The law of diminishing returns
Lower inflation trends have supported equities all year – through higher valuation multiples – even in the face of a generalized economic slowdown. However, as we have already come down from 8% to a much more palatable 3% range, the future tailwinds from lower Consumer Price Index (“CPI”) readings are bound to diminish. In other words, for equities to work for the rest of 2023 and next year, with multiple expansion harder to come by, the baton will have to be passed to earnings growth. A return to positive earnings per share (“EPS”) momentum is certainly plausible if we experience a “soft landing” ahead of a 2024 economic upturn. Positively, this just happens to be our base case and that of BMO’s Economics team. As always, stocks will discount this rosier scenario well before it is reflected in most economic data, and we may actually be experiencing this with the very recent reversion to “risk-on” behaviour. We believe there are large pockets of value in North American stock markets (e.g., Industrials, Consumer Discretionary and Financials), but we continue to strongly advise investors to be selective and emphasize companies with significant competitive advantages and pricing power.
The impact of higher rates has not yet been fully felt by the real economy; there is typically a six- to 12-month lag for tighter monetary policy to be felt across the economy. However, corporate earnings are holding in for now, particularly thanks to continued strength in consumer spending, as well as corporate spending related to Artificial Intelligence (“AI”) and other emerging technologies.
Another medium-term risk to ponder is growing labour power and associated compensation increases in multiple sectors. A simple Google word search shows that “Employee Strike” references are currently at the highest level seen in years.
A few tangible examples include: 1) the Writers Guild strike in Hollywood (which is hurting all studios by paralyzing new content production); 2) a potential strike by the United Auto Workers (the head of the UAW union has voiced support for current pay to increase about 40% over the life of the four- year contract); 3) American Airlines pilots ratified a four-year deal that includes roughly 46% increases in compensation (Delta saw a 30%+ increase earlier); 4) West Coast Dock workers received a 32% pay increase through 2028; and 5) UPS drivers will average $170,000 in pay and benefits at the end of a recently signed five-year deal.
The silver lining though is that unit labour costs (which includes productivity gains) are still benign and could continue to be despite the aforementioned massive wage increases, thanks in large part to the tailwind from technologies such as digitization, cloud computing and AI solutions.
10-year bond rates have moved up significantly – Historical sector performance
With 10-year interest rates at levels not seen in 15 years, we thought it would be timely to compare the historical market and sector track record when rates have risen by 3% or more. Our partners at Ned Davis Research helped with their impressive data set and came up with four periods that met the criterion, all of them in the late 1970s and in the 1980s1. While every cycle is different, the conclusions are largely encouraging. While the market tends to struggle while interest rates are rising (i.e., negative 2022 performance), investors adapt to the new normal of higher rates relatively quickly.
After the initial increase in long-term rates, a number of sectors have shown very strong two year and subsequent returns. Defensive sectors such as Consumer Staples and Healthcare top the list, but more cyclical sectors such as Financials, Consumer Discretionary, Energy and Industrials also generated good profits for investors. The one exception is Technology which always tended to struggle following a reset higher in rates, most likely because this sector has, at times, traded at very high valuation multiples which then compress. We think the current cycle will not be an exception to this rule.
Market technicals
We’ve noticed much media coverage about how September is traditionally the weakest month of the year for stocks, and strictly speaking, that’s absolutely true. Over the past few decades the average return for the S&P/TSX Composite Index in September is -1.57%, and -0.66% for the S&P 500 Index. This year has the potential to be different since most of the gauges in our short-term timing model have given a combined set of new buy signals for the first time since March 2023.
Those Q1 buy signals came on the heels of the mini banking crisis and resulted in a 10% to 12% rally in the major averages over the following six weeks. In terms of the current price action, all major averages have recently broken above their 50-day moving averages, which clears the way for the rally to extend back to their July peaks (S&P/TSX: 20,677; SPX: 4,607; and Nasdaq: 14,446). Breakouts there would likely result in the S&P 500 Index and Nasdaq Composite Index challenging their all-time highs at some point in late Q3 or early Q4 (S&P 500: 4,818; and Nasdaq Composite Index: 16,212). In Canada, the main number to pay attention to is the upper end of the nine-month trading range at 20,843. A breakout there would signal a resumption of the long-term uptrend and clear the way to challenge the Index’s all-time high of 22,213.
The return to 2%!
The focus is obviously on the proverbial 2% inflation target, but we are citing the return to 2% real interest rates. Not only have real monetary policy rates (net of inflation) turned positive this summer and are at, or close to 2%, but with the summer pullback in the bond market, so have most real rates across the yield curve.
This has positive implications for fixed income investors. First, at the shorter end of the yield curve, it confirms the policy rates are now restrictive and should help slow economic growth and inflation. More importantly, it reduces the need for further rate adjustment. This confirms that if not there yet, we are very close to the end of this rate hiking cycle.
Second, the combination of better economic growth, more limited upside policy risk, increased government debt supply, and a higher-for-longer rate narrative led medium- to long-term real rates higher to their best levels since the Great Financial Crisis of 2008. In our opinion, this is offering an attractive opportunity to lock in high real yields, a condition that rarely existed in the last 10-plus year low growth/inflation period that preceded COVID. Back then, fixed income investors rarely earned a positive real yield, let alone covered inflation.
These developments support our recommendation to lengthen/adjust bond portfolio’s average maturity to maintain a similar interest rate sensitivity to one’s benchmark index.
Looking forward, we could argue that a scenario for lower – not higher – rates is gradually emerging for the next six to 12 months. This may not be a straight line lower and will include some volatility. This means that in the near term, investors will continue to earn not only a high nominal rate, but also now a high real rate. This also means that if right, declining interest rates in the future will provide greater capital gains potential that neither short-term securities nor GICs will be able to match.
With higher yields, many securities are being offered at deeply discount values. Considering capital gains are taxed at a more advantageous rate, deep discount bonds are offering an opportunity that has rarely been available to bond investors. The advantage of buying a bond at a discount is that a portion of the future return will come from price appreciation (the difference between the discounted price and the maturity value of $100), which is treated as a capital gain. Considering the capital gains inclusion rate of 50%, this means that half the capital gain is tax-free while the other 50% is added to the coupon income and taxed as regular income. In comparison, 100% of the return of a GIC comes from interest income and is taxed as regular income. It is important to note that GICs remain an attractive option for tax-exempt investors.
Please contact your BMO Nesbitt Burns Investment Advisor if you have any questions or would like to discuss your investments.
[1] Given relentlessly lower interest rates starting in the early 1980s we only have four historical examples. The cycles studied are those with end dates of: December 29, 1978; October 29, 1980; May 7, 1984; and October 14, 1987.
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