Interest rate stability at last?
The Bank of Canada (“BoC”) and U.S. Federal Reserve (“Fed”) were at it again, recently raising rates another quarter point. While we think those latest increases were unnecessary given already sharply lower inflation trends, at least we now have a good chance they are on indefinite pause, meaning no more hikes. Our excellent BMO Economics team puts it best: “It’s our forecast that the tug-of-war between the economic headwinds and tailwinds during the coming months will tilt to the former, causing enough growth deceleration and disinflation to turn a September skip into a more prolonged pause. In other words, welcome to terminal territory.” Anything is possible of course, and their ultimate decision will be “data dependent” – as they are wont to say – but having visibility on rates has to be seen as a positive for the bond and stock markets. History has shown that stocks tend to have their best returns when interest rates are stable. Going back to the early 1980s, the S&P 500 Index and S&P/TSX Composite Index have enjoyed strong double-digit median returns when rates were flat(tish), independent of their absolute levels.
While the high end of the new Fed target range of 5.5% is the highest level in 22 years, taking a longer-term view shows us that this level has not been particularly sinister over several decades. In fact, the economy and financial markets have been able to withstand far higher levels while staying buoyant. In other words, the recent anomaly is not rates at 5% plus, but rather the free money that was showered on consumers and investors for years. History shows that people engage in unhealthy speculative behaviours when interest rates are close to zero and this cycle was no exception (e.g., cryptocurrencies and extreme valuation for tech growth stocks).
With the odds of a North American recession in the next year steadily decreasing on our models (now below 50% for the first time this year), we think the set up for Canada (which has a far more economically sensitive market than the U.S.), and oil equities in particular, is quite positive.
Fixed income conclusions
Even with all the central bank rate hikes since March last year, the economy continues to surpass expectations. Consumers have been resilient and are supported by high levels of employment, wage growth, savings and immigration. While the economy remains strong, those central bank rate hikes are moderating inflation toward the long-term goal. Central bank rates are now higher than they were in 2007, and are having a real impact on slowing the economy as seen through slowing inflation.
Canadian interest rates are at their high for this cycle and with the reopening boom and rate hike cycle largely behind us, it is a great time to revisit fixed income allocations. We recommend keeping portfolio duration in line with long-term targets and to lock in these attractive yields for the years to come.
When inflation is below 3% (Canada’s Consumer Price Index recently dipped below that level), the top 15 industries are virtually all cyclical. Multiple sectors and the market as a whole tend to do well six and 12 months following a pause from the Fed.
Revisiting our bullish stance on oil, moving to sidelines on gold
Years of underinvestment by the industry (limiting supply growth), and the steady increase in demand from China and India along with spiking global travel in a post-COVID world, should keep oil prices elevated, even in a continued slower growth environment this year. However, when the unavoidable upturn happens (likely in 2024), oil prices could top the US$100/bbl mark once again which will likely propel stocks higher. At the same time, we believe that Canadian energy remains the most undervalued major sector in North American equities, with some stocks sporting free cash flow yields (cash available for dividends, share buybacks etc., as a percentage of market capitalization) over 20%. We also continue to recommend large-cap banks (Canadian banks in particular) as they will benefit from higher and stable interest rates and the recovery in the housing market.
Conversely, while gold retains long-term appeal as an inflation and political upheaval hedge, history has shown that bullion performs best in a declining real interest rate (nominal interest rates minus inflation) environment. With the Canadian and U.S. central banks having relentlessly increased rates despite declining inflation trends, we find ourselves in a tougher environment for the yellow metal and we expect this to persist for the foreseeable future, limiting near-term appreciation potential for precious metal equities.
Technical analysis
As we pass the mid-point of the year, we felt it would be prudent to review our medium-term timing model. These indicators measure three to six plus month trends, so this is effectively a call on how the second half of the year is likely to play out. The punchline is that they are all bullish and supportive of more upside which means the bias for equities should remain to the upside throughout the remainder of the year. For example, momentum gauges remain fully bullish, and while some are overbought, that's not a bad thing during this phase of the cycle. In the early stages of new bulls, they usually get overbought and stay overbought for more than a year.
In terms of participation, the rally has broadened out significantly in recent weeks and we’re starting to see signs of small- and mid-cap outperformance, which is to be expected now that we’re nearly a year past the bear market low. And, our Composite Sentiment indicator sits at a fresh 18-month high.
The massive improvement in this indicator in recent weeks is the biggest three-month change since the lift-off from the pandemic low (sharp bullish spikes like this are a common event coming out of significant bear market lows). Overall, sentiment is still well below the level required to become a serious headwind for equities. In fact, we don’t expect it to be a problem for equity markets at any point in 2023.
In terms of what we would be buying, we took a look at the 13- and 26-week forward performance of the 11 major S&P 500 sectors nine months past major bear market lows to get a sense of how they might perform for the remainder of the year. There wasn’t anything too surprising in the data which showed that pro-cyclical, economically sensitive areas like Industrials, Consumer Discretionary, Technology and Communication Services outperform, while the traditionally defensive areas like Healthcare, Consumer Staples and Utilities consistently underperform.
What’s interesting about this study is that it’s exactly what we are seeing today. The S&P 500 Industrials Index recently broke out to a new all-time high, the Consumer Discretionary and Communication Services Indexes just broke out of year-long base patterns and Technology stocks are roaring. Those are the areas investors should be focusing on during any near-term weakness that may develop through these historically lackluster late summer months.
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