a brief outlook, sort of the headline outlook for markets this year? What do you think investors should expect?
HSM: Yeah, I think investors should expect another rocky year where macro data is disappointing, economic growth is slowing down. I think we are going through a, I would say, a mild recession. That being said, I think there is going to be opportunities for equities to get a bit more aggressive in portfolios at some point, maybe in the first half. Again, that's a work in progress. But I think in the first half of 2023, if the market is going much lower, there’s going to be opportunities to be a bit more aggressive in portfolios, not now, but maybe at some point in 2023. So, the first half could be challenging for stocks, back half I think it could be a bit better. That would sum up ‘23.
SM: Okay. We'll get in hopefully to some of the details around that. But maybe we start at the macroeconomic and policy level. What are the main forces driving those situations that you just described? Is it essentially much the same thing as we experienced in the back end of 2022?
HSM: Yeah, I would say that that's the same thing. Like we have started to see inflation moderating, but it's still well above central banks’ targets, whether it's Canada or the U.S. And we had a meeting, Fed meeting, not so long ago. And the Fed told us basically that they want to continue to tighten their monetary policy, in other words raise their benchmark rates and there is a lag between a rate hike and the full impact on economy. So, all the tightening we had in 2022, I mean, the full impact of this will be seen, I would say probably in the summer of ‘23. That lag is very important to understand. So macroeconomic conditions to some extent worsened in 2022, global growth slowing down. But I think going into 2023, the economy might have a bit of trouble to swallow this very steep and aggressive tightening cycle we've been seeing for basically all of 2022. So that's why we're calling for at least a modest recession in 2023.
SM: Right. And the Fed, which is the central bank of the United States, in some respects, looks to be even more aggressive than the Bank of Canada, certainly suggesting that they're not done yet with increasing rates. In your report, you talk about how like once the tide turns on that it can actually turn pretty quickly. What did you mean by that? That the rates could fairly soon start coming down, even though the Fed is being as aggressive as it is?
HSM: Yeah, I would put a caveat. I mean, the Fed, what we call the terminal rate, so that's the rate at which the Fed will stop tightening, could be around maybe 5.25%. So, as we speak today, U.S. Fed funds are at 4.5%, maybe they push that up to 5.25% at some point. I think in Q1 2023. After that, they will likely take a pause to see, again, the cumulative impact of all the tightening of 2022. But I think the next step is macro conditions will deteriorate to the point where at some point we have job losses in the economy. So, what does that mean for the Fed at that point in time? Probably later in 2023, they might reverse some of those rate increases. So in fact, they might do some easing. That might start later on ‘23. But still, I think that's something we can take a look at or something we can expect. Historically speaking, the last Fed rate hike and the first Fed rate cut, if you looked at all the cycles, there's a gap of about six months between, again, the last rate hike and the first rate cut. So, if the Fed stops tightening in Q1, we could potentially see a rate cut again at some point in Q4 of 2023.
SM: Right and you're mostly talking about the Fed, so the United States. Do you see the situation being more or less mirrored in Canada?
HSM: Correct. I think the Bank of Canada probably has room to stop at a lower level and before the Fed given that the economy is certainly more levered to interest rates, more sensitive, if you will, to interest rates than the U.S. When you compare Canadian economy versus U.S. economy, clearly the Canadian consumer has much more debt than in the U.S. So Canadian consumer balance sheets, I would say is more stretched and the tightening base could have more impact. So, I don't think the Bank of Canada will have to be as aggressive as the U.S. Federal Reserve.
SM: Okay, let's get back to the markets. Given all of those factors that you just talked about and you mentioned earlier how the first half of the year could be challenging, but also I guess has some opportunities, where do you see that going? What do you tell your clients and the people who depend on you for your advice?
HSM: Yeah. So basically, I think the first half, especially the first half of this year, could be very challenging for equities. The S&P 500 not so long ago was above 4,000. We're not taker, we're not buyer at that level. I think we will see more appealing entry points in the first half. What could be underappreciated is the earnings backdrop. When you looked at earnings expectations for 2023, consensus is still expecting earnings to grow. If we have a recession and go back in the last 50, 60 years. In recessions, earnings are not growing, they're contracting. And I think this is underappreciated by the market at this point.
SM: So, what you're saying is that in spite of that consensus, it's likely that many companies, their earnings, the amount of money they make or the profits that they make are going to decline, they’re going to continue to decline. So, what sort of immediate impact does that have on markets or investors? It makes them run away?
HSM: Well, usually, yeah. I mean, you want to be more careful in your asset allocation, sector positioning and earnings are basically a reflection of what's going on at the economic level. So, if we're talking a recession, earnings going down, that's not good. Usually, the stock market that would put pressure on stock prices if earnings were to decline.
SM: So, what are the options for investors then in those sorts of circumstances?
HSM: Yeah, if you looked at your options from an asset perspective, I would say cash is not a bad place to be. Maybe next couple of quarters, at least. Three month T-bills in the U.S. are now yielding maybe 4.25, around 4.25% That could go up with Fed funds, probably closer to 5%. So, I would say cash is not a bad place to be for the next three to six months. Then I would prefer bonds. So cash would be my number one, bonds number two and number three equities. Again, as I mentioned, there's probably more negative earnings revisions coming. In the U.S., especially the market is still expensive, not so much in Canada or elsewhere, but clearly in the U.S. market, it's still pricey. So, cash, then bonds, then equities.
SM: All right. And if you're going to go the equity route, do you look at dividend paying stocks in particular, would that be sort of your first target?
HSM: Dividend payers, yeah. I would say not just dividend payers, but companies that can over time grow consistently their dividend. We found out in our work that those companies were usually outperforming, maybe not all the time, but on average they tend to outperform the market good times, bad times. So yeah, clearly for investors, given an elevated inflation, having some companies that can grow consistently their dividend could be a good way to ride out the storm and mitigate the impact of elevated inflation, I would say.
SM: And are there sectors where those types of companies are more prevalent?
HSM: Well, usually those type of stocks are found more in more defensive areas of the market. They tend to be on average less cyclical. So, I would say our asset allocation is more defensive as we speak, we're overweight some defensive sectors such as, let's say staples, some utilities, pipelines, with more cash. So those are the sectors where you can find those type of stocks, if you will.
SM: So cash, maybe more of the way to go. Bonds, with equities coming in third. You see that sort of flipping back the other way in the back half of the year?
HSM: Yeah, correct. I'm looking for a few things to get more constructive on equities. So, I would say I'm looking at specifically for things that I would like to, let's say, check on my to do list. The Fed has to be done tightening, not just diminishing the pace of rate hikes, but calling it quits, saying, ‘Okay, we're done for next few months.’ Just a time we assess, again, the cumulative impact of all the tightening of 2022. So that would be number one. Number two, I would say a reset in earnings expectations. When the companies report their Q4 earnings, so the reporting season, the earnings season will start January, February, Canada, U.S. Maybe guidance from companies will be lower. And then Wall Street and Bay Street could reduce more significantly their earnings expectations for ‘23. It won't be a full reset, but clearly we would like to see earnings expectations for ‘23 coming down relatively sharply. Some leading economic indicators for the economy, I would like to see them at least starting a bottoming process or stabilizing, if you will, before we get more constructive on stocks and some signs of capitulations as well. So, when you looked at surveys just looking at the asset allocation for retail investors, the equity portion is still elevated. The cash allocation, it has gone up, but it’s still low and not high enough to call for a market bottom as we speak. So, I would say, nutshell, if we can check some of those boxes, we could get more bullish equities again at some point in 2023.
SM: Okay. Last question, geographic distribution, what are you looking at in terms of sort of more favoured markets for investors?
HSM: Yeah, I would go outside the U.S., clearly if there was a global recession we see global earnings risk everywhere around the world. I would see the extra risk or the additional risk on the U.S. market is valuation. As I mentioned before, the S&P is still extremely pricey versus its own history, but also versus global equity markets. If you use, let's say one valuation metric, it's called a forward price earnings ratio. So, in the U.S., when we do this, it was still around 18 times forward earnings. In other markets were closer to 12 or 13 times. So, the U.S. market is way more expensive and that could be an additional risk in 2023. What we think could happen elsewhere, I would say a couple of things. You have the earnings risk as well, but given that valuation is so low, I think in the back half, what we call a rerating, so an expansion in valuation metrics could mitigate the decline in earnings. So, if we have that, I mean, overall, 2023 could be quite bumpy, but the year-end result could be maybe slightly up or closer to flattish, if you will, despite a very challenging first half, maybe the back half is better. And overall, at least for the TSX and global equities, we have better performances or superior performances versus the U.S. market. Especially if you take into account a falling U.S. dollar. When you put all global equity markets in the same currency, I would say a decline or a weaker U.S. dollar will boost the performance of what we call international equities versus the U.S. So I think global stocks could beat U.S. equities in 2023.
SM: Okay. Well, I think we'll leave it there. It looks like a challenging front half, fingers crossed for a slightly better back half and end up with a flat-ish 2023, would you say that's the simplest way of putting it?
HSM: That is correct.
SM: Hugo, thank you very much for joining us today. I really appreciate you taking the time.
HSM: Thank you very much.
Announcer: I’ve been speaking with Hugo Ste-Marie, Director, Portfolio and Quantitative Strategy, Global Equity Research at Scotiabank.
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