Volatility in a capital market setting is a characteristic traditionally associated with the equity market. In contrast, bond market volatility has historically been benign. This year, however, bond market volatility has risen to the highest since the great financial crisis of 2008-2009 (as measured by the Bank of America MOVE Index). Even though the U.S. Federal Reserve and Bank of Canada have slowed the pace of rate hikes this year, intermittent pauses have introduced a higher degree of uncertainty to the future path of interest rates.

Starting at the beginning of August, the sentiment that rates will stay “higher for longer” has grown to become a popular view among many central bankers, economists, and investors. Surprisingly, it was just two years ago that “lower for longer” was the mantra being chanted by this same crowd. In fact, the U.S. Federal Reserve’s own forecast of interest rates in September 2021 indicated that their benchmark rate would remain close to zero for all of 2022 and only get to 1.0% by the end of 2023. Six months later, in March 2022, they started hiking and their benchmark rate now sits at 5.50% as we approach the end of 2023.

Just as the data didn’t justify “lower for longer” in 2021, we think the decelerating trend of inflation and employment data don’t support a “higher for longer” thesis on rates now. We think interest rates could start declining sooner than many expect, and we are positioning our portfolios to benefit from the tailwinds that lower interest rates should bring.

Supply chain recovery is the real hero in bringing down inflation
Economics 101 taught us that prices are a product of supply and demand. Pandemic related disruption to the global supply chain was the chief culprit responsible for the spike in inflation. Government handouts aggravated the situation by boosting consumer demand precisely when supply of goods and services were curtailed.

While central banks will inevitably take the credit, we think much of the progress to date on inflation has been due to supply chains normalizing. Indeed, inflation peaked in June 2022 while the Bank of Canada and Federal Reserve were just getting started with rate hikes. According to the Global Supply Chain Pressure Index tabulated by the New York Federal Reserve, the global supply chain has not only reverted to pre-pandemic levels, but there now appears to be excess supply.

The latest reading for October 2023 shows that slack within the global supply chain currently stands at the highest in over 25 years. This is becoming increasingly evident in lower wholesale commodity prices and shipping costs, rising inventory levels, and shortened delivery times. Even the supply of labour has improved as evidenced by the 70bps and 50bps increase in the unemployment rate for Canada and the U.S., respectively, from the lows earlier this year.

Higher interest rates now impacting consumer demand
Interest rates always impact the economy with long and variable lags. Unique features of the current cycle have included excess pandemic-era savings and low locked-in mortgage rates for some consumers. These have propped up consumer demand and cushioned the economy from higher interest rates, leading some economists to conclude that rates need to go even higher if inflation is to be brought under control.

However, after more than 18 months of rate hikes, recent data suggests that higher interest rates are only now starting to penetrate the defenses surrounding consumer wallets, resulting in potentially slower demand and further progress on inflation in the months to come. Specifically, retail sales have stagnated, credit card and auto loan delinquency rates are rising and have surpassed pre-pandemic levels, and personal savings rate has declined. The inflation outlook has changed so abruptly that Walmart’s CEO recently stated that “we may be managing through a period of deflation in the months to come.”

Central banks have paused… how long before cuts start?
Canadian consumer price inflation has decelerated to a year-over-year rate of 3.1% as of October, a significant drop from the peak rate of 8.1% in June 2022. In the U.S., October’s inflation rate declined to 3.2%, a meaningful drop from June 2022’s peak of 9.1%. We think the one-two punch of supply chain recovery and weakening consumer demand will continue to drive inflation lower as we look into 2024.

Meanwhile, concerns about economic stagnation are growing. Canadian GDP growth was -0.2% in Q2 and flatlined in July and August. Depending on how September fares (data is due November 30), Canada may be a whisker away from recession. And the current consensus for 2024 is calling for only 0.7% GDP growth in Canada, well below historical average. 2024 GDP growth expectations for the U.S. and Europe are 1.0% and 0.7%, respectively. (Bloomberg)  With growth rates barely above stall speed, we think central banks will have to pivot away from “higher for longer” and start cutting rates to protect against downside risks.

Based on market-based pricing of interest rate futures, the first rate cuts by the bank of Canada and the U.S. Federal Reserve are likely to be in Q2 2024. Both countries are expected to cut a full percentage point in calendar 2024 and keep cutting into 2025.

Barbell strategy of income and growth
The “higher for longer” sentiment on rates, particularly from the beginning of August to the end of October, hurt bond and equity markets alike. Interest rate sensitive sectors, such as REITs, utilities, banks, and telecom experienced the greatest pressure. Supported by cooling inflation and employment data in recent weeks, the most-watched interest rate benchmark, the 10-year U.S. Treasury yield, has reversed course and has already declined more the 0.5% since the end of October.

If rising interest rates were a headwind to the valuation of interest rate sensitive sectors, then declining rates should be a tailwind. Knowing that we couldn’t precisely determine the timing of this pivot, we have been steadily increasing portfolio exposure to interest rate sensitive sectors and bonds throughout 2023. With the normalization of interest rates being the catalyst, we expect that a reversion to historical valuation multiples for these investments should generate attractive returns over the next 12-24 months.

We started 2023 with an underweight position in technology. Even though the tech heavy Nasdaq index had declined 32% in 2022, valuation dropped from a frothy 32x forward price/earnings ratio at the beginning of 2022 ratio to a still rich 22x at the beginning of 2023. Breakthroughs in artificial intelligence, however, have revitalized earnings growth for several companies and the technology sector has been the strongest performer so far this year. We used recent market weakness to raise portfolio exposure to select companies (see below) that are at the forefront of AI hardware and software development.