“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
James Carville, advisor to President Bill Clinton, 1993
Politics and capitalism clashed on both sides of the world in October. Bond and currency markets took down the political leadership of the U.K., the world’s sixth-largest economy. President Xi Jinping, leader of the world’s second-largest economy, blew a hole in China’s stock market.
In the U.K., volatility in bond and currency markets forced the resignations of Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng. This proved that leaders of free and open capitalist economies are subject to fundamental laws of economics. President Xi solidified his tenure as leader. A less capitalism-friendly tone emanating from the Party Congress sent investors fleeing from Chinese stocks.
Liz Truss's historically short tenure is just a footnote. The real story is the return of a relationship between capital markets and politicians that has been dormant for a decade.
Before the 2009 financial crisis, politicians and central bankers were regularly kept in check by – or fear of – borrowing costs rising beyond their control. This is where the so- called bond vigilantes come in. They are bond traders who threaten to sell, or do sell, large amounts of bonds to signal their disapproval of the issuers’ policies. Selling bonds depresses their prices and pushes interest rates up. The term was coined in the 1980s when bond traders sold U.S. Treasury bills as backlash to the growing power of the U.S. Federal Reserve (the Fed). The ever-present threat of bond vigilantes generally prevented politicians from pursuing populist overspending/under-taxation policies and central bankers from floating easy monetary policy in the face of inflation.
Then came the 2009 financial crisis followed by the 2020 pandemic, which prompted central banks to print money while governments handed it out freely. These emergency responses were expected to spark inflation. However, for a decade, inflation didn’t happen (until now). The prolonged absence of inflation convinced many that the bond vigilantes were extinct and that free money for all was viable policy. It turns out inflation was just in hibernation, and so were the bond vigilantes.
The recent wild ride in U.K. markets and revolving doors at numbers 10 and 11 Downing Street mark the vigilantes’ return and capital markets’ critical role of imposing fiscal discipline on governments by forcing borrowing costs higher when governments embark on ill-conceived (but popular) fiscal junkets.
Capital markets and economies must adjust to the reality of high inflation, higher interest rates, less easy money, slowing growth, and increased geopolitical tensions. We see this adjustment as a return to normalcy in many cases. While the road back to normal is proving painful, normalcy is essential. Zero or negative interest rate policies are neither normal nor healthy. Interest rates are the price of money. Free money is undesirable because it distorts necessary price incentives in the economy. Cheap money coddles those who should be put out of business. It is a disincentive to innovation, hard work, and competition – all of which we should embrace as keys to progress.
Many assets and geographies have come a long way toward a return to normal. Markets look to the future; they regularly over and undershoot. We are encouraged that U.S. and Canadian stock markets, where we have our largest weights, have tested their 2022 lows three times – twice in October. Although last month was a rocky ride for many mega-cap tech stocks, it was a winning month for equities broadly. Mid-month saw a sharp rebound, generating one of the strongest rallies in more than two years; the S&P 500 climbed 8% and the S&P/TSX Composite 5.3%. Sharp rallies following selloffs are common. This is a critical and compelling reason to stay invested.
Economic data continue to be mixed. Media and politicians such as Deputy Prime Minister Chrystia Freeland and Bank of Canada (BoC) Governor Tiff Macklem are warning of recession. Yet, U.K. pension funds and volatile U.K. markets have settled down, and new British Prime Minister Rishi Sunak appears to be more pragmatic than his predecessor. U.S. midterm elections loom, and the consolidation of power in China continues to weigh.
Central banks delivered October’s most important development. After tightening financial conditions for months, central banks are now at least whispering about (overtly discussing in Canada) balancing the inflation fight against concerns over slowing growth. One year into a bear market, capital markets don’t need “good news.” Anything less bad will suffice.
Canada – First in, first out
For October, the S&P/TSX Composite gained 5.3%. Canadian equities underperformed many of their global counterparts, but since they hadn’t previously fallen as hard, they didn't need to bounce as high. Despite the BoC’s lighter-than-expected 0.5% rate increase (markets anticipated and priced in 0.75%), the loonie rose 1.5% against the greenback to US$0.734, or CAD$1.362. Higher oil prices boosted our dollar. West Texas Intermediate oil prices climbed 8.9% to US$86.53 a barrel. Oil prices rose amid fears of supply constraints as OPEC cut production targets.
The BoC rate decision saw Canadian bond yields come off their pre-announcement highs. Still, the drop wasn't enough to lift bond markets into the green. For the month, two-year Canadian yields rose from 3.79% to 3.89%, while 10-year yields rose from 3.17% to 3.25%.
Among the world’s major central banks, the BoC was one of the first to start raising interest rates (and the first to begin shrinking its bond purchase programs). Therefore, it’s not surprising that the BoC would be one of the first to content itself with a moderate rate hike. Canada has moved the farthest and fastest on interest rates while boasting one of the lowest inflation rates, currently at 6.9% (apart from Japan’s 3% rate). We are lower than Australia (7.3%), the U.S. (8.2%), Britain (10.1%), and Europe (10.7%).
Additionally, air is coming out of the Canadian housing bubble, the labour market is cooling, and households are more indebted. The BoC’s smaller move may have been unexpected but may well be what is needed.
United States – "Jay be nimble” not “Jay be quick”
For October, the S&P 500 roared ahead 8% and U.S. government bond yields continued their ascent. Two-year yields rose from 4.28% to 4.48%, while 10-year yields rose from 3.83% to 4.05%.
The annualized Consumer Price Index (CPI) inflation rate moderated from 8.3% in September to 8.2% in October, but was still higher than expected. Annual core inflation unexpectedly accelerated for a second straight month from 6.3% to 6.6%. These elevated inflation readings, coupled with more warnings and weak results from bellwether retailers, drove much of the early-month volatility.
Cracks are showing in some parts of the U.S. economy, while other areas remain resilient. Real economic growth (Q3 GDP) returned after two quarters of decline, keeping the economy above water so far for the year. Service sector prices, plus rent and home ownership costs are now driving inflation, taking over from rising goods prices as the villains. Spending on services will likely stay firm as consumers keep their wallets out, tapping their still-considerable savings. Savings will eventually dwindle, so this impetus should be less concerning to the Fed. House prices are cooling, and real-time readings on rental prices are starting to fall.
Fed Chair Jerome Powell’s aggressive rate increases (Jay be quick) need time to work through the economy. While the Fed hiked rates by 0.75% on November 2, rumours in October that Fed rate increases could slow (Jay be nimble) sent equity markets on their late-October tear. Unlike the summer rally, bond yields rose – an outcome more tolerable to a Fed trying to keep financial conditions tight.
Europe – Surprises everywhere
European inflation surprised to the upside, despite cooling energy prices. Even with Russian natural gas cut offs, European gas stockpiles are brimming and prices are down 60% from their August peak. European economic growth doubled estimates, with Q3 real GDP growth of 0.2%. Many indicators still point to weakness ahead, and the European Central Bank (ECB) continues to raise rates. However, like many central banks, the ECB is increasingly worried about the growth outlook.
European bond yields followed global bond yields higher. For October, the Euro STOXX 50, German DAX, and U.K. FTSE 100 stock market indices posted gains of 9%, 9.4%, and 2.9%, respectively.
Asia – Decoupling
Political developments sent shivers across Chinese stock markets even as the economy rebounded faster than expected in Q3. President Xi consolidated power to take an unprecedented third term and ousted key liberal-leaning politicians. Market turmoil was amplified when the U.S. introduced sweeping controls on exports to China of semiconductor technology. These developments point to an increasing decoupling between the West and China over technology and add to worries about U.S.-China relations. The result was a 16.8% decline in the MSCI China Equity Index.
The Bank of Japan stands alone in its pursuit of easy monetary policy. For now, the vigilantes are only succeeding in the currency market because the government has been able to hold bond yields down. The Japanese yen fell to a 30-year low. The weaker currency boosted Japanese stocks; for October, Japan's equity benchmark Nikkei 225 rose 6.4%.
Our strategy – Solidly balanced
We believe it remains appropriate to stay reasonably close to our long-term strategic benchmarks with some prudent tactical tweaks. In turbulent times, investors are best served when we stay well-balanced on a solid foundation.
Our fixed income positions remain at a slight underweight. We feel bond yields have risen very near to and, in some cases, above levels necessary to reflect the path ahead for growth, inflation, and future central bank actions. Additionally, coupon income and maturing securities in our bond portfolios are being reinvested at higher yields. We believe our bond positions will provide a level of safety if a recession takes hold.
We remain slightly overweight equities. Our geographic alignments reflect our views on where the best risk-adjusted opportunities lie ahead. We are underweight international developed markets (primarily Europe and Japan) and overweight to North American equities. Canada’s commodity-related companies do well in inflationary environments. U.S. equity markets and the U.S. dollar have historically offered relative safety in periods of weak global growth.
The last word – Wheat from the chaff
Even though the move to higher bond yields has jolted fixed income investors, current interest rates are not high by historical standards. Borrowing costs in the mid-single digits are normal. Similarly, a protracted downturn in stock markets is infrequent but not unusual. Investing in the stock market comes with risk. It is the very presence of risk that yields the reward: no risk, no reward.
In late 2020, US$18 trillion worth of bonds globally traded at negative yields, a phenomenon never before witnessed in the history of money. Investors who paid those prices were guaranteed to lose money if they held those bonds to maturity. Right now, this number is under US$2 trillion. Investors currently have a host of more attractive fixed income choices. Our clients are earning in the 5% range in the fixed income component of their portfolios.
Heading into 2022, there was a lot of complacency about risk in the stock market. Between January 2017 and January 2022, the total return of the S&P 500 soared 132% (an annualized return of 18.4%). That’s roughly twice the historical rate of return from U.S. stocks. Furthermore, every setback was quickly followed by a V-shaped recovery. In this environment, investors can lose sight of the long-term nature of providing businesses with capital (a.k.a. investing in stocks). Currently, the five-year total rate of return from the S&P 500 to October 31, 2022, is 64% (10.4% annualized), much closer to the long-term average.
We have now endured almost a full year of difficult and volatile equity and bond markets. These market environments are never pleasant. Yet, they don’t last forever, and they do purge the system of complacency. They also separate the wheat from the chaff, shaking out the quick-buck artists who lack the stamina to achieve the rewards of the long-term investor. The return of bond vigilantes is good news and, looking forward, we see better investment opportunities today than we did a year ago.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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