The Grass is Getting (a Little) Greener
A very odd title to use for a Toronto-based team as we enter December we concede. Still, we are seeing tentative signs that better times are coming, and perhaps sooner than many investors expect. The environment has been volatile and downbeat for most of the year but with inflation peaking – a call we have repeatedly made over the last few months – things are falling into place, including a peak in long-term interest rates (the two are very clearly related), better credit market trends and a sharp improvement in beaten-down cyclical areas of the stock market. While inflation is still rising, we continue to vocalize that the market looks for trends in data and not necessarily the absolute values. What matters most right now is that the pace of inflation is decreasing.
In July, despite a near unanimous opinion to the contrary, we stated that a recession was not a foregone conclusion. Even if we do see a recession, the recent nascent improvement in relevant macro variables strengthens our call that it will be a very mild one by historical standards.
Notably, we are getting closer to the end of the Central Bank tightening cycle. The following phrase in the recently released U.S. Federal Reserve (the “Fed”) minutes were quite encouraging in that respect: “... a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate.”
Another encouraging element is the credit trends in the U.S.; High-Yield Credit Default Swap (“CDS”) prices (essentially an insurance contract that protects against a default from risky borrowers) are falling significantly, meaning that the fixed income market is becoming less concerned about a severe economic slowdown. By historical standards, the stress level – even at its recent peak – was not even in the same stratosphere as during the financial crisis.
So, after an entire year of cautious and defensive positioning, our message to investors is that it is time to start adding high-quality economically sensitive stocks to portfolios. This is not an “all- in” call, rather a recognition that economic momentum will improve next year and that the stock market – as it always does – will discount it several months ahead of time and certainly well before it becomes obvious to most observers. Therefore, an incremental move in that direction should be beneficial to portfolio performance.
Technical Analysis – Russ Visch
This month’s review of our medium-term timing model (which measure three to six-plus month trends) shows nothing but improvement in all areas vs. the prior month. Weekly momentum gauges are now “4 for 4” bullish for both the S&P/TSX Composite and the S&P 500 indices after giving new buy signals in September/October; the first such combined buy signal since the pandemic low.
It’s also important to note that most of the indicators in our momentum timing model are giving new buy signals from levels that only occur as equity markets are transitioning out of cyclical bear markets and into new cyclical bulls. Breadth indicators measure the quality of a market rally in terms of the number of stocks participating. There has been continued improvement in the percentage of NYSE stocks trading above 50- and 200-day moving averages, and the latter just registered its highest reading since March.
Small- and mid-cap stocks have also been outperforming the S&P 500 Index since the October low, so the market is really firing on all cylinders.
Last but not least is sentiment. Recent surveys were uniformly higher yet again, resulting in the eighth week in a row that our composite sentiment indicator has climbed, the first time that’s happened since 2011.
Expanding bullish sentiment means more money being put to work in equities. Other conditional elements that are not part of the timing model but are equally important these days are the recent downside reversals in both the U.S. 10-year yield and the U.S. Dollar index.
Both had been major headwinds for equity markets since late summer and now appear to be in the early to mid stages of medium-term pullbacks which should keep them under pressure well into the first quarter of 2023. That will be an additional tailwind for equities.
In terms of new money, keep focusing on the pro-cyclical economically sensitive areas of the market such as Industrials, Consumer Discretionary and Financials. There have been dozens of base breakouts in those sectors over the past few weeks, which is fairly typical action at the beginning of new bull markets.
Interest Rates: Did I hear Pivot?
After a sustained period of high bond volatility, short-term yield variation in excess of 80 basis points (0.80%) – like we just saw in the Canada 10-year bond – felt almost like normal business. Despite further tightening and still-high inflation, the Government of Canada 10-year bond yield ended November below 3.00% after peaking at 3.76% less than six weeks ago. This was also accompanied by strong performance from risk assets, particularly High Yield spreads and Credit Default Swap levels tightening by 15% and 25%, respectively. However, the impressive reversal of sentiment after quarters of rising rates and inflation fears, leave some investors puzzled about what messages it conveys.
On one hand, moderating inflation led to a slight tilt with Bank of Canada and the Fed narratives promoting a slower tightening path ahead. It opened wider the door for an early 2023 pause – even an end to rate hikes. This is a positive for government yields as historically speaking, the end of policy tightening has translated into excellent bond buying opportunities. On the other hand, despite a relatively strong consensus expecting a shallow recession on both sides of the border, some are now suggesting the U.S. could avoid an economic contraction; a definite positive for corporate bonds which had been pricing – up until recently – some risk of an economic slowdown. While the odds are just above 50%, a recession may not be a foregone conclusion, and this would not be without precedent. In 1995, Canada and the U.S. narrowly avoided a recession after raising rates by 4.25% and 3.00%, respectively.
Can we reconcile the two different messages? Yes and no. Despite some obvious parallels with previous cycles, including the 1970s inflation, today’s is different and unique. One of the main differences is the surprisingly strong labour market that could continue to pressure wages higher. This will force Central Banks to find a delicate balance to calibrate policy to achieve their inflation target while mitigating risk to the economy. The problem is that without an economic contraction, labour markets and consumer demands could be slow to normalize, therefore delaying inflation returning to target, leaving little room for near-term reversal of monetary policy (i.e., rate cuts). Not only is there a risk for higher inflation for longer but ultimately a risk for higher rates for longer; something not well received by the markets.
In fact, with the recent optimism, markets are pricing in rate cuts starting as early as summer 2023 in the U.S. and Q4 in Canada. In our view, this seems to be a relatively aggressive path considering how slow inflation may come down. Our economists continue to believe rate cuts will be a 2024 story.
In the near term, the lists of positive scenarios for geopolitics, inflation, the economy, and rates can be matched with an even longer lists of things that can go wrong in the next six to 12 months. This is a reminder of just how uncertain the outlook remains. In volatile markets, and more questionable liquidity, small improvement and deterioration that used to gradually impact markets can now quickly turn into wide momentum swings. For us, the near-term strategy does not change: our main three themes are: 1) a gradual return to a neutral portfolio duration; 2) increase in government exposure; and 3) maintain a higher-quality bias for our corporate exposure.
We continue to recommend adding to bond portfolios, gradually investing liquidities and maturities, taking advantage of the better tax efficiency opportunities the market offers. However, we admit that following a strong market swing like we just experienced – without significant changes to underlying fundamentals – means we are becoming a bit more cautious and may slow down reinvestment until the smoke clears.
Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your investments.
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