It has been a while since our last update, so for context on where markets stand today, let’s conduct a quick and slightly irreverent economic recap of the past three years: 

• 2020: To prevent the economy from catching COVID, central banks chopped interest rates to 0% while governments handed out free money to citizens. Peoples’ savings grew rapidly, partly because of the free money and even more so since there was nothing really to spend on
• 2021: As fear subsided, consumers engaged in revenge-spending, especially on goods. Both consumers and businesses used the ultra-low interest rates to borrow for further spending and for investment. Because supply chains were still gummed-up, the surge in demand gave every business pricing power and so inflation spiked. By the end of the year, the Fed blew the whistle, indirectly saying that they would start raising interest rates next year to quell inflation
• 2022: Before the Fed could get to work, the unexpected war in Ukraine caused oil, gas and food prices to soar, giving a double-pump to inflation. Realizing they were now well behind the play, the Fed and Bank of Canada hiked interest rates at a breath-taking pace, the fastest in four decades
• 2023: Markets held their breath waiting for something to break from the rapid increase in rates. It finally did as several US regional banks failed in the spring…and yet, that didn’t seem to matter. The Fed contained the financial blast zone from the failures, and the economy continued to chug along.

Which brings us to today. 

Given the above context, there are essentially two big questions now hanging over financial markets: 1) is the job of taming inflation actually finished; and, 2) is the economy really handling a historic jump in interest rates without flinching, or is there economic pain still coming down the pipeline?

For the first question, these next few months should be the moment of truth. The inflation rate peaked at 9.1% in June 2022, so with every month that passes we are now lapping smaller price hikes. That means the hurdle is lower for inflation to pick up steam again. Interestingly, this is happening just as oil prices have started to rise, with both WTI and Brent crude up about 20% since late June:

Brent oil, spot price (US$/bbl): 2023 YTD

Source: Bloomberg

In addition, if this winter is actually cold in Europe then the IEA predicts potential fireworks for natural gas prices once again. On the other side of the inflationary coin, rental price increases are decelerating which is particularly important as shelter cost is by far the largest component of CPI. Taken in aggregate, while there are arguments for both sides it still seems like winning the battle on inflation remains a “show me” story at this point.

On the second question regarding economic pain in the pipeline, however, the evidence is pretty stark. All signs point to the fact that we are late in an economic cycle: inflation is high, interest rates have risen, GDP growth is slowing, credit conditions are deteriorating, etc. Reflecting this, a number of economic indicators with 100% hit-rates for predicting recessions are flashing red. The most notable of these is the inverted yield curve for government bonds in Canada and the US:

US interest rates: 10-year bond yield minus 3-month bill yield (1967 – present, recessions in blue)

Source: Bloomberg, JP Morgan Equity Strategy

Every time that the yield curve has flipped negative since WWII, a recession has followed, albeit sometimes with a lag. Is this time really going to be different? Interestingly, the financial rule of thumb for interest rate changes that it takes 18 months for them to actually impact the economy. The first rate hikes by the Fed and Bank of Canada occurred 17 months ago.  

In conjunction with this, lending standards by banks have now tightened to levels typically only seen in a recession. That’s occurring at the same time as demand for new loans has also dropped to recessionary levels, which isn’t surprising given that the cost to borrow is now so expensive (charts below, recessions shaded in blue):

Left: US domestic banks increasing lending standards (1990 – present)

Right: US domestic banks reporting stronger demand for loans (1990 – present)

Source: Federal Reserve Board, JP Morgan Economics

Of course, the key offset to this economic negativity has been the resilient jobs market. The unemployment rate continues to hover near all-time lows. There are two flies in that ointment, though. First, job gains have been steadily deteriorating in 2023, declining consecutively in every single month this year. Second, unemployment is a trailing indicator. Historically, unemployment doesn’t just gradually rise…instead it hovers at a low level, like today, and then spikes when a recession arrives (see chart below). If the question is whether higher interest rates have generated pent-up economic pain that is still on its way, the unemployment rate can’t answer that. It will only tell us what is happening once the pain has already arrived:

US unemployment rate and recessions (1948 – present, recessions in blue)

Source: BLS, JP Morgan Equity Strategy

One thing that seems clear from where we sit is that while there may be question marks around a coming recession in the US, here at home in Canada, the die has been cast. It seems like a recession here is imminent because: a) our economy is so much more sensitive to interest rates than the United States; and, b) despite that, the Bank of Canada has oddly opted to increase rates here in almost lock-step with the Fed.  

Part of our country’s sensitivity to rates is due to structural differences in our residential mortgage market. In the US, the most common type of mortgage is a fixed-rate 30-year term (!!), on top of which homeowners can generally refinance early without a penalty. That latter feature meant that many Americans refinanced in 2020 and 2021 to lock in ultra-low rate mortgages that won’t mature until 2050. As a result, today only 8% of Americans have floating rate mortgages and the average fixed term remaining is 21 years (source: Moody’s, Wharton). 

By contrast, about 25% of Canadian mortgages are variable and the maximum term for fixed-rate mortgages is almost always 5 years. Even accounting for the Canadian quirk that many variable rate mortgages actually have fixed payments, that means roughly 20% of mortgages in Canada are getting renewed every year at prevailing market rates. To make that more tangible, here’s a chart showing the percentage of Canadian mortgages that are renewing at higher payment rates:

Percentage of Canadian mortgages resetting to higher rates, relative to Feb 2022

Source: Bank of Canada

To put that in plain English: over 40% of mortgagees will have been forced to reset to higher payments by the end of this year, and that proportion will increase to roughly two-thirds by the end of next year. By 2026, virtually every residential mortgage in the country will have been reset. Again, for context, over the same period less than 10% of Americans homeowners will face higher mortgage payments.

Running the math, the average mortgage payment increase upon renewal in Canada is now in the range of 25% - 30%. Not coincidentally, that increase is very similar to the rise in rent now experienced when an apartment or condo rolls over to a new tenant. About 35% of Canadians have mortgages and another 35% are renters, so quick math says that 70% of Canadian are going to have a quarter of their disposable income redirected to paying more for shelter in the near-term, leaving them no choice but to reduce other spending. To be fair, the percentage will be somewhat less since renters will increasingly choose not to move – but regardless, for an economy in which consumer spending comprises approximately 70% of GDP, the increased cost of shelter is going to pack a punch.

The other reason that Canada is much more sensitive to interest rates than the US is because of the how indebted our consumers are here. An often overlooked consequence of the Financial Crisis in 2008 was that household leverage in America not only plummeted, but it then kept declining. In fact, US household leverage hit a generational low in 2019, only to then drop even further due to COVID benefits. Meanwhile, here in the north – well, you can see the pattern for yourself below. Acknowledging that Canada’s number will always be higher by roughly 20-points due to a difference in calculation methods, the debt of our consumer can probably best be described by Buzz Lightyear’s tag line, “To infinity and beyond”:

Household debt to disposable income: 1993 – 2023 (Canada = red, USA = blue) 

Source: Bloomberg, StatsCan

So again, while there remains a reasonable debate to be had over how much the US economy may slow in the near-term, our far higher sensitivity to interest rates here at home suggests to us that a Canadian recession is a matter of when, not if.

Now, all of the above is economic talk. While financial markets and the economy are related, they tend to resemble each other more like cousins rather than identical twins. So perhaps it shouldn’t be surprising that equity markets, and more accurately tech stocks specifically, have managed to rally since the spring despite the economic uncertainties above. The optimistic focus there has been on the silver-lining of a weakening economy – potentially lower interest rates – as well as the open-ended growth narrative that AI presents. 

What is surprising, though, is how little attention is being given to the corresponding drop in earnings power that is coming from that same weakening economy. As of last quarter, average earnings for S&P 500 companies have now fallen into negative territory, down 6% year-over-year. That means the rally in the S&P has been entirely due to valuation – the forward P/E ratio has now risen to a lofty 19x. Even when excluding the tech sector from the equation (chart below), valuations are still at the high end of historical standards, especially considering that interest rates are no longer at 0%:

S&P 500 NTM Price/Earnings ratio, excld’g Technology (2003 – present)

Source: Datastream, JP Morgan Equity Strategy

Even for the large companies that are still reporting higher earnings, like Pepsi for example, the growth this year has almost exclusively come from higher prices; actual unit volumes have generally been negative. If the Fed is keeping rates high until inflation falls back to 2%, and an important source of earnings has been higher prices, isn’t there only one thing that can really happen to earnings growth as inflation drops? Yet consensus estimates for S&P earnings growth next year is still forecast at a surprising +10%. If that forecast proves to be wrong, then the equity market’s forward P/E ratio is actually even higher, at more like 20x – 21x. 

So, with valuations high and earnings poised to be under at least some pressure in the near-term, equity markets seem somewhat stuck for the time being. That’s not to say that certain stocks and sectors won’t perform well – it just that the odds now seem in favour of that leadership coming from somewhat less sexy, more defensive companies with generally more modest valuations, rather than from high-flyers continuing to drive the market.

Reflecting that, as we roll back into autumn – a season which historically has produced more than its fair-share of financial fireworks – we’ll be continuing to play it a little safe in the portfolios. It doesn’t seem like there’s much room for error built into financial markets just now, so while we’re generally glass half-full people, now seems like an appropriate time for some caution. While we wait to see what September and October have in store, we hope you all enjoy these final weeks of summer.