At the close of business last Friday, global equities were lower on the week as the yield on the US 10-year Treasury note surged as high 4.5% on the week before drifting down to 4.47%. The price of a barrel of West Texas Intermediate crude oil added $0.50 to $90.50 while the price of a barrel Brent crude reached $95 before easing slightly. Volatility, as measured by the Cboe Volatility Index (VIX), rose to 16.8 from 13 the week before.
Soft landing? Hard landing? No landing? These terms seem to be front and centre in the financial media, and many aren’t even sure what they mean. Essentially, the question is whether we’ll experience a recession in the U.S. and Canada. Year to date, despite economies absorbing the aggressive policy tightening we’ve seen so far, economic activity in developed economies have proven to be more resilient and avoided recessions amid potential job hoarding, pent-up savings, and a rebound in the services sector.
At this point in the cycle, the key for us is to try to identify where the balance of risks lies. Our best tool remains the same as we’ve used in the past: our table of recession indicators. Given the economic data that we look at, it seems to suggest that the recession has been postponed, but not cancelled.
From energy to food to shipping, many of the factors that drove inflation higher over the past couple of years have eased considerably, which has largely resulted from base effects. However, core inflation remains stubbornly high—a result of a strong labour market and resilient consumer, which points to the risk that inflation doesn’t fall within central bank targets in the near term. As a result, it leads us to believe the market is premature in its pricing of dovish pivots from central banks (in the U.S., markets are pricing in six cuts for next year), both in terms of timing and magnitude. As a result, markets need to reassess the central bank put for asset prices.
While we’re constructive longer term, there’s much uncertainty in the near term with markets pricing in a soft landing, inflation trending lower linearly, and central banks cutting interest rates materially next year. In this environment, any headline surprises that may speak otherwise create the potential for downside risks.
Look no further than the recent negative market reaction following the headlines out of China and comments about the pace of inflation by the Fed at their most recent meeting. The fragility of the real estate market in China is top of mind for investors again with the recent news from Country Garden Holdings (one of China’s largest real estate developers) and the lack of positive impact on the Chinese economy from it reopening. Strong U.S. retail sales have illustrated the strength of the U.S. consumer, which has led Federal Reserve officials to express their concerns that further interest hikes may be necessary.
And finally, we’re entering a historically weak period for markets, which could compound the impact of any negative headline news.
The opportunity in bonds is arguably the best it has been in 15 years. While there’s no denying this, we believe it’s more important to not just invest in bonds, but the right bonds, at the right time. As we’ve written in the past, we believe the opportunity in fixed income is likely to unfold in three phases: clipping the coupon, duration is your friend, and take on risk.
The first phase has continued to play out well. Last year’s pain in fixed income provided an opportunity going forward—yields across most, if not all, fixed-income instruments, regardless of maturity, type, or credit quality, haven’t been this high in quite some time. This has allowed investors to benefit from the yield provided by the bond or “clipping the coupon.” We believe the sweet spot is currently in investment-grade bonds, those rated BBB or above, in Canada or the U.S. For these bonds, it’s not just about the yield but about the potential for capital gains, given that the average price is approximately $88 and the majority mature at $100. Although there’s no specific transition from one phase to the other, the weaker economic data is signaling that we’re nearing the second phase.
In this second phase, we want to begin embracing longer-duration and higher-quality fixed-income instruments. In phase two, by increasing duration and quality while transitioning to longer-dated government bonds, investors could potentially mitigate risk while also likely increasing their return opportunity.
There have been many surprises year to date from both an economic and market perspective. However, given the data that we follow, we believe it’s premature to pop the champagne and declare victory over a recession. While we’re constructive on the longer-term outlook for equities, we believe it’s prudent to overweight fixed income over the near term. Within a context of a slowing global economy, geopolitical risks that remain heightened, falling but sticky inflation, and central banks that are committed to higher-for-longer interest rates, a lack of equity market volatility can give investors a false sense of security. This environment may cause near-term choppiness in equities. A portfolio that’s properly positioned for what comes next will help you remain focused on your longer-term goals.
CANADIAN ECONOMIC NEWS
We are having a very good year despite the interest rate environment we are currently experiencing. We have gone through a tough period in Canada with the rising interest rates.
Going forward, we are expecting more short-term volatility as we are in the month of September, which traditionally is the most volatile month of the year. Markets are always forward looking, so their performance is an expectation of where the markets see things six months to a year ahead.
Bonds have been extremely hard hit as we have been in an increasing interest rate cycle. Your fund managers have recently been adding significant exposure to Canadian long term duration bonds, especially in government, corporate and institutional bond offerings. Their reasoning is that as we enter a mild recession in 2024, interest rates will finally start coming down. As this happens, the bond portion of your portfolio should not only see the interest rates offered by the bonds, but also a capital gain. Bonds lose money when interest rates are going up and make money when interest rates are going down. We expect the Canadian bond portion of your portfolio to experience equity like returns in 2024 and 2025.
Regarding Canadian equities, your fund managers are currently repositioning your portfolio to include more small and Mid Cap equities. We are in the early stages of a new bull market and small and Mid Cap equities traditionally outperform at this stage. In short, your fund managers are positioning your portfolio for very robust performance from your portfolio in 2024 and even better performance in 2025.
US ECONOMIC NEWS
The Federal Open Market Committee met this past week, and they signaled a US recession is less likely. The FOMC raised its 2023 growth outlook to 2.1% from an earlier 1% forecast, lowered its view for peak unemployment to 4.1%, down from 4.5%, and projected that inflation won’t reach its 2% target until 2026. Bottom line: The Fed sees a soft landing but expects rates to stay higher for even longer.
EUROPEAN ECONOMIC NEWS
A downward inflation surprise allowed the Bank of England to break its streak of 14 consecutive rate hikes this past week. The decision to pause was a close call, with five members of the Monetary Policy Committee voting to pause and four voting for a hike. With the economy sluggish and inflation falling, the BOE may have reached peak policy rates.
The Swiss National bank also held rates steady on Thursday, while Sweden’s Riksbank and Norway’s Norges Bank both hiked rates and each indicated another hike is likely by the end of the year. On Friday, the Bank of Japan left policy unchanged and did not alter its guidance.
JAPAN, CHINA and EMERGING MARKETS ECONOMIC NEWS
The big news at the end of last week was that the Bank of Japan said it would maintain short-term interest rates at -0.1%. The bank capped the 10-year Japanese government bond yield around zero and the Japanese yen sank about 0.5% to about 148.3 against the U.S. dollar.