Good morning,
A sense of optimism fueled by the third quarter earnings season helped markets recover from the drop in September. Reassuringly, the breadth of the market move has been healthy and most of our stocks participated in the advance. The other notable, albeit expected, development was confirmation from the U.S. Federal Reserve that it will begin to reduce its asset purchase program, which was one of several measures put in place at the onset of the pandemic.
It has become common practice for monetary authorities to telegraph major shifts in policy well in advance. As a result, investors knew that a “tapering” announcement from the U.S. Federal Reserve was coming. Nevertheless, this decision adds to a growing list of central banks, including the Bank of Canada, who have begun to wind down some of the monetary stimulus put in place over a year ago.
Some central banks, in the emerging markets in particular, have taken their approach a step further and have begun raising interest rates in recent months. Those actions may also be on the horizon in the developed markets. The Bank of England recently indicated it may raise rates sooner rather than later given confidence in its economic recovery and the persistence of inflationary pressures. And in North America, investors are coming to the realization that interest rate hikes may be less than a year away. In fact, current market expectations are for close to four interest rate increases in Canada over the next year, beginning as early as spring. Meanwhile, in the U.S., investors are looking for rate increases to begin in the summer, with a few anticipated before year-end. While those forecasts may prove to be a tad aggressive, it’s clear that interest rates may be higher a year from now.
Historically, most major equity market declines have corresponded with economic recessions in the U.S., the world’s largest economy. And most U.S. recessions have been preceded by periods of tight credit conditions characterized by consumers and businesses that are less inclined to borrow because of high interest rates, as well as banks that are reluctant to lend. That is undoubtedly not the environment we are in today. Moreover, it’s hard to imagine those conditions forming next year given the interest rate hiking cycle will only be starting to get underway and interest rates will still be quite low, particularly relative to economic growth which should remain well above average given the ongoing reopening. In other words, it may take much more time and numerous interest rate hikes to create the kind of circumstances that would define a more restrictive credit environment.
Investors don’t seem that bothered by the prospects of higher rates. And history would suggest they shouldn’t be. Since 1958, there have been eighteen interest rate hiking cycles in the United States. In the months leading up to the first rate hike, equity returns in Canada and the U.S. have generally been positive, and in some cases quite strong. This is reasonable as many of these periods were characterized by robust economic growth and healthy corporate earnings trends. Not surprisingly, equity returns were more volatile around the time of the first interest rate increase. But, as the months went by, the economic and earnings trends seemed to reassert their influence on equity returns.
The interest rate regime is set to change in 2023. But rates will still remain relatively low, and credit conditions should be relatively favorable for borrowers. At some point in the future, the cost of financing will become more prohibitive, and consumers and businesses will push off their spending plans or projects, while banks will become more particular about who they lend money to. We believe we’re still a ways away from that happening. And that is one of the factors that keeps us constructive on the outlook ahead.
The Conundrum faced by central banks.
To put it lightly, Central banks have their work cut out given the massive stimulus injections into world economies and the aftermath from the pandemic. A recent analogy I heard from our Portfolio Advisory Group equated central banks facing a situation similar to a traffic jam. I have paraphrased this analogy and added a YYC twist.
Picture yourself heading South on Deerfoot and you just passed the turn off for Glenmore Trail. A car up ahead, say around Anderson, breaks to avoid an accident and comes to a halt. Although a serious accident was avoided, a traffic jam begins to form and you find yourself in gridlock even though that car has now resumed speed. Traffic (the economy) was running smoothly until it was forced to stop because of a sudden obstruction (the pandemic). Although traffic restarted, the slowdown left a series of supply disruptions and associated inflationary pressures. While the traffic jam is expected to be transitory, it is difficult to predict how long it may last and whether there were any additional ramifications. Taking this further, central banks (traffic authorities) want to ease the congestion as soon as possible, however, the tools at their disposal will not work instantly. Traffic authorities can re-route traffic between Glenmore and Anderson (raise interest rates to slow demand), however this may only have a marginal benefit and doing so runs the risk of causing problems elsewhere in the economy or the city’s traffic. We all know that with time, the traffic jam will resolve itself naturally, which is why the authorities (central banks) will want to take a wait and see approach to determine if direct intervention is required.
This analogy is not perfect and admittedly corny, but it does help conceptualize the conundrum faced by central banks – especially the Federal Reserve in the US. Under the new evidence-based approach, the Federal Reserve has indicated that it isn’t willing to step-in and begin withdrawing stimulus prematurely. Instead, being that some disruption and inflationary pressures are expected following a shock such as the pandemic, the Fed is allowing inflationary pressures to build and allow the economy to run until a point where i) this rise in prices does not reflect a one-time shift in price-level and ii) there is not going to be an increase in the supply of labor (rise in the participation rate) to offset the tight labor market conditions we are currently being experienced. In Canada, our current forecast is for a rate hike within the first half of 2022 while we do not see the Fed lifting rates until Q3.
Please let us know if there is anything our team can do to assist as Shannon, Tom, Brett and I all stand ready to listen and speak with you. We can also be made available to speak with any friends or family members who may need reassurance during these times.
Enjoy the weekend,
Devin