When looking at the economy below the hard deck, North American corporate profit growth remains healthy between 8% and 10%1. Other economic fundamentals such as the labour market, manufacturing and service activity, corporate balance sheets and consumer confidence are also showing clear skies. These variables have slowed from the Mach speeds of 2021 to the cruising altitude speeds of 2022. Nonetheless, the economy is still operating with two jet engines fully functional. As an investor, if you were to focus on the economic picture independently you would likely conclude that the stock market is trending higher.
Clearly, that has not been the case. Currently, the S&P 500 is down approximately 13% while the S&P/TSX is down approximately 2%, both year-to-date2. The turbulence is coming from two primary sources: Inflation remains well above the long-term trend, and central banks are tightening financial conditions by raising interest rates in hopes of dampening inflation soon.
So how does one determine whether cooler inflation and continued economic growth or a pending recession will prevail? Instilled in Matco’s investment management process is a keen focus on fundamentals. We have created our “Investment Horizon Indicator” to achieve this objective, which we first published in March of this year. This indicator is designed to identify where we are in the economic cycle, and how to adjust the risk within our investment portfolios. The horizon indicator combines U.S. consumer confidence, labour market health, the Bloomberg Financial conditions index, the Citi Group economic surprise index, the steepness of the yield curve and the expensive or cheapness of the S&P 500 stock market index. These factors serve as the instruments in our cockpit. When the market is grappling with whether a tailspin or smooth flying lies ahead, we rely on these instruments to support the discipline of our investment management process.
Matco’s Investment Horizon Indicator
*S&P 500 Value is measured on a logarithmic scale
Source: Matco Investment Team, Bloomberg
Speaking more specifically, when the horizon indicator is in the lower green zone, this indicates a long and healthy investment landscape is on the horizon. When it reaches the upper red zone, this indicates an amber signal and that the investment horizon is much closer to the end of the investment cycle. When the indicator is moving through the white neutral zone, the economy is progressing through the middle of the economic expansion and investment bull market. Since mid-2020, the indicator has progressed from the green zone and now finds itself two-thirds through the neutral zone. Importantly, it has not yet reached the red zone.
The Bottom Line
Volatility has been caused by two blunt factors, causing enough uncertainty to distract investors from the positive signs that remain. However, we anticipate inflation will begin to moderate in 2023, while the pace of tightening financial conditions will slow. These developments are likely to clear the skies for economic reacceleration in 2023. The pilot has left the seat belt sign on for the time being, and turbulence will prevail for the remainder of 2022. Nonetheless, the pilot’s instruments indicate that the final descent is further out the horizon.
We remain focused on selecting dividend-paying companies with reasonable valuations that continue to grow their profits within our equity investment portfolios. From an investment mix perspective, a modest tilt to a growth allocation complimented with inflation protection remains our focus. These positions will help our portfolios navigate the turbulence while also capitalizing on economic reacceleration once the pilot re-engages the engine thrusters, which we expect to occur as we approach 2023.
Trevor Galon, CFA
Chief Investment Officer
1Corporate growth rates as of June 6th, 2022
2Performance rates as of June 6th, 2022
delivered to your inbox once a month