Reporter: “What good, though, is a bargain if the market never recognizes it as a bargain? What if the stock market never comes back?”
Warren Buffett: “I asked Ben Graham… about that. He just shrugged and replied that the market eventually does. He was right – in the short run, it’s a voting machine, in the long run, it’s a weighing machine.”
Warren Buffett, Forbes Magazine, November 1974
This investment commentary is not just an important way to communicate our thinking and strategy to clients. Stepping back from day-to-day trading to reflect on a month, quarter, or year reminds us that capital markets are voting machines in the short term where the influence of investor emotions plays an outsized role. But in the long term they are weighing machines – driven by company and sector fundamentals such as earnings, debt levels, assets, cash flow, and so on.
In September, stocks, bonds and currencies were whipped to a frenzy of volatility and red ink. For the quarter, however, many core assets performed much less dramatically. In a large number of developed equity markets, losses were less than 5%, and in Canada bonds preserved capital. Prices for currencies and commodities were the most volatile as they continued to seek a new equilibrium in an uncertain world.
The U.S. dollar’s continued strength is becoming a problem. About 80% of global trade is conducted in U.S. dollars, so a surging greenback squeezes income and worsens inflation pain for the rest of the world. Currencies are an integral part of how economies and markets rebalance excesses. Some countries are acting on political motivations, continuing to stimulate their economies with reckless spending. These moves are counterproductive if the goal is to tame inflation. Japan and the U.K. fall squarely in this camp, and Canada to a lesser extent.
Capital markets enforce discipline on this counterproductive behaviour. For example, the U.K.’s new Prime Minister announced a massive fiscal plan of unfunded tax cuts and spending – an inflationary move. Markets reacted by pricing in higher interest rates, which sent currency and bond markets tumbling. The Bank of England (BoE) was then forced to buy U.K. government bonds to stabilize the situation. Thus, the BoE is both pushing and pulling, raising interest rates to tighten financial conditions while buying bonds, which loosens financial conditions. We shall see if this delivers stability.
Markets and economies must adjust to the reality of high inflation, elevated interest rates, less easy money, slowing growth, and increased geopolitical tensions. In the first half of 2022, many assets and geographies made progress toward this adjustment. The third quarter saw more adjustments, both up and down. In the first six weeks, some equity markets were up 7% to 10% (the NASDAQ was up 19% in six weeks), while fixed income saw gains of 3% to 4% in July alone.
In September, the euphoria faded. Stock markets tumbled, and many fell below earlier year lows. Declines like this year’s often follow a “W” pattern – a rebound (July) comes after the initial decline. Then the markets re-test the earlier decline (or go somewhat lower). Historically, this is not unusual and is often necessary for markets to find a bottom.
Bond yields have scaled new heights, yet total returns were flat. The earlier reset to higher yields is bearing fruit – the self-healing ability of bonds in action. Getting to higher yields is painful. Once you are there, the pain subsides as the income component of fixed income makes up for the earlier hard work. Think of it as diet and exercise – they are hard to endure, although they ultimately leave you healthier.
There are conflicting messages around inflation. Prices for many commodities are now falling from prior spikes (oil down 35%, lumber down 75%, wheat down 28%). Supply-chain costs are also easing; freight rates for global shipping containers have fallen 62% from peak levels a year ago. Conversely, wage inflation, rising rents and higher mortgage payments remain worries. Remember that inflation is embedded in corporate earnings, which are the lifeblood of share prices. Costs are up, but so are prices as businesses have been able to raise prices (a.k.a. inflation) to protect profit margins. Now that commodity prices are falling, one source of cost-push inflation is losing steam.
North American central banks are well along the path to tightening financial conditions. They are hiking rates at the fastest pace in decades in order to combat the highest inflation in decades. Unfortunately, their hawkish rhetoric for 2023 is frightening markets. It remains to be seen whether central banks need to cause a recession to beat back inflation. If there is a recession, we believe that the current solid employment, plus healthy households and businesses, will make it shallow. If that’s the case then stock markets that are down 20% to 30% already reflect a lot of this bad news.
Expectations for corporate earnings growth that we felt were too high are coming down. Where earnings settle will be the ultimate test for stocks (this is the weighing machine part). There are recent signs that earnings growth is faltering in certain areas, especially the production side of the economy (versus services). This is the inevitable and desired outcome when too much demand and too few goods were part of the problem causing inflation. Signs of weakness like this, along with softening housing markets and eventually fewer job openings – and perhaps a rise in unemployment – are exactly the conditions required to quell inflation.
While calling the bottom is impossible, bond yields and stock prices have made major strides toward incorporating these realities. If we have a recession, fixed income yields should fall from current levels, and bonds should provide upside in addition to the already improved level of income. For many stock markets that are currently at depressed levels, our analysis tilts slightly toward scenarios with more upside than downside. Stocks (and some bond yields) don’t need conditions to be “good” in order to make price gains; they simply need to be “less bad” than today’s low-bar expectations.
Canada – Not immune, but better than many
For September, the S&P/TSX Composite fell 4.6% (-2.2% for the quarter); Canada’s market continues to outperform many global counterparts. Our dollar was hit hard, falling 5% against the U.S. dollar to US$0.723, or CAD$1.383. A tumbling loonie helps cushion Canadian exporters and companies with global operations since these companies receive revenues in U.S. dollars but pay many expenses in Canadian dollars.
Our dollar weakened in large part because it’s closely tied to interest rates and oil prices. Canadian two-year yields rose from 3.65% to 3.89%, while 10-year yields rose from 3.12% to 3.32%. However, in recent weeks Canadian bond yields tumbled below their U.S. counterparts. The Bank of Canada (BoC) had been acting and talking more aggressively than the U.S. Federal Reserve (the Fed), but the Fed is now the more hawkish of the two. Additionally, recent signs of weakness in Canadian employment, housing, and consumer spending may persuade the BoC to be less aggressive than the Fed. Falling oil prices weighed down our currency as West Texas Intermediate oil prices fell 12% to US$79.55 a barrel on escalating fears of a global recession.
United States – Pluses and minuses
For September, the S&P 500 fell 9.3% (-5.3% for the quarter). U.S. government bond yields jumped to their highest levels in over a decade. Two-year yields rose from 3.49% to 4.28%, while 10-year yields rose from 3.19% to 3.83%. U.S. dollar strength cut the S&P 500 loss in half to -4.6% in Canadian dollar terms, one of several reasons we continue to favour U.S. equities.
The annualized Consumer Price Index (CPI) inflation rate moderated from 8.5% in August to 8.3% in September. On the other hand, core inflation unexpectedly accelerated from 5.9% to 6.3%, leading investors to conclude that neither inflation nor central bank tightening has peaked. Markets are eager to hear central banks discuss the end of tightening; such hopes sparked July’s rally for stocks and bonds. However, rising stock and bond prices cause financial conditions to loosen, which is the opposite of central bankers' inflation-fighting goals. Central bankers have little choice but to talk tough. The Fed’s 2023 median outlook predicts the Fed’s target rate will crest at 4.6%, which sent stocks down and bond yields up.
Europe – Recession bound
Europe is troubled by high inflation, fighting in Ukraine, weak productivity, and political frictions. We see few catalysts for European equities to stage a lasting rebound. Compared to North America’s situation, Europe’s economy is less favourably positioned to handle the rate hikes necessary to quell surging inflation. Odds of a recession here are higher.
European and Japanese equities have significant export exposure to China, which is a potential positive even though disappointing developments in China likely spell a slower recovery. The euro and Japanese yen are under downward pressure, given that monetary policy and growth prospects in these countries lag those of North America; we see little potential for either currency to gain much ground.
European bond yields followed global bond yields higher; record inflation may force the European Central Bank to raise interest rates more aggressively. Huge tax cuts and spending announcements from the new U.K. Prime Minister saw sterling plunge toward parity with the U.S. dollar, an all-time low. For September, the Euro STOXX 50, German DAX, and U.K. FTSE 100 stock market indices registered losses of 5.7%, 5.6%, and 5.4%, respectively.
Asia – Pushing on a string
China’s economy is responding to stimulus measures and exports remain buoyant. Yet, investor sentiment (Buffett’s voting machine) remains very weak as uncertainty looms on several fronts. COVID lockdowns can come at any time. The property crisis continues despite Beijing’s increasingly desperate measures to shore up the sector. China’s upcoming Party Congress, held twice a decade, may bring significant policy changes.
Currency troubles plague China and Japan. The Chinese yuan is at its weakest level since 2008. Despite Japan’s efforts to support the yen, it sits at a 20-year low. For September, Japan’s equity benchmark Nikkei 225 fell 7.7%, while the MSCI China Equity Index shed 14.7%.
Our strategy – More defensive
Our portfolios are purpose-built to serve a variety of investor needs and are designed to weather storms. Being well-balanced and well-diversified is the best positioning to handle any outcome.
We have increased our exposure to bonds in balanced portfolios to a less underweight position. It’s our view that bond yields have risen very near (and above in some cases) levels necessary to reflect the path ahead for growth, inflation, and future central bank actions. Additionally, we are reinvesting coupon income and maturing securities in our bond portfolios at higher yields. We believe our bond positions will provide a level of safety if a recession takes hold.
We remain slightly overweight equities and shifted our geographic alignment. We moved to underweight international developed markets (primarily Europe and Japan). Over the medium term, prospects for a rebound and sustained gains there are not as attractive as North American equities.
We remain overweight to North American equities. Canada’s commodity-related companies do well in inflationary environments. U.S. equity markets and the U.S. dollar have historically offered relative safety in periods of weak global growth.
The last word – Stay invested
Given how often it is repeated, "stay invested" may seem like just another financial cliché. But history shows that it is perhaps the single most important piece of advice when it comes to growing your capital over the long run, in both good times and bad.
Recession and inflation fears will linger, and we expect continued volatility. Eventually, market headwinds will ease – as they have in all past economic cycles. It's called the business cycle, not the business straight line. Investor emotions and behaviours also follow a cycle. We should not fall into the classic pitfalls of buying high and selling low based on short-term, emotional reactions.
Time horizons matter. The longer you stay invested, the more confident you can feel about generating a positive return. Markets can have a bad day, week, month or even year, yet history suggests that you are far less likely to suffer losses over longer periods – especially with a well-diversified portfolio. Be Buffett-like because “…the market always eventually does (come back). In the long run, it’s a weighing machine.”
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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