Welcome to another installment of our monthly market commentary. It's November the 3rd, 2023. I'm Brent Joyce, Chief Investment Strategist for BMO Private Investment Counsel. Thanks for taking the time to join us.
October marked the third consecutive month of equity market declines, and certainly the month was marred by horrific developments in Israel and Gaza. Those are adding to the ongoing tragedy in the Ukraine. But it was really too hot economic growth in the United States, causing bond yields to keep climbing, that has markets most upset.
U.S. real GDP clocked in at 4.9% annualized rate for the third quarter. That's a level that capital markets and the U.S. Federal Reserve will regard as too hot. An overheated economy suggests interest rates need to remain elevated longer than previously thought.
Outside the U.S., economic growth and inflation are cooling. European, Canadian, and Chinese inflation all surprised to the downside, and growth is weak in these places too. The U.S. is the only place where bond yields face upward pressure thanks to robust economic growth. That growth is driven by a resilient consumer, a manufacturing construction boom, and heavy deficit spending by the U.S. government.
Now, spending by Uncle Sam is particularly concerning. It's juiced the U.S. economy, and by extension, the U.S. dollar. Excessive fiscal largesse in an economy with full employment and solid growth is certainly not the textbook definition of what's prudent. The U.S. Federal Reserve agrees, and this may lead the Fed to go higher or longer or both than it otherwise would on interest rates.
Yet the unfortunate reality is that U.S. interest rates set the tone for global interest rates and bond yields. Now, higher for longer might be appropriate and bearable for now for the U.S. economy, but with economic growth faltering and inflation falling most everywhere else in the world, it risks seeing bond yields and interest rates in all other countries higher for longer than may be necessary. Now, this could lead to growth and inflation falling too much. So the U.S.'s soft landing or perhaps no landing (inflation and economic growth remain high) may drive a bumpier landing elsewhere.
The good news is there are signs that the road ahead sees inflation and growth cool in the U.S., as it is elsewhere. So the race is on to see if the world economy can stay afloat while it waits for the U.S. economy to slow, paving the way for interest rates to ease somewhat.
What does this mean for stocks and bonds? Slowing growth and retreating inflation are the intended and expected outcomes of tightening monetary policy. This was never going to be easy for equity markets or bond markets. But we're 22 months into the process. We certainly believe that we are closer to the end than the beginning. In fact, we may have already achieved the higher part of higher for longer for bond yields. All major central banks have paused rate hikes in their most recent meetings. Additionally, the U.S. 10 year bond yield, the bellwether for the U.S. market, it crested above 5%, but it did not remain there. It abruptly turned lower after that initial crest.
Additionally, higher for longer yields isn't much about inflation anymore. It's about strong real economic growth. The kind of growth that leads to better than expected corporate earnings, which is precisely what is happening. Looking out to 2024, earnings growth expectations sit in the 7% to 10% range. Earnings growth is the lifeblood of equity market gains.
Our base case scenario sees stock markets recover from recent weakness. This will happen when fear and risk aversion driven by politics and geopolitics subsides. Higher borrowing costs curb enthusiasm for government spending and inflation continues to cool. Bond yields will then have room to stabilize or retreat. This scenario may take several months to unfold, but when it does, it has the potential to deliver equity returns in the low to mid-teens and bond returns in the mid-single digits.
As far as the impact of conflict and war, evidence from dozens of prior events is clear. In the vast majority of cases, markets experience a negative initial reaction, which is then followed by a recovery. As always, we strongly recommend against overreacting to the current volatility. The key is maintaining a well-diversified portfolio including cash, bonds, high quality stocks, and selected alternative investment strategies.
The recent pullback in stocks is now officially in correction territory for the S&P 500. That's down 10% from the recent peak. Pullbacks in corrections are not unusual. Equity investors should expect them roughly every 8 to 18 months. For the S&P 500, this is the first correction in a year, but earlier in 2023, we did have two declines in the 7% range. Stepping back from these normal declines, the S&P 500 is up 17% from last year's October low and 8% so far in 2023.
As for Canadian stocks, they didn't go down as much last year, but haven't gone up as much this year either. The bottom line remains, an investment in both markets over the 22 months since this market turbulence started are both still below the highwater marks, but on a total return basis, that loss is less than 5% for either market.
Now, that's investment results for the past 22 months that certainly have been disappointing, and it's testing the patience and fortitude of investors. However, imbalances in the economy are being worked off, and these are sowing the seeds to reap the reward of a solid inflation adjusted and tax preferential investment return as we move forward.
That's our market outlook for the month of October, 2023. Thanks for joining us. We'll see you next time.
