As quarters go, this was one for the record books. Taking three months, or a calendar year, to have any particular significance makes no sense, but it’s difficult to quell it. So, here is an attempt to summarize what’s changed in the last three months from the point of view of markets.
Two huge shocks dominate the landscape — the sharp hawkish turn by the Federal Reserve and other central banks, and Russia’s invasion of Ukraine. These events between them naturally increased the risk of a recession or economic slowdown. They also dented hopes for earnings growth. Higher interest rates, international disruptions, and spiking commodity prices all make it harder for companies to make money.
Recession Fears Up, Earnings Prospects Down
Handily, Absolute Strategy Research of London conducts a quarterly survey of big fund managers that asks investors to put percentage probabilities on specific outcomes. Since the last quarter, the fear of a global recession has risen sharply, accompanied by falling hopes for higher earnings:
However, it’s not clear that reduced earnings expectations have found their way into market pricings yet. The desire to wait for the situation in Ukraine to clear up has probably inhibited analysts from producing new forecasts. If we look at “earnings momentum,” defined as the proportion of earnings forecasts that are upwards, then work by the quantitative team at Societe Generale SA shows that positivity is indeed declining. However, there are still barely any more downgrades than upgrades:
Meanwhile, Bloomberg’s survey of estimated earnings for all of 2022 has shown minimal change during the first quarter (outside of the energy sector) across developed markets. This chart is in local currency terms — Japanese earnings forecasts are down if we take into account the pummeling the yen has taken:
Emerging markets estimates have taken a hit, but so far the figures reported to Bloomberg for the developed world have barely changed. Where there is great confidence, however, is that earnings multiples will come down. This is a natural consequence of rising interest rates, according to the prevailing logic most investors learned at business school. The Absolute Strategy report finds fund managers braced for stocks to command a lower multiple of lower earnings in 12 months’ time. Not cheery, but logical.
Logic therefore demands that end-year forecasts should decline. And they have, a bit.
Where Will We Be on Dec. 31?
The business of predicting a market level on a specific day 12 months in the future is pretty silly. But equity strategists seem compelled to play the game. In December, I wrote about research by Aneet Chachra of Janus Henderson Investors US LLC. You can find it here. Among many interesting findings, he showed that “average” years are uncommon. Typically, the stock market advances by double-figure percentages, punctuated by occasional serious falls. It might average out to about 7% or 8%, but years with a solid single-figure percentage increase are unusual.
However, that’s what the great majority of the big sell-side houses were predicting in December. This is the scorecard Chachra offered then.
At the prices in early December, this on average implied a gain of just over 8% — though very few actually expected that outcome. Then a great finish to December left their end-2022 targets looking much less exciting, at 3%. Now, Chachra has repeated the exercise. The drama of the first quarter has churned up forecasts, but not all in the same direction:
After the events of the last 90 days, three strategists have seen fit to increase their estimates for the market level Dec. 31. The number of houses predicting a decline for the year has risen to three from two. One predicting a fall at the turn of the year now thinks there will be a gain. Overall, the implicit projected return for the year has dropped to 1.5%.
However, the good news is that strategists now almost universally believe that now is a decent time to buy. From where the market closed Thursday, only two houses — Barclays and Morgan Stanley — think there will be a negative return by year-end. And both believe the market will only be slightly lower:
The range remains canyon-like. But that might be reasonable, because a bad first quarter portends excitement for the rest of the year. In the following chart, Chachra ranks performance for the last nine months of the year according to whether the first quarter was positive or negative. The market tends to better after a bad quarter, which is sensible enough as buying prices will have just dropped when investors bought. However, the median return for those nine months is very weak after a negative first quarter, showing that the overall average is driven by a few outlying big recoveries. And the standard deviation of returns is far, far greater than after positive first quarters:
Conclusion: It was a pointless exercise to try to predict the index level on Dec. 31 anyway, and it’s even harder now after a bad first quarter.
Hasta La Victoria Siempre!
Arguably the most conspicuous victor of the first quarter, in both absolute and relative terms, was Latin America. Stock markets there have staged a prodigious rally, with Brazil’s the strongest performer in the world. Relative to the all-world index, including both developed and emerging markets, the MSCI Latin America has just had its best quarter on record. (I had problems with the graphics software, so the following chart comes straight from Excel, for which I apologize):
As it stands, the continent with its many materials producers is the big gainer from deglobalization, as the rich world looks for new suppliers. It also benefits from having no further to fall. The region’s trajectory in this century has been painful, riding the rise of China and the commodity boom to massive outperformance in the first decade, tanking as commodity prices fell, and then sustaining a terrible blow from the pandemic. It hit bottom — at a relative level not seen since a Brazilian currency crisis in early 1999 — on the last day of 2021.
There is a reason why investors still seek out low-priced or good value assets. The money you can make in a hurry in a rebound is special. If we really are in the early stages of a fresh upward wave in commodity prices, which looks increasingly likely, then the chart demonstrates that there is room for LatAm stocks to rip much higher still.
Stocks Versus Bonds
I don’t have the energy to dive back into the controversy over the inverted yield curve just now. A fierce and fascinating debate is under way over how seriously to take the brief inversion this week, and whether to regard the bond market signal as distorted by central bank intervention. The fall in short-dated bond prices that helped the curve invert made for a historically bad quarter for government bonds. Now that they’re cheaper, however, and the yield curve is signaling a recession ahead, it might be wise to position for bonds to outperform stocks over the next five years.
This chart is from Luca Paolini of Pictet Asset Management Ltd. and shows five-year stock performance relative to bonds against the spread of 10- and two-year bond yields, with a five-year lag. The ability of the yield curve to determine which asset class will do better over the following five years looks uncanny:
On this basis, stocks’ great outperformance this quarter may end up looking like a head-fake. However, this chart shows five-year returns; when it comes to returns over just the next 12 months, Absolute Strategy found fund managers still expecting stocks to outperform. Still, the proportion believing this is the lowest since the third quarter of 2019, so confidence is beginning to shift.
If there’s a pain trade for the rest of the year (excluding whatever horrors await Ukraine), it could involve equity multiples finally bending in the face of rising bond yields. For the last few weeks, the pain has been in the surprising rally for speculative stocks.
I’m tempted to say that it’s great that the quarter is over. But it’s just a date in a calendar. Once April gets under way, Russian troops will still be in Ukraine, and inflationary pressure across the world will still be intense.
Survival Tips
More bulletins from the earworm wars. My son came close to driving me mad by wandering around the apartment incessantly singing “Livin' on a Prayer” by Bon Jovi. I forced him into submission by playing Lightning I, II, the new Arcade Fire single, until he knew it by heart. Now, he’s come up with a response, and won’t stop singing Cum On Feel The Noize by Slade. Meanwhile, the female contingent among my offspring are already addicted to As It Was, the new Harry Styles single. Asked what I thought of the video, I revealed my age by saying that his tattoos looked ridiculous and he must regret them by now. This was greeted with hilarity and condescension. (It is a good song, though, and the video ends at the Barbican Centre in London, which I liked.)
I’m not sure what my next move should be. I’m tempted to hurl a more singable Arcade Fire song at him, like No Cars Go. Or I could at least try to improve the calibre of my son’s taste in early ’70s heavy rock dinosaur songs: Paranoid by Black Sabbath maybe, or Smoke on the Water by Deep Purple, or 20th Century Boy by T. Rex, or We Will Rock You by Queen. Another great riff to sing as you go around the house might be Bowie’s Ziggy Stardust. Or You Really Got Me, the first great heavy riff; I've heard it claimed that it was the first-ever heavy metal song, and after hearing Metallica do it, I think I can believe that. I can handle any of those as an earworm more comfortably than anything by Bon Jovi. Any other suggestions?
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