September Market Update 2022

Markets continue to experience above average volatility as we move into the fall season of a year that has been very challenging for both equity and bond investors. Increasingly it appears that we may have seen the market low for the year on June 17^th but this is by no means is certain. Since then the market has retraced 50% of it’s peak-to-trough losses, due in part to better than expected earnings in the second quarter and strength in consumer spending. Since World War II, there has never been an instance where the market has established a lower low after a 50% retracement. More recently we have seen the market give up some of its gains following FOCM Chair Jerome Powell’s speech in Jackson Hole on August 27th, in which he re-confirmed his steadfast commitment to fighting inflation by continuing to raise interest rates and keeping rates high, until there is clear and consistent evidence that inflation has been tamed. Up until this speech the market doubted the FED’s commitment to bringing inflation down, preferring to believe the FED was more dovish than it was admitting, and that a pivot to lower rates in the near term was possible. After Jackson Hole the market seems to be getting the message, higher rates are coming and they are likely going to be with us for some time.

Meanwhile the US and Canadian economies continue to show resilience. Second quarter GDP in Canada came in at 3.3%, bolstered by strong oil exports and high commodity prices. The US economy contracted 0.9% in the second quarter, the second consecutive quarterly decline, which technically describes an economic recession, but in reality does not meet the broader definition of recession that would include widespread economic decline. In fact, in many ways, the US economy continues to show considerable strength, with recent new job creation for the past two months exceeding 300,000 new jobs per month. Manufacturing activity continues to expand at a modest albeit declining rate, and the consumer seems more than willing to spend for now, even if it means credit card debt in the US just exceeded $1.2 trillion, a new all-time record.

Globally, Europe is struggling to find affordable energy sources to replace Russian natural gas, triggering concerns that there will be a significant recession next year. China continues to restrict re-opening of their economy as they fight a resurgence of the Omicron variant of Covid-19. In many industrial cities air quality measures of carbon dioxide are at very low levels, indicating factories are not operating anywhere near full capacity as workers remain quarantined at home. China meanwhile is also struggling with a real estate credit crunch and rising defaults, falling real estate prices and global manufacturing supply chains pivoting away from China to cheaper and less politically uncertain geographies such as Vietnam and India. All told, the US and Canada remain the most attractive places for investors right now, at least on a relative basis, in spite of higher valuations.

With uncertainty elevated globally, I thought it would be useful to discuss some of the economic and market indicators worth following, in order to assess when we might expect a market turnaround.

Bond yields remain inverted in the US and Canada, a traditional indicator of a slowdown ahead, although it is not always predictive of a recession. Five year Treasury yield breakeven futures are at 2.58% and indicate the bond market thinks inflation is likely to stabilize in the coming years. Market expectations are for the FED to take interest rates to 3.75-4.0% by year end, up from their current level of 2.5%. The best read on the current bond market’s expectations for how high the FED will take interest rates is the 2 year Treasury yield, currently at 3.476% (Sept 7/22). Meanwhile the 10 year Treasury yield stands at 3.292% (Sept 7/22) and has been rising lately back towards it’s intra-year high of 3.48%, which corresponds to the market low in June. The 10 year is the bond market’s estimate of the neutral interest rate that is neither stimulating nor contracting the economy.  The equity market has not reacted well this year when the 10 year Treasury yield is above 3.0%, so this is a key indicator to watch as rates continue their climb to year end.

Volatility, as measured by the VIX, has been elevated all year as markets search for a bottom. Over the long term the VIX has averaged 20, with a standard deviation of 8. Market bottoms have tended to occur when the VIX rises close to 36, a two standard deviation variant. Conversely, when the VIX drops below 20, the market tends to rally. Today the VIX stands at 26.9 (Sept 7/22) and appears to be moderating after hitting intra-year highs in June.

Inflation data also appears to be moderating, with last months US CPI coming in at 8.5% (core inflation ex food and energy 5.9%), down from 9.1% the month prior. In Canada, last months read was 7.6%, down from 8.1% in June (core inflation 5.3%). While encouraging, it’s premature to draw meaningful conclusions at this point, and so we will have to see this pattern continue for many more months before central bankers and investors can expect lasting inflation relief.

The strong US dollar is also a key indicator to watch as global institutional investors seek the safety of US Treasuries, bidding up the USD. Think of this as a fear index for global investors. Until we see the US dollar index begin a meaningfully decline (and the Canadian dollar and other currencies rise) we can expect to continue to see volatility in equity markets and no clear sign that we are coming out of this bear market.

Inflation and rising interest rates are the key drivers of the stock and bond markets this year. We continue to expect markets to remain volatile in the near term as we watch for indications that inflation is moderating. We believe the FED and the Bank of Canada when they say they are committed to fighting inflation even if it means inflicting some pain on the economy and the stock market. As a result, until inflation is ultimately brought under control the markets will remain volatile. As we move into 2023 there will be rallies along the way but the start of any new sustained up cycle cannot happen until central bankers say they are finished with raising interest rates. That will not happen any time soon. We also must remember that the economic impact of rising rates operates on a 6 to 12 month lag, and we only saw our first rate hike in March of this year. Therefore any discussion about whether we will be going into a recession will not be answered until 2023. However, with a strong US jobs market and unemployment running at 3.7% in the US and 4.9% in Canada (74,000 jobs lost in Canada in June and July), and interest rates still at relatively modest levels, it seems likely that any economic decline we eventually see in 2023 will be mild. Only time will tell. In this environment, investor patience is required.

We continue to recommend a balanced approach to the markets, under-weight technology and growth stocks, and over-weight defensive sectors such as consumer staples, healthcare, utilities, energy and materials. Bank financials remain core holdings and we have added modestly to positions recently. 

As always, if you would like to talk about anything mentioned in this letter, or would like to review your portfolio in light of the inflationary cycle we are now in, please call or email me. We would be happy to arrange an in-person meeting (or via telephone or virtual) to review your portfolio, or discuss any matter related to your financial well-being.

Gordon Forsey Advisory Group:

Gordon Forsey P.Eng., MBA, CIM, FCSI

Portfolio Manager, Sr. Wealth Advisor

gordon.forsey@cibc.ca

Tel: 902-420-6203

Andreas Demone  BBA

Client Associate

andeas.demone@cibc.com

Tel: 902-420-9624

Terri MacPhail

Client Associate

terri.macphail@cibc.ca

Tel: 902-420-8263

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