"Humankind cannot bear very much reality.”
― T. S. Eliot, Four Quartets
August brought a reality check to global capital markets as rip-roaring stock market gains took a breather. All major global equity markets fell in August, with losses in the 1.5% to 4% range. Chinese equities were harder hit, declining 8.5%. Global bond markets ended the month essentially flat.
A variety of factors drove the volatility: rising real bond yields; debt-rating downgrades for several U.S. banks; a ding to Uncle Sam’s once-perfect credit rating; ballooning U.S. debt issuance; and continuing global growth woes, especially in China.
With rising real yields (a real yield is the yield on a bond after adjusting for inflation) being the main culprit, the month saw weakness for both stocks and bonds (bond prices and yields move in opposite directions). Some softer economic readings at month-end triggered a retreat for real yields, ushering in a rally where prices for stocks and bonds clawed back most of the mid-month losses.
Rising real bond yields is not a new phenomenon; they had climbed from negative levels during the pandemic into the 1.5% range as early as last fall. However, markets were spooked into a sell-off when North American real yields ventured into 2% territory, a situation we had not seen since 2009. Because one part of a real yield reflects a healthy economy, we probably wouldn’t see this rise in real yields (above 2%) if markets didn’t expect the U.S. economy to keep humming along.
The rest of the story isn’t so rosy and is all about U.S. debt over-supply and under-demand. The U.S. Treasury announced a heavier-than-expected debt issuance schedule to fund the ballooning U.S. budget deficit, which has grown to more than $2 trillion in a year. Interest costs recently hit 14% of tax revenues, a figure that has historically forced governments to embrace some austerity (although this message has yet to reach Ottawa or Washington). A day later, major credit rating agency Fitch downgraded the U.S. to AA+ from AAA, citing concerns over the nation’s mounting debt and apathy toward reining it in.
On the demand side, central banks aren't just raising interest rates – they are also selling government bonds they had previously purchased. This requires finding buyers for both new and old government bonds. Foreign appetite for U.S. debt isn’t what it used to be. Russia has essentially cut its holdings of Treasuries to nil, and China has reduced its holdings by about a quarter since early 2021. Japan, the largest holder of U.S. debt, trimmed its exposure by 10% in the past year. In addition, the Bank of Japan has recently let bond yields go higher, making Japanese government bonds slightly more attractive.
Bond yields have been rising since last year, negatively impacting many assets. When the real yield component increases, the impacts are more acute. Any reason that sends bond yields higher (real or inflation) is bad news for investors who already own bonds. Higher yields will eventually repair the damage, but that takes time.
For stocks, rising yields pose several problems. Most companies borrow, so higher interest costs eat into corporate profits. Additionally, stocks are valued based on their ability to generate profits. A share of a company is perpetual ownership of a company's future earnings growth. Today's share price reflects that earnings stream's discounted present value. Calculating that present value requires a discount rate, which is derived from prevailing bond yields. Mathematically, the higher the discount rate, the lower the current share price.
If bond yields are higher on inflation alone, stocks have a fighting chance – the earnings stream is expected to grow with inflation (if companies aren't raising prices, inflation doesn’t happen). However, stocks have less defence if yields rise due to rising real yields.
Lastly, higher real bond yields are more attractive to investors than higher yields simply due to inflation. After all, earning more from a bond only to see that return eaten up by inflation isn't “real”; there is no tangible change to an investor’s purchasing power. Ultimately, real returns are what should matter most to investors.
Stocks are also real assets; however, with higher real returns on offer from bonds, stocks face stiffer competition for investors’ money. Stocks used to benefit from TINA (There Is No Alternative); her sister TIAA is now in town (There Is An Alternative).
On the bright side, corporate earnings growth is coming in better than expected. Looking ahead to 2024, the outlook is improved. Earnings growth is forecast around 10% in North America. We see August’s low, single-digit reality check in equity markets as a healthy and normal consolidation of the year’s gains. Stock markets have room to make additional advances in the year ahead. And higher bond yields mean better forward-looking prospects for the bond market.
Canada – Still standing
The S&P/TSX Composite fell 1.6% in August. The Canadian economy, buffeted by fires, strikes, and the impact of higher borrowing costs, is showing signs of weakness – not collapse. We’re still standing. The 0.2% annualized dip in Q2 activity was a shocker because consensus expected a 1.2% advance. Quarterly declines aren’t that rare: GDP also surprisingly dipped in Q4 last year. BMO Economics sees this stop-start pattern continuing in coming quarters, yet still pegs real growth at 1.1% for all of 2023.
Inflation’s yearly rate rose 0.3% to 3.3%, while core measures were unchanged at 3.6% and 3.7%. Retail sales grew, lifted by autos. The housing market is stabilizing; sales and new listings are roughly back to pre-COVID norms. Benchmark housing prices remain off 10% from peak early-2022 levels, but have rebounded just under 7% from their March 2023 lows. We expect this mix of data to cement the end of Bank of Canada rate hikes.
The price of West Texas Intermediate oil rose 2.2% to US$83.60 a barrel; the loonie fell 2.4% to US$0.740, or C$1.351 per U.S. dollar on broad-based U.S. dollar strength. Canadian bond yields were little changed; the 2-year yield closed at 4.64%, and the 10-year yield at 3.56%, leaving the FTSE Canada Universe Bond Index down 0.2%.
United States – Still strong
U.S. equities pulled back only modestly. Equity markets recovered at month-end from a near 5% mid-month decline thanks to better-than-expected earnings growth, a solid economy, and some early validation of the AI phenomenon (AI chipmaker NVIDIA posted eye-popping earnings growth). For August, the S&P 500 and the NASDAQ fell 1.8% and 2.2%, respectively; the Russell 2000 Index of smaller companies was down 5.2%, giving back most of July’s gains.
Even though the U.S. economy remains resilient, driven by exceptional strength from consumers, there are pockets of weakness. Manufacturing activity was in contraction for a ninth straight month – but numbers aren’t worsening. The services sector remains in expansion territory – but is weakening. Even the labour market is starting to loosen-up as more people enter the work force, while wage growth is less robust. This is exactly the sort of softness that rate hikes by the U.S. Federal Reserve (the Fed) are meant to deliver. Annual headline CPI inflation rose (slightly) from 3.0% to 3.2% – but annual core inflation was down a bit to 4.7%. The data are still sending mixed signals, making it unclear what the Fed will do next. Markets think one more rate hike may come this year, although not at September’s meeting. We think the Fed is done. U.S. 2-year government bond yields fell from 4.88% to 4.86%, and 10-year yields rose from 3.96% to 4.11%.
Europe – Still flat
Although European GDP growth is bouncing back slightly, it’s likely not the beginning of a sustained rebound. Forward-looking measures of business activity remain in contraction territory. Employment growth is slowing yet remains consistent with a solid labour market.
Germany, the region's economic engine, remains sluggish; the economy was flat in Q2, ending two quarters of decline. German consumer spending was also flat, and exports marked the second drop in the last three quarters. European headline inflation held steady in August at 5.3%, while core inflation fell 0.2% to 5.3% as expected. The European Central Bank is caught between high inflation and a sluggish economy; we believe it will pause rate hikes at its September 14 meeting. The Euro Stoxx 50, German Dax, and U.K. FTSE 100 fell 3.9%, 3.0%, and 3.4%, respectively.
Asia – Still weak
Further signs of weak economic growth in China weighed on global equity markets. Not surprisingly, the declines hit Chinese markets hardest; the MSCI China Index fell 8.5% in August. Data suggest that growth remains lacklustre, mostly thanks to the drag from the embattled property sector and resulting weak confidence. However, signs of stabilization are visible. Notably, authorities are rapidly and forcefully increasing fiscal and monetary stimulus. Despite the fact that the U.S. and China continue to exchange barbs on trade, the U.S. Secretary of State’s visit ended with some encouraging signs. Now that the level of angst seems overly pessimistic (all three August issues of The Economist featured negative China cover stories), the question is how much of the bad news is reflected in asset prices? The negativity toward Chinese assets has discounted prices so much that we are keeping a close eye – mindful of Warren Buffet’s sage advice to be greedy when others are fearful. While increasing our investments in Chinese assets is tempting, given the unpredictable geopolitical situation, we are monitoring our positions as we temper our actions.
Japanese equities followed global weakness; the Nikkei 225 Stock Index fell 1.7%. Inflation seems to be cooling a little, although the decision to let 10-year bond yields rise is rippling through global bond markets.
Our strategy – Balanced, with an equity bias
Our portfolios remain well balanced. With asset-class performance in August volatile yet finishing the month fairly flat, our asset mix remains within acceptable medium-term targets. In some portfolios, we plan to increase equity overweights toward our desired targets.
Overall, in our broadest representative portfolios, we are overweight Canadian and U.S. equities, and neutral weight to international developed markets (Europe and Japan) plus emerging markets.
The current yield from our well-diversified bond positions is increasing as yields rise. There is enough income coursing through portfolios that increases in bond yields dent rather than crush total fixed-income returns. The higher yields go, the greater protection they offer if the economy slows.
The last word – Positive real yields are normal and welcome
Modestly positive real yields should be welcomed, not feared. A simple yet elegant view of longer-term bond yields suggests that they are the sum of inflation and real economic growth. For example, if inflation runs at 2% and real GDP runs at 2%, long-bond yields should find a natural equilibrium at 4%. Long-bond yields are currently cresting 4% in the U.S. (about 3.5% in Canada). That is a rebalance from where they have sat over the last decade – when low inflation and subpar economic growth combined to deliver long-bond yields that averaged below 2.5% in the U.S. and below 2% in Canada.
Bond yields are the price of money, which shouldn't be free. Humanity wastes resources when they are cheap; money is no exception. Higher real yields reward savers. They also curb profligate government spending and impose discipline when households and businesses are making investment and spending decisions. By August’s end, real yields had retreated to 1.85%. For now, it appears that 2% was too much to handle. As T.S. Eliot said, “Humankind cannot bear very much reality.”
The pain of adjusting to higher real yields is a finite event – it will pass. We are seeing positive signs. Inflation continues to trend lower, and productivity is perking up (in the U.S. now, likely followed by other economies). This increase in real yields sets the stage for a healthier economic and investing landscape ahead.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
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