Research Report: A Slow Growth Environment?

BY: Richard Croft
A SLOW GROWTH ENVIRONMENT If you listen to the analysts, first quarter earnings will be challenged. Consensus estimates have earnings declining by 6% to 7% year over year across the entire S&P 500 spectrum of companies. This is the most severe reset since the first quarter of 2020, when earnings toppled by 32% year-over-year, although […]



If you listen to the analysts, first quarter earnings will be challenged. Consensus estimates have earnings declining by 6% to 7% year over year across the entire S&P 500 spectrum of companies. This is the most severe reset since the first quarter of 2020, when earnings toppled by 32% year-over-year, although 2020 was an outlier due to the COVID lockdowns.

The analysts are right to downplay current earnings, but the question is: how much of this data has been baked into stock prices? Stock prices react to actual versus anticipated earnings, and we know with certainty that expectations are well off historical averages. A decline of -6% to -7% against a backdrop of earnings having risen by an average annual rate of 13.4% over the past five years and 8.4% over the last decade is evidence that the economic pendulum’s swing has lost momentum.

However, extreme negative forecasts are subject to upside surprises. If there are enough of these surprises, the perception among analysts that a recession is the base case could alter. Reducing the odds of a recession would go a long way to changing investor’s mindset, which might be a catalyst for higher stock prices. To be fair, I am not offering a ringing endorsement that we are setting up for a bull run. Think of this as an alternative universe of possibilities to balance the bull vs. bear debate.

To add some meat to the “upside surprise skeleton” consider that much of the negative earnings sentiment may already be priced into stocks. S&P 500 companies have been ‘talking down’ earnings since central banks began hiking interest rates and the parade of downward revisions picked up near the end of 2022. It’s notable that 106 of the 500 S&P companies had issued downside revisions coming into the first quarter of 2023.

What this tells us as we enter first quarter earnings season is that investors have set a low bar, which suggests that the number of upside surprises may be larger than expected. As for market performance, I would argue that the S&P 500 stocks, while not cheap, are not irrationally exuberant. In fact, the S&P 500 index is about where it was when central banks began their aggressive rate hiking campaign earlier last year (see chart above).

Back to the surprises – it is notable that J P Morgan Chase (symbol: JPM) started the earnings parade with revenue and earnings that beat expectations by a wide margin (EPS of U.S. $4.32 vs expectations of U.S. $3.41). Revenue surged 25% to U.S. $39.34 billion, bolstered by a 49% surge in net interest income (U.S. $20.8 billion). Not surprisingly, the stock rallied 7% on April 14th.

The fact that JPM experienced a surge in net interest margin – supposedly the weak link across the banking sector – should bode well for other financials including the big six Canadian banks. And it was not a one quarter outlier. In its forward guidance on the analysts call, JPM noted that for all of 2023 the company expected to generate U.S. $81 billion in net interest income, versus previous expectations of U.S. $74 billion. Look for more surprises in the financial sector as first quarter earnings reports gain momentum.

To that latter point, Bank of America (symbol: BAC, NYSE) also posted some strong numbers when they reported on Monday April 17th. Goldman Sachs (symbol: GS, NYSE) did not fare so well as the company raised its’ loan loss reserves for the Marcus which is Goldman’s digital banking platform that connects consumers with financial products and tools.

The other question in our earnings discussion is: which sectors are likely to feel the brunt of the pain? Certainly, we do not expect the pain to be equally distributed across the economy. Of the eleven sectors in the S&P 500 index, six are expected to report year-over-year declines in earnings. Notable among this group are companies in the materials, healthcare, IT, and communications sectors. Of the sectors reporting year-over-year earnings growth, consumer discretionary, industrials and financials are expected to lead.

Despite the banking crisis last month, the financial sector expects the highest year-over-year revenue growth rate of 9%. However, there are caveats as not many financial companies issue forward guidance, with JPM being an exception that proves the rule. That said, I suspect regional banks to underperform as large depositors rethink their exposure to bank runs.

In the broader context, earnings growth peaked in most regions in the first quarter of 2022 and continues to trend lower. This is a direct result of slowing growth as rate hikes begin to take a bite out of economic activity and profit margins.

And there lies the rub: if profit margins are squeezed because of rising labour costs – think the service sector – we could see flat earnings despite higher revenue, which adds another layer of complexity to any investment thesis.

On the one hand, rising consumption should boost GDP, thereby reducing the probability of a recession. However, rising input and labour costs would also squeeze profit margins, dampening any upside in stock prices. Unfortunately, there are no reliable playbooks to guide us through these scenarios.


Recent U.S. inflation data came in better than expected – not by much, but the trend is in the right direction, which suggests that the aggressive rate hikes orchestrated by the U.S. Federal Reserve (Fed) seem to be having the desired effect. The latest read on the U.S. Consumer Price Index (CPI) released on April 12th showed March month-over-month prices rising 0.1% with the year-over-year increase coming in at 5.0%. These numbers beat consensus estimates of 0.2% and 5.1% (0.4% month-over-month and 5.6% year-over-year excluding food and energy). Suggesting that the aggressive rate hikes orchestrated by the US Federal Reserve (Fed) seem to be having the desired effect.

The headline inflation figures benefited from a 3.5% drop in energy costs and an unchanged food index. Grocery prices fell 0.3%, the first drop since September 2020, though it is still up 8.4% from a year ago. Egg prices, which had been soaring, tumbled 10.9% for the month, putting the twelve-month increase at 36%. A 0.6% increase in shelter costs was the smallest gain since November, but still resulted in prices rising 8.2% on an annual basis. Shelter makes up about one-third of the weighting in the CPI and is being watched closely by central bank officials on both sides of the border.

The bad news is that, while inflation appears to be decelerating, it is still well above the Fed’s 2% target. While the month-over-month data was the best (i.e., lowest) since June 2021, the pace of the decline is slowing, which implies that getting to the 2% target rate will likely require a recession.

As the economy slows, we think consumer prices will slow further and should bring inflation closer to the Fed’s long-run target of 2%. So far, markets have reacted positively to the latest CPI numbers – investors believe that, should the Fed raise rates at the next meeting, it will be the last hike for the foreseeable future.

However, we are not suggesting a Fed pivot, but rather a pause. Over the past year, the Fed has raised its benchmark interest rate nine times for a total increase of 4.75 percentage points, the fastest pace of tightening since the early 1980s. The Fed was clearly playing catch up as officials initially dismissed inflation as transitory, expecting it to fall as pandemic-related factors dissipated. They were wrong, however, as such pandemic-related price increases proved more durable.

There are other uncertainties regarding the unexpected strength in the labour market. Demand for workers has continued to push up wages and prices, although that situation has eased somewhat in recent months. In March, U.S. nonfarm payrolls increased by 236,000, the smallest gain since December 2020, and average hourly earnings rose at a 4.2% annual pace, the lowest level since June 2021.

The Fed is hoping it can calibrate policy so that the slowdown it is trying to engineer in the U.S. labour market doesn’t tip the economy into recession. That’s not the base case, although recent data from the Atlanta Fed revealed that first quarter gross domestic product growth is coming in at a 2.2% annualized pace. That said, many economists expect a contraction to come later in the year.


The question is not so much about whether a recession is coming, but how deep the coming recession will be. Our expectation is that the next recession will be less damaging than the 2008 global financial crisis but, unfortunately, the full extent of the economic impact won’t be known for some time.

As a guide in these uncertain times, we turn to research done by Capital Economics that looked at seventy years of data, including the last eleven economic downturns. We will use the results of their work to address some of the questions you may have about recessions.

Defining a Recession

A recession is commonly defined as at least two consecutive quarters of declining GDP that follows a period of growth. The National Bureau of Economic Research (NBER), which is responsible for business cycle dating, offers a more comprehensive definition as: “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale-retail sales.”

What causes Recessions?

Past recessions have occurred for many reasons, but typically are the result of economic imbalances that, ultimately, need to be corrected. For example, the 2008 recession was caused by excess debt in the housing market, while the 2001 contraction was caused by an asset bubble in technology stocks. In the current environment, the onset of a recession comes from the unexpected shock of the COVID-19 pandemic that led to widespread damage in corporate profits and severe job cuts.

When unemployment rises consumers typically reduce spending, which restricts economic growth, company earnings and stock prices. These factors, in turn, can fuel a ‘negative feedback’ cycle that further reduces consumer and corporate confidence, pushing an economy into contraction and recession. While that is the typical trajectory for a recession, what makes predictions so challenging this time is the unexpected strength in the labour market noted earlier.

Although they can be painful to live through, recessions are a natural and necessary means of clearing out excesses and inefficiencies before the next economic expansion.

Peak to Trough Timing of Recessions

The good news is that recessions generally haven’t lasted very long. When Capital Economics examined the eleven recessions since 1950, the average time from peak to trough was ten months, with the shortest recession lasting two months while the longest transition took eighteen months. That can seem like an eternity for those who lost their job or their business. Fair enough, but investors with a long time horizon would be better served looking at the full picture.

Looking at recessions from the perspective of long-wave economic cycles, the data is compelling. Contractions last approximately ten months, GDP declines by -2.5% resulting in the loss of 3.9 million jobs. In contrast, economic expansions typically last sixty-nine months, GDP surges by 24.6% and creates 12 million new jobs. The bottom line is that recessions have negatively impacted the economy less than 15% of the time, and subsequent expansions deliver far more benefits than contractions take away.

How Recessions Impact Stock Markets

The exact timing of a recession is hard to predict, but it’s still wise to think about how one could affect your portfolio. Bear markets (equity market declines of 20% or more) and recessions (economic declines) have often overlapped —with markets tending to lead an economic cycle by six to seven months on the way down and again on the way up.

The chart below shows two lines comparing the average S&P 500 Index market cycle and the average economic cycle (using industrial production as a proxy). The S&P 500 market cycle peaked several months before the economic cycle, and it also started accelerating from its bottom several months before the economic cycle.

A negative number (left of the cycle peak) reflects the average change in each line in the months leading up to the cycle peak. The positive numbers (right of the cycle peak) indicate the average changes after the cycle peak.

Recession Indicators

Wouldn’t it be great to know ahead of time when a recession is coming? Despite the impossibility of pinpointing the exact start of a recession, there are some generally reliable signals worth watching.

There are many factors that contribute, predict, or indicate an impending recession. What we know is that the primary driver of the next cycle will likely be very different from what propelled previous recessions. The best we can do is examine various segments of the economy in search of excesses and imbalances. Keeping in mind that any indicator should be viewed more as a mile marker than a distance-to-destination sign.

The chart below shows five economic indicators that can warn of a recession, the average number of months between the signal and the start of a recession, and the status of the indicator.

An inverted yield curve, which occurs when ten-year yields fall below two-year yields, is a classic and well-publicized indicator. It generally precedes a recession by an average of 14.5 months. That its current status is showing as red indicates that this threshold has been met.

Rising unemployment is another key indicator that typically flashes a warning sign about 5.6 months before the onset of a recession. This signal has yet to turn down and as such, is showing green.

If consumer confidence declines from the previous year, that indicates a recession trajectory with a lead time of 2.9 months. This threshold has been met and is flashing red.

Another key indicator is that Housing starts decline by at least 10% from the previous year, with an average lead time between this signal and a recession of 5.3 months. To date, the current status of this signal does not indicate a recession.

The Leading Economic Index (LEI) is a composite indicator that includes the performance of the stock market. If the LEI has declined by at least 1% that tends to signal a recession is imminent. It will often precede the onset of a recession by 3.6 months and, at this point, this threshold has not been met.

Recession Proofing Your Portfolio

If you accept that stocks do not fare well during a recession, one should sell equities and raise cash to weather the recessionary storm. The problem with that approach is that one must be able to time the market. Even if you were able to sell stocks before the recession begins, at what point do you buy back into equities to take advantage as the economy begins to rebound. Sounds good in theory, but in practice is almost impossible to execute.

A better model is to re-balance the portfolio across asset classes – by, for example, reducing equity stakes in sectors that historically have not done well during a recession and replacing those positions with an allocation to fixed income securities (i.e., bonds and preferred shares).

The chart below shows how many times each of the sectors in the S&P 500 have outpaced the index during the most recent ten market declines between 1987 and 2022. As you can see, consumer staples, utilities and health care were the outperformers while IT, Financials and Industrials were the under-performers.

Adjusting Fixed Income Allocations for A Recession

Fixed income is often key to successful investing during a recession or bear market. That’s because bonds can provide an essential measure of stability and capital preservation, especially when equity markets are volatile.

What makes the current environment unique is the fact that during the 2022 sell-off bonds did not provide the diversification benefits that they typically provide to dampen portfolio volatility. However, in the seven previous market corrections, bonds — as measured by the Bloomberg U.S. Aggregate Index — rose four times and never declined by more than 1%. The chart below shows returns for the Bloomberg U.S. Aggregate Index versus the S&P 500 Index during nine recent stock market corrections.

Achieving the right fixed income allocation is always important but, with the U.S. economy entering a period of uncertainty, it’s especially critical for investors to focus on core bond holdings that can provide balance to portfolios. That’s why we have been increasing our bond allocations to bolster stability ahead of a recession. Maintaining a portfolio asset mix that is well diversified between equities, fixed income and cash is key to managing your investments through the uncertainty that resonates from an impending recession.

Richard Croft, Chairman & CIO

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