“It isn’t enough to talk about peace. One must believe in it. And it isn’t enough to believe in it. One must work at it."
– Eleanor Roosevelt, U.S. First Lady, activist and diplomat
October marked a third consecutive month of equity market declines. The month began with horrific developments in Israel and Gaza, which added to the ongoing tragedy in Ukraine and other fraught geopolitical situations. Economic growth outside the United States is slow. However, the U.S. economy is running very hot, causing bond yields to keep climbing.
That prompted our headline this month: The Trouble with Five.
We’re facing a trifecta of 5% readings for key U.S. metrics. First, the Federal Reserve’s funds rate (which effectively dictates the cost of money in the U.S. economy) sits at 5.5%. Next, U.S. government bond yields for 10- and 30-year debt crested 5% during the month (the highest level for the 10-year yield in 16 years). These yields are the benchmark for borrowing costs for corporations and households. And last, U.S. real GDP clocked in at a 4.9% annualized rate (we’re rounding up) for the third quarter – a level capital markets and the Fed regard as too hot. An overheated economy means interest rates will remain elevated longer than previously thought.
The U.S. is the only country where bond yields face upward pressure thanks to robust economic fundamentals. For our neighbours to the south, the combination of strong real growth, exceptionally resilient consumer spending, a tight labour market, a manufacturing construction boom, and hefty deficit spending by the government all indicate that yields (along with interest rates) will need to stay higher for longer. It’s our view that higher-for-longer yields will eventually slow U.S. economic growth as consumers, businesses, and governments feel the pinch of the end of free money. For now, all three continue to spend – especially Uncle Sam – stoking fears that inflation will stay elevated, and the Fed will need to raise interest rates even higher or keep them higher for longer.
The unfortunate reality is that U.S. interest rates set the tone for global interest rates and bond yields. Most everywhere else in the world economic growth is faltering and inflation is falling (surprisingly fast in some areas). October numbers on annual European consumer prices (CPI) came in much lower than anticipated: they fell from 4.3% to 2.9%. China is experiencing outright deflation. Canadian inflation remains elevated, but CPI declined 0.1% for September, causing the annual rate to fall from 4% to 3.8%. Canadian bond yields bucked the U.S. trend (a rarity). Lower Canadian yields led the FTSE Canada Universe Bond Index to post a monthly gain of 0.4%. The divergence in U.S. and Canadian bond yields weighed heavily on the Canadian dollar. It fell 2.2% on the month to US$0.721, or C$1.388 per U.S. dollar.
Economic themes
The goal is lower inflation, allowing central banks to loosen monetary policy before economic growth cools too much. Outside the U.S. (Britain being an exception), central bankers are seeing ample evidence that their current high-interest policies are slowing growth and inflation.
A number of key questions remain unanswered. Will torrid U.S. economic growth persist? If so, will that keep the word economy afloat? Can the world economy stay afloat while it waits for the U.S. economy to slow, paving the way for interest rates to ease somewhat? For Canada, the answer to these questions should be yes. However, recent data cast some doubt.
Typically, Canadian and U.S. GDP growth track very closely, but this hasn’t been the case lately. U.S. growth approaching 5% in Q3 contrasts sharply to projected flatlined growth in Canada. The 30 years before COVID saw only two quarters when U.S. growth exceeded Canada’s by such a large margin. Moreover, this was not a single-quarter fluke. The U.S. economy has expanded 2.9% year over year, while our Q3 estimate shows Canadian GDP up a meagre 0.6%. A yearly gap of more than 2% is at the upper boundary of normal over the last 60 years.
Two apparent reasons impact the divergence: high Canadian household indebtedness and lower government spending. Canadian households are more sensitive to higher borrowing costs than U.S. households (due to legacy and structural differences in housing markets). Canadian consumers are now keeping their wallets in their pockets. Year over year, U.S. real consumer spending rose 2.4%, while Canadian real spending climbed a modest 1.6%.
In government spending, Washington tops Ottawa. The latest numbers peg the U.S. deficit widening to US$1.7 trillion, or more than 6% of GDP. Meanwhile, Ottawa’s deficit landed (surprisingly) below forecast at C$35.3 billion, or 1.3% of GDP (down from 3.6% the prior year). Mild fiscal policy tightening in the face of full employment and inflation is the textbook and more prudent path. U.S. fiscal largesse is causing the Fed to go higher or longer (or both) on interest rates than it otherwise would. For now, government largesse has juiced U.S. growth and, by extension, the U.S. dollar. Yet, the costs negatively impact all other countries via a higher-for-longer rate environment.
Capital market themes
Slowing growth and retreating inflation are the intended and expected outcomes of tightening monetary policy. This was never going to be easy for equity and bond markets. Yet, 22 months into the process, we are closer to the end than the beginning. While we see the sharp upward movement in U.S. bond yields as the primary driver of weakness in equity markets since July, other factors bear mentioning. The Israel-Hamas war is a clear risk-off event, as are risks of a U.S. government shutdown and dysfunction around replacing the speaker of the U.S. House of Representatives. All of this is happening in early autumn, a period when stocks have historically been fragile.
For capital markets, the most pressing and enduring of these issues is the prospect of higher-for-longer bond yields. However, we may have already achieved the higher part of higher for longer. All major central banks paused rate hikes in their most recent meetings. In addition, U.S. 10-year bond yields did not remain above 5%, turning abruptly lower after the initial crest.
The recent pullback is officially in correction territory for the S&P 500 Index (down 10% from the recent peak). Pullbacks and corrections are not unusual; equity investors should expect them roughly every eight to 18 months. For the S&P 500, this is the first correction in a year, but earlier in 2023 we twice saw declines of more than 7%. Stepping back from these normal declines, the S&P 500 is up 17% from last year’s low and 8% in 2023.
Uncharacteristically, the S&P/TSX Composite Index hasn’t been buffeted by the same level of volatility. It’s stuck in a trading range that saw no bear market in 2022 and no 10% correction over the last year. Boring isn’t so beautiful considering the S&P/TSX is down 2.6% for the year. As we noted in last month’s commentary, both markets on a total return basis in Canadian dollars are within striking distance of recouping all the losses associated with this market turbulence that began 22 months ago. They are just taking different paths to get there.
Higher-for-longer yields aren’t as much about inflation anymore. They’re about strong real economic growth, the kind of growth that leads to better-than-expected corporate earnings, which is precisely what is happening. Current quarter S&P 500 earnings growth is running at 2.5%, better than the forecast decline of 5%. S&P/TSX earnings are beating expectations by 9%, but that still leaves them down 2.5% versus last year. Encouragingly, 2024 earnings growth expectations sit in the 7% to 10% range.
Regional equity market recap
Declines in regional equity markets were tightly grouped in the 3% range. For the month, the S&P/TSX Composite Index fell 3.4%, the S&P 500 Index fell 2.2%, the NASDAQ Composite fell 2.8%, the European Stoxx 50 Equity Index fell 2.7%, Japan’s Nikkei 225 Equity Index fell 3.1%, and the MSCI China Equity Index fell 4.4%.
Our Strategy
In October, we reduced our exposure to high yield bonds. To date this year, high yield bonds (loans to companies with lower credit ratings) have held up well in the face of rising government bond yields, shrinking profit margins and a corporate earnings recession. However, tighter credit conditions and a slower-for-longer economy are not ideal for high-yield borrowers. Companies are buffered by the fact that they borrowed heavily at advantageous interest rates before yields began rising sharply in 2021. Those bonds will need refinancing. Looking ahead to 2024 and beyond, this “maturity wall’ presents a risk for them.
Proceeds from our sale of high yield bonds were deployed into higher quality corporate, provincial and government bonds. This reduces our overall risk profile, but only at the margin. This trade is more about relative value within fixed income than a shift in our overall risk stance.
We remain exposed to risk assets through our equity overweight to North American stock markets. Equities provide a hedge to inflation, and they are always levered to growth – two scenarios we see more likely than a recession. The ugly scenario is one where growth and inflation fall too much. Should that scenario unfold, we expect bond yields to fall, and our fixed income positions to deliver sizeable 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) subside, higher borrowing costs curb enthusiasm for government spending, and inflation continues to cool. Bond yields will then have room to stabilize or retreat slightly. This scenario may take several months to unfold. 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. The patience and fortitude of balanced investors are currently being tested; however, the seeds are currently being sown to reap the reward of a solid, inflation-adjusted (and tax-preferential) investment return.
The last word – Peace requires belief and effort
The human toll in both the Middle East and Ukraine is heartbreaking. While these events have contributed to short-term bond and stock volatility, exogenous shocks like these tend not to have a long-lasting impact on the markets. By far the most important drivers of financial asset returns are the economic cycle and interest rates.
This isn’t merely our opinion. We follow the data and rely on the weight of historical evidence to form our best judgments about the future. Researchers looked at the S&P 500 market reaction to 25 of the most significant geopolitical crises since World War II. On average, the S&P 500 dropped by about 4%, reaching bottom in 15 days but recovering fully in 33 days. In other research going back to 1940, the median downdraft was 2% in the month leading up to a geopolitical event, followed by a 10% gain in the subsequent year.
Assets most sensitive to a geopolitical flare-up are U.S. bond yields, gold, and the U.S. dollar. Because it’s the Middle East, oil prices are also a key factor. Recent price movements for these assets suggest market sentiment leans toward caution, not extreme worry that the conflict will spread. After a brief spike in oil prices and a flight-to-safety retreat for bond yields, oil ended the month 11% lower, and U.S. bond yields higher – contrary to the expected reaction. Gold has risen 8% since the attacks, but the U.S. dollar was flat for October, ending three months of strength. If there were a greater worry, these perceived safe-haven assets would likely show more strength.
We are monitoring the situation and potential economic and market fallout. Evidence from dozens of past events is clear: in the vast majority of cases, a negative initial reaction is followed by a recovery. As always, we strongly recommend against overreacting to current volatility. The key is maintaining a well-diversified portfolio, including cash, bonds, high quality stocks and, if applicable, select alternative investment strategies.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
