After a strong push higher in the first half of the year, the S&P 500 Index took a step back in the third quarter, reporting a -3.3% return in U.S. dollars. Despite this retrenchment, the market capitalization-weighted S&P 500 is still up a respectable 13.1% year-to-date (YTD). Compared to the average long-term stock market return of 7% to 8% per annum, the return thus far in 2023 has still been relatively strong. However, peeling back the layers tells a different story. The equal-weighted S&P 500, which is more representative of the average stock’s performance in the index, is only up 1.8% YTD. This is in line with the sideways trend of the S&P/TSX Composite, which returned 3.4% YTD and -2.2% in the third quarter in Canadian dollar terms. The same narrow market leadership that we have noted in past quarterly letters remains intact.
The “Magnificent Seven” is the group of U.S. mega cap giants including Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta. Their dominant performance can be attributed to the emergence of generative artificial intelligence and the hype surrounding its capabilities. Without understating the technological potential of AI, we recognize it is still in its infancy stage, with investors only recently becoming infatuated with it. Clients who remember the internet boom in the early 2000’s and the market exuberance surrounding the dot com stock bubble understand that inflated expectations can lead to downside risk. For context, the Magnificent Seven is up an average 83.6% YTD and is clearly the driving force behind the S&P 500’s gain, with these seven companies alone accounting for 29.4% of the index’s market capitalization. This top-heaviness, or lack of market breadth, is a concerning sign of market fragility.
Source: Bloomberg, QV Investors Inc.
A PAINFUL WAY UP
Government bond yields rose sharply in the third quarter, eroding any positive returns that may have been earned YTD. Recall that bond yields and bond prices move inversely with each other, so the repricing in yields has been painful for bond investors. In fact, both the U.S. Treasury and Government of Canada bond markets are on track to report a third consecutive annual decline, which would set a new record.
Source: Scotiabank GBM Portfolio Strategy, Bloomberg
The U.S. Federal Reserve (Fed) and the Bank of Canada (BoC) both announced rate hikes in July, raising their policy rates to 5.5% and 5.0%, respectively. It is well understood that this current rate hiking cycle has been one of the most aggressive in modern financial history. And considering how restrictive policy rates already are, it is surprising that central bankers are still debating whether they are finished with rate hikes or not. Both central banks have already surpassed their peak policy rates from the 2004 to 2006 hiking cycles that preceded the great financial crisis and have done so in a much shorter timeframe. As well, both central banks continue to justify their decisions because of the persistently high inflation backdrop and have guided for future hikes if price pressures are not tamed.
Source: Bloomberg, QV Investors Inc.
At his most recent September press conference, Chairman Jerome Powell shared that the fed funds rate is likely to be held at elevated levels for longer due to stubbornly high inflation. His comments sent long maturity bond yields on an upward trajectory as the market repriced itself to the higher for longer narrative.
Nominal bond yields can be decomposed into a real yield component and the market’s expectations for future inflation. Despite the concerns regarding persistent inflation, it is worthwhile to note that it has been the real yield component that has driven U.S. nominal bond yields higher in 2023, while inflation expectations remain unchanged (2.3%). The U.S. 10-year real yield traded around -1.0% from 2020 to early 2022 and has since risen to 2.2% at the end of September, a level not observed since 2007/2008. Similarly, 10-year inflation expectations in Canada were well behaved (1.8%), while the 10-year real yield rose to a new cycle high of 2.3% to close off the quarter.
Assuming real GDP growth in the U.S. and Canada is 1.5% to 2.0%, and as long as North American central banks can manage inflation back to the 2% target over the next ten years, a nominal 10-year bond yield between 3.5% and 4.0% is quite reasonable. However, this range is not reflective of current market pricing (at the time of writing) with a nominal yield of 4.8% on the UST10Y and 4.2% on the CAN10Y, implying that either the 2% inflation target is unachievable over a ten-year period, or that real potential GDP growth will be structurally higher over the next decade.
Source: Bloomberg, QV Investors Inc.
Current starting yields are attractive for these high-quality government bonds. While the repricing to higher yields has been painful, these levels have not been seen since 2007 and currently offer good interest income as well as attractive prospects for capital appreciation should they revert lower.
LEADS AND LAGS
Higher policy rates and higher bond yields result in restrictive borrowing costs that hinder economic growth through slower investing activity and compressed valuations. The policy rate hammer wielded by central banks is a proven tool in stemming inflation, but it can take up to 24 months before its full effect is felt across the economy. If history is a guide, we may begin seeing the long lags of policy start to bite sometime by the spring of next year, considering that initial rate hikes from the Fed and the BoC were announced in March 2022.
Another leading indicator, the yield curve, remains deeply inverted despite some of the steepening that occurred in the quarter. Historically, the yield curve inverts approximately 6 to 24 months before the onset of an economic slowdown. Both the U.S. Treasury and Government of Canada yield curves, as measured by 10-year yields minus 2-year yields, inverted in July of 2022. Should history rhyme, as it typically does, this suggests an economic slowdown between now and the summer of 2024.
BILLS, BILLS, BILLS
Inflation, as measured by the Consumer Price Index (CPI), peaked at 9.1% in the U.S. and 8.1% in Canada in June 2022. Price pressures have since trended down between 3% to 4%. The improvement is notable but remains above the central bank target range of 1% to 3%. The final push lower lies with the labour market as wage growth of 4% to 5% in North America is simply too high to achieve price stability. Chairman Powell and Governor Macklem both openly support the linkage that labour market rebalancing is required to help rein inflation back within their targeted range.
Labour market strength has been evident as the unemployment rate has held steady at multi-decade lows for over 18 months. But a decelerating trend in new job hires is now visible. U.S. nonfarm payroll growth has slowed from the strong numbers seen in the post-COVID recovery phase and is now closer to the key level of 100,000 monthly new jobs (which is considered the breakeven level that prevents the unemployment rate from rising). A further deteriorating trend would indicate labour market weakness and softer wages.
Source: Bloomberg, QV Investors Inc.
A painful reversal in the unemployment rate may be necessary in the name of price stability. Wage inflation is stubbornly high, and central bankers have set their sights on a rebalancing of the labour market to carry out their inflation-targeting mandate.
EMPHASIZING QUALITY
Our investment teams continue to invest in and lend to quality franchises that we believe have sustainable competitive advantages and durable earnings streams. Bottom-up security selection remains our bread and butter and we are not abandoning the compounding abilities of our businesses. Our equity teams continue to own opportunities that offer attractive risk and reward in a variety of scenarios. Our emphasis towards durable free cash flow, balance sheet strength, and proven management teams has helped clients preserve and grow their wealth through prior cycles. Long-term returns and risk management go hand in hand and so we remain committed to these key characteristics.
We remain cautious of consensus earnings estimates as they continue to reflect an optimistic growth scenario next year, exposing investors to de-rating risk should economic growth decelerate. Equity market valuations, while not at unreasonable levels, are also at risk should earnings revise lower, highlighting the importance of maintaining a valuation advantage in our respective strategies.
Source: John Aitkens Investment Strategy, TD Cowen
ALL WITHIN BALANCE
“Everything in life… has to have balance.” – Donna Karan
We have upgraded quality in our bond strategy with government bonds as yields have risen. While quality corporate bonds remain attractive, the intent has been to increase the strategy’s capacity to offset potential equity volatility within a balanced portfolio. With attractive starting yields offering decent return potential, our balanced asset mix maintains a more conservative equity weight relative to fixed income and cash.
At this point in the cycle, we believe conservative portfolio positioning focused on capital preservation rather than return maximization is a prudent approach. We remain respectful of the compounding abilities of our businesses and recognize that our strategies are differentiated from the market. But we also recognize that businesses do not operate in a vacuum and have been preparing our strategies for potential market volatility ahead. This includes tightening up our inventory lists ahead of time to ensure our ideas are fully vetted. Markets move in cycles and the best buying opportunities often present themselves when prices disconnect from fundamentals. Erring on the side of conservatism now when expectations are optimistic will help us take advantage of attractive entry points later.
