Written as of September 15, 2023.
View the Nicola Wealth Investment Returns: August 2023
Highlights this Month
- Rising bond yields, historical implications, and the potential risks they pose to markets.
- Market concerns over rising interest rates center on potential inflation-driven monetary policy tightening.
- The Fed is closely monitoring moderating wage growth amid economic uncertainties and fluctuations.
- Inflation and China's economic struggles pose significant market tail risks.
- Geopolitical factors are exerting significant pressure on the Chinese economy.
- Nuclear threats, AI, election uncertainty, ongoing COVID-19, and climate change pose varied risks.
August in Review
August is traditionally a sluggish month for financial markets, characterized by reduced liquidity. It's crucial to consider this factor when assessing investment returns. However, it's worth noting that investors who were on vacation and not closely monitoring their portfolios were spared from the challenges of what turned out to be a tough month. Both stock and bond prices experienced declines.
In the equity markets, all major global indices closed the month in negative territory. The S&P/TSX was down 1.4% (total return in Canadian dollars), the S&P 500 saw a decline of 1.6% (total return in U.S. dollars), and the NASDAQ experienced a 2.1% drop (total return in U.S. dollars). Emerging market equities faced even steeper declines.
As bond yields continued to rise, most fixed income investments also delivered negative returns. However, it's worth noting that credit spreads remained relatively stable, helping to mitigate some of the adverse price impacts caused by higher interest rates.
While absolute returns may not have been severely negative, the overall sentiment among traders was rather bleak, as the markets struggled to generate any positive momentum. In fact, the S&P 500 narrowly avoided posting two consecutive up days throughout the month, with only a four-day winning streak towards the end preventing this, a feat not witnessed since 2002.
Carson Investment Research suggests that the markets could be entering a phase of seasonal weakness. Historically, the S&P 500 has tended to consolidate for a few months after achieving more than a 10% gain by mid-year. Additionally, TS Lombard's analysis indicates that the S&P 500 is following the trajectory of market recoveries observed after minor bear markets rather than recessions. Both of these factors suggest that the likelihood of further upside in the coming months is higher than the potential for a sharp downturn for the rest of the year.
However, there's a less optimistic perspective to consider. Yale University's U.S. Crash Confidence Index, which measures investor concerns regarding a stock market crash, has reached its highest level since the onset of the pandemic. This index defines a crash as a situation where there's a greater than 10% probability of a severe downturn akin to the 1987 Black Monday, during which the S&P 500 plummeted nearly 30% over just four trading days. Of note, 34% of individual investors and 44% of institutional investors now believe such an event is possible within the next six months.
Bank of America's monthly survey of global fund managers consistently points to inflation and hawkish central banks as the likely culprits that could trigger such a crash. This concern has persisted since April 2021 when investor fears were dominated by the COVID-19 pandemic for about a year. Considering the potential impact of these factors on the markets, this month, we will delve deeper into this tail risk and touch upon other brewing storms that could threaten the financial markets.
Rising bond yields, historical implications, and the potential risks they pose to markets.
While experiencing stock market declines is never enjoyable, last month, our primary concern shifted to the drop in bond prices, resulting in rising yields. This shift in focus is particularly concerning from a tail risk perspective. A recent report from Bloomberg drew attention to the fact that 10-year bond yields have been steadily declining since 1985. Historically, any disruption in this downward trend has been associated with unfavourable outcomes.
According to Bank of America, not only have 10-year yields reversed their course and started to rise, but they are also poised to deliver negative returns for the third consecutive year. This is unprecedented in the history of the U.S., where bonds have never sustained losses for three successive years. Higher bond yields typically exert pressure on stock valuations, a scenario witnessed last year as stocks declined alongside rising interest rates.
Interestingly, this year has seen a notable decoupling of stock valuations and bond yields. However, this poses a future risk for stock prices unless interest rates reverse their trend and begin to decline. However, a recent Bloomberg MLIV Pulse survey indicates that most investors are not overly concerned. The majority of respondents believe that even if 10-year treasury yields were to rise from the month-end levels of 4.1% to 4.5%, the S&P 500 would only experience a modest drop of less than 10%. Nearly a quarter of the 331 survey participants believe that stocks would continue to rise, regardless of 10-year yields reaching 4.5%.
The recent break in the 10-year yield trend has raised concerns, primarily regarding the underlying reasons. Notably, the rise in nominal rates has been primarily attributed to an increase in real rates, as 10-year inflation breakeven rates have shown minimal movement in recent years. Goldman Sachs points out that a substantial part of this increase is linked to market perceptions of improved economic growth prospects and expectations of progressively tighter monetary policy. Strategas suggests that if the Fed has completed its rate hikes, 10-year yields may be nearing their peak.
Market concerns over rising interest rates center on potential inflation-driven monetary policy tightening.
The market's concern about rising interest rates is less focused on strong economic growth and more on the potential impact of higher inflation, which could necessitate continued tightening of monetary policy by the Federal Reserve. The Fed remains a critical factor influencing market dynamics, with traders currently divided on whether the Fed has completed its rate hikes. According to Bloomberg's August MLIV Pulse survey, most respondents believe it is premature for the Fed to declare victory over inflation, with 79% anticipating higher interest rates and inflation for at least the next five years. Additionally, 55% believe that a financial crisis, rather than declining inflation or job market concerns, would be the catalyst for the Fed to lower interest rates.
A crucial factor for the market is determining the event or issue that would prompt the Fed to reduce interest rates; currently, with inflation appearing to be manageable, the focus is shifting away from whether the Fed will implement another 25 basis points increase and more toward the duration of their pause and the timing of potential rate cuts. According to Bridgewater, both market expectations and the Fed's dot plot suggest a significant easing move in the coming year, although these expectations have consistently been delayed as the Fed aims to maintain higher rates for an extended period. Additionally, there is growing scrutiny regarding the long-term trajectory of interest rates, often referred to as R*. This term represents the short-term real interest rate that keeps the economy neither too accommodating nor too restrictive and is estimated to be around 0.5%. Many, including the Fed itself, believe that factors such as demographics and substantial deficits might be pushing R* higher. According to Bloomberg, a swaps-based proxy, determined by how U.S. 5-year inflation-adjusted yields are priced to trade in 5 years, also indicates an upward trend in the so-called neutral rate. A higher neutral rate implies that even when the Fed begins to cut rates, the reductions may not need to be as substantial as in previous easing cycles.
In the short term, the Federal Reserve is grappling with mixed signals regarding the effectiveness of its monetary policy in curbing inflation. While many indicators suggest that the U.S. economy is still operating at a robust pace, there is disparity in economic growth predictions. In Q2/23, GDP surged by 2.3%, surpassing the Congressional Budget Office's estimate of potential GDP growth for the U.S. economy. Bloomberg Economics' USGDP Nowcast anticipates a 2.8% increase in Q3/23. The Atlanta Fed is even more optimistic, forecasting a remarkable 5.6% growth rate for the U.S. economy this quarter (as of September 11). However, Bloomberg's survey of economists predicts a more modest +2.1% growth, and the St. Louis Fed anticipates a contraction of 0.3% in Q3 GDP.
Adding to the complexity, there are two methods for measuring economic output: GDP (Gross Domestic Product) and GDI (Gross Domestic Income). Although they should ultimately align, GDI has recently lagged GDP. Over the past four quarters, GDI has contracted by 0.5%, while GDP has shown a growth of +2.5%.
The landscape of inflation is equally intricate; while there is a clear trend of inflation cooling, reaching the Federal Reserve's 2% target might be a prolonged and uncertain journey, with the Fed's latest forecast indicating that headline PCE may not approach 2% until Q4 2025, and Core PCE could take even longer, given the Fed's cautious approach to potentially volatile data in light of past inflation fluctuations.
The Fed is closely monitoring moderating wage growth amid economic uncertainties and fluctuations.
The Federal Reserve places a significant emphasis on wage growth, which is currently showing signs of moderation, with reports indicating that companies are offering lower pay for the same positions compared to the previous year, and ADP's data suggests that annual pay increases for job-switching workers have returned to levels seen in June 2021, while the Indeed Wage Tracker indicates a notable slowdown in posted wages in the U.S over the past 18 months.
However, it's worth noting that news headlines suggest a different trend, with growing union support and high-profile labor negotiations poised to disrupt the long-standing decline in workers' share of corporate profits. For instance, Strategas highlights that full-time UPS workers successfully negotiated an 18% pay increase over five years, resulting in an average top hourly rate of $49, translating to an annual pay and benefits package of $170,000 in 2028 for the average full-time UPS driver. American Airline pilots secured an even more substantial raise, a 40% increase over four years, mirroring the demands of U.S. autoworkers, particularly the UAW, who are advocating for a 46% pay hike over four years, along with a return to traditional pensions, retiree healthcare, annual cost-of-living adjustments, and a shorter 32-hour workweek. UAW leader Shawn Fain argues that despite record profits over the past four years, automakers have only granted hourly workers two 3% raises, prompting the call for a 46% wage increase, aiming to align with the average executive pay hike among the big three automakers during the same period. Additionally, it's noteworthy that GM CEO Mary Barra has earned $200 million in the last nine years. Despite union membership declining to 10% in 2022, ongoing efforts to organize at companies like Amazon and Starbucks indicate that unions are seeking to leverage the still tight job market.
The rise in wages signifies a positive development for consumers as they begin to experience genuine wage growth. However, this is crucial because the Federal Reserve has reported that excess savings in the U.S. were depleted in the first quarter of the year. There is increasing evidence of consumer stress, with a noticeable uptick in delinquencies on auto loans, consumer loans, and credit cards according to Equifax/Moody’s Analytics. The fact that this is occurring during a tight labour market serves as a warning signal for the Federal Reserve.
Currently, markets seem content with the current inflation and monetary policy dynamics. JP Morgan notes that recession probabilities across asset classes have decreased significantly since last October, especially in equities and credit markets. Goldman Sachs has recently revised its 12-month recession probability down to 15%, while Deutsche Bank's models still indicate estimates over 90%. Interestingly, markets have exhibited more positive reactions when economic news is negative, as it increases the likelihood that the Federal Reserve has concluded its rate hikes. This aligns with the market's concerns regarding the tail risk of inflation and a hawkish Fed.
The prevailing narrative in the market suggests that inflation is under control, and economic growth remains robust, essentially indicating a soft landing. Interest rates can gradually rise to reflect the economic strength, in line with a higher neutral rate, as long as they are not increasing due to inflation concerns that necessitate further Fed tightening. Looking ahead, the question for the market revolves around the implications of a prolonged period of higher rates on the economy and whether economic growth can be sustained if rates remain at their current levels.
Inflation and China's economic struggles pose significant market tail risks.
Inflation and a hawkish Federal Reserve undeniably represent significant tail risks for the market, especially given the conflicting data that the Fed must assess. However, it's noteworthy that a hard economic landing in China has also emerged as a noteworthy concern, deserving consideration as a potential market tail risk.
Reports indicate that the likelihood of a hard landing in China may be higher than in the U.S., as suggested by the volume of headlines. Forecasts for China's 2023 GDP growth rate have been on the decline, with the average projection now falling below China's official target of 5%. Bloomberg reports that China's retail sales continue to lag behind their pre-pandemic levels, and the housing market has been mired in a slump for over two years. Considering the pivotal role of the housing market in both economic growth and household wealth in China, these indicators paint a concerning picture for the nation's economic future.
For a deeper understanding of the challenges confronting China, we recommend listening to Nicola Wealth’s Lead/Impact Webcast between Chairman and Chief Executive Officer John Nicola and Michael Pettis, an expert on China’s economy, titled "Unveiling China’s Economic Landscape." Drawing parallels with Japan in the early 1980s is plausible due to China's debt and demographic issues, but China's lower GDP per capita sets it apart. China's economic transformation requires a shift away from export and investment-driven growth toward increased consumption, which is a politically challenging endeavour, especially when leadership may not fully empathize with the struggles of the average worker – a scenario reminiscent of "tough love."
Geopolitical factors are exerting significant pressure on the Chinese economy.
The U.S. and other Western developed nations are actively working to restrict China's advancements in strategically vital industries, particularly those linked to the military. This adversarial relationship poses a risk to China's economic growth. According to Strategas, Mexico, and to a lesser extent, Canada, are reaping benefits from the shift away from trade with China. However, the U.S. could also face repercussions from the deteriorating relationship between the two nations. This is because China plays a crucial role in numerous strategic research projects and surpasses the U.S. in publishing scientific papers and allocating resources to research and development.
Furthermore, China holds a leading position in several strategically vital and rapidly growing industries, notably in clean energy technology and supply chains. According to Alpine Macro, China's capital expenditure in the "Green" sector surpasses that of other developed countries by a substantial margin. A recent Financial Times article underscored China's dominant presence in the global clean energy supply chain. As reported by the Financial Times, China has achieved self-sufficiency across the battery supply chain and is positioned favourably to assert its dominance in the electric vehicle market.
However, in the short term, the most crucial question for the markets is whether a severe economic slowdown in China holds significance. While news headlines often depict a concerning scenario for the Chinese economy, financial markets exhibit a relatively lower level of concern. Chinese stocks have experienced some underperformance, but the Shanghai Composite is still up 3.5% for the year (in local currency). Moreover, as highlighted by Strategas, Chinese tech stocks (KWEB), in comparison to U.S. tech stocks (QQQ), have not reached new lows. Additionally, although Chinese bank stocks are displaying weakness, they are not weaker than their U.S. counterparts. Iron ore prices, which would typically decline if the Chinese economy were in turmoil, remain stable, as do Chinese 2-year bond yields.
It's challenging to envision that economic challenges in the world's second-largest economy would have no adverse effects on global growth. However, it's essential to recognize that the impact is unlikely to be uniform across the globe. According to Bloomberg, nearly 40 countries have China as their top export market, with commodity-producing nations dominating this list. Notably, Germany maintains substantial economic ties with China, and even the U.S. has exposure through affiliated businesses operating in China. The New York Times reports that a significant portion of Qualcomm's sales, 64%, is derived from China, and Boeing anticipates that 20% of their sales over the next two decades will originate from the Middle Kingdom.
Despite the grim headlines, we suspect that the state of the Chinese economy may not be as dire as portrayed, given the relative stability in markets. China still possesses policy leeway to stimulate growth, and from a bottom-up perspective, it remains a formidable competitor in several strategically vital industries. However, if the headlines indeed accurately predict a hard economic landing in China, it's likely that markets are currently undervaluing this tail risk. Over the long term, China's challenges are expected to pose headwinds for global growth, a factor that may not yet be fully incorporated into market expectations.
Nuclear threats, AI, election uncertainty, ongoing COVID-19, and climate change pose varied risks.
There is no shortage of concerns to consider regarding other potential tail risks. The conflict in Ukraine has raised apprehensions about the use of nuclear weapons, not just due to Russia's potential threats but also the possibility of Russia aiding North Korea or Iran in their pursuit of a strategic nuclear arsenal.
Artificial intelligence presents a dual scenario, where it could drive growth and productivity gains, contributing to economic expansion without generating inflation. However, it could also lead to social unrest as jobs become automated and eliminated. There is also the looming fear akin to a "Terminator" scenario.
The forthcoming 2024 U.S. election poses challenges for the market to gauge and factor in. While it's difficult to predict, scenarios could emerge where democracy faces threats.
Lastly, COVID-19 has not yet left us, and new waves of cases could potentially dampen activity levels and impede economic growth.
Climate change remains a significant market tail risk, challenging accurate pricing. Businesses and investors often prioritize the costs of decarbonization over physical effects. Research by the IMF indicates that equities have not fully accounted for climate change risks. Analyses by Cambridge Econometrics and Ortec Finance suggest that a 60/40 portfolio could suffer cumulative returns nearly 40% below baseline if global temperatures rise by more than 4°C from pre-industrial levels by 2100—a figure that some consider conservative. Recent record temperature increases, and numerous natural disasters indicate an accelerating timeline for climate change.
While numerous potential tail risks exist, Goldman Sachs has recently noted a contrary trend. They suggest that based on the one-year rolling count of three standard deviation daily market moves, the number of tail risks has significantly decreased and is currently at its lowest point since the 1990s. However, it's worth considering that low volatility may be a contrarian indicator, with potential volatility impacts from these tail risks still ahead of us.
Market volatility becomes particularly susceptible when changes in tail risks occur. For instance, the Bank of America Fund Manager Survey indicates that high inflation and hawkish central banks are seen as the most significant tail risks, and these are already factored into market pricing. However, if factors like a global recession, a systemic credit event, or worsening geopolitical issues take precedence, cross-asset volatility is likely to increase. While markets may struggle if inflation unexpectedly rises, we believe it is a recession or severe economic downturn that could inflict more substantial damage. The future remains uncertain, with the potential for many more surprises in store.
Disclaimer
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer, and Investment Fund Manager with the required provincial securities commissions. All values sourced through Bloomberg.
