Q3 Economic Review and Outlook

The North American economy has demonstrated remarkable resilience, surpassing the expectations of many economists during the third quarter. A tight labor market and steadfast consumer spending have contributed to robust economic performance throughout the first half of 2023. This scenario has bolstered the market's argument for a "soft" landing, where a gradual deceleration in economic growth is expected to effectively mitigate inflationary pressures without precipitating a significant recession.

 

However, this narrative began to unravel somewhat as we progressed through September. The economic softening orchestrated by central banks has raised concerns about the potential downturn in economic conditions. A significant increase in credit card balances and an uptick in debt delinquencies presents a mixed message. While consumers continue to exhibit the confidence to spend, an increasing number can not pay their bills. Given that the U.S. economy relies heavily on consumer spending, this mixed message presents uncertainty about the consumer and general economic strength going forward. What we are witnessing is likely a bifurcation of the consumer, as high income earners continue to spend while inflation and higher interest rates have had a larger negative impact on those with lesser incomes.  The job market has also begun to loosen recently, causing those who are concerned about their future employment to tighten their belts.

It has been evident for some time that we are operating in a "higher for longer" interest rate environment. This change is largely attributable to central banks discontinuing their "Quantitative Easing" programs, which have been in place since the 2008-2009 financial crisis as an economic stimulative measure. These programs had the effect of artificially suppressing long-term bond yields, and their cessation marks a move toward a more natural situation in the fixed income markets.

 

In addition to the discontinuation of Quantitative Easing programs, another pivotal factor contributing to the current "higher for longer" interest rate environment is the tapering of unchecked M2 money supply growth that occurred during the Covid-19 lockdowns. This rapid expansion of the money supply had a pronounced inflationary impact, putting further upward pressure on interest rates as central banks aim to curb inflation.

 

By reining in both Quantitative Easing and the growth of the M2 money supply, we are witnessing a more controlled and normalized financial landscape, which is more in line with traditional economic principles. This dual cessation serves to mitigate artificial influences on long-term bond yields and inflation, marking a significant shift toward a more traditional interest rate environment. The era of ultra-low rates spanning the past 15 years has largely concluded, as central banks worldwide remain committed to normalizing interest rates. While central banks may be approaching the conclusion of their current rate-hiking cycle, it is improbable that they will promptly reverse their course unless confronted with significant economic deterioration.

 

The market is now grappling with the realization that we are entering a wholly distinct environment compared to the preceding decade. Throughout most of the 2010s, bond yields were at historic lows, rendering them unappealing for investors and compelling them to seek growth in equities, which appeared to be the sole avenue conducive to realizing financial objectives. In the present context, with bond yields hovering around 5%, they have emerged as a substantially more viable and appealing investment option, offering an alternative and synergistic addition to equities in a diversified portfolio allocation. The validity of the much used acronym "TINA" (There Is No Alternative) to stocks has diminished with guaranteed returns now available in the 5% range. This shift has been particularly detrimental to stocks that investors would buy primarily for income, like pipelines and 

utilities. The attractiveness of a 5% dividend in an equity is significantly muted when you can get an equivalent guaranteed yield on high quality bonds with no risk to your principal when held to maturity.

 

The obvious question is can the market perform well with interest rates this high? History shows us that the answer is yes. The interest rate environment we have entered seems high relative to recent history, but when we look back over the past 70 years, we see that we are in a much more “normal” environment with the ultra low rates of the 2010’s being the exception to the rule. We are experiencing a turbulent market period as participants grapple with the idea of higher rates as any money manager under the age of 45 has never experienced this type of environment in their career. Once a degree of comfort with the environment is reached, stocks can continue their historical march upwards and will once again take their place as the top way for Canadians to grow their wealth and reach their financial goals.

War in the Middle East

In recent weeks, there has been a surge in hostilities, perpetrated by Hamas, an organization with deep-seated ties to Palestine, targeting Israeli civilians. The unfolding situation in the Middle East holds the potential to exert significant repercussions on global financial markets and the North American economy. This potential impact is particularly pronounced should the regional tensions broaden to involve nations like Iran.

 

Financial markets have displayed a remarkable degree of resilience in the days following these attacks. Nevertheless, it is crucial to underscore that any escalation in the conflict is almost certain to carry far-reaching consequences. The United States, a steadfast ally of Israel, finds itself increasingly embroiled in a quasi-multi-front conflict, as it concurrently extends its support to Ukraine in its ongoing struggle against Russia. Despite the obvious humanitarian issues at hand, the market appears to be largely shrugging off a potential geo-political escalation.

 

Our Response - Your Portfolio

We have made a number of pro-active adjustments to our client portfolios to take advantage of the opportunities presented by the current environment. In order to insulate our clients from the recent market volatility we have raised some excess cash from the equity portion of our mandates. This cash has been temporarily reinvested in money market instruments that have no volatility while also providing a very attractive yield. To take advantage of the higher bond yields, we have increased the weighting towards fixed income in our balanced accounts—locking in the current attractive yields up to five years. Conservatively extending the duration of our fixed income allocation mitigates the “reinvestment risk” of yields being significantly lower when our short-term bonds mature. By extending duration across our 1-5 years maturity range, we have reduced the reinvestment risk where central bankers have lowered short-term rates to offset the effects of their current policy designed to slow down the economy, create slack in employment and ultimately bring inflation down to their 2% target.

 

Within the equity markets, leadership (and your portfolio) has transitioned into the super-mega-cap companies. Traditionally, these companies are of exceptionally high quality and many have very consistent, predictable above average earnings growth rates that have historically shown exceptional resilience to economic slowdowns. The valuation on these companies has become much more attractive during 2022 due to the unprecedented, rapid increase of short-term interest rates by central bankers to stem inflation. With this period now behind us, these high quality growth companies are much more attractively priced and their resilient growth characteristics are bringing them to the forefront given the outlook for generally slowing economic growth. The list of such companies includes: Microsoft, ServiceNow, Adobe, UnitedHealth Group, Cencora, Eli Lilly, Amazon, McKesson, Visa, Nvidia, TJX Companies, Alphabet, Costco and Walmart.

 

A well-structured, diversified portfolio acts as a formidable fortification against the short-term vagaries of the market. By allocating resources across a spectrum of investment styles and economic sectors, an investor can mitigate the impact of any single asset's poor performance.  These time-tested principals provide resilience when certain market segments falter, ensuring that the overall portfolio remains robust. Nevertheless, diversification alone is insufficient to navigate the complex financial landscape. Active asset management is equally indispensable. It involves constant vigilance, fine-tuning the asset mix, and adapting to changing market conditions. Actively adjusting individual holding and weightings between stocks, cash and bonds to reflect underlying macro-economic and market conditions can not only reduce volatility but also improve returns in the longer-term. Seed Financial Group understands that shrewd asset management doesn't mean standing idle and hoping for the best, but entails the art of rebalancing and optimizing holdings to seize opportunities and minimize losses. In today’s dynamic financial realm, the confluence of diversification and active management is the beacon that guides investors toward the vital objective of capital preservation and the ultimate realization of their retirement goals.