A sense of optimism, fueled by the results from the third quarter earnings season, has propelled many global equity markets to new highs in recent weeks. Reassuringly, the breadth of the market move has been healthy, with many stocks across a broad range of sectors participating in the advance. The other notable, albeit expected, development over the past two weeks was confirmation from the U.S. Federal Reserve that it will begin to gradually reduce its asset purchase program, one of several measures it put in place at the onset of the pandemic.
U.S Federal Reserve Tapering
It has become common practice for monetary authorities to telegraph major shifts in their policies. As a result, investors knew that a “tapering” announcement from the U.S. Federal Reserve was coming. Nevertheless, the actual decision by the U.S. Federal Reserve added to a growing list of central banks, including the Bank of Canada, that have begun to wind down some of their monetary stimulus put in place over a year ago.
Some central banks, in emerging markets in particular, have recently taken their approach a step further and have begun raising interest rates. Similar actions are on the horizon in the developed markets. The Bank of England recently indicated it may raise rates in coming months, given confidence in its economic recovery and the persistence of inflationary pressures. In North America, investors as a group are pricing in the commencement of interest rate hikes in the middle of next year. Current market expectations are for close to four rate increases of 0.25% each in Canada over the next year, beginning as early as late spring. In the U.S., the bond market reflects an expectation for rate increases to begin in the summer, with a few anticipated before year-end. While those forecasts may prove to be aggressive, it is clear that interest rates are expected 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. 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. This is not the environment we are in today. In addition, it is unlikely that tight credit conditions will form in 2022, given that the interest rate hiking cycle will only be starting to get underway and interest rates will still be very low. We expect economic growth in 2022 to remain well above average (about +4%) given the ongoing economic reopening. It may take much more time and numerous interest rate hikes to create a restrictive credit environment.
So far, investors have not been daunted by the prospects of higher rates. History supports this sentiment. 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. These are logical outcomes, 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, however, as more months passed, the positive economic and earnings trends reasserted their influence on equity returns.
The interest rate regime is set to change. Nevertheless, we expect that rates will remain relatively low, and that credit conditions will be relatively favourable 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 restrictive about who they lend money to. We believe, however, that we are at least two years away from these conditions. We continue to be constructive on the outlook ahead.
Should you have any questions, please feel free to reach out. Drew Pallett, LL.B. CFP www.pallett.ca