Highlights this Month
- Canadian economy has more of what the World is looking for right now, namely materials and energy.
- Bonds have failed to exhibit the same enthusiasm as stocks.
- US unemployment fell the most in a decade.
- While inflation has been increasing, bond yields have started to decline.
- What didn’t have an impact on Bond yields was the pandemic.
- What variables affect how quickly we go back to normal?
May in Review
Traders were again faced with the reality of a market continuing to grind higher last month. Leading the way for a change has been Canadian stocks, with the S&P/TSX gaining 3.4% in May. Given the strength in the Canadian dollar, which appreciated nearly 2% last month and is up nearly 5% year to date against the US dollar, Canadian stock returns in US dollar terms gained 5.3% in May, and just over 21% so far in 2021.
By comparison, the US S&P 500 gained a mere 0.7% in May and 12.6% year to date. The technology-heavy NASDAQ fared even worse, losing 1.4% in May, and up only 7.0% so far in 2021. For American investors, Canadian equities have been a very profitable trade in 2021.
Despite the good performance in May, Canadian stocks still look cheap compared to their American alternatives, with the S&P/TSX index’s relative 10-year CAGR trailing that of the S&P 500 by nearly two standard deviations. Foreign investors appear to have taken note, with Scotiabank reporting positive flows from international investors in March, the ninth in a row for Canadian capital markets.
Canadian economy has more of what the World is looking for right now, namely materials and energy.
Both the materials and energy sectors led the S&P/TSX higher last month, as did value and small cap management styles. When the Canadian economy is recovering and growth is abundant, cyclically orientated companies tend to outperform, which is the sandbox small-cap value managers typically play. The same was true for the S&P 500 last month, but the energy and material sectors play a much smaller relative role in the US market and don’t have as much influence on the broader US sandbox (index). Like in Canada, however, the value style continued to outperform in May.
Timing is everything when it comes to the markets, however, and what works today may not work tomorrow. According to Bank of America, institutional investors see inflation as the market’s biggest tail risk, which is why they identified that inflation assets will attract the biggest inflows as a percent of AUM in 2021.
According to the Bank of America, investors have been adding more Financial stocks and Inflation Protected Notes (TIPs) to their portfolio than any other asset so far in 2021. Financial stocks, like Banks, tend to outperform as inflation pushes interest rates higher and the yield curve steepens, making their lending portfolios more profitable. Given financials are also considered value stocks, it should come as no surprise that value also outperforms in line with higher inflation. The Bloomberg US Pure Value Portfolio, in fact, has moved up lockstep with 5-year break-even rates. Interestingly, however, both trended lower in the last couple of weeks in May. They were still up for the month but lost momentum in the second half of the month.
Bonds have failed to exhibit the same enthusiasm as stocks
Bonds, in fact, have failed to exhibit the same enthusiasm as stocks for a few months now, with 10-year yields starting to drift lower after hitting 1.74% at the ending of March. As of May 28th, US 10-year treasury yields had actually declined to 1.59%. As a result, the yield curve is no longer steepening and has been virtually unchanged in three months.
10-year breakeven rates, a useful benchmark for the financial markets’ expectations for future inflation, topped out on May 17th at 2.56% and have been declining ever since. What gives? Normally the bond market is a good early predictor for the stock market, with falling yields a concerning barometer. Credit markets appear just fine, however, with investment-grade spreads at their lowest level since 2007 so the fixed income barometer isn’t completely broken. Why are bond yields not confirming the stock market’s (and credit markets) positive trend is a question worth pondering. Is the reflation trade deflating (in which case stocks are wrong), or just taking a breather? We say the latter, but we admit, the bond market has some explaining to do. We’ll do our best on its behalf below.
US unemployment fell the most in a decade
While it is true we may finally be at the point where economic growth will no longer exceed expectations, it is doing so at a level of economic growth not seen since the early 1980s. Last month, long-term unemployment in the US fell by the most in a decade, and while there are still 9.8 million Americans unemployed and apparently available to work, there are a nearly equal 9.3 million unfilled positions, the highest on record.
Granted, the April and May jobs report disappointed, but most attributes to this are the generous unemployment benefits and reluctant workers unable or unwilling to re-enter the workforce due to commitments at home. The Federal reserve might be fixated on the unemployment rate and labour participation rate, which remains too low, but once employment benefits start to expire, which according to Morgan Stanley should start in June and be largely complete by September, markets should get a better take on the true state of the job market.
- What could prolong this process is if the decline in employment is due to retiring baby boomers who have no intention of going back to work, or if business investment during the pandemic increases productivity such that fewer workers are needed in order to support stronger economic growth. If the baby boomers have called it a day, wage growth could accelerate. If productivity growth has materially increased, the opposite could happen, namely, the economy can grow and run hotter, without creating inflation. If this is the case, maybe last month’s flat bond market makes more sense.The bottom line – it could take several months for the employment picture to become clearer.
Either way, based on what’s happening in the economy right now we don’t see a reversal in the reflation theme anytime soon. If anything, the risk remains that inflation will continue to surprise to the upside, as is indicated by the Citi Inflation Surprise Index. Contributing to the surprises in April was headline CPI, which at 4.2% was at its highest level since September 2008. According to Bank of America, inflation has been a hot topic on company conference calls, as well as in the financial media.
Pressure is building as businesses find it harder to build inventory and hire workers
Referred to as the “I” word on the cover of a recent issue of Barron’s, businesses are expecting higher unit costs over the next year, and they plan on passing it on to consumers. Even with paying higher prices and wages, businesses are finding it harder to build inventory and hire workers. Pressure is building. Not surprisingly, consumers and forecasters have started to get worried. The University of Michigan’s mean expected change in prices during the next year is forecasting inflation of 5.75%, while the US CPI Economic Forecast is nearly 3%.
One can’t get too carried away, however. Yes, April CPI was high, and we might see inflation move even higher in the short term. The driver, however, has mainly been a small number of categories, like energy and used cars. According to the Bureau of Labor Statistics, most of April’s CPI increase came from categories with a combined weight of only 13%, and while the increases were large, they are not likely to be sustainable (read transitory).
Used cars, airfare, and hotel prices will settle down once the initial re-opening supply and demand dynamics balance out, though a rebound in healthcare costs and housing could help keep inflation elevated through next year. Perhaps a better indicator for monitoring sustainable inflation is the Atlanta Fed’s Core Sticky CPI, which so far is not showing a meaningful increase in prices.
Less concerned with inflation longer-term are financial market indicators.
According to the Philly Fed’s quarterly survey of professional forecasters, CPI is expected to hit 2.4% in 2022, but only 2.3% over the next 10 years. Breakeven rates on inflation-protected notes show the same longer-term trend. While 2-year breakeven rates on June 8th were 2.79%, 5-year breakeven rates were just 2.49%, and 10-year breakeven rates only 2.37%.
According to the University of Michigan, median consumer inflation expectations for the next year are around 4.5% but fall to 3% over the next 5 years. Skewing expectations higher are a small number of participants who fear big price increases, which is what we see in the financial press as well. Fear sells papers or internet subscribers. Most see inflation up moderately and believe the current spike will be transitory, while a smaller contingent sees a more meaningful and lasting increase.
The bottom line – markets appear to believe the Fed, that inflation will be high, but transitory.
The US dollar has weakened
Any debate over the future path of inflation inevitably leads to a discussion about the US dollar. Because the Federal Reserve has effectively taken control of the bond market, or at least at the short end of the curve, many now see the US dollar as a better barometer of the future direction of inflation and markets. The Fed may choose not to raise rates if inflation increases, but the result will be a weaker currency. Based on the recent movement of the US dollar, the Greenback is giving a different reading than the US Bond market, namely, inflation is going higher and rates should be moving upwards.
After a seven-year bull market, the Greenback has been under pressure since March of last year, with many wondering how low the US dollar can go. Higher inflation is a headwind for the value of any country’s currency given it drags real interest rates lower. From this perspective, with US real 2-year rates closing in on negative 3%, the future path for the dollar continues to be weaker. A growing current account and budget deficit, also known as the dreaded twin deficits also provide a negative backdrop for the dollar.
The typical retort to arguments regarding the imminent demise of the US dollar is it is the least dirty shirt, meaning other countries look worse. While we still believe this point has merit, especially given the ability for the US to vaccinate its population and re-open its economy quicker than most other developed economies, higher global bond yields have narrowed the interest rate gap US bondholders have enjoyed.
The upside-down world of negative rates has started to right itself
This starts with global aggregate negative-yielding debt declining from its $18.3 trillion peak. Perhaps Chinese 10-year government bonds provide the most appealing alternative presently. While Chinese 10-year rates have been declining this year, at over 3% they are still higher than any sovereign bond yield investors will find in Europe, Japan, or North America. One can also argue China has behaved with more fiscal and monetary restraint during the pandemic.
Of course, there is the whole capital control issue and trust in an autocratic government, but from a purely financial perspective, it’s no wonder the Chinese Renminbi has been moving higher over the past year.
The Canadian Loonie has outperformed most major currencies this year
Rather than diversify into the Chinese Renminbi, some see the Canadian dollar as a good alternative, which is why the Loonie has outperformed most major currencies this year. Unlike the US dollar, which is negatively correlated to commodity prices, the Canadian dollar is considered a cyclical currency and has historically strengthened when commodities prices increase.
The Canadian economy has also done a better job at getting people back to work, which has also helped convince traders the Bank of Canada is serious when they claim to be moving towards a tighter monetary policy. In April, the Bank of Canada became the first major economy to start the tightening process by reducing its monthly bond-buying program, prompting traders to price in a rate hike early next year versus no US rate hike through 2023.
In fact, a recent Bloomberg/Nonos poll found nearly half of Canadians support higher rates in order to help cool the housing market increases, which further supports the Canadian dollar in the short term. We would caution, however, a strong currency can be counterproductive for a country needing to diversify away from energy and basic materials, thus making the longer-term sustainability of the rally in the Loonie more suspect.
While inflation has been increasing, bond yields have started to decline
A stronger Canadian dollar and weaker US dollar might be sending an inflation warning to the markets, but it still doesn’t explain why bonds were sending the opposite message. While inflation has been increasing, bond yields have started to decline, and according to Scotiabank, traders are now net long option and futures positions on 10-year Treasury Notes. Federal Reserve messaging might be part of the reason why. Chairman Powell has said they were not even talking about raising rates, but minutes from the Federal Open Market Committee meeting in late April showed several members argued in favour of tapering if the economy continued its rapid progress.
This could be seen as a bullish sign for the bond market and might have been one of the reasons yields and break-even rates fell last month. Traders who were concerned the Fed would let inflation get out of control and were inclined to sell bonds, would have found some conform in the fact the tightening process is at least being discussed.
Extreme levels of liquidity have made Investors desperate for a place to put money. So abundant has the Fed made liquidity, 1-month T-Bills have traded at negative yields since March. This is bad news for the wall of money that has swamped money market funds, forcing many to park money in reverse repos at the Federal Reserve in order to at least earn some positive return. Now perhaps investors can get more comfortable investing in longer-term bonds, believing the Fed won’t let inflation destroy their future real returns.
US pension funds have also been active buyers of bonds
Also buying US bonds are foreign investors, taking advantage of cheap and plentiful dollars which enables them to profitably hedge their FX exposure back into their home currency. According to Goldman Sachs, US pension funds have also been active buyers of bonds. Goldman recently pointed out the top 50 US Pension funds are now 98.4% funded (thank you bull market rally), so taking a little risk off the table and doing a little duration matching by buying bonds makes sense. It’s also likely a lot of investors have started to buy into the Federal Reserve’s transitory inflation argument, especially since US employment numbers have fallen short two months in a row. Evidence of this was clear immediately after May’s job report was released, with yields breaking sharply lower.
The bottom line for bonds – while rates are low, there are still buyers of US Treasury’s, and last month, the buyers outnumbered the sellers.
What didn’t have an impact on Bond yields was the pandemic.
Right or wrong, the market has moved on. While the developed world appears to have the upper hand, much of the World remain unvaccinated and vulnerable. According to BMO, over 50% of the Canadian population has had at least one dose, and by the end of August, 89% of the population over 12 years old is forecast to be vaccinated with 80.5% expected to be fully vaccinated. This would put Canada ahead of the US, which BMO expects to have partially vaccinated only 82.5% and fully vaccinated 73.5%. Canada’s edge? More Canadians appear to want to be vaccinated, which could prove to be a competitive advantage for the Canadian economy, and an unforced error for the American economy.
What variables affect how quickly we go back to normal?
How many people get vaccinated is an important variable, but as a recent article in the Globe and Mail highlighted, how quickly we reopen, how quickly we get our second doses, and how good the vaccines work against the new variants are also key.
The variant of most concern is the so-called Delta variant, which originated in India. The Delta variant is thought to be both more transmissible (50% more than the Alpha variant, which originated in the UK), and probably more severe. Vaccine efficacy against the Delta is also not that good after only one dose. According to a study done by Public Health England, after one dose, the Pfizer vaccine was only 33.5% effective against the Delta variant versus 51.1% effective against the Alpha variant. After two does, efficacy rose to 87.9% against the Delta variant and 93.4% against the Alpha variant.
The bottom line – you need to your population fully vaccinated as quickly as possible. And until you do, reopening too quickly could lead to another wave of infections.
Regardless of the pandemic, it’s business as usual in the US
We are worried this message isn’t getting through in the US, which has a higher reluctance towards vaccination, but yet appears quick to reopen. Interestingly, it also appears there is more activity in States with less than 45% percent of the population vaccinated than in States with more than 45%. Foot traffic is higher in airports, hotels and theaters. More people are going to stores, including apartment stores, and restaurant traffic is higher than it was two years ago. And most of them are not wearing masks. Most States have removed mask restrictions and most States have fully reopened. Just watch a sporting event on TV. It’s business as usual.
Average new daily COVID-19 cases have fallen dramatically
Now, one can take comfort from the fact the seven-day rolling average of new daily Covid-19 cases has fallen dramatically. As of June 3rd, they were just under 19,000, down 48.4% over the previous two weeks. When were new cases at levels his low? Well, you would have to go all the way back to, what do you know, June 3rd of last year, exactly one year ago.
This is a disturbing coincidence because as Goldman Sachs recently pointed out, there appears to be a seasonal pattern to Covid-19 cases. Now we accept the fact vaccinations and immunity through infection mean a large portion of the population is likely immune and this is why cases are falling, but we also think a false sense of security might be building and the US may be setting itself up for a resurgence in the late fall. a late fall. We hope we’re wrong. Either way, markets probably won’t care.
Institutional Investors still believe the S&P will outperform
According to the Bank of America, institutional investors still believe the S&P 500 will outperform in 2021, though slightly less than the month before. Despite the rally in bonds last month, which we admit we struggle to understand, bonds or cash are unlikely to outperform.
According to Schroder’s strategist, Sean Markowicz, if you believe we are in a low but rising inflationary environment, which we do, stocks, TIPS (inflation-protected notes) and commodities have historically provided the best returns. Bonds provide the worse returns, a fact Bank of America’s institutional clients appear to have picked up on. The weak US dollar appears to be flashing a red warning, even if bond yields have not. Valuations are stretched, especially if interest rates do start moving higher, but its earnings growth driving stock prices higher over the past year. As long as vaccines do their job, and the economy continues to grow, we don’t see an end to the current bull market. At least not this month.
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.