January 13, 2023 | macro-economic research report

Research Report: A View From 40,000 Feet

BY: Richard Croft
Despite clear signs that inflation is cooling, central bankers remain hawkish. Notable among the hawks is U.S. Federal Reserve (Fed) Minneapolis President Neel Kashkari, who penned a recent essay that put a bold exclamation point on their concerns about inflation. He believes the Fed should keep raising rates until it can say, with confidence, that the policy initiatives have quelled inflation. In short, look for more rate hikes at least through the next two meetings and possibly through June 2023.



Despite clear signs that inflation is cooling, central bankers remain hawkish. Notable among the hawks is U.S. Federal Reserve (Fed) Minneapolis President Neel Kashkari, who penned a recent essay that put a bold exclamation point on their concerns about inflation. He believes the Fed should keep raising rates until it can say, with confidence, that the policy initiatives have quelled inflation. In short, look for more rate hikes at least through the next two meetings and possibly through June 2023.

Once seen as consistently dovish, Kashkari has morphed into the most hawkish among the Fed Presidents. His main concern is that we could see a 1970’s style inflationary spike should the Fed pause prematurely. Citing a better-safe-than-sorry strategy, he believes the Fed should, at a minimum, get to a 5.3% to 5.5% terminal rate before pausing. He goes on to say that the terminal rate could “potentially be much higher,” if there is slow progress on bringing inflation down. The Fed funds rate is currently at 4.5%.

His views are worrisome for two reasons: 1) Kashkari will be a voting member of the Fed’s interest-rate committee this year; and 2) his position goes against prevailing market sentiment that the Fed would stop raising rates at 5.25% this summer and then quickly start to ease policy.

The market’s view is predicated on recent data that support the cooling effect from the 2022 rate hikes. The Fed’s preferred inflation indicator indicates that inflation has been in a downtrend since July.

The Consumer Price Index has shown a similar trend. If, for no other reason than altered starting points, we could see year-over-year inflation decline below 5% by the end of March. The month-over-month data (see Figure 2) has been muted since the above-trend reading in June. Even if we were to assume that month-over-month data comes in at twice the level witnessed over the last five months, year-over-year inflation would fall to 4.8% by the end of the first quarter.

Much of the positive news around inflation comes down to timing. As we drop the front months that experienced above-trend readings, year-over-year data is receding.

So, what is the Fed seeing that we are not? The answer is wage inflation, which is a laggard in terms of the data. Wages tend to be the last component in the PCE or CPI to recede and with a hot labour market, consensus thinking is that it will take a recession to cool labour costs.

When we talk about costs, we are really talking about payrolls. The data most used is the nonfarm payrolls report. The December 2022 payrolls data was released before the market opened on Friday January 6, 2023. The growth in hourly earnings decelerated in December but was still higher than expected, a sign that the labour market remains strong even as the Federal Reserve tries to slow economic growth.

According to CNBC, “nonfarm payrolls increased by 223,000 for the month, [which was] above the Dow Jones estimate for 200,000, while the unemployment rate fell to 3.5%, a full 0.2% below expectations. The job growth marked a small decrease from the 256,000 gains in November, which was revised down 7,000 from the initial estimate.”

What piqued the interest of financial markets was the fact that wage growth came in less than expected, indicating that inflation pressures could be weakening. Average hourly earnings rose 0.3% for the month and increased 4.6% from a year ago. The respective estimates were for growth of 0.4% and 5%.

Financial markets rallied sharply on the news as investors took this as an indication that the labour market was cooling. In theory, robust employment numbers are acceptable if labour costs are moderating.

However, we must remain cautious as one datapoint is unlikely to soften the Fed’s hawkish stance. To that point, we have altered our base case and now anticipate at least two more rate hikes before a pause. We think that’s what will be required to assuage the Fed’s fear that inflation could ramp up as it did after a pause in the 1970s.

In the Fed’s view, it is better to keep their foot on the rate hike cycle until there is clear evidence that the jobs market is cooling. Primarily, the Fed is looking to bridge the gap between demand and supply. As of November, there were 1.7 job openings for every available worker, an imbalance that has held steady despite the Fed’s rate hikes. The strong demand has pushed wages higher, though they mostly haven’t kept pace with inflation.

December’s wage data, though, could provide some encouragement that the Fed’s efforts are impacting demand. At the very least, it suggests that things are moving in the right direction.

The drop in the unemployment rate came despite an increase in the U.S. labour force participation rate, which edged higher to 62.3%. The labour participation rate is still a full percentage point below pre-covid levels in February 2020.

For those of us who are looking for evidence of a slowing labour market, we are seeing massive layoffs in the tech sector. Particularly among the largest companies, with Amazon looking to furlough 18,000 workers, Salesforce (10,000 layoffs) and Meta with more than 14,000 layoffs support the position that most companies expect the economy to slow over the next two quarters.

It is not surprising that tech companies are leading this process because most were overstaffed. In fact, press releases from the three tech giants cited these layoffs as right sizing not downsizing. The point is, other sectors that are not as bloated, will begin the same process over the coming months which should increase the unemployment rate and bring the number of available jobs relative to unemployed persons into equilibrium. However, that will likely not occur until the summer.

If wage growth slows in a robust employment environment that satisfies the Fed’s dual mandate (low inflation and full employment). But we are not there yet. Looking at a more encompassing measure of unemployment that accounts for discouraged workers and those holding part-time jobs for economic reasons, the so-called household count of employment also declined to 6.5%, its lowest-ever reading in a data set that goes back to 1994. Under that definition, we saw a huge 717,000 increase in jobs. Economists generally pay attention to the household survey, which lags the establishment count.

As the U.S. heads into 2023, Fed policy tightening aimed at tamping down inflation is still running near its highest level since the early 1980s, and most economists are forecasting a shallow recession. However, the economy closed 2022 on a strong note, with GDP growth tracking at a 3.8% rate, according to the Atlanta Fed.
Fed officials at their last meeting noted that they are encouraged by the latest inflation readings but will need to see continued progress before they are convinced that inflation is coming down and they can ease up on rate hikes.

Fortunately, financial markets are forward-looking and will transition before a Fed pause. It is a question of timing. Our strategy is to remain cautious through the first half of the year, bolstering client accounts with a healthy allocation to investment grade short-term fixed income assets (i.e., bonds) where we can earn decent returns while hedging against downside risk.

As things stand, we expect the Fed to raise rates by 0.25% on February 1st at their next meeting with another 0.25% hike at their subsequent meeting,- March 22nd.


The best we can say about 2022 is that it is over! After years of central bank accommodation that created an environment of speculative excesses, we experienced a tsunami of rate hikes designed to combat surging inflation. It was, by all accounts, a perfect storm that negatively impacted all financial assets with nowhere to hide.

When central banks raise interest rates, they are altering the short-term risk-free rate of return. The risk-free rate is the foundation on which all risk assets are valued. Ultimately, the intrinsic value of any security — stock, bond, real estate — is the present value of future cash flows (dividends, interest payments, distributions) discounted by the risk-free rate. In a rapidly rising rate environment, the discount rate is constantly changing, making it more difficult to accurately determine the intrinsic value of assets.

As the risk-free rate increases it has an outsized impact on financial asset valuations. The impact was felt across all financial assets including bonds, which are generally used to dampen portfolio variability. The result was a decline in portfolio values from the most conservative to the most aggressive allocations. It didn’t help that we had to deal with, US midterm election anxiety, an about face on China’s zero-COVID policy, and a Russia-Ukraine war that could drag on for years.

Against that backdrop, the 2022 performance of a traditional 50/50 portfolio was the worst since 1937. Given this gloomy backdrop, it is not surprising that investors will start 2023 engaged in a tug of war with hope on one side and fear on the other.

How we position portfolios in 2023 depends, to a large extent, on whether the Fed can engineer a “soft landing.” Investor optimism has been bolstered by the belief that a Fed pause is in the offing. Mind you, we experienced several robust bear market rallies in 2022 on the back of such optimism.

While we expect continued bouts of volatility through 2023, it will be set in motion by the outlook for corporate profits rather than Fed adjustments to the discount rate. Predicting how significantly corporate profits will be impacted is the challenge and largely depends on a soft-landing thesis, which historically, has only happened three times… in the mid-1960s, 1984 and 1994

While we think the primary issue for 2023 will come down to corporate profits, we are not dismissing the Fed’s potential impact on financial markets. We share the sentiment of many analysts who fear that the Fed, having to play “catch up,” will raise rates too aggressively to compensate for having waited too long to enter the inflation battle. The risk of being too aggressive in rate hikes to cool inflation is in causing a financial trainwreck by gumming up global capital markets. From the perspective of Main Street, raising rates too aggressively could trigger a deep recession that impinges upon corporate profits and causes an unacceptable decrease in employment.

If Fed jawboning continues to shore up the “whatever it takes” mantra, it will, at a minimum, establish a ceiling that equity markets will have trouble penetrating. If the fallout from the pandemic has taught us anything, it is that financial markets do not always mirror economic reality. Consider that as the pandemic was gaining momentum and economies were being shuttered, markets rallied propelled by the view that vaccines would eventually alleviate shutdowns, earnings would return to normal, and the job market would rebound. Easy monetary policy and massive government spending also aided the pandemic recovery. The point is, sentiment looked past the economic reality of a raging pandemic and markets rallied.

We saw a similar narrative in 2022 as financial assets buckled despite a moderately expanding economy, reasonable corporate profits and a robust labour market. Investors focused instead on slowing fiscal spending, China’s zero-Covid policy and the Russia-Ukraine war.

Whether we are witnessing a change in investor behaviour or a short-term aberration, the gap between market forces and economic datapoints has amplified since the onset of the pandemic.

This disconnect is critical as we position for 2023 in an environment where markets expect a slowdown in economic activity, a reset of corporate profits, and an uptick in unemployment. This potential recession is the most anticipated in modern history, which implies that financial markets will start to turn before the economy, earnings, and job market data hit rock bottom. The objective is to position portfolios in a way that can weather the downside while being able to capture that eventual turn.

To that end, we are utilizing three strategies: 1) focus on stocks with above average dividends that will participate in the eventual turn; 2) hedge risk with investment grade short term fixed income assets; and 3) seek out opportunities in undervalued sectors that have positive long-term potential.

Dividend Payers with Upside

One of the most interesting phenomena in 2022 was the great number of days with outsized market swings. On an intraday basis, the S&P 500 Index produced gains or losses of +/-1% 52% of the time. The last time we experienced so many spurts in intraday volatility was 2008.

Sentiment that focused on surging Inflation, a don’t-fight-the-Fed mantra, geopolitical tensions and slowing growth propelled the intraday declines. Short-lived rallies were supported by hope that inflation would soon slow, that the Fed would pause/pivot from its aggressive rate hikes and that a strong labour market would dampen recessionary expectations.

While hope can be a good thing, it is not an investment strategy – hence the rationale that underpins a defensive posture. The trick is to ensure that we do not ignore the inevitability that central banks cannot hike rates indefinitely and, eventually, negative sentiment will be replaced by unbridled optimism and higher valuations.

Historically, notes State Street Global Advisors (SSGA), “dividend payers have a consistent track record of returning value to shareholders but aren’t overly allocated to defensive market segments. And, they typically have a strong relationship to the value factor — a pro-cyclical exposure.” Utilizing above-average dividend payers allows us to position for a cyclical recovery, without needing to pinpoint the timing of the pivot.

Dividend stocks thrive in prolonged inflation-driven markets. According to SSGA, “since 1948 — including three periods of high inflation in the 1950s, 1970s, and 1980s — high-dividend stocks significantly outperformed their low-dividend peers and the broader market when 12-month average CPI inflation was in the top two quintiles (above 3.25%).”

That’s an important point, as dividends are typically more stable than earnings, which provides a buffer during a period when earnings are being downgraded. The bottom-up consensus S&P 500 earnings per share (EPS) estimates for 2023 have been cut by 7% to USD $233 since their June 2022 peak, compared to a historical average decline of 3% in the quarter leading into a new year.

More earnings downgrades are likely. We are looking for S&P 500 earnings to be reset to USD $220 before the market bottoms. Additional datapoints when fourth quarter 2022 earnings take center stage will help clarify this position. The point is, despite these downside revisions, more than 90% of North American firms report they plan to keep or increase their dividend in 2023.

In fact, notes SSGA, “the median decline in dividends paid by S&P 500 companies in the past 12 US recessions since World War II was just 1%. And there was no decline in four of those recessions when inflation was above 5%, in 1974, 1980, 1981, and 1990.
Given that dividend payments are more stable than stock price movements — providing an income cushion for total return — dividend strategies have, on average, also had reduced drawdowns and lower volatility during bear markets. In the 13 bear markets since 1960, high dividend stocks outperformed low dividend paying firms, as well as the broad market, by an average of 12% and 8%, respectively. In fact, high dividend equities have demonstrated consistent outperformance, as they outpaced low dividend paying firms and the broader market in 11 of those 13 bear markets.”

High dividend stocks underperformed only twice — during the 2007 through 2009 Global Financial Crisis (GFC) and the COVID-19 pandemic — when the respective impairment of the banking system and the public health system caused many companies to cut or suspend their dividends. Unlike those two periods, our current economic downturn is driven by typical slowing of aggregated demand on the back of monetary tightening. So far, dividend stocks have shown similar resiliency to what we saw during most other bear markets, outperforming the broad market by 16% in 2022.

While mindful that central banks will continue to tighten until they see clear signs that inflation is cooling, we cannot ignore the emergence of green shoots as previous rate hikes have begun to filter through the economy. Global supply chains continue to normalize and wage inflation (see: What Are We Missing) and rent increases are slowing.

That said, the current headline inflation, while declining, is still above historical levels. Looking forward, these disinflationary forces will accelerate and, barring an unexpected spike in energy prices, should dampen consumer prices. At that point – probably around the third quarter of 2023 – we expect central banks to shift their focus to growth worries and begin easing. A policy pivot could potentially renew sentiment toward more cyclical segments of the market.

Key to this thesis is the view that dividend paying stocks, while more defensive than the broader market, are less defensive (and more offensive) than low volatility strategies. Which is to say, the selection of optimum dividend payers should provide more upside momentum versus what you would expect from low volatility strategies.

We saw that thesis unfold in 2022. Underpinning our view that this will continue through 2023 is the fact that, through most of 2022, investors held an underweight position in dividend payers. Notes SSGA, “after underperforming the broad market for three consecutive years, dividend stocks’ relative valuations were within the bottom decile over the past two decades based on price-to-forward earnings, price-to-book, and price-to-cash-flow ratios at the beginning of 2022.”

What that tells us is that despite their significant outperformance in 2022, their relative valuations are well below their long-term median (31st percentile based on price/forward one-year earnings; 25th percentile based on price/cash flow and 21st percentile based on price/book).

Indicators produced by SSGA, using aggregated and anonymized custody data of $43.7 trillion in assets, show that investors’ holdings of dividend stocks have declined since the GFC, as dividend stocks underperformed growth stocks for most of those years. During the pandemic, investors’ relative holdings in dividend stocks reached their lowest level in two decades, as growth beat dividend yield exposures by 21% on an annualized basis in 2020 and 2021.

Enhanced market volatility has caused many investors to increase their dividend allocations. But, notes SSGA, “allocations increased only to the 20th percentile over the past 20 years, indicating a significant underweight by historical standards. If dividend stocks continue showing resilience amid elevated market volatility and economic downturns, mean reversion in investors’ allocations may further support dividends’ performance in 2023.”

Short-Term Investment Grade Fixed Income

Given the hawkish tone from central banks, it is unlikely that medium- (maturities beyond 5 years) and longer-term bonds will produce positive returns in 2023. We expect a similar outcome for high yield debt as credit spreads are likely to widen. Which is why we are focusing on short-term investment grade fixed income assets.

Bonds maturing in one to four years have been impacted the most by rate hikes, so short-term fixed income has become a viable option as we move away from an era of low-rate near-zero yield. These opportunities are, however, predicated on the view that central banks will remain overly aggressive, at least in the near term. As we await the inevitable Fed pause, elevated yields at the short end of the curve provide some portfolio protection, while enhancing total return.

Fed officials downplayed the positive data from the December payrolls report by reenforcing their position that one datapoint is not a trend. Fed officials stressed that they need to see sustained easing of pricing pressures before pausing. Accordingly, beyond what was done in 2022, some economists are forecasting 25 basis point hikes through June 2023.

Despite Fed jawboning, the spread between two-year U.S. Treasuries is below the historical average. At the time of writing, the two-year Treasury/Fed Funds spread was +14 basis points, below the +36 basis points spread that has historically existed and well below the +126 basis point differential in 2022. This tells us two things: 1) assuming the average relationship holds, the U.S. two-year yield could eclipse 4.85%, a level not seen since 2007, at some point in 2023; and 2) the market does not expect the Fed to become more aggressive right away, given that the current premium is below the historical average.

The other consideration is the impact further rate hikes would have on the yield curve. For example, the current spread between two-year treasuries and ten-year treasuries is -69 bps. That spread should tighten if we get stepped-down rate hikes as the Fed has been signaling. The ten-year rate should rise faster than the two-year rate as it is trading at the deepest discount against two-year treasury notes since 1980 and bond investors may see stepped-down rate hikes as positive for growth, which would lead to a steepening of what is currently a deeply inverted yield curve.

What’s the upshot for bond portfolios for 2023? Core bonds with maturities in excess of four years are likely to once again be subjected to price declines. However, shorter term maturities (four years or less) offer more attractive yield and total return prospects with less risk.

In contrast, investing in high-yield bonds ended badly in 2022 and will likely under-perform in 2023. Credit spreads (the spread between investment grade bonds and below investment grade debt) are well below their 20-year average (70th percentile) which means high-yield debt simply does not offer sufficient return to offset the risk. Credit spreads will likely expand in 2023 as investors become more anxious, given that high yield bonds have had twice as many downgrades as upgrades over the past two quarters. If history is any guide, more downgrades usually mean increased defaults over the ensuing twelve months.

In short, higher rates for shorter-term maturities offer a defensive strategy that should temper portfolio variability while providing a decent total return.

Undervalued Sectors with Long-term Potential

Rising rates, geopolitical tension, and sluggish growth made 2022 unique. It was the first time in history where stocks and bonds both entered bear market territory at the same time. And the phenomena spread across the globe as just 33% of countries and only one sector posted positive median returns. The carnage in global bonds was record setting. According to SSGA, “every country, sector, maturity bucket, and credit quality rating band in the 32,000 bond holdings within the Bloomberg Global Multiverse Bond Index suffered losses.”

Now, as a result of this pain, many markets trade well below their perceived fair value — some justifiably, given the confluence of risks. Unfortunately, the three factors inflicting pain at the close of 2022 are unlikely to change in 2023 — not immediately, at least. At some point, though, Fed policy may become less aggressive, and earnings sentiment could find a bottom.

As the markets hit their inflection point, sentiment will inevitably shift. In that scenario, the undervalued sectors should be the first to revert to their mean. That lays a foundation for a resurgence throughout some international markets. And there lies the rub. Given the negative sentiment that permeates through the international landscape, one might think that all foreign markets present opportunities. Unfortunately, that is not the case.

Outside the U.S. – particularly in terms of Canadian equities – the valuation case has merit. Non-US equities now trade at around 12 times next year’s earnings, 20% below their historical median average of 14.9 and well below the 17.1 P/E multiple for S&P 500 stocks.

That said, one must be mindful that some international markets are cheap for a reason. Emerging markets, for example, have experienced 11% downward earnings revisions. And that trend is continuing as growth projections for 2023 have declined to 1.7% from 6.0% over the past three months.

Small cap stocks, on the other hand, have not been subjected to the same negative sentiment. Unlike the emerging markets where growth is projected to be flat or negative through every quarter in 2023, small caps finished 2022 with a 14% bump up in earnings and 2023 consensus estimates are calling for a 4% growth spurt.

Semiconductor stocks are another example where valuations support an outsized recovery. The semiconductor industry was one of the worst performers in 2022 as the sector was hampered by supply chain issues and significant price increases. Semiconductors underperformed the S&P 500 Index by 9% after registering positive excess returns in eight of the past nine calendar years. This was the industry’s worst relative performance since 2012, when it fell 10% relative to the market.
Given this dour return backdrop, semiconductor stocks appear to be trading at attractive valuations. Notes SSGA, on an absolute basis, “valuations are in the lower 20th percentile relative to the broader US equity market. But beneath the surface, three metrics are in the bottom 5th percentile: price to earnings, forward one-year price to earnings and enterprise value relative to EBITA. These percentile rankings are much more attractive than broad-based tech, a sign that semiconductors carry a differentiated profile than the broader sector.”

While valuations have come down, the growth outlook is positive. Expected 3-5-year EPS growth has increased from 17.7% at the beginning of 2022 to 18.8%. Compared to the broader tech sector, this seemingly minor one percentage point increase is substantial, as the tech sector saw its longer-term forecasts ratcheted down to 12.9% from 14.6% over the same time frame.

The growth also comes off a more profitable base. Of the six other sub-industries within the broader Tech sector, the semiconductor industry has the largest percentage of firms (70%) with positive earnings-per-share figures over the past 12 months.

Future semiconductor growth could be further supported by the recently passed CHIPS and Science Act, which provides USD $39 billion for construction of semiconductor plants and USD $11 billion for semiconductor research and development to be disbursed through 2026. The CHIPS and Science Act could add significantly to the momentum in capital expenditure and the ongoing trend of reshoring semiconductor capacity. Announced semiconductor plans have already surpassed USD $138 billion.

Preferred Shares

As we enter 2023, many investment-grade preferred shares are yielding more than 6% – a yield that has not been seen since the onset of Covid. The excess dividend yield reflects the fact that preferred shares have longer durations, which subjects them to volatility similar to that of longer-term fixed income securities. Preferred shares are also subjected to the fear/hope effect analogous to equity securities. That said, it does not appear that the excess yields are the result of credit risk. Preferred shares issued by banks and insurance companies are not likely to cease paying their dividends, especially since recent stress tests gave most financial institutions a clean bill of health.

Even with higher global rates we have not been able to find any sector with investment-grade options that offer a yield above 6%. Which is to say, preferred shares offer a deeply discounted investment-grade yield opportunity, tax advantages and some upside participation as investor angst mitigates.

Richard Croft, Chairman & CIO

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