Following a challenging 2022, when stock and bond markets saw notable declines, much of the damage was repaired in the first seven months of 2023. By the end of July, the S&P 500 Index was up nearly 20%, thanks to significant gains among some of its technology heavyweights. The TSX, meanwhile, was up a respectable, 6.7%. The bond market, while not producing much in the way of appreciation, had at least found some welcome stability.

Since then, however, the markets have given back much of those early gains. Such ebbs are often seen in the August through October period, but reviewing some of the causes can help us formulate an outlook for the coming months.

Rising bond yields: After spiking to more than 4% last year, the US 10-year bond yield cooled off in the first half of 2023, falling as low as 3.3% in April. Lately, however, it has jumped above 4.75% for the first time in 16 years. In Canada, the 10-year Government of Canada bond yield has also surpassed 4% for the first time since 2007. This has two important implications for investors. First, higher interest rates tend to slow the economy, which could hurt corporate earnings. Second, even if the economy remains resilient, some investors that had abandoned bonds due to their low yields may be selling some of their equities in favour of lower-risk bonds that now offer a reasonable yield to maturity. Such selling pressure has likely been a headwind for stocks in recent weeks.

Bond Yields Now Higher Than Dividend Yields

                                                                                          Source: Factset, RBC Wealth Management

Consumers getting squeezed: Persistent inflation, rising gasoline prices, high interest rates, declining savings, and the re-start of US student loan payments have created concerns that consumers are going to pull back on spending in the coming months. Given that consumer spending comprises 70% of the economy, investors remain on edge regarding the impact of rising household costs.

Work stoppages: The months-long walk out by the Writers Guild of America has ended, but the Screen Actors Guild strike means that many Hollywood shows and movies will remain on pause. As important as those are to the California economy, the United Auto Workers strike has broader implications for the North American economy. Negotiations between the UAW and car manufacturers remain tense. Finally, some investor selling may have been due to the prospect of a potential US government shutdown. A last-minute agreement saw that risk put on hold for 45 days, but until longer-term funding for the government is in place, there will be reason for some apprehension.

Presidential uncertainty: Investors may be looking ahead to the 2024 US Presidential campaign with some trepidation. The six months leading up to a presidential election tend to generate some volatility in the stock market as investors try to gauge the impact of the candidates’ policies. This time around, legal and health questions surrounding the leading Republican and Democratic candidates may be causing some early investor anxiety.

Context Matters

While stock market declines are never welcome, the roughly 8% retracement in the US and Canadian equity markets is not out of the ordinary – particularly at this time of year when we tend to experience some seasonal weakness. Amongst the aforementioned concerns that investors are struggling with, some may prove to be transitory. For example, while labour negotiations can often be characterized by strong language and posturing, work stoppages eventually come to a conclusion.

Interest rates may also pull back if less consumer spending cools off the economy. If that happens, while the labour market remains healthy, we could get the much-sought-after “soft landing”, in which the economy eases without falling into a recession. In this scenario, if central banks then signal an end to their rate hikes in the coming months, it could spark a relief rally in the stock market. Below is a table of how the TSX has performed following the final Bank of Canada rate hike over the past eight tightening cycles.

Forward TSX Returns following final Bank of Canada rate hike:

The biggest risk to stocks, in our view is if interest rates continue to move higher. This could happen if inflation reverses its recent downward trend and central banks continue their rate hikes. We remain optimistic that this won’t be the case, but we will remain vigilant in tracking the economic data and the language from the US Federal Reserve policymakers.

Will Central Banks End Rate Hikes As Inflation Cools?

                                                                           Source: LSEG Datastream, RBC Wealth Management

In the meantime, we believe now that the 10-year Government of Canada bond yield is higher than the TSX dividend yield, bonds offer an attractive opportunity for investors whose portfolios may have become overweight on equities over the years. If the economy slows down and bond yields fall, bonds purchased today will rise in value. On the other hand, if bond yields continue to rise, we believe that will put downward pressure on stocks, allowing bonds purchased today to outperform. Maintaining the appropriate mix of equities and fixed income is an important discipline in portfolio management.

If you have any questions, please do not hesitate to Contact us!