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Entering 2022, we highlighted the many risks facing investors this year, which then included stretched valuations, accelerating inflation and consequently, looming rate hikes. We warned that inflation and slowing economic growth were set to weigh on corporate margins, with investors likely to deal harshly with potential earnings disappointments.
Yet, even as we fast forward six months and many of these risks have been realized, their magnitude continues to surprise. The war in Ukraine has contributed to multi-decade high inflation numbers and we have seen a steep rise in U.S. Treasury yields on a series of Fed rate hikes, with more to come.
With higher yields competing with equities, growing recession fears and an inverted yield curve, it is no wonder that equity indices have crossed into bear territory. Even though valuations have corrected, we see reasons for caution as we look ahead.
What can markets expect for the second half?
The Fed hikes will continue: With inflation still well above 5%, expect the Fed to stay the course and raise its overnight rate to 340 bps by year end, which represents the consensus target of Fed governors and an increase of 170 basis points (bps) from here.
Ten-year yields are likely to rise: Not surprisingly, when the Fed raises rates by 150 to 200 bps over six months, 10-year U.S. Treasury yields typically rise, with the corresponding increase averaging 70 bps since 1980. As a result, we would expect 10-year Treasury yields to reach 350 to 400 bps by year end.
Expect multiples to contract: We expect the trailing S&P 500 P/E ratio to fall, as its inverse, the earnings yield, rises to compete with higher yields. The earnings yield typically trades at a premium to 10-year treasuries, compensating investors for risk. The current earnings yield, based on trailing 12-month earnings through Q1 2022, sits at roughly 520 basis points, for a ~225 bps premium over 10-year treasuries. Given growing uncertainty regarding 2023 earnings and our expected move in treasury yields, we conservatively expect the S&P earnings yield to reach 560 basis points at year-end, equivalent to a trailing P/E multiple of 17.85x.
Current earnings for Q2 and Q3 leave room for further downside: For the S&P 500, current TTM earnings estimates through September 30th sit at ~$207. At our multiple of 17.85x, this implies a post-Q3 level of for the S&P 500 of ~ 3,696, down approximately 2% from the S&P’s current level of ~3,790. Add potential misses on index earnings over the next two quarters and/or higher equity premiums, and the result would be material downside from here.
The NASDAQ is just as risky if not more so: Based on Bloomberg data, the NASDAQ forward Price/Earnings (P/E) ratio averaged 20.6x in the ten years ended December 31, 2019, with the forward Price/Sales (P/S) ratio averaging 2.2x. The index is currently trading 14% above the average P/E and 27% above the average P/S from the pre-pandemic period, leaving further room to correct, in our view. (We use forward multiples because the NASDAQ is much more growth-focused, which ties it more closely to forward expectations.)
On a relative basis, the S&P/TSX looks cheaper: At 11.2x currently, the S&P/TSX index is trading at its lowest forward P/E since the beginning of the financial crisis in September 2008. While earnings may yet fall on an economic slowdown, the S&P/TSX multiple is likely at or near a bottom, reducing one source of risk.
Based on the scenarios have described, we think a defensive stance is warranted for the remainder of 2022. We view Staples, Utilities and REITs as relative safe havens, and we remain underweight Financials. U.S. dollar strength and economic worries are likely to undercut Materials and Energy in the early phases of any slowdown, however we note that gold has proven to be a good hedge against weak equity returns, particularly as economic conditions worsen.
Our holdings emphasize companies with strong cash flows, good management teams and the ability to withstand economic headwinds. We continue to benefit from the work of the analyst team at Veritas Investment Research, who have demonstrated over the years that they have a strong handle on fundamental and cyclical risks.
Year-to-date through June 30, 2022, the NASDAQ was down 29.2%, the S&P 500 was down 20.0% and the S&P/TSX was down 9.9%. Over the same period, our Canadian Equity Fund fell 6.3% and our Absolute Return Fund was 1.9% lower. (Performance based on F series).
In the year ended June 30, 2022, the S&P/TSX returned negative 3.9%, while our Canadian Equity Fund was up 0.8% and our Absolute Return Fund gained 7.1%. We continue to focus on preserving capital during the current market volatility and investing opportunistically to drive returns. (Performance based on F series).