“Whenever I ask their opinion, they say on the one hand, so-and-so; but on the other hand, so-and-so. I would like to meet an economist with one hand!”
Harry S. Truman
A broad swath of assets posted sizeable gains in January, extending the recovery from October’s bleak lows. Many global equity markets posted monthly gains in the range of 6% to 8%, with Chinese equities and U.S. technology stocks (2022's most battered areas) leading the way.
Although central banks continued to hike interest rates, bond yields retreated as inflation continued to trend lower. Canadian bond investors enjoyed returns in the 3% range for the month.
The rebound from October’s deep equity-market losses and elevated bond yields has been substantial, but the markets’ current enthusiasm may be a bit over the top. We remain constructive that equity markets can post gains in 2023. It’s notable that the speed and magnitude of January’s upswing is roughly half of what we had penciled in for the whole year (see our 2023 Market Outlook: The End of Free Everything?). The global economic outlook has improved; but, as usual, capital markets are prematurely eager to fast-forward to the endgame while we are only at halftime.
Last year, capital markets needed to adjust to new realities of high inflation, higher interest rates, less easy money, slowing growth, and increased geopolitical tensions. We believe much of the heavy lifting on these fronts has been done, but finessing the final tidy-up remains. What happens in the first few months of 2023 should reveal how much work is left to do. Capital markets must still contend with inflation, monetary policy, recession risk and politics/geopolitics.
Our concerns over inflation are fading quickly because global inflation continues to show signs that it has peaked and is in retreat. However, January saw surprise upticks for inflation in Spain and Australia, spooking markets and reminding everyone that economic numbers rarely travel in a straight line.
The risk that central banks will make errors in judgment as they set monetary policy now outweighs our concerns over inflation. While the Bank of Canada (BoC) has signalled it will pause rate hikes, other central banks remain more hawkish. If they go too far in raising interest rates in their effort to tame inflation (even though inflation is now in retreat), there’s a risk of slowing the economy more than necessary.
As long as the war in Ukraine rages on, geopolitics will be a worry. The other major problem of 2022 was the discord between China and the West. Encouragingly, 2023 is seeing signs that tensions with China could be easing ever so slightly (let’s hope a “stray” balloon doesn’t set things back too far). For capital markets, U.S. domestic politics may supplant geopolitical concerns as both sides must come to some agreement about raising the government’s debt ceiling.
The crosscurrents of inflation, slowing growth, central bank policy and capital market positioning are lining up along distinct narratives, which can't all be correct simultaneously. For the stock market, the current rally is predicated on what has been called “immaculate deflation,” a scenario in which inflation and wage growth cool with little damage to the economy. In this scenario, central banks back down on raising interest rates while corporate margins and earnings stall briefly then pick up late in 2023 and early 2024. Earnings growth is currently lackluster, and profit margins are under pressure (which is good for bringing down inflation), so the coast is not all clear.
The economic backdrop will be weak; yes, we may avoid a recession, but we won’t see gang-buster growth. This backdrop, along with lingering inflation and tight monetary policy, is not exceptionally fertile ground for stocks. As usual, the stock market is getting ahead of the data in the short term. This doesn't mean that all or even a good portion of the equity rally is unjustified. It simply means that a brief pullback for stock markets would not surprise us.
The messages from the bond markets are more nuanced as they thumb their noses at central bank threats to keep monetary conditions tight. The decline in bond yields does give us pause. We are happy to see yields fall due to lower inflation. However, yields falling because the economy will slow precipitously is not desirable. From today’s vantage point, it is difficult to separate whether the yield decline is a good thing due to falling inflation, or a warning signal that a recession is coming.
January’s price action for stocks and bonds has gone in the right direction but may have overshot in the near term.
Canada – Pausing
For January, the S&P/TSX Composite gained 7.1%, a solid result but less stellar than many of its global peers. The lag is understandable given that Canadian equities outperformed handsomely in 2022.
The Bank of Canada (BoC) raised interest rates 0.25% to 4.5%, a widely expected move and the smallest hike since rate hikes began last March. BoC Governor Tiff Macklem said the bank would “pause” rate hikes to assess whether inflation continues to moderate. We support this courageous call, given recent strength in employment, better-than-expected GDP growth, and continued firm wage growth. Canadian bond yields declined alongside their global counterparts. Despite BoC dovishness, the Canadian bond market (also a top global performer in 2022) outperformed U.S. and European benchmarks. For the month, the FTSE Canada Universe Bond Index gained 3.1%. Two-year Canadian yields fell from 4.05% to 3.75%, while 10-year yields fell from 3.30% to 2.91%.
Even though global recession fears are easing and China’s reopening is gathering steam, oil prices were little changed. West Texas Intermediate oil prices fell 1.7% to US$78.87 a barrel. Our dollar gained 1.9%, rising to US$0.752, or C$1.33 per U.S. dollar. The loonie’s strength is notable in a month when oil prices declined, the BoC turned dovish, and the difference between U.S. and Canadian bond yields widened in the greenback’s favour. These moves typically weaken the loonie. It’s a sign of underlying strength when an asset price moves up in the face of adversity. We expect the loonie to creep higher by a few pennies in 2023.
United States – Pressing on
In January, the S&P 500 gained 6.2%, lagging many other markets. Notably, two other mainstream U.S. equity benchmarks topped the charts. The NASDAQ rose from the ashes, up 10.7%. The benchmark for small and medium-sized U.S. companies, the Russell 2000 Index, jumped 9.7%. Both markets fared worse than most in 2022. This highlights a theme in January; 2022’s most battered areas made the greatest comebacks. January’s outperformance in speculative areas of the market (a basket of “meme” stocks jumped 25%, and Bitcoin rose 38%) is an unfortunate sign that the speculative fervour that plagued markets before last year’s cleansing still has vestiges of life. We expect that in 2023 companies with good fundamentals (great products, good management, cost consciousness, gains in market share) will be rewarded while the weaker players will be forced to adapt.
U.S. government bond yields fell in January as the annualized Consumer Price Index (CPI) inflation rate continued to decline, dropping from 7.1% to 6.5%. U.S. 2-year yields fell from 4.43% to 4.20%, and 10-year yields fell from 3.87% to 3.51%. On February 1, the U.S. Federal Reserve (the Fed) lifted its benchmark rate by 0.25% and said more rate increases are to come. Investors were cheered by Fed Chair Jerome Powell’s optimism about the economy and capital markets reacted like they think the Fed is bluffing. Market watchers will be hyper-focused on clues that might reveal the central bank’s thinking before its next meeting on March 22.
Europe – Work to do, but less than expected
European equity markets have been outperforming most of their global peers since late 2022. They are heavy with export-oriented businesses, and in general are more exposed to China than North American equities are. An improved global outlook, especially in China, has been a boost. Additionally, energy prices have retreated, and European natural gas stockpiles are swelling thanks to emergency imports of LNG and a milder winter thus far. European economies are holding up better than feared, and eurozone inflation is also cresting, albeit not uniformly by country. The European Central Bank, which has been a laggard at tightening policy, raised rates by 0.5% on February 2 and pledged to keep going. Yet here, as elsewhere, expectations about where rates will peak are falling quickly.
For January, the Euro STOXX 50, German DAX, and U.K. FTSE 100 stock market indices posted gains of 9.8%, 8.7%, and 4.3%, respectively.
Asia – About face
Political developments continue to drive stock markets in Asia. Over the last two years, China has pursued several agendas that have been headwinds for investors: zero-COVID; reining in excesses in the property sector; cracking down on technology and education companies; and jingoistic rhetoric toward the West. The harshest stances on these policies coincided with 2022’s significant political calendar. After President Xi Jinping made himself supreme leader for life at the once-every-five-years National Congress, China quickly pivoted on each of these fronts. This is positive for global growth and, hopefully, for U.S.- Sino relations. Chinese equities have been on a tear, with the MSCI China Equity Index up 12.3% in January, rallying more than 50% since October’s low.
The Bank of Japan surprised markets in December by allowing the 10-year government bond yield to rise to 0.5%, but failed to follow through on further policy tightening. For January, Japan's equity benchmark Nikkei 225 rose 4.7%, lagging most global markets.
Our strategy – Balanced
Our asset mix strategy continues to be well balanced with a slight overweight to equities and underweight to fixed income. Last year’s reset, when stocks and bonds both fared poorly, opens opportunities. We are optimistic that returns can be had from stocks and bonds across a wide swath of global markets.
Given January’s gains, mid-single digits are what we see for stocks through the rest of 2023. In our bond portfolios, we are reinvesting the coupon income and maturing securities to achieve higher yields. If there is a recession, we believe our bond positions will deliver a level of safety.
Our geographic equity weights remain tilted toward North America. However, the fundamentals for non-North American equities have improved; these markets have outperformed lately. We are deliberately allowing these increased weights to remain.
The last word – Long and variable lags
Harry Truman’s plea to find a one-handed economist poked fun at this group who are notorious for providing a multitude of scenarios that are often contradictory. The crux of the debate in 2023 is a classic example. Capital markets are weighing the probability of three scenarios unfolding: a soft landing (inflation retreats quickly, no recession); a mild recession; or a hard landing (a tough recession to stamp out inflation). BMO’s Economics Team assigns an 85% probability to the first two scenarios, leaving the third scenario (a tough recession) at 15%, down from 25% three months ago. The 85% combined total is positive for equities and bonds. Markets are moving to price in these more optimistic outcomes.
Should central bankers overdo rate hikes, the likelihood of a hard landing rises. They frequently say that monetary policy has “long and variable lags” in its economic impact. In 1961, Nobel-prizewinning economist Milton Friedman coined this phrase, which means that monetary policy has delayed and uncertain effects. However, more recent studies (including the Fed’s own work) indicate that the impacts are much shorter and less variable than they were 60 years ago.
What is currently keeping us up at night is the reality that central bankers are human and fallible. If central bankers are genuinely data dependent as they claim, and if the data keep trending in the current positive direction, hopefully hubris, or a desire to repair their damaged credibility, doesn’t cloud their judgment on appropriate monetary policy. Let’s swap out “long and variable” for “patience is a virtue.”
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