[Shawn Beber. Sr. Executive Vice President and US Region Group Head]
>>Shawn: Hello, I'm Shawn Beber, Senior Executive Vice President and US Region Group Head. I'm pleased to welcome you to our 2023 outlook call. This is my first time joining the outlook call, so maybe just a bit about me to begin. I was appointed to lead our US region in November, a role I'm excited to have. I've been a member of the CIBC team for 20 years, including as part of our corporate strategy team that led our efforts to grow in the US through acquisition. Since then, I've led our US capital markets group and spent time as CIBC's General Council and Chief Risk Officer. Across our commercial banking, capital markets and private wealth teams, we work to understand your unique goals and challenges and to provide the right financial tools to help you succeed. That's been our commitment for 155 years.
We're fortunate to have a team of experts who are passionate about serving our clients, driven by our purpose of helping you realize your ambitions. Two of our team members are with us today to provide their views on what's ahead for 2023. Dave Donabedian, Chief Investment Officer, and Tricia Bannan, Head of Equities, both with our CIBC US Private Wealth Group. Dave and Tricia will cover the financial and economic themes that are top of mind for investors and business leaders alike, from inflation, Fed policy and recession risk, to supply chain disruptions, labor challenges and consumer spending. I know we're all eager to hear what they have to share, so let me just say thank you for the trust you place in CIBC as your financial partner. I look forward to meeting many of you in the coming year and please do reach out if I can be of assistance. Now Dave, let me turn it over to you to get started.
>>David: Shawn, thank you.
[David L. Donabedian, CFA. Chief Investment Officer]
And happy new year everybody, and as investors we're certainly happy that 2022 is over and here you can see why.
[Graph titled “A look back: Market scorecard. 2022: A bear market for stocks and bonds. Total returns as of December 31, 2022.]
By some measures, it was the worst combined year for equity and bond returns since 1969. Stock market returns both in the US and internationally were down double digits.
[A red box outlines numbers for US, Developed International, and Emerging Markets stocks under the "Year-to-Date” category. The numbers, in order, are: -18.11%; -14%.45%; -20.09%]
Both investment grade and high-yield bond returns were also deeply negative due to the significant rise in interest rates that occurred.
[A red box outlines numbers for Long-Term Treasuries, Intermediate Govt/Corp and Corporate High-Yield bond returns under the “Year-to-Date” category. The numbers, in order, are: -29.26%; 8.28%; -11.22%]
Only commodity prices enjoyed positive results amongst the major asset classes.
[A red box outlines 16.09%, which is the year-to-date return for the Bloomberg Commodity Index]
So now what about 2023? Well, let's start with where the economy stands today. As we say here, there's good news and there's bad news.
[“US Economy: Good news, bad news” sits on a partial backdrop of the American flag]
The good news is inflation is finally coming down. The Consumer Price Index annual change peaked debt 9.1% in June, but retreated to below 7% by year end. The Fed's preferred inflation measure, the core PCE, slowed to under 5%. So inflation has peaked and is likely to come down throughout 2023. That's the good news.
The bad news, recession risk is rising. The housing market is already in a tailspin and the manufacturing sector is on the verge of decline.
[Line graph titled “Good news, bad news”]
You can see here that the ISM Manufacturing Survey, usually a good leading indicator, has plummeted into territory normally associated with a decline in the industrial economy. It's the consumer and a good job market that's really keeping the economy afloat now, but we think that's going to get more challenging as the year progresses. In recent years consumers have benefited from the wealth effect as their investment portfolios and home values rose quickly, that changed in 2022 for portfolio values and more recently for housing. So when we consider all of this, as well as the fact that other leading indicators of recession, like higher interest rates, like an equity bear market, title monetary policy and inverted yield curve, all these things are in place so our baseline expectation is that a global recession, including in the US, is likely to occur sometime in 2023. So we've got good news and we've got bad news on the economy. What will the Federal Reserve do about it?
[The words “Federal Reserve” slides across a large stone building with an American flag on the top]
We know what the Fed did last year, they raised short-term interest rates from zero to 4.5% in just eight months. One of the biggest, fastest tightening cycles ever. So where do they go from here? Well in their meeting minutes released in early January, the Fed acknowledged that inflation numbers were starting to behave better, but also said that it needed to see quote substantially more evidence of progress on inflation. So the Fed is not quite done raising interest rates. And here's another way to look at this issue:
[Bar graph titled “They are not done yet”]
What you're looking at here is the history of Federal Reserve rate hikes in the context of inflation. So it shows the relationship for all the major rate hike cycles going back to the 1970s. The gray bars show the peak Fed funds rate. In other words, the point at which the Fed stopped raising interest rates. The red bars show the rate of inflation at the same time. And there's a very obvious pattern here, if you look at the eight prior examples, the gray bars are higher than the red bars. In other words, the Fed stops raising interest rates only when the interest rate they control, that Fed funds rate, is above the rate of inflation. But you can see in the red box that that's not where we are today. The interest rates are on four and a half percent, inflation around seven. So the Fed has some more work to do, and we foresee two or three more rate hikes between now and springtime with rates cresting just above 5%. Then we see the Fed watching and waiting to see how the economy reacts.
[“The bond market” sits on top of a backdrop of multi-colored bars]
As for the bond market, the ten-year treasury yield peaked at four and a quarter percent last October and has since come down. Because we see inflation coming down and the economy weakening, we think that four and a quarter percent yield will not be reached again in this cycle. And in terms of credit markets, we do see further room for spreads to widen as businesses face tougher economic conditions, higher financing rates, and for poorly capitalized companies, rising default rates.
[The word “Equities” sits on a partial-back drop of a building with a financial ticker.]
Now on to the equity markets. You might think that given our somewhat dim outlook for the economy, that we have a similarly dim view of the stock market, but that's not really the case. The going may be tough here in the early part of the year, but historically, recessions have been the things that end bear markets and start new bull markets, and here's the evidence.
[Chart titled “The odd couple: Recessions and bull markets”.]
In each of the last 10 recessions, the S&P 500 formed an important bottom before the recession ended, on average, about four months before. And in nine of those 10 instances, it proved to be the beginning of a durable new bull market with an average return of more than 32% in the 12 months that followed.
So why does this seemingly contradictory tandem of a recession in a bull market happen? Well, we attribute it to the fact that markets look through the windshield, not the rear view mirror. They look ahead. And recessions typically trigger more accommodative policies from the Fed and markets discount the expectation of a new economic and earnings recovery as a result. And in the end, our forecast for 2023 includes both high risk of recession and the beginning of a renewable market for equities.
[Patricia Bannan, CFA, Head of Equities, CIBC Private Wealth, US]
To discuss the stock market further I'm joined now by our head of equities, Tricia Bannan. Tricia is also co-portfolio manager of the 18 billion dollar CIBC discipline equity strategy. So Tricia, with odds of recession high, or at least at a minimum in economic slowdown this year, what are your thoughts on what that means for corporate earnings?
[What are your thoughts on corporate earnings?]
>>Tricia: Well, I think in either circumstance, a recession or a slowdown, consensus earnings for the broad market, and for the broad market we look at the S&P 500, they're probably too high. And while estimates have come down from about 250 a share to 230 a share, this still represents a mid-single digit increase for 2023 over 2022. And that just seems optimistic when you break down the components.
So first of all, let's look at demand. So demand will likely be lower in a challenged economic environment and that'll translate directly to lower revenue growth. But also, lower demand certainly can have an impact on a company's ability to price and get price increases, making it much more difficult. And margins are the other issue, as you can see on the chart.
[Line graph titled: “Corporate profit margins challenged as the economy weakens"]
Margins are and are expected to be near all-time highs. How did they get there? Lower tax rates, lower interest rates, globalization, which among other things kept wage costs competitive. So arguably much of these things either have changed or are changing. In particular, we would note that higher interest costs and wage costs will not likely come down in tandem or as quickly as revenues. So while we don't expect a severe recession, we do think that consensus expectations for earnings to grow is really quite optimistic.
>>Dave Donabedian: No, that makes sense. So you've covered profits, the other big variable we look at with the equity market is valuations. Where are we there?
[What does that mean for valuations?]
>>Tricia: So to start with the conclusion, valuations are kind of middling with the S&P 500 at about 17 times based on a $3,900 value for the S&P 500 and taking a haircut to that 230 consensus estimate. So that's on forward earnings.
If we look to 2024, and the market will start doing that as we move into mid-year, multiples are probably around 15 times. So generally speaking, higher inflationary times tend to be associated with lower PE multiples and in lower inflationary times, PE multiples tend to be higher. So, if inflation levels out around 3%, using history as a guide, US stocks look to be about fair value. And if inflation is a little bit higher, perhaps stocks are a little less attractive. And if inflation is a little lower, stocks are perhaps a little bit more attractive. We really do believe that drilling down to the individual stock level is important and an important key to success in managing individual strategies. So when we look at today, the fact that there's some significant concentration in the major indices and some of the bigger components, the larger components within the indices are more expensive stocks, it just tells us to drill down a little bit further in order to look at value of individual stocks.
>>David: That makes a great deal of sense. So we've talked a lot about the overall market, but are there any specific areas of the equity market that look attractive?
[Are there any areas of the market that look attractive?]
>>Tricia: There are two areas that I would call out and that would be small caps and international.
[Line graph titled "Small caps likely to lead the next bull market...but it's not here yet"]
And you can see on the chart that small cap stocks on average carry about the same PE as their large cap brethren, but currently they sell at about 70% of the large cap multiple. So going back to the mid-‘80s, you can see that they’ve rarely sold cheaper. Timing is a question though, as smaller companies usually underperform into a recession, but it is definitely worth watching, especially since they also tend to lead coming out of a recession.
[Chart titled “Overseas stocks are relatively inexpensive”]
So moving on to international, note on this chart that while US stocks are at about an average historical valuation, every ex-US market here is selling at well below historical averages. And in many cases, emerging markets that are growing faster in the US have market caps that lag well behind their share of output. So there's nothing that is ringing the bell here, but it certainly suggests that this could normalize over the coming years.
>>David: Tricia, any final words of wisdom?
>>Tricia: Well, I guess I would say, let's not forget that markets sometimes reset, reset being code for going down. We are not all that surprised that markets did come down here after a hundred percent increase from 2021. But markets do tend to go up over time, and there can be a large penalty for being out of the market and missing up moves. So we just believe that having a quality, well-balanced, well diversified portfolio should lead to attractive results over time.
>>David: Tricia, thank you. Those are wise words for volatile times. So let me just finish with our key investment themes.
First, inflation pressures should abate this year, but at the price of a global recession. The Federal Reserve will likely tighten policy further in early 2023, but is not far from the end of its rate hike cycle. Markets though may be disappointed later in the year when the Fed does not immediately shift from rate hikes to rate cuts. Long-term government bond yields have peaked in the cycle, we do think that credit spreads may experience further widening as economic conditions get tougher. We think the equity bear market is likely in its final stage, but could last for a good part of the first half of the year. We do however expect that a new bull market will begin sometime in 2023. So it's likely to be another eventful year in the markets, but ultimately we believe a better one than 2022.
>>Robert: Thank you, Dave, and thank you, Tricia. We really appreciate your insights to help us navigate through these interesting and volatile times. There's a lot for business owners and leaders to decipher when reading and hearing about the economy and the geopolitical events. I hope you found Dave's and Tricia's comments on the market environment helpful. In addition to Dave and Tricia, we have a number of other talented professionals within CIBC to help you interpret the economic data, as well as to help you in developing and executing on your business plan and personal goals. My purpose and our team's purpose are to help you realize your ambitions. We look forward to connecting with you soon, we appreciate our relationship and the trust that you place in us. I want to, again, thank you and want to wish each of you a happy new year and for a successful and healthy two-thousand and twenty-three.
[CIBC Commercial Banking]
[Screenshot of CIBC Private Wealth Management disclosure]