After a strong start to 2023, markets around the world took a breather in the third quarter ending Sept 30^th, with Canadian stocks declining 2%, and global stocks declining 3-4% (Source: Thomson Reuters).  Bonds also fell during the quarter, as long bond yields rose in response to persistent inflation, which weighed on bond prices.

While the economy is showing few signs of weakness, as evidenced by the strong employment numbers in Canada and the U.S. this past week, global markets are forward-looking, and are keenly aware that it takes 18-24 months for rising borrowing costs to have their impact.  We will see if that results in the recession that so many have forecast for the past year.

The good news is that inflation is starting to level off, albeit at higher rates than our central bankers are comfortable with.  Supply chains have normalized, as evidenced by world container prices and supplier delivery times, which have returned to their pre-Covid averages.  However, average rents and wages remain stubbornly high.  This means rates may remain at a higher level than we had become used to over the past decade of ultra-low rates.

Better yet, investors are getting the best compensation from several types of investments than they have in decades.Government bonds of various maturities are now offering yields of 4-5%, investment grade corporate bonds yield 6%, and high yield strategies offer yields in the 7-9% range.  As you can see from the table below, long bond yields tend to decline after the final hike by central banks (even including the high inflation period of the early 1980s), which means bond prices could increase from here.  Short term bond rates tend to fall much more sharply, as central banks are forced to cut borrowing rates to stimulate the economy.  If history is a reliable guide, some of the pain felt by bond market participants over the past two years should be reversed.  To recap, we have not seen bond yields this high in over 15 years, and they may not be around for long, as the median rate decline over the following 12 months is 0.91% (or 91bps), as illustrated below (source: Piper Sandler). 

 

 

Turning to the stock market, Canadian banks, pipelines, utilities, and telcos offer dividend yields in the 5-8% range and have long track records of managing their balances sheets to ensure their dividends can be maintained and increased at a sustainable pace.  Further afield, stocks in the Emerging Markets, Europe and Japan trade at steep discounts to their historical averages, implying that a lot of the bad news is already “priced in”.  In the U.S., the opportunities are more selective and nuanced, as the broader market is expensive, but many companies are well positioned to benefit from long term trends and have more resilient earnings streams than in the past.

 

The Bottom Line

If a recession emerges over the coming months, it will be one of the most telegraphed ones in recent memory.  Markets follow predictable patterns during economic slowdowns.  First, valuations compress, then earnings fall, and finally, layoffs begin as companies try to preserve their margins.  Bond markets rally as interest rates typically decline during these final two phases.  We have certainly experienced part one of this pattern, as the broader U.S. market’s valuation has fallen from a peak of 23x forward earnings to 17x today ), and its foreign peers have followed suit (Source: Thompson Reuters.  What remains to be seen is how companies manage through part two and three.  To date, inflation has helped companies with pricing power, but unit growth is starting to fade, which could weigh on revenue growth going forward. It is an easy decision for someone struggling to pay their mortgage or rent to shift from a brand name to a no name brand at a fraction of the price.  Layoffs have begun, but the labor market remains tight. As illustrated in the chart below, earnings estimates have already fallen about 10% this year and next, so investors are already projecting part two of this slowdown.  If it is does not come to pass, or is milder than expected, stocks are great value.  If not, many of them are paying you to generously to wait.

 

(Source: Piper Sandler)

 

Q3 Recap

Here’s a quick recap of the dominant themes moving markets during the past few months:

• Rising rates.  Long bond yields jumped higher around the world in August.  With inflation stubbornly above the 2% target held by most central banks, bond investors priced in the potential for central banks to keep rates “higher for longer.”  They also demanded additional compensation for the risks posed by rising fiscal deficits (and political disarray) in key OECD nations like the U.S. 
  • US 10-year yields jumped 0.74% to 4.58% to highs last seen in 2006(!).  Short-term borrowing rates were more subdued, staying in a tight trading range from 5.45-5.50%.
  • Canada largely followed suit, with 10-year yields rising 0.67% to 4.03%.  However, short term borrowing rates also moved up 0.30% after Canada’s hot inflation and jobs numbers in September.
  • USD$ strength.  Long bond rates rose in Europe and Japan, but with a few notable exceptions (Italy and the UK), are not anywhere near as high as their North American peers.  The more attractive rates in the U.S., along with its safe haven status during periods of turmoil, caused the USD$ to strengthen against a broad basket of currencies as investors shifted their funds to U.S. bonds.

 

• Rate Sensitive Securities Fell.  Sectors that depend on high levels of debt (40-50% of their market values) to finance their operations, like utilities, telecoms, pipelines, real estate, and other infrastructure investments, saw their valuations fall sharply during the quarter.  Typically, these sectors perform well during economic downturns, but sustained higher borrowing costs will impact their ability to return capital to shareholders as more capital goes to servicing debt.  Likewise, high growth stocks (i.e.tech), who don’t borrow a lot, but are typically valued on the present value of their future cash flows, also fell sharply as their valuations are equally sensitive to higher “risk free” rates.     

 

• Jump in oil bad for inflation, but price action not followed by other commodities.  Energy prices jumped 30% as Russia and Saudi Arabia extended their supply curbs, which amount to 1.3MM barrels per day, through to year end, while demand remained stronger than expected.  This does not bode well for inflation cooling in the months ahead.  However, other industrial commodities like copper and food inputs like wheat, corn and soybeans saw sharp drops in prices through the quarter.

 

• Consumer under pressure. With excess savings from the COVID lockdowns largely depleted, the consumer has less available cash to deal with rising gas prices and 30-year highs in mortgage rates.  This is evident in the performance of retail stocks and rising credit card delinquencies.

 

• GLP-1 makes their presence known.  AI is not the only theme dominating markets this year. Glucagon-like peptide-1 receptor agonists (or “GLP-1”) like Ozempic and Wegovy are revolutionizing diabetes management and weight loss in the U.S.  While its most immediate impact is a stratospheric rise in Eli Lilly and Novo Nordisk stock (the latter is a core holding in Walter Scott’s International Equity mandate), it is having far-reaching impacts beyond health care.  For example, Wal-Mart’s CEO noted a drop in “calories purchased” during their most recent earnings call, and it has clearly weighed on the stocks of several fast-food restaurants and high caloric consumer goods companies like Pepsi and Coke.  An analyst recently postulated here that United Airlines could save $80MM on fuel annually if their average passenger lost 10lbs.  Like AI and climate change, we are just beginning to understand the potential long-term implications of a leaner, fitter population.

 

Disclaimer: Yields/rates quoted are as of October 8th,2023 and are subject to availability and change without notification. Minimum investment amounts may apply.