As 2023 dawned, the consensus of economist forecasts pointed to an elevated risk of recession sometime during the year. After all, central bank interest rates had risen dramatically from virtually zero in early 2022 to 4.25% in Canada and 4.5% in the U.S. by the end of 2022. Consumer price inflation peaked in June 2022 at 8.1% in Canada and 9.1% in the U.S. and was already in retreat by early 2023. Market-based pricing of the future path of central bank interest rates indicated they would end their rapid pace of interest rate hikes by spring and interest rate cuts would commence by the fall of 2023. The U.S. regional banking crisis in March served to reinforce this thesis.
The post-pandemic consumer, buoyed by surplus savings and healthy employment prospects, remained resilient far longer than expected and forced central banks to continue tightening interest rate policy. With the economic reaction to every interest rate cycle subject to extended and variable lags, the essence of the early 2023 forecasts was legitimate, but the timing was off. Similarly, our cautious portfolio positioning at the beginning of 2023 appears premature in retrospect. We have continued to make several portfolio adjustments throughout the year to respond to evolving data and opportunities.
While many portfolio holdings have under-contributed year-to-date, we are confident that significant embedded value should surface over the medium-term as interest rates normalize and valuations’ mean revert.
Alas, the economy isn’t immune to higher interest rates
While homeowners with variable-rate mortgages have been feeling the pinch of every interest rate increase, the overall economy has remained resilient. But there is mounting evidence that the most aggressive rate hiking cycle in four decades has created enough headwind now to impact the broader economy. This is most evident in Canada, where recently reported Q2 GDP was -0.2% versus consensus expectations of +1.2% and the Bank of Canada’s rosy forecast of +1.5%. Meanwhile, Canada’s unemployment rate has risen to 5.5% as of July, compared with a low of 5.0% at the beginning of the year.
The stop-and-go behaviour of the Bank of Canada earlier this year confused consumers and businesses alike. With the benefit of hindsight, it appears that our central bank was hiking rates and voicing hawkish rhetoric even as the economy was shrinking. The totality of the data now confirms that the Bank of Canada’s instinct to pause in January was the correct one. After two additional 0.25% rate hikes in June and July, the Bank of Canada paused again at this week’s rate announcement. Only history will be able to tell us where and when interest rates peaked but given the sudden and surprising slowdown of the Canadian economy, we attach a high probability that the peak has already arrived.
The U.S. economy has been faring better mainly due to homeowners refinancing and locking into low 30-year mortgage rates during the pandemic. While this has supported consumer spending, leading economic indicators and recent employment data suggest that the U.S. economy is also decelerating. Specifically, average job growth for the last three months is 55% below the previous 12-month average. The unemployment rate has ticked higher to 3.8% as of August versus a low of 3.4% in January. With several European economies flirting with recession and China experiencing a muted post-pandemic rebound, we think it is only a matter of time before the U.S. relinquishes its status as an oasis of economic strength. All things considered; however, the U.S. economic glide path is likely to be relatively gentle compared with other large economies, especially if the U.S. Federal Reserve pauses rate hikes.
With inflation having decelerated into the low-3% range as of July, unemployment rising, and GDP slowing, we have increased conviction that Canadian and U.S. interest rates have climaxed, and the discussion will now shift to how long the pause will last and when rates will start to be cut. We expect interest rate-sensitive holdings within our portfolio, such as banks, utilities, REITs, and bonds, to experience a rebound in valuation from depressed levels as the market shifts focus to the downward slope of the interest rate cycle.
Higher interest rates now fueling inflation
Central banks use interest rate policy to moderate the pace of the economy and control inflation. The current interest cycle was instituted to tamp down inflation triggered by excessive fiscal spending during the pandemic, ultra-low interest rates, supply constraints, a war-related spike in commodities, and pent-up demand. As of July’s data, many of these underlying drivers have normalized, and headline inflation has decelerated to a year-over-year rate of 3.3% in Canada and 3.2% in the U.S.
Proponents of higher interest rates suggest that inflation could be “sticky” in the current range and that further progress is needed to return inflation to the desired level of 2%. The latest data, however, indicates that a significant factor contributing to the stickiness of inflation are interest rates themselves. With housing carrying the largest weight in the basket of goods and services used to calculate inflation, higher mortgage interest costs are placing material upward pressure on the overall rate of inflation. While Canada’s headline inflation reading in July was 3.3%, the heavily weighted mortgage interest component increased by a whopping 30.8% year-over-year, a direct result of the Bank of Canada’s aggressive rate hiking policy. Removing the mortgage interest component from the headline data reveals an inflation rate of only 2.4%, significantly closer to the 2% target than the headline suggests. Furthermore, it appears that landlords are passing on higher interest costs to tenants in the form of higher rent. Rent also carries a large weighting in the inflation basket.
Combined with the latest GDP readings and employment data, this alternative view of inflation supports a growing chorus of economists calling for a halt to rate hikes. Should the economic trajectory continue to weaken, we think the Bank of Canada could be forced to begin cutting interest rates sooner than many currently expect.
Market breadth expected to improve as central banks pause
The two most prominent influencers of equity markets so far this year have been the ongoing rate hiking cycle and artificial intelligence. The former has weighed on the performance of many interest-rate sensitive sectors, while the latter has propelled a few technology companies higher (“The Magnificent Seven”: Apple, Nvidia, Microsoft, Amazon, Meta, Tesla, Alphabet). Because of the large relative weightings of these technology stocks, year-to-date (YTD) performance of prominent stock market indices has diverged significantly. To the end of August, the S&P500 was up 18.8% (in CAD terms), with 75% of the gain attributable to the seven companies listed above. Meanwhile, the Dow Jones Industrial Average Index, which is weighted more broadly across sectors, is up only 6.5% (in CAD terms) over the same period. (All return data per Bloomberg).
The (YTD) divergence between the S&P500 and the Dow Jones Industrial is the widest we have witnessed in over 70 years. During past instances of wide divergence, the underperforming index has typically outperformed over the following 12-month period. We expect a similar outcome as the end of rate hikes and eventual cuts trigger a reversion to the mean across sectors and expanded breadth.
Canadian stocks, as measured by the S&P/TSX Composite Index, have delivered a total return of 7.0% YTD through August. The financials, energy, and materials sectors (which collectively represent 50% of the index weighting) have all underperformed the index so far this year. The Canadian banking sub-sector, to which we have an overweight exposure in our managed portfolios, was down 0.7% YTD to the end of August. While banks have not contributed to YTD portfolio performance, we are enthusiastic about their future return potential as valuation is below historical averages and dividend yields are near cyclical highs.
Enthusiastic about artificial intelligence, but taking a measured approach
Hardware and software advancements have converged to push artificial intelligence (AI) into the commercialization phase of its evolution. These innovations are creating viable business applications where AI infrastructure can be used to increase revenue and boost productivity across numerous industries. Generative AI is among the early applications of this nascent technology and refers to systems that are designed to create new and original content including text, images, music, and even 3D models by using probabilistic models.
Analogous to the early days of the internet, the full potential of AI is uncertain. At this point, the makers of the “picks and shovels” are the initial beneficiaries, including chip makers such as Nvidia, and “hyperscalers” such as Alphabet, Microsoft, Amazon, and Meta who operate much of the infrastructure needed to facilitate AI applications. Alphabet has been a core portfolio holding, and we have recently added positions in Microsoft and Global X Artificial Intelligence & Technology ETF, which holds a diverse portfolio of large cap hardware and software companies with outsized AI exposure. While this emerging technology holds promise, we have taken a measured approach and are cognizant that current valuation is already discounting near-term growth opportunities.
Bonds have lagged but our conviction remains high
With central banks continuing to raise interest rates longer and higher than we anticipated, the fixed income segment of our managed portfolios has detracted from overall portfolio performance so far this year. While it appears we were early in our decision to raise the allocation to bonds, our conviction for this asset class remains high. In addition to high absolute interest rates, there is an opportunity to generate capital gains in this asset class as interest rates eventually reverse course.
