Canadian equities likely have a bit further to fall, but won’t decline as much as in prior recessionary periods
Pedestrians walk past stock market numbers in Toronto’s Financial district in September. Photo by Peter J. Thompson/National Post By David Rosenberg and Brendan Livingstone
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With recessionary pressures on the rise, we decided to look at which assets have gone the furthest towards pricing in a downturn and which areas of the market still have a ways to go.
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Our approach was to use a simple probit model that looks at the percentage change (or, where relevant, basis-point change) from the 52-week high (or low) in these assets in recessionary and non-recessionary periods.
Broadly speaking, our results were consistent with our a priori expectations. In general, most assets have discounted very high odds of a downturn (75 per cent on average), although the dispersion is quite wide. This analysis heavily relies on the assumption that they will behave similarly in the current recession as they have in the past (which, as always, may or may not be the case), but we still believe important insights can be gleaned.
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As you can see from the accompanying table, a number of assets have already had drawdowns consistent with a recessionary outcome. This would include United States small caps, lumber, base metals, and investment-grade and high-yield credit. Thus, while we cannot rule out further weakness in these areas as the economy slows, investors should take solace that there is already a lot of bad news discounted. From our standpoint, this at least partially limits the scope of further potential downsides.
Besides U.S. small caps, another area of the stock market that is close to fully discounting a recessionary outcome is Asia (96 per cent). This is not a huge surprise as the MSCI Asia Pacific index has fallen about 37 per cent from its high, an even larger drawdown than during the COVID-19 recession (30 per cent). Similarly, emerging-market equities (84 per cent) and U.S. equities (82 per cent) are approaching the sorts of declines we would expect to see when a recession is in the price.
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For reference, based on this analysis, the S&P 500 will need to fall to at least 3,500 before U.S. stocks have appropriately accounted for forthcoming economic weakness. In contrast, our modelling suggests that the declines thus far in European (51 per cent) and Canadian (31 per cent) equities have not gone far enough given past recessions.
For example, in Europe, we believe a decline of a bit more than 30 per cent from the highs is consistent with a recession, whereas the Stoxx 600 has only fallen 22 per cent thus far. Given that the region probably has the greatest economic challenges of anywhere in the world (due to the ongoing energy crisis), the risk/reward — in terms of thinking about having equity exposure in Europe — remains unfavourable, despite its allure of being “cheap.” Put differently, we view Europe as a classic value trap, and would not be looking to add exposure at the current time.
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Canada is a different story. Largely due to its high exposure to energy (roughly 20 per cent of the index is in this sector), it has hung in well this year on a relative basis. Oil demand is likely to deteriorate as the global economy falls into recession, but supply challenges will result in a higher floor on prices. This should serve the energy sector well, with stocks roughly only discounting US$75 per barrel WTI at current valuations. Thus, we believe there are good reasons to expect Canada will not see the sort of equity market drawdown we have seen in prior recessionary periods, although it likely still has further to fall from current levels.
What is perhaps most interesting from our analysis is what the Treasury market is telling us. Note that the Merrill Lynch Option Volatility Estimate (MOVE) index (which tracks fixed-income market volatility) is consistent with a recession being fully discounted. In other words, the extent of the volatility in the Treasury market has been so extreme that it would suggest very high odds of the economy being in recession. The decline in 10-year breakeven rates (down about 90 basis points from the high), also suggests rising recession odds (75 per cent), although there is further to go on this front.
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In contrast, a decline of at least 150 basis points in the 10-year Treasury yield from its 52-week high would ordinarily be expected as the market accounts for the twin combination of weaker economic growth and growing deflationary pressures. But not this time around. The U.S. Federal Reserve’s push to aggressively drive the federal funds rate higher, even amidst a weakening economy, has limited the scope of the yield decline.
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Article content Ultimately, we expect the Fed will be successful in creating the conditions necessary to return inflation towards its two-per-cent target, which means that although the timeline has been pushed out, there will come a point when yields pull back sharply as the Fed takes its foot off the gas and inflation melts. Patience will be required, but it would not be a surprise to see the 10-year Treasury yield return to at least 2.5 per cent.
Many assets are increasingly moving towards pricing in a recession. But, in general, equities have further to go, which suggests further downside from current levels (particularly in Europe). That said, the asset that appears most inconsistently priced are 10-year Treasuries: sharp yield declines are a hallmark of recessions, but this has not yet transpired. This can be traced to the Fed’s aggressive rate hike path, which has limited the extent of any yield pullback thus far.
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Article content However, looking ahead, we believe the Fed will be successful in returning inflation to its two-per-cent target — faster than it currently anticipates — which will not only cause inflation expectations to fall, but also result in a lower real rate as the market accounts for a less restrictive policy stance. Thus, while the timeline of the Treasury rally has been pushed out, we think it is coming, and would thus be looking to add exposure.
David Rosenberg is founder of independent research firm Rosenberg Research & Associates Inc. Brendan Livingstone is a senior markets strategist there. You can sign up for a free, one-month trial on Rosenberg’s website.
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