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Equity markets have struggled this year amid waves of volatility and uncertainty. How will investors know if the bottom is close to being reached? Greg Bonnell speaks with Christian Medeiros, Portfolio Manager at TD Asset Management, about the signs investors should keep an eye on.
Transcript
Greg Bonnell: It’s been a tough year for stocks. But we’ve also seen several big moves to the upside in between the decline. So, amid these so-called bear market rallies, what signs might tell us if we’re near a market bottom? Our featured guest today has a checklist that he’s keeping an eye on. For more on all this, we’re joined by Christian Medeiros, portfolio manager at TD Asset Management. Welcome to the show, Christian.
Christian Medeiros: Thank you.
Greg Bonnell: All right. So we got four here. We’re going to reveal them one at a time in terms of your checklist and trying to figure out when we can see an end to this pain. Well, let’s take them one by one. The first one on the list is inflation.
Christian Medeiros: Inflation, yeah, it’s one of the most important metrics. It’s one that we wouldn’t have included in the checklist in past bear markets, because over the last couple of decades, we’ve had low, steady inflation. It hasn’t been a major concern. This time around, inflation obviously is quite high and hard to get under control. The Fed is dead set on bringing inflation down. And with high and rising rates, that’s going to be a major headwind to markets. So until that inflation problem is solved, it’s going to be hard to see markets turning around.
So how are we looking at inflation? How are we measuring this in the checklist? Well, we took an analogy that we find very helpful from the Fed’s, John Williams. Inflation is like an onion. On the outer layer, you have globally-traded commodities. These are things that we’re used to rising in price over the last year. Lumber was expensive. Oil was through the roof. Gasoline was a huge challenge. A lot of these things have come in. And we’ve seen that in our checklist. Those are mediated. The second layer is goods inflation. We’re all used to the supply chain disruptions, the high cost of durable goods. We also see that improving. Looking at many of our fast-moving data indicators, we said that supply chains have improved globally, backlogs are down, and goods prices are starting to fall. The inside layer is housing. And we can see in the US, rents have been so strong over the past year and have continued to rise.
However, we do see in faster-moving rental indices that marginal rents are falling. And into next year, we do expect rents to mediate. But then we get to the core. And this is the problem with the overall inflation indicator that we’re seeing. Core services inflation is still very, very strong. The consumer is too strong. We see that across consumer spending data, cards data. They’re spending similar amounts as before despite higher rates. Employment is strong. And wages are strong. So what the Fed is very focused on is getting that wage inflation under control. And that’s going to still require higher rates than we have at present. So as a result, our overall checklist for the inflation metric has seen inflation fall from a peak but is not yet at levels that we’d be comfortable with, given the strength of the consumer and wages.
Greg Bonnell: Yeah, those levels still pretty high. I found out from Canada today — 6.9% headline, the United Kingdom 10.1%. All right, that’s inflation. That’s number one on the checklist. Let’s get to the next one — growth. What do you need to see here?
Christian Medeiros: Yeah. So growth is one of the most important metrics in any checklist. Economic growth ultimately is what drives markets over the long run. What we’re looking at growth is fast-moving indicators, like surveys of purchasing managers and looking at consumer activity. And so on the growth side, what we would hope to see is that the growth metric would turn down quite substantially and then inflect. And once we see that inflecting on the fast-moving data, we’d be comfortable that we’re hitting more of a bottom on that indicator. What we’ve seen so far is that a lot of purchasing manager indices have fallen down from very lofty levels to around midpoint levels, around neutral. But in a recessionary scenario, in a scenario in which we’d expect inflation to come under control, we would need these growth indicators to fall much lower than the neutral level into, let’s say, the 40 or 30 range on the PMI. So there’s still more to go on growth, but we are moving in the right direction. And we expect this to weaken over the course of the next few months into the midpoint of 2023, and then hope to see an inflection in the growth metrics.
Greg Bonnell: All right. Inflation, growth — number one and two on the checklist. Next one is risk sentiment. What are we seeing here?
Christian Medeiros: Yeah. Risk sentiment’s really interesting. We see across a whole host of surveys of fund managers, of individual investors — sentiments as bad as it’s been. And that’s not surprising, given what we’ve seen over markets over the past year. And when we look at volatility, another good measure of investor fear, we also see that at elevated levels. However, when we look at our checklist and what we’re looking for, we’d really expect to see a blow off in volatility, very high levels of volatility. And we haven’t seen that so far this year. Volatility has been elevated but has actually been relatively tame as markets have slowly ground down over the course of the year. So we’re really looking for much higher levels of investor risk aversion and fear with a crash or market drawdown than we’ve seen currently. That would be more consistent with the bottom of an equity market drawdown.
Greg Bonnell: All right. That’s three out of four. The final one on the checklist to try to figure out if we’re past the worst of all this — earnings and valuations. This is a good one, considering we’re getting into the thick of earnings season now.
Christian Medeiros: Exactly. So this is important because we want to see the fundamentals of companies within the equity market. And that will help us determine if investor expectations are properly pricing in the market trough. So the bulk of the equity market drawdown this year has been driven by valuations coming from the mid-20s down to the mid-teens, so quite a big drawdown in valuations for US companies. We think a lot of this has already happened. But the second aspect is earnings and earnings revisions. And this is what analysts are expecting for earnings across the companies. And what we’ve seen actually is that they haven’t really come in very much. Only until recently have we started to see earnings revisions starts to tick down. And right now, as we’re looking at it, we only see about low single digits decline in earnings. And we don’t think that’s sufficient to price in a recession. A mild recession would see high single digits. And a normal, deeper recession would see up to 20% decline in earnings. So there’s more to go unfortunately as well for earnings revisions for us to be comfortable on our checklist that we’ve hit the market bottom.
Greg Bonnell: All right. So investors definitely — this is the question they keep asking every time they see these rallies. And I know your colleague Michael Craig has sat in that chair and said, until we start to see a big change and stuff, he calls them bear market rallies, so inflation, growth, risk sentiment, and earnings, and valuations. Once we can check off these four boxes, then we just patiently wait for the turnaround. Because it’s still hard to time a market. There’s definitely criteria to say like are we passed the worst. But would it necessarily mean, Okay, I’ve checked off all four. Here we go.
Christian Medeiros: Yeah. That’s precisely right. It’s very challenging to call the market bottom. We don’t know if this checklist will give us the exact day and the exact price point. But it’ll give us comfort to start legging back into risk assets as these criteria are met. And so we’ve mentioned those criteria. We’d expect inflation to need to come under control, especially like core services inflation, for the Fed to be able to lighten up, perhaps pause, perhaps pivot. On growth, we need to see growth starting to trough and inflect. On sentiment, we need to see much higher levels of investor risk aversion and fear of equity markets. And lastly, we would expect and hope that analyst revisions continue to decline to reflect the evolving economic condition that we’re seeing in the growth metrics, so there’s more to go. And it’s more of a directional thing. We don’t need to call the exact bottom, but we do need to see a troughing and inflecting of these metrics. And that’s been consistent with past economic cycles and market drawdowns.
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