Quarterly Commentary as of September 30^th, 2023

The mixed economic data prints for the month of September did not do much to quell investor worries, which caused a broad selloff in bond markets and sharp increase in yields, particularly the US and Canadian 10-year yields, which increased ~0.50% in September alone. What this means for investor portfolios is that the expected pick-up in performance from the fixed income portion has been delayed as bond indices have continued their negative performance. The good news that we should remind ourselves of is that this performance is rather inevitable, particularly because central bankers consider the current level of interest rates as “restrictive” and markets expect them to decrease rates within the next 12 months, albeit at a slower speed than initially thought (hence, why the performance has been delayed).

 

Investor patience is about to be rewarded

 

As central banks wind down interest rate hikes, we believe that the fixed income asset class will ultimately add to portfolio performance in the coming quarters. For over 18 months, bonds have been adjusting to central bank decisions to reflect interest rate increases. What is unusual about this period is that it resulted in the largest rate increase in 40 years. Consequently, the contribution to fixed income returns was negative on investment portfolios between January 2022 and September 2023.

On the other hand, if we look to the future, future fixed income returns for the next few years now show an average return of over 5%. In fact, we haven’t seen such high interest rates since 2009.

As we mentioned in our Quarterly Commentary as of June 30^th 2023, central banks began tackling the inflation problem more seriously as of mid-2022 and, as a result, they are now no longer in catch up mode. Therefore, further interest rate moves will be highly data dependent considering that many signs point to the fact that higher interest rates are working with a delay, and that economic activity is likely to slow in the coming quarters, which should lead to a more manageable inflation number.

 

Benchmark bond rates progression – Government of Canada

Gov. of Canada Historical Bond Rates	13-Oct-23	16-Sep-23	31-Dec-18	29-Dec-17
2 year	4.78%	4.69%	1.86%	1.69%
5 year	4.16%	3.96%	1.89%	1.86%
10 year	3.94%	3.68%	1.97%	2.04%
30 year	3.71%	3.52%	2.18%	2.26%
Source: RBC DS Global Insight daily October 16 2023

 

Performance at September 30^th 2023

Canadian dollar results for a balanced portfolio are around (-1.0%) for the last three months.

The results in CAD of the various indices for the quarter ended September 30^th 2023: (-2.2%) for the Canadian S&P/TSX index, (-0.8%) for the US S&P 500 index and (-2.3%) for the Europe-Asia-Far East index.

In fixed income, the benchmark FTSE TMX Canadian Bond Index posted a negative return of (-3.9%). The appreciation of the US dollar against the Canadian dollar had a positive impact of 2.6% on US strategies over the same period.

Balanced portfolio returns over the last twelve months are generally between +4.0% and +6.0% in CAD.

 

As for equities, we continue to focus on quality in anticipation of a slowdown

Central banks have maintained a restrictive monetary policy for more than a year now. We expect their effect to be felt more strongly on the economy for a prolonged part of next year. Of course, there can always be exceptions to the rule, but historical probabilities point to a slower economic growth scenario for 2024.

We reiterate that companies with resilient balance sheets and sustainable dividends will be best placed to take advantage of the opportunities that will inevitably present themselves in the recovery. Stock markets typically anticipate the start of an economic expansion several months before it begins.

We remain defensive on the equities front as the restrictive environment and high valuations relative to long-term bond yields do not make for a compelling case to overweight equities for the time being. The table below shows average S&P500 index returns for years with different ranges of Real GDP growth.

Source: RBC Capital Markets, Macroscope Oct 2023

 

Real GDP is forecast to be 2.2% in 2023, and 1% in 2024. This would place expected S&P500 performance in the flat-to-down camp. While we do not place too much emphasis on these types of analyses on their own, it is yet another lens which incorporates aggregate investor psychology and macroeconomic expectations to help confirm that the time to jump into an overweight equities positioning has not yet come. In fact, there is another more interesting opportunity…

 

The Discount Bond Opportunity

As discussed with many of you, discount bonds are a notable byproduct of the dislocation in fixed income markets following a several year period of low interest rates. For Canadian taxable investors, these bonds offer the opportunity to lock in a significant portion of the yield in capital gain rather than interest income, making the asset class even more interesting on an after-tax basis. For example, the Gov. of Canada bond maturing on 03/01/2026 with a 0.25% coupon, over 90% of the bond’s yield to maturity will be in the form of capital gains (otherwise known as the “pull-to-par”, which means that a bond purchased at, say $90 will mature at $100, regardless of what happens to interest rates).

For a Canadian taxable investor, the difference between pre-tax yield and the tax equivalent yield (the yield an investor would require from a 100% interest-bearing instrument to be indifferent between both instruments) can often be more than 2% annualized (7% vs. 5%).

 

This opportunity came about due to the unusual shifts in rates in recent years – from an all-time low of close to 0% to a multi-decade high of 5% within a year and a half. The bonds issued in 2020 & 2021 were issued with low coupons and close to their par value of $100. Once interest rates rose as much as they did, the market value of these bonds had to be adjusted downwards to reflect the new interest rate levels (yield to maturity is made up of the coupon, which is fixed, and the market value, which can fluctuate). This also means that the opportunity will not exist forever, since the maturing issues will be refinanced with bonds paying much higher coupons. Many bonds are issued with 3, 5, or 7 year terms, so discount bonds have maturities concentrated in 2028 and earlier.

 

Featured Article: Global Insight – New normal, old normal, or no normal?

By Thomas Garretson, CFA

After the Global Financial Crisis, markets participants were left wondering what the new normal would be in an era where deleveraging by US consumers in addition to an anemic fiscal policy response meant that monetary policy was left to do the heavy lifting; subpar economic growth gave way to a stretch where too-low inflation was the primary problem facing central banks. The net result was the first 0% policy rate from the Federal Reserve and other global central banks, on top of large-scale asset purchase programs (quantitative easing). Now, it looks as though those issues have reversed: fiscal response to the pandemic went above and beyond, economic growth has been above trend and inflation is well above target levels.

 

The “neutral” rate of interest, that is the rate that neither boosts nor restricts economic activity, is a theoretical concept that has long guided central banks. Knowing for sure where exactly this neutral rate sits is a difficult endeavor, particularly because there are other confounding variables that can affect an economy, including the time it takes for monetary policy to make its way through the economic system.

One model of the “natural” or “neutral” real rate of interest estimates it to be around 0.56%, or 2.56% in nominal terms (including the Fed’s 2% inflation target).

Interest rates have been in a steady state of decline over the past 40-or-so years, which suggests that the current episode of historically high policy rates is more than likely an aberration rather than a break from the post-financial crisis era. One theory for this trend is the maturing economies; as global population ages, the demand for what are perceived to be safe assets goes up.

The Fed also navigates via another, more directly observable star: the natural rate of inflation, which has formally been 2% since 2012. According to the author, there may be 3 main reasons why natural rates could shift higher:

1. The strong policy response to the pandemic that sparked a brisk recovery and an environment where inflation is modestly more structural than it has been.
2. The very low level of interest rates gives central banks very little room to stimulate the economy in an economic downturn. As the lower bound of 0% is quickly reached, the Fed must revert to other alternative tools beyond the policy rate.
3. The last reason is artificial intelligence (AI), though it is a relatively unknown issue at this point, it could be an underlying long-term dynamic that has investors reassessing the future interest rate levels. Low productivity has long been a drag on potential economic growth rates. Should AI deliver on its rosiest of promises, then perhaps markets may be starting to price in the chance that AI fuels a productivity boom and, therefore, a higher potential growth.

Bottom Line: Long-term trend of lower rates will remain largely in place. There is no “normal”, as monetary and central bank toolkits will continue to evolve with each business cycle and perceived economic era. Long-dated treasuries are still down by over 20%, but the tide may already be shifting.

 

Please feel free to contact us if you have any questions or if you would like to discuss your portfolios.

 

Thank you for placing your trust in our team and we wish you a wonderful fall season,

Mathieu & Anthony

 

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