“The two most powerful warriors are patience and time.”
Leo Tolstoy, War and Peace
In last month’s commentary, we said that January’s upswing for stocks and bonds might have been overly and prematurely optimistic. February made good on that statement.
Although 2023 got off to a roaring start, global equity and bond markets were weak last month. For stocks, February’s shallow decline dented but didn’t erase handsome year-to-date gains. Bond yields have reversed their earlier-year decline, which pressured bond prices. But, thanks to the now-decent level of income flowing from bonds, year-to-date gains remain in the green.
February’s U-turn can be broken down into three factors: a giveback of some of January’s overshoot; an adjustment to the reality of new data; and now, perhaps, an overshoot in the other direction. If January’s zeitgeist was too optimistic, we believe February’s narrative was too dire. We expect this flip-flop volatility to persist. When the path forward is uncertain, investors tend to overreact to near-term data.
Overreactions aside, incoming data indicate that the future remains unclear. A month ago, market sentiment was buoyed by hopes that economic growth would gently slow and inflation would weaken in an orderly fashion. Market watchers described this as “immaculate disinflation.” In other words, we would see a soft landing (inflation falls, inflicting only minor economic pain). The opposite would be a hard landing – inflation so persistent that only a deep recession could cool it.
February's data saw hotter-than-expected global inflation (Canada excepted), robust consumer income and spending, better-than-expected economic growth (especially in Europe), and blowout employment numbers in the U.S. and Canada. Bond yields responded by moving sharply higher. Based on these latest readings alone, central banks would need to keep raising interest rates to bring inflation under control.
February’s surprisingly robust economic data prompted market watchers to consider a third option – “no landing,” a scenario in which the economy runs hot, and inflation lingers. It is unclear how “no landing” might end. Some suggest it means a harder landing later; barring adjustments elsewhere, this is likely true.
However, the “no landing” scenario buys time. Even the most pessimistic recession forecasters are revising their views on when a recession will hit. Last year they said Q4, then it became Q1 2023, and now some have pushed that out to 2024.
In many areas of life, time can be a friend. With commodity prices falling and supply chains recovering, wage growth is the lone focus of the world’s inflation concerns. If “no landing” means the economy cruises below potential for a while, this provides labour markets time to adjust (workers laid off in one industry find employment elsewhere, immigration helps fill the gap).
This scenario has spawned another new catchphrase – the “rolling recession.” Here sectors decline in turn, not all at once, and some perhaps not at all. Strength in other areas keeps the economy as a whole out of recession.
We see indications that this scenario is unfolding: mounting layoffs, weakness in housing and manufacturing, and people with lower incomes running out of savings. In addition, financial conditions are tightening (surging mortgage rates, for example), banks are pulling back on lending, and consumers are increasingly tapping their credit cards.
On the positive side, labour force participation is rising in the U.S. and Canada, yet wage growth, while still robust, continues to decline. When the main problem is a lack of workers and rising wages, these two developments are extremely important. Additionally, consumer and business balance sheets remain in good shape overall and provide a buffer to any downturn. Companies that found it challenging to hire may be hoarding workers; this also shelters the economy from the traditional recession playbook.
In our view, the odds still favour outcomes that are desirable or at least palatable for investors: a soft landing; no landing; or a rolling recession.
Canada – Realists
For February, the S&P/TSX Composite fell 2.6%, leaving it up a healthy 4.3% on the year. The Bank of Canada (BoC) has hiked rates 4.25% since last March, so it’s no surprise that the economy stalled at the end of 2022. The housing market remains weak, and businesses are dialing back their capital investments, but employment, household spending, and incomes remain strong. This leaves the overall outlook cloudy.
Inflation eased for a third month, slowing to 5.9% in January from 6.3% in December, one of the few global inflation rates to come in below economists' forecasts. The data support the BoC decision to pause rate hikes for now. However, despite the evidence and the BoC’s public defence of its pause, yields in the bond market rose alongside developments in the U.S. and fears that the overnight rate might need to move higher in the back half of 2023.
The FTSE Canada Universe Bond Index fell 2% for the month, leaving the index up 1% on the year. Canadian 2-year yields rose from 3.75% to 4.20%, and 10-year yields rose from 2.91% to 3.33%. West Texas Intermediate oil prices were down 2.3% to US$77.05 per barrel. Our dollar gave back its earlier-year gain, off 2.5% to US$0.733, or C$1.365 per U.S. dollar.
United States – Resolute
Disappointment with the speed and trajectory of U.S. inflation was the primary driver of U.S. and global equity and bond markets in February. Stubborn inflation numbers turned expectations for future U.S. Federal Reserve (the Fed) monetary policy upside down. Bond yields rose, and stock prices dropped.
For February, the S&P 500 fell 2.6%, leaving the index up 3.4% on the year. U.S. 2-year government bond yields rose from 4.20% to 4.82%, and 10-year yields went from 3.51% to 3.92%. Annualized U.S. Consumer Price Index (CPI) inflation fell to 6.4% from 6.5%, but did not achieve its expected decline to 6.2%. Other measures of inflation also disappointed.
The U.S. Personal Consumption Expenditure Core Price Index (Core PCE), a key measure the Fed watches closely, increased year over year. This development jettisoned hopes that the Fed might be almost done with rate hikes. Now the consensus view is that interest rates will likely peak at 5.4% and there will be no cuts in 2023.
The silver lining is a bond market that had previously thumbed its nose at the resolve of the Fed is now squarely aligned with the Fed's guidance. This is a reminder that if expectations can shift this much this quickly, they can certainly turn again. The Fed will factor in two upcoming inflation readings and an employment report before its next rate-decision meeting on March 22.
Europe – Reaffirmed
European equity markets continue to outperform in local currency terms. Numbers are showing that the eurozone has skirted a deep recession and the short-term outlook is improving thanks to the resiliency of European consumers. While this is good news for the economy, it doesn’t bode well for stubbornly high European inflation. There was little expectation that the European Central Bank (ECB) is close to being done hiking rates, so the bond market took this as less of an about-face and more of a reaffirmation of more rate hikes. European bond yields rose alongside their global counterparts.
For February, the Euro STOXX 50, German DAX, and U.K. FTSE 100 stock market indices posted gains of 1.8%, 1.6%, and 1.4%, respectively.
Asia – Returning
China's economy is roaring back to life. Despite “ballooning” geopolitical tensions and a shrinking population, the near-term impacts are positive for global supply chains and global growth. The decoupling of China and the West is real but not universal. Change is afoot in strategically important areas, but major Western retailers, aircraft and auto manufacturers still view the country’s enormous market as a promising long-term bet.
Sanctions against Chinese entities by the West continue to expand, with Chinese-owned social media app TikTok the latest target. Meanwhile, signals from Beijing are erratic: it is courting Western investment and businesses while urging state-owned companies to phase out use of the four biggest international accounting firms. Geopolitical fears weighed heavily in February. The MSCI China Equity Index fell 10.2%, erasing the January gain.
Japanese equity and bond markets were quiet in February. With the nomination of a new central bank governor, Japan seems ready to keep the status quo of ultra-easy monetary policy. For February, Japan's equity benchmark Nikkei 225 inched up 0.4%.
Our strategy – Balanced
Our asset-mix strategy continues to be well balanced: slightly overweight to equities and underweight to fixed income.
February’s developments highlight the tightrope that equity markets must walk. A better economic backdrop supports corporate earnings, but higher bond yields weigh on share prices via valuations. It’s encouraging that stock markets have been resilient despite the increased fear that central banks will be forced to raise rates even higher. We remain constructive on equities.
Bond yields move higher if growth looks firmer and inflation stays elevated, so February brought a larger adjustment to bonds. After raising an eyebrow at how far yields fell in January, we are now more comfortable that the bond market is appropriately priced, given the current backdrop. Our bond portfolios continue to deliver solid yields and benefit from reinvesting the coupon income and maturing securities into 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 continue to outperform, and we are adjusting accordingly.
The last word – Wild oscillations
The current environment features wide swings in the prevailing narrative, many botched forecasts and eye-popping economic data. For example, according to government labour statistics, in January half a million new jobs were created in the U.S. and 150,000 in Canada. In one month – really? These are seasonally adjusted figures and seasonal adjustment in January is notoriously quirky; post-pandemic it’s been even worse. Without seasonal adjustment, the U.S. lost 2.5 million jobs and Canada lost 125,000.
This is just one example that shows we are not in a normal business cycle. WWII, and the years immediately following, was the last time the global economy experienced anything like the last three years. We’ve seen massive global government spending to counter the devastating economic and healthcare impacts of COVID, unprecedented labour and supply disruptions, a release of pent-up consumer demand, and a year of war in Ukraine.
Wild oscillation in capital markets reflects the uncertain global economic environment. The slightest shift at the margin brings hyper-scrutiny in capital markets when global growth is slowing, profit margins are shrinking, inflation is running hot, central banks are raising interest rates, and geopolitical tensions are on the boil.
Humans are impatient and capital markets are the sum of human decisions. Our aversion to uncertainty draws us to forecasts about the future. But with so many novel and disruptive factors at play, it’s not prudent to overreact to every new release of a statistic.
Our base-case scenario that the economy will muddle through was very much in vogue in January. One short month later, some market watchers have shifted their views to the other side. We remain encouraged that households and businesses are resilient. Inflation continues to trend lower, albeit slower than we all would like. Labour markets are adjusting – it’s encouraging that the majority of jobs created were in areas with the most acute shortages. We have maintained a balanced stance in our portfolios for an extended period. This is a position of strength because it relies on the ingenuity of diversification to carry us through while the global economy adjusts and recovers from the extraordinary shocks of the last several years.
January and February have shown us two versions of the path forward. The story is still unfolding. We are watching closely but not overreacting, knowing that one month does not a trend make. As Leo Tolstoy observed in War and Peace, the two most powerful warriors are time and patience.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
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