Written as of March 9, 2023.
View the Nicola Wealth Investment Returns: February 2023
Highlights this Month
- Fixed income investments underperform equities as short-term U.S. rates reach multi-year highs.
- Potential negative effects of higher interest rates on U.S. consumers and companies may take longer to materialize.
- Canada's high household debt makes its economy more sensitive to interest rate changes.
- Economic growth shows resilience, but earnings outlook is still uncertain.
- Theories behind equities resilience amidst rising rates, and the potential shift towards alternative investments.
- Geopolitical risks rise, but stock valuations remain expensive.
- U.S. debt levels pose uncertain concerns for markets as inflation emerges.
February in Review
In January, robust markets instilled optimism among investors that the bear market had been surmounted. However, declines in February evoked apprehension that a bottom has yet to be attained. Last month, most global equity indices experienced a slump, with the S&P/TSX and S&P 500 dropping an almost identical 2.4% in local currency terms. The S&P/TSX fared a little worse in U.S. dollar terms, losing 4.6% due to the Canadian dollar's depreciation against the U.S. dollar in February. Foreign markets were hit harder, particularly emerging economy stocks. Like in 2022, equities were not the sole asset class to suffer last month, as cross-asset returns were all negative. Except for cash, high-yield bonds provided investors with the highest returns of -1.4%. According to Bloomberg, U.S. Treasury bonds experienced a decline similar to that of big-cap stocks, falling approximately 2.5% as 10-year yields escalated over 40 basis points to nearly 4%.
The decline in month-to-month returns was not limited to the top-line index results, as various sectors that performed well in January exhibited poor performance in February. This was due to the sectors moving in line with their historical sensitivity to interest rates. For instance, communication services, consumer discretionary, information technology, and real estate typically perform better when rates are declining rather than rising. Consequently, with yields increasing last month, these four sectors experienced significant losses.
Morgan Stanley recently observed that while equity markets have reacted to the correction in the bond market, the overall move has been relatively restrained. In January, growth stocks tended to outperform value stocks when bond yields were falling, but they more or less maintained their position in February as yields increased significantly. This observation applies to stocks in general. Despite a decline, the S&P 500 has increased by 3.7% year-to-date, while the NASDAQ has maintained a 9.6% gain.
Fixed income investments underperform equities as short-term U.S. rates reach multi-year highs.
Fixed income investments have not performed as well as equities recently. Short-term U.S. rates reached multi-year highs in early March, with 2-year yields hitting levels not seen since 2006, according to Bloomberg. While 10-year yields are still below their October highs, momentum appears to be in their favour. This trend was not limited to the U.S., as higher yields were seen across developed economy bond markets. Unlike stocks, global bond returns gave up nearly all their January gains. It raises the question of whether we should be questioning why stocks weren't down even more last month, rather than trying to figure out why they were down at all. We aim to delve into both topics in more detail below.
While the market weakness in February may be explained in part by the fact that February is typically a weak month for equity returns, according to Bloomberg, being the third worst month for the S&P 500 over the past 25 years, with the second half of the month being particularly weak according to Jeffrey Hirsch, CEO Hirsch Holdings. However, historical data suggests that March and April have been strong months, as reported by Carson Investment Research and LPL Research, with March having the fourth-highest proportion of positive returns since 1950.
Although seasonality may have contributed to the recent decline in stocks, we believe that other factors played a more significant role. The main driver was inflation, which saw an unexpected surge in February, as indicated by various indices such as PCE, CPI, and PPI. This was particularly concerning because sticky service prices remained high, despite predictions that they would decrease. The Federal Reserve (Fed) faces a dilemma because, while a pause or pivot in its tightening cycle had seemed likely as inflation cooled, the resurgence of inflation last month has renewed concerns that the Fed may need to raise rates more than expected and for longer.
The Federal Reserve faces a challenge as the recent surge in inflation has caused market concerns that it may need to raise rates higher than initially anticipated and for a longer duration. Despite the possibility of a pause or pivot in the Fed's tightening cycle as inflation was previously cooling, last month's resurgence has shifted market expectations for the terminal Fed Funds rate. In late January, futures markets predicted the rate would reach 4.91% by July before falling to 4.55% by the end of 2023. However, by February 24th, these expectations shifted higher and later, with a prediction of 5.40% by September 2023, and continued to trade even higher in early March. Jefferies reports that the September 2023 Fed Funds futures have increased from approximately 5.0% to 5.4% over the past several months. As a result, the futures market now predicts that Fed Funds will only decline to 5.31% by December 2023, meaning no rate cuts in 2023. This is disappointing because, historically, the gap between the Fed's last rate hike and its first cut has averaged only three months.
Given this more hawkish outlook for monetary policy, it is no surprise that equity markets sold off in February. Although some believe that last month's counter-trend inflation reports were an outlier, others worry that equity markets are overly complacent. Despite this, equity markets have been more resilient than bond markets, with some investors continuing to believe that the trend for inflation is down. However, the recent surge in inflation and the Fed's potential reaction to it remain key risks to watch in the coming months.
The rise in interest rates exerts pressure on equity valuations, and this was a key factor behind the decline in equity returns last year. Looking ahead, investors are growing increasingly concerned about how higher interest rates will affect economic growth and corporate earnings. However, from a broader perspective, the harm seems more manageable, or at least delayed. According to Bloomberg's Financial Conditions Index, financial conditions are more favourable than they were a year ago. A similar index created by the Chicago Fed also indicates that financial conditions are looser than they were in March last year, although they are tighter than they were in early 2022. Jefferies notes that U.S. real federal funds have only just turned positive and remain negative when adjusted for actual headline CPI inflation.
Potential negative effects of higher interest rates on U.S. consumers and companies may take longer to materialize.
Regarding the potential negative effects of higher interest rates on U.S. consumers and companies, it is possible that any damage could take longer to materialize. Bloomberg reports that over half of U.S. mortgages were originated during the pandemic, with rates below 4% and 30-year terms. As for U.S. corporations, many highly leveraged loans will not mature for several years, so higher rates have had a limited impact thus far. However, smaller companies that rely on floating loans may begin to feel the effects of higher rates. While banks have started to tighten lending standards, private debt has been filling the gap. This suggests that the U.S. economy may not be as vulnerable to higher rates as it has been in previous tightening cycles, which could be one reason why equity markets have been relatively unfazed by the recent uptick in rates.
Canada's high household debt makes its economy more sensitive to interest rate changes.
Canada's economy is likely to be more sensitive to changes in interest rates due to the high level of household debt, which is 185.2% of income. Canadians have also increased their exposure to variable rate mortgages, with over 20% of new mortgages in 2020 reported as variable rate by Fitch. CIBC reports that 20% of their existing residential mortgage portfolio saw loan balances increase in the first quarter due to monthly payments not covering the interest portion of the loan. Bloomberg reports that nearly 60% of Canadians expect higher interest rates to have a negative impact on their finances, which explains why economists see the Bank of Canada as one of the first central banks to end their tightening cycle. Overnight rates are expected to peak at 4.5%. If the Fed continues to raise rates to levels above 5.5%, the Canadian dollar is expected to weaken.
Aligned with the accommodative financial conditions in the U.S., there are no clear indications of a significant slowdown in the U.S. economy. A recent survey conducted by Bloomberg/MLIV Pulse showed that a majority of respondents expect a soft landing for the U.S. economy, with a growing number suggesting there may not even be a landing, and the economy continuing to expand at a healthy pace. However, it's important to establish a common understanding of what constitutes a "soft landing." For most, it would mean inflation declining below 3% without a significant decline in economic activity. Despite this positive outlook, investors should remain cautious and avoid jumping to conclusions too quickly. As per BCA Research, almost all hard landings (i.e., recessions) start as a soft landing.
Economic growth shows resilience, but earnings outlook is still uncertain.
Despite initial concerns, economic growth has demonstrated more resilience, leading to similarly durable corporate earnings. As Goldman Sachs notes, earnings forecasts by analysts typically decline at the start of a year, yet the adjustments made for 2023 have been relatively modest. The Daily Chartbook similarly reports that the present trajectory for S&P 500 forward earnings is following a pattern observed in non-recessionary years, as confirmed by historical trends tracked by Factset and UBS. Could it be that we have already accounted for the worst-case scenario in terms of earnings?
We don’t think so. The decline in Morgan Stanley's Non-PMI leading indicators and the decline in earnings quality suggest that earnings may still have further to fall. Profit margins are at historic highs and are at risk of mean reverting, according to Morgan Stanley. Additionally, most analysts are predicting revenue growth to moderate as inflation declines, which might be overly optimistic given the strong wage pressures. Therefore, it may not be wise to assume that the worst is over for earnings.
In addition to earnings and profit margins, what other factors are contributing to the equity market? One possibility is the improvement in prospects for global economic growth, particularly with China emerging from its pandemic lockdown. Global purchasing manager indices have also increased, led by China, which recently saw its PMI reach its highest level since April 2012. According to Goldman Sachs, mobility in China has surpassed pre-Covid levels, as evidenced by traffic congestion indices in major Chinese cities.
Although the recent improvement in global economic growth, particularly in emerging market economies, is a positive development, its impact on equity market returns remains uncertain, particularly given that the MSCI China index lost over 10% last month. However, China's influence on market liquidity may have a more significant impact. Central bank liquidity has been known to have a strong influence on markets, as evidenced by the tight correlation between the size of the Federal Reserve's balance sheet and the S&P 500. While the Fed has been shrinking its balance sheet, some strategists point out that the Bank of China and the Bank of Japan have been expanding theirs, which has contributed to global liquidity.
Theories behind equities resilience amidst rising rates, and the potential shift towards alternative investments.
One potential explanation for why equities haven't been as affected by higher rates could be the expanding balance sheets of the Bank of China and the Bank of Japan, which have helped to maintain global liquidity despite the Federal Reserve's efforts to shrink its own balance sheet. Another theory put forth by Jefferies' David Zervos is that, because the Fed's quantitative easing program during the pandemic resulted in the government owning many of the bonds that would otherwise have been held by investors, the losses from higher rates are being absorbed by the government rather than individual investors. Additionally, higher yields on fixed income investments make them more attractive to investors than in previous years, which could also be contributing to the relative strength of the equity market. However, while U.S. stocks have historically outperformed bonds over the long term, this may not hold true in the near future, particularly as fixed income yields appear attractive compared to historical levels and S&P 500 earnings yields. As a result, some investors are shifting towards alternative investments rather than relying solely on equities, as reflected in the catchphrase "TARA" or "TIARA" - "there are reasonable alternatives" or "there is a reasonable alternative" to stocks.
From a valuation standpoint, it could be argued that stocks are still relatively expensive. Despite the increased attractiveness of fixed income due to higher yields, large-cap U.S. equities are trading well above their historical averages, unlike small-cap and international stocks, which appear to be more reasonably priced at present. Additionally, when compared directly to bonds, stocks appear even less attractive, with the equity risk premium (the earnings yield minus the 10-year bond yield) for the S&P 500 recently reaching a 15-year low. According to Bloomberg, a portfolio comprising 60% stocks and 40% bonds currently yields less than six-month T-bills, indicating that even this relatively conservative allocation may not provide sufficient returns for some investors.
Geopolitical risks rise, but stock valuations remain expensive.
When considering the current macro and geopolitical risks facing the world, such as the Russia/Ukraine conflict, Iran's nuclear capability, and escalating U.S./China tensions, stock valuations appear even more expensive. Strategas reports that during the Cold War, the S&P 500 had an average trailing P/E multiple of 13.8 times, which increased to 19.4 times after the fall of the Berlin Wall. It raises the question of whether we have entered a new era similar to the Cold War years. The ongoing conflict in Ukraine poses a significant threat to global stability and could impact financial markets. A recent Bloomberg/MLIV survey revealed that investors fear the worst outcome would be a Russian victory, but a Russian defeat that leaves an unstable military superpower with one of the world's largest nuclear arsenals would also be undesirable. Unfortunately, there are no good outcomes. However, despite the potential risks, Google Trends data indicates that people do not appear to be overly concerned. Even investors are not panicking or flocking to safe-haven investments such as gold or U.S. Treasury Bonds.
The Federal debt ceiling is currently a risk on investors’ radar. The Congressional Budget Office has stated that it must be raised between July and September to prevent the U.S. Treasury Department from defaulting on payments. Although it may not be a major concern, the political climate in Congress has made it nearly impossible to pass measures requiring bipartisan support. The Republican party, previously known for fiscal restraint, is now focused on spending cuts or limiting the Democrats' spending leading up to the 2024 Presidential election. Despite the likelihood of a deal being made, Democrats may need to make concessions to get Republicans to agree. While approximately 71% of economists in a January Bloomberg survey put the odds of a default at less than 10%, during the 2011 debt ceiling crisis, the S&P 500 fell almost 20%, while Treasury bonds rallied, which is ironic given that they were the very financial instruments at risk of default.
Although the risk of a U.S. default this summer is considered low, the growing levels of U.S. debt pose a long-term threat that must be addressed. However, the lack of public concern for this issue is alarming, with only 3% of Americans citing national debt as the biggest problem in a recent Gallup poll, compared to 17% in 2011. Historically, austerity measures have only been implemented when interest costs reach 14% of tax revenue, a level that Strategas predicts the U.S. could reach by the end of this year. It is crucial for policymakers to address this issue before it becomes a more significant problem.
U.S. debt levels pose uncertain concerns for markets as inflation emerges.
The matter of U.S. debt levels is a concern that could eventually become an issue for the markets, albeit the timing is uncertain. Our disregard for the debt ceiling issue is not due to its insignificance, but rather the political maneuvering surrounding it. When interest rates were low, debt levels weren't a pressing matter; however, inflation's emergence has compelled the Fed to maintain higher rates for an extended period. Consequently, the U.S. debt issue will require resolution. This has the potential to become a "Wile E Coyote moment," not perceived as an issue until it materializes, causing the market to plummet. According to Bank of America, inflation remains the market's top tail risk, an interesting observation given that investors consider higher inflation and lower economic growth (stagflation) as the most likely economic outcome. If everyone anticipates this outcome, how can it be a tail risk? Although most investors view the market's rally since September/October as a bear market rally, if the market has already fully accounted for higher inflation expectations, perhaps the bulls are correct. Alternatively, it could be that investors are slightly complacent and disregarding the warning signals emitted by the bond market.
The U.S. Energy department's report on the origins of COVID-19 from a Chinese lab was prefaced with a statement of "low confidence," and the market appears to be trading with a similar level of concern. While there are worries about inflation and economic growth, there is also a belief that the Fed will pivot or that the impact on growth has already been factored into the market. However, we believe that the market may be too complacent and has not fully taken into account some of the potential risks, such as persistent inflation, falling earnings, and geopolitical instability. Despite these concerns, the market has shown resilience, possibly due to its liquidity or investors' willingness to overlook potential risks.
Fortunately, the recent increase in interest rates has provided investors with a safe haven in the form of short-term bonds and money market funds. According to Bloomberg, cash is now considered a safe investment, with 6-month T-bills yielding 3% more than stocks. This has led to large inflows into short-term bond ETFs and money market funds. However, investors must consider the opportunity cost of holding cash if inflation has peaked and the Fed pivots to cut rates. In this scenario, cash yields would disappear, and bond prices would rally, leading to declines in equity valuations. Therefore, investors need to assess their confidence level in the future path of inflation, interest rates, and corporate earnings before making any trade-offs.
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.
