There are three kinds of lies: lies, damned lies, and statistics.”
― Mark Twain, 1907, attributed to Benjamin Disraeli, 19th century British Prime Minister
September saw both stocks and bonds decline, reinforcing its reputation as an ugly month for investors. Going back to 1950, anxiety has been justified. This year, September was a disappointing end to a disappointing Q3.
July’s roaring gains for equity markets seem like a distant, fond memory. Weakness in August accelerated in September and sunk the quarter. All three months in Q3 were losers for the bond market, culminating in a 3.9% quarterly decline for the FTSE Canada Universe Bond Index. This year’s first-half gain of 2.5% dwindled into a year-to-date loss of 1.5%. However, the bond market has pockets of positive performance. Canadian investment-grade and high-yield corporate bonds are up 0.7% and 4%, respectively, year to date. Our portfolios hold positions in these assets.
Tandem declines for stocks and bonds feel like a nasty flashback to 2022. But some perspective might help here. The decline’s magnitude is actually much smaller – it's just a single quarter – and the overall situation is less precarious than it was in 2022. Year-to-date gains in most equity markets (including reinvested dividends) remain positive on a total-return basis.
Regional equity market recap
The S&P 500 Index fell 4.9% for September, down 3.7% for Q3, but remains up 11.7% for the year. The European Stoxx 50 Equity Index fell 2.9% for September, 5.1% for Q3, yet remains up 10% for the year. Japan's Nikkei 225 Equity Index fell 2.4% in September, 4% for Q3 and remains up 22.1% for the year. Canada is a laggard in performance for the year, yet the benchmark S&P/TSX Composite Index outperformed the S&P 500 in September and Q3. It fell 3.7% on the month, and 3.1% for Q3 but remains up 0.8% year to date. Add in dividends and the year-to-date total return climbs to 3.4%.
Many clients are frustrated because they believe Canadian equities have been underperforming. It is important to take a step back and look at the broader picture. Since January of 2022, when most equity markets last sat at all-time highs, the S&P 500, S&P/TSX Composite and MSCI EAFE (international developed stocks, excluding the U.S. and Canada) indices on a total return basis are all running neck and neck – $100 Canadian invested in any one of them at the beginning of 2022, today sits between $97 and $99. This is generously described as a flat return. These results are better than feared, given the excesses and imbalances the economy and markets have been forced to navigate.
Economic themes
Overall, the main question for the economy remains whether deliberately slowing growth to quell inflation will produce a soft landing, hard landing or no landing (the economy runs hot and inflation lingers). The jury is still out. When we deliberately slow the economy in order to tamp down inflation, we are intentionally forcing the economy’s growth rate to shrink. As growth rates get closer to zero, much like when an airplane gets closer to the ground when it lands, turbulence increases. It’s caused by more crosswinds and updrafts versus smoother air of high altitudes. We are currently experiencing market turbulence, buffeted by substantial crosswinds and updrafts.
The known crosswinds are higher borrowing costs and depleted household savings, factors that hamper economic growth. Growth is diverging across the globe. The U.S. economy appears resilient, but is not immune. Canada is slowing, Europe has hit stall speed and China remains stuck on the tarmac. The updrafts are labour unrest and higher oil prices. In the U.S., add the turbulence associated with the politics of funding the government and the return of student loan repayments.
We have been in the soft-landing camp from the get-go. Our concerns are increasing, however, with crosswinds and updrafts swirling. Yet, dire outcomes are not inevitable. Central bankers have options. If growth falters and turbulence turns into a bumpy landing, we believe it will be a short-lived situation. Central bankers would abruptly pivot and begin cutting rates. The best case is a continued orderly retreat of inflation. There is ample evidence to support each camp’s argument – inflation resumes its downward trend or remains stubbornly sticky. We simply need more time to tell.
Fixed income market outlook
Only three possible scenarios can unfold for the bond market: yields go higher; they stay flat; or they fall. So far, it has been a case of yields moving higher, which has been painful. In Q3, bond yields moved substantially higher. Canadian 10-year bond yields jumped from 3.27% to 4.02% and U.S. 10-year yields went from 3.84% to 4.57%. The move higher in the third quarter was less about inflation and more about a move up in real yields. Real yields move for various reasons, but an important one is their close correlation to real economic growth.
Here the U.S. is driving the bus and all other countries are simply hanging off the bumper. U.S. growth remains strong, and inflation is behaving better than most everywhere else. Another important driver of real yields is the supply and demand of government bonds. Again, the U.S. is leading the charge. While most Western governments face large deficits, the U.S. budget deficit is ballooning (it’s not helpful that they are arguing over the debt ceiling). These two forces (one good, one bad) both pressure yields higher. With U.S. bond yields higher, unfortunately the rest of the world generally must follow suit. However, central banks appear very close to ending their rate-hiking campaigns (Canadian, U.S. and U.K. central banks all paused in September), and inflation is well off its highs. We believe the end of rising bond yields is approaching.
If yields stay flat (higher for longer), that delivers higher income for longer – a positive for bond investors. Should yields retreat, the pain of getting to higher yields is like compressing a coiled spring: the elastic energy releases in the form of higher bond prices, delivering capital gains to investors.
Bond yields fall in two ways – one good and one bad. The good: inflation retreats, allowing central banks to gently lower interest rates; bond yields would also head lower and everybody wins. The bad: the economy unravels and central banks quickly cut interest rates to stave off rising unemployment and recession. In the bad scenario, bond investors win, but the economy loses in the short term. Victory over inflation would be a silver lining.
Previous episodes of adjustment in capital markets lacked something we do have today: cash and bonds are yielding ~5%. Looking ahead, two of the three scenarios for bonds are positive outcomes.
Equity market outlook
If we need interest rates to stay higher for longer, that likely spells slower-for-longer economic growth (assuming the economy avoids recession). When economic growth is low, investors fret that any shock or misstep could send the economy into contraction. A contracting economy is bad for corporate earnings (the pie is smaller). Also bad for corporate earnings are things that eat into profit margins (how much companies can wring out of the pie). Companies currently face higher costs for borrowing, labour, and energy. Profit margins have come down, but that has in part led to lower inflation.
Even though corporate earnings growth is coming in better than expected, we haven’t had earnings growth for five quarters (it was expected to be much worse). This represents the fourth earnings slump since 2009. Earnings slumps are a normal part of the business cycle. It will pass. The previous earnings recessions and sideways returns for equity markets ranged in duration from four to seven quarters and all featured heightened volatility. We’ve had five quarters of earnings slump, so we are past the shortest ones and more than halfway through the longest ones.
Even if we have a mild recession, equities may fare okay if investors take the victory over inflation as a signal to act.
Looking forward, there is still some work to do to overcome various obstacles, but stock and bond markets are setting the stage for better results ahead. Once inflation is closer to being tamed, businesses and households will be poised to benefit from lower borrowing costs and easing price increases. This is a fertile environment for stocks, especially when accompanied by mostly reasonable equity market valuations like we have now. With 2024 earnings growth forecast at roughly 10% in North America, stock markets have room to make additional advances in the coming year. September's declines are padding our forward return forecasts.
Our strategy – Balanced, with an equity bias
Predicting inflation is exceptionally hard. Anyone who doesn’t admit that there are wide-ranging possible outcomes for growth and inflation is asking for trouble. Returning to the aircraft analogy, turbulence is an aggravating nuisance for everybody, including pilots and crew, but it’s also normal. In turbulent times, it’s imperative to remain alert, with all hands on deck, all eyes on the controls, and two hands on the yoke. For us, this means sticking to our strategy of remaining balanced and always well diversified, with a keen eye for risks and opportunities. We are maintaining portfolios within acceptable medium-term targets, staying relatively close to our strategic benchmarks.
Given the increase in medium-term bond yields, we have shifted some of our bond positions to take advantage of these movements (lengthening duration). Shorter-term bond yields continue to offer slightly higher yields, but the trade-off isn’t as large as it was earlier this year. Buying some longer-term bonds locks in the higher yields available today that may not be available down the road. Additionally, longer-term bonds will deliver superior gains in a scenario of declining interest rates. These moves are measured and incremental.
Overall, in our broadest representative portfolios, we remain overweight equities, specifically Canadian and U.S. equities. We are neutral weight to international developed markets (Europe and Japan) and Emerging Markets.
The last word – Inflation was never going down in a straight line
Inflation has come down significantly over the last year. In Canada and the U.S., it peaked in the 8% to 9% range and has fallen to around 3% or 4%. The months ahead will be bumpy for Canada; last autumn’s soft inflation readings already set that stage. After one of history's most aggressive cycles of interest-rate hikes, central banks now need to exercise patience.
During August and September, the downward trend of some inflation metrics stalled, garnering outsized attention from market watchers. We need to remember that inflation itself is not the disease; it is a symptom and part of the cure. Inflation is too much money chasing too few goods and services. High prices are part of the cure for high prices; they curb demand and incentivize fresh supply, creating a new equilibrium.
The quote made famous by Mark Twain implies that statistics are deliberately distorted, a sin highlighted as worse than lying. In fact, statistics are just numbers, open to interpretation that must be filtered through human biases, conscious and unconscious. Blame not the statistic; blame the interpretation.
Measuring inflation involves tracking prices of many goods and services. Looking at inflation in a variety of ways, removing some items and trying to smooth out the data is not lying; it is a rational way to treat such a critical but volatile statistic. On top of these objective measures of inflation, you can ask people’s opinions about prices. Then even more bias enters the public narrative. Inflation measures are also ripe for misuse in the hands of posturing politicians and agenda-driven media. Perhaps that is the sin worse than lying.
One way or another, inflation will be tamed. We think this can happen faster than the current zeitgeist is forecasting. Or, getting a handle on inflation could simply take more time. This does not automatically equate to Armageddon or even unrelenting investment losses. Investors can make gains through periods of inflation; it’s just a little more challenging. After inflation, (real) returns might be lighter for a time, but that's not a foregone conclusion, either. Inflation is complex. The statistics might be crude, but we must work with what we’ve got. That doesn't make them lies.
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