“Deal with the difficult while yet it is easy; deal with the big while yet it is small.
The difficult (problems) of the world must be dealt with while they are yet easy; the great (problems) of the world must be dealt with while they are yet small.”
Lao Tzu, Tao Te Ching, around 400 B.C.
August brought both euphoria and fear to stock markets. Weeks one and two saw equity markets cheer lower inflation in North America. However, in late August the situation reversed.
Central bankers stated in no uncertain terms that more interest rate hikes are coming. Investors reacted swiftly with a market sell-off.
This course correction came after a short period of optimism, encouraged by positive signs such as easing recession fears, lower inflation readings in North America, rebounding stock markets, falling gas prices, and rising U.S. job numbers.
Meanwhile, central bankers had been watching with concern the speed and extent of the stock market's recovery and ebbing bond yields. Rip-roaring stock markets and lower bond yields (i.e., falling borrowing costs) work to stimulate the economy – the opposite of what’s needed now. They weren’t yet seeing enough evidence to alter their “higher, and for longer” outlook on interest rates. Central bankers, who began raising rates in March, are aiming for a cooled-down economy in order to rein in inflation.
The latest lower inflation readings had prompted equity investors to think that central banks might pause on more rate increases, and possibly set the stage for rate cuts in 2023. Instead, central bankers poured cold water on market expectations and warned that there’s still work to be done before inflation is tamed. By month-end, most equity markets had erased all the early gains and then some.
This tale of two clashing perspectives ended with a bombshell on August 26. Jerome Powell, Chair of the U.S. Federal Reserve (the Fed) and the world’s most influential central banker, delivered a forceful speech asserting that the Fed will keep raising rates until inflation is much closer to their 2% target.
While all central banks continue to pound the table and emphasize that the job of raising rates to quell inflation is far from done, Mr. Powell’s warning drove the point home. Stocks tumbled and bond yields rose.
Despite poor investment results for stocks and bonds (the seventh of eight months so far this year), and given the inflation problems and other uncertainties the world currently faces, we see August’s developments as welcome and necessary. Economic data softening, but not collapsing, is healthy. There are signs of weakness, especially housing, but this is warranted (desirable, in fact) considering the overheated pace of home-price appreciation during the last few years.
Other areas such as wages, employment growth, business investment, and consumer spending are holding up well. This is good news. However, stock markets getting too excited about a bit of good news isn’t helpful. Stock markets overshoot and undershoot all the time; June looks like an undershoot, mid-August more of an overshoot. Ultimately, capital markets need to find a new equilibrium that factors in slowing growth, inflation, and rising interest rates. Nobody likes to see stock markets go down. Rising interest rates are good news for some (savers) but not others (borrowers). Yet, when stock markets get ahead of themselves that is a problem as well. If interest rates need to rise, that is a reality we must accept.
North America could achieve the desirable but elusive soft landing – the economy cools but doesn’t freeze, and inflation eases. That outcome seems a tad more likely today than it did eight weeks ago.
For the stock market, we want share prices to move higher because of improved corporate earnings – not because central banks ease off (potentially too soon) fighting inflation. While corporate earnings remain on track, and continued growth is forecast, these expectations are built on fragile ground not stable enough to withstand much bad news. The equity market rally that started in mid-June was getting ahead of itself. A pause is normal and constructive; a retreat or temporary reversal is not unusual.
Stock markets moving up now to price in rate cuts in 2023 doesn’t square with the negative consequences for corporate earnings growth that would accompany an economy so slow that central banks would be in rate-cutting mode. Earnings growth is the lifeblood of share-price growth. Stocks shouldn’t cheer interest rate cuts so loudly – those rate cuts will only come if central bankers see the economy softening, and that means less corporate earnings growth.
Bond yields were not as surprised by the Fed Chair’s hawkish speech, having risen throughout the month. In our opinion, yields below 3% at any maturity date for the bond market do not square with reality. While rate hikes seem to be taming inflation, it is still above 7% in North America (and higher in Europe). Currently, the entire yield curve beyond six months in Canada and the U.S. sits above 3%. Canadian two-year yields at 3.65%, and U.S. two-year yields at 3.5% bring the bond market, once again, in closer alignment with central banks’ stated intentions to keep hiking.
Canada — Hanging in, but slowing
For August, the S&P/TSX Composite fell 1.8%, yet outperformed many global markets. Three of 11 sectors gained, led by healthcare and consumer discretionary, while information technology lagged. Financials weighed down the benchmark, off 2.3% on mixed earnings results from Canada’s banks. Shares in energy companies held up better than oil prices, which declined. The energy sector fell 1.8% and West Texas Intermediate oil plumbed the lowest level since March, ending the month down 9.2% to US$89.55 a barrel.
In welcome news, July’s annualized Consumer Price Index (CPI) inflation rate fell to 7.6% from 8.1% in June. However, Canada’s housing market is slowing. From its February 2022 peak, home sales volumes have declined 30%; nationally, home prices declined 6%. Five-year fixed mortgage rates rose above 5%. Canada's Q2 real GDP came in at an annualized 3.3%, which was 1% below expectations. Consumer services spending jumped 16.3%.
Our loonie ended August 1.2% weaker at US$0.762, or CAD$1.31. Canadian bond yields rose and the yield curve remains inverted. Two-year yields rose from 2.96% to 3.65%, while 10-year yields rose from 2.61% to 3.12%.
United States — Mixed, but hopeful
For August, the S&P 500 fell 4.2%. The energy and utilities sectors were the only gainers. Heavyweight sectors information technology and healthcare led the slide, each off about 6%. U.S. government bond yields rose and the curve remains inverted, an ominous sign of weak growth ahead. Two-year yields rose from 2.88% to 3.49%, while 10-year yields rose from 2.65% to 3.19%.
July’s annualized CPI inflation rate moderated from 9.1% in June to 8.5% for July. Consumer spending is hanging in, with “spend but don’t splurge” currently being the U.S. consumer’s mantra. Softer inflation readings were good news on top of an employment surge, continuing business investment, and more job openings. The housing market is slowing and there are warning signs about the future growth outlook. Even so, current conditions don’t support the conclusion that the U.S. is (or was, for the last two quarters) in recession. An alternate measure of economic activity, real gross domestic income (GDI versus GDP) shows expansions of 1.8% and 1.4% in Q1 and Q2, respectively, versus the ‑1.6% and ‑0.6% contractions registered by the more widely followed GDP measure.
Europe — Darkening clouds
Russia continues to restrict natural gas flows to Europe. On a positive note, refilling natural gas storage in Europe is well ahead of schedule, so the coming winter may be manageable. Electricity and natural gas prices are surging. German producer prices (a similar measure to consumer prices but for factories) were up an eye-popping 37.2% year over year.
Some of the negative outlook for Europe is already reflected in European asset prices. European large-cap equities are cheaper than their U.S. and Canadian counterparts and offer elevated dividend yields. In fact, the discount to U.S. stocks is the highest since at least 1987. The euro touched parity with the U.S. dollar in August, a level not seen since the euro debuted in 2002. Versus the Canadian dollar, the euro sits at a ten-year low.
European bond yields followed global bond yields higher; record inflation is pressuring the European Central Bank to raise interest rates. Benchmark German 10-year bund yields rose from 0.82% to 1.54%. For August, the Euro STOXX 50, German DAX, and Britain’s FTSE 100 stock market indices registered losses of 5.2%, 4.8%, and 1.9%, respectively.
Asia — Slow growth, more stimulus
Growth forecasts for China’s economy are down, but the export machine is still in full gear. The real estate sector has been in turmoil and Zero-COVID policies remain a headwind. Drought is also causing problems, and geopolitical tensions are front and centre. Nonetheless, equity markets in the region were better performers than Western markets as China increased stimulus. Beijing lowered a variety of key interest rates and announced more fiscal measures to boost the economy. For August, Japan’s equity benchmark Nikkei 225 rose 1%, while the MSCI China Equity Index gained 0.1%.
Our strategy
Given the many forces buffeting the world economy, and the resulting rapid seesawing in capital markets, our message remains clear: the most prudent course of action is to remain diversified and well balanced. This means staying reasonably close to strategic benchmarks, with some prudent tactical tweaks. Coupon income and maturing securities in our bond portfolios are being reinvested at higher yields. We believe our bond positions will provide a level of safety if a recession takes hold.
We remain slightly overweight to equities – stocks have historically weathered inflation better than other asset classes. In portfolios where it was appropriate and necessary, trading activity in August was designed to maintain a 3% overweight to North American equities. Canada’s commodity-related companies do well in inflationary environments. U.S. equity markets have historically offered relative safety in periods of weak global growth.
The last word
Fed Chair Powell’s speech emphasized that getting inflation under control early and firmly is the easier path in the long run. This echoes the thinking of Lao Tzu (which means ‘old master’), a Chinese philosopher credited with authoring the Tao Te Ching. More than 2,400 years ago he wrote, “Deal with the difficult while yet it is easy.”
Mr. Powell pointed to the multiple failed attempts in the 1970s and 1980s to lower inflation before a lengthy period of very restrictive monetary policy was ultimately needed to get the job done properly.
Today, some market watchers are speculating that inflation has already peaked. Realistically, with North American headline inflation over 7%, that number must be whittled down. Only then can we reasonably talk about central banks easing off on rate hikes.
It’s possible that central banks will pause around the 3.5% level to see how the economy reacts to rate hikes already in place. This could allow time for inflation to continue to drop toward the level of interest rates. Still, prematurely halting rate hikes is risky business. The longer inflation persists, the bigger a problem it becomes. As Lao Tzu observed, “The great (problems) of the world must be dealt with while they are yet small.
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.
You should not act or rely on the information contained in this publication without seeking the advice of an appropriate professional advisor.
BMO Private Wealth is a brand name for a business group consisting of Bank of Montreal and certain of its affiliates in providing private wealth management products and services. Not all products and services are offered by all legal entities within BMO Private Wealth. Banking services are offered through Bank of Montreal. Investment management, wealth planning, tax planning and philanthropy planning services are offered through BMO Nesbitt Burns Inc. and BMO Private Investment Counsel Inc. Estate, trust, and custodial services are offered through BMO Trust Company. BMO Private Wealth legal entities do not offer tax advice. BMO Trust Company and BMO Bank of Montreal are Members of CDIC.
®Registered trademark of Bank of Montreal, used under license.
