BACK TO RISK-ON
Following steep declines in 2022, stock markets rebounded in the first quarter as investors began to anticipate the end of the Federal Reserve’s interest rate hiking cycle. The trajectory was far from smooth however, as markets digested high inflation, strong job gains and the March 9th failure of Silicon Valley Bank. The tech-heavy Nasdaq 100 entered a technical bull market, rising more than 20% with growth stocks outperforming alongside declining long-term interest rates. Many of the worst declining stocks of 2022 subsequently rebounded the most amidst a resurgence of risk-seeking behaviour despite generally deteriorating business fundamentals. In perhaps the most prominent example of investor risk-taking, short-dated call option volumes on equities such as Tesla and Cathie Wood’s ARKK ETF reached highs that surpassed the previous euphoria of 2021.
Meanwhile, sectors which outperformed in 2022 such as energy, consumer staples and healthcare, lagged in Q1 as capital flowed back into technology and as WTI crude oil temporary fell to $66 before closing the quarter at $76. US banks were notably weak following the regional bank crisis in March. After the worst year in decades, bonds reverted to gains, rising 3% (albeit along an unusually volatile path).
With a strong start to the year, investors may be wondering whether this is the start of a larger upturn in equities. Historically, stocks tend to rise in the later stages of interest-rate hiking cycles as well as during periods where inflation is declining from high levels. At current valuations however, history suggests the distribution of probabilities remains skewed to the downside once the rate hiking cycle concludes. Anecdotally, widespread risk-seeking of the variety experienced in Q1 hasn’t typically coincided with high return junctures.
ALL EYES ON INFLATION, INTEREST RATES, AND THE FED
Markets remain laser focused on the short-term path for inflation and interest rates. In February, headline inflation continued to decline towards 6% in the US and 5% in Canada, aided by lower commodity prices and normalization in shipping rates. In contrast, less volatile measures of inflation such as the sticky consumer price index remained elevated, underscoring the concern that higher prices could remain entrenched in the economy.
Meanwhile, the US yield curve, which measures the difference between long-term and short-term government bond yields, temporarily reached its most negative level since 1981. Even two-year treasury bonds now offer a lower yield than the central bank interest rate. This inversion of the yield curve, where longer term rates yield less than shorter term rates, is the market’s way of screaming that monetary policy is too restrictive and the outlook for the economy is deteriorating.
Monetary policy is a very blunt tool and there are limits to what the Federal Reserve can do to tame inflation if it becomes embedded in areas like services, wages and rent without great sacrifices to the economy and asset price stability. At the Fed’s March meeting, interest rates were increased 0.25% for the second time this year as Chairman Powell reiterated his commitment to both controlling inflation and achieving maximum employment. In many ways, the Fed is attempting to thread the eye of a shrinking needle. On one hand, inflation looks increasingly sticky at levels above their stated 2% target; on the other, keeping interest rates high for longer to tame inflation is increasingly pressuring the economy and the financial system.
For perspective, the 4.75% increase in the Fed Funds rate since 2022 is tied for the sharpest increase in the bank’s 108-year history. Alongside quantitative tightening, money supply is now in decline. It’s well known that monetary policy works with a long and variable lag. The Bank of Canada’s decision in March to pause rate hikes with a ‘wait and see’ approach is a tacit admission that the effects of raising rates will only fully be revealed with time. When central banks ratchet up interest rates as quickly as they have, fragility in the financial system and economy are exposed, often in unexpected places. In March, US regional banks became a classic case in point.
While Silicon Valley Bank and select others are isolated cases of financial mismanagement, their failures sparked a panic leading to an exodus of deposits at other regional banks. Aside from lasting impacts on funding costs, competitiveness and bank profitability, the broader consequence for the economy is a credit crunch as regional banks respond by tightening lending standards.
While March’s bank crisis appears to have settled for the time being, its reasonable to expect further signs of fragility in other areas of the economy as the effects of restrictive monetary policy continue to ripple through the financial system.
WOULD THE REAL ECONOMY PLEASE STAND UP
Many economic indicators continue to suggest caution. In February, US housing prices fell for the first time in 11 years as higher mortgage servicing costs continue to impact consumer pocketbooks. Data released in February showed that consumer debt rose at the fastest rate in 20 years during the prior quarter while consumer spending rose less than 3%, an anemic level when considering current inflation levels. Meanwhile, the latest reading for the US manufacturing business outlook survey has fallen to levels which have historically coincided with recessionary environments (shown by the light teal bars below).
Source: Federal Reserve
Market commentators point to an incredibly tight labour market as a counterfactual to the claim that the economy is weakening. US unemployment fell to 3.4%, the lowest level since 1969. Despite widely reported layoffs in Silicon Valley, hiring remains robust in areas like leisure and hospitality, healthcare, and professional services. There is a narrative that employers will be hesitant to cut their workforce after the last three years of chronic staffing issues and so unemployment will therefore remain low. While this is possible, past cycle lows in the unemployment rate have only shortly preceded recession. If corporate profits are pressured, cost cutting has been the precedent rather than the exception.
Source: JP Morgan, Bloomberg Finance
UNCERTAINTY AND OPPORTUNITY
Restrictive monetary policy, a weakening consumer and declining manufacturing activity have set a narrow path for the economy. Tightening lending standards following the March banking crisis only further complicate the outlook. Yet, consensus still expects corporate earnings to grow modestly in 2023 before reaccelerating in 2024. These expectations seem increasingly disconnected with their odds.
The S&P 500 trades above long-term averages at 19x current year estimated earnings and 17x the 2024 expectations. Meanwhile, the S&P 500’s earnings yield offers the narrowest premium to risk-free treasury bills since 2000. Risks appear further skewed to the downside than the upside given the potential headwinds to earnings. The caveat is that markets discount information quickly and much of the above concerns are well known. If economic data and corporate earnings are simply less bad than feared, asset prices may yet react positively in coming months.
Source: QV Investors, Bloomberg
The Canadian stock market remains much cheaper than its US counterpart at 13x earnings, but it is also more cyclically exposed. However, the lower valuation and higher dividend yield continue to suggest a differentiated outcome relative to US stocks. Over the last decade there has been a mass exodus of capital from Canadian stocks into both US stocks at increasingly higher valuations as well as illiquid investments in private equity and infrastructure which had previously benefitted from declining interest rates. In an age of higher structural inflation, the benefits of hard assets and the happy oligopolies which populate the Canadian stock market look increasingly attractive.
RISK MANAGEMENT DRIVES DIFFERENTIATED OUTCOMES
QV’s asset mix was unchanged in the quarter and remains conservatively balanced between high-quality equities and stable bonds which generate a 4.3% yield to maturity. Within our equity strategies, we remain conscious of valuation levels, earnings cyclicality and balance sheet strength in a weakening environment. We also remain focused on our businesses’ ability to compound per share value over time as it provides a crucial offset to the corrosive effect of inflation on purchasing power. Our fixed income strategy holds a mix of government bonds and investment grade corporate debentures designed to provide ongoing income as well as ballast through weaker periods of the economic cycle. Despite a deteriorating outlook for the economy, we anticipate reasonable outcomes from our strategies over the next three to five years and that our risk-managed approach will continue to offer a differentiated value proposition in an uncertain environment.