Prices Cool in a Scorching Summer: What Happens Next?
As the end of the summer approaches, the biggest story in markets is economic resilience.
Despite aggressive interest rate hikes and months of speculation about a possible recession, the economy remains fairly healthy—the labour market is reasonably strong, and consumers continue to hold up their end of the bargain. As a result, we see little reason to shift to a more defensive asset mix at this time. We do concur that there are some signs of softness. But those have been evident for several months, and so far, they haven’t proven to be overly detrimental.
“We see little reason to shift to a more defensive asset mix at this time.”
Going forward, we’ll remain on the lookout for three potential signs of a more rapidly cooling economy: a bigger drop in employment numbers, more weakness on the consumer front resulting in earnings disappointment, and hawkish comments from central banks. Until one or more of those potential catalysts materialize, we believe a relatively neutral stance remains the wisest course.
A Little Higher, a Little Longer
North American economies and labour markets continue to show resilience, providing ammo for central banks to keep rates elevated over the near term. Beijing, meanwhile, is seen stepping in further to lift China out of its economic doldrums.
In terms of recession risk, the likelihood is still there as long as the yield curve remains inverted and the Fed is still far away from cutting rates. If inflation falls more quickly, that will allow the Fed to start normalizing rates, which would definitely relieve pressure on the economy. As long as rates stay high, recession fears will persist.
Sentiment in Emerging Markets (EM) has improved marginally on the back of stimulus announced in China, and rate cuts commencing in Brazil and Chile. On top of that, we are seeing signs of international trade bottoming out with the post-COVID goods demand normalization likely behind us. Going forward, with Chinese incoming data remaining weak, we think further stimulus measures as well as monetary policy easing will underpin growth in the second half of the year.
BMO GAM House View
• Further disinflation through the second half of 2023 will help take pressure off the Fed
• Core inflation will remain sticky
• Delaying the recession means a higher range for the Fed’s neutral rate
• The bar is high for a negative rate surprise over the next few months
• You cannot have a recession without labour market pain
• Canada and the U.S. are still creating jobs, pushing downturn further out
• U.S.-China relations can be expected to remain strained
• U.S. has moved to restrict investment in parts of the Chinese economy
• Rising government debt issuance will result in higher term premia in U.S. rate market
• Lack of clarity around who will run in 2024 is creating uncertainty
• Wage growth is outpacing inflation
• Recession won’t likely be triggered by consumer, but rather businesses
• The market is bottoming out sooner than expected
• In Canada, there is still a huge imbalance between supply and demand
• Fresh downgrades for regional lenders weigh on sector outlook
• Smaller banks tend to be more exposed around recessionary cycle
After a big rally over the past several months, it seemed like equities were looking for a reason to take a knee, and that’s what we’ve seen since the end of July. In this case, the Fitch downgrade of the U.S. credit rating seemed to fit the bill as the catalyst for a selloff that the market was looking for. In general, volumes in August tend to be fairly light, so it’s likely too early to claim that this is a high-conviction pullback. Q2 earnings were good, but the reaction to positive surprises was muted, with beats on revenues and earnings per share (EPS) below the historical norm. Many strategists are predicting that Q2 earnings will be the bottom in terms of year-over-year declines, and Q3 estimates are holding up well so far. The big difference has been a reversal in Tech—we’ve seen some of the big names coming back down, with Nvidia being the primary example. That’s been driven, in part, by the U.S. 10 Year Treasury yield popping up quite a bit on U.S. Treasury Secretary Janet Yellen’s higher-than-expected announcement of the refunding activity and issuance of new U.S. treasuries that will be happening over the next 12 months. Markets never move up in a straight line, and with as many positive days as we had in July, some negative days in August could be expected. Is this the start of a Fall pullback? Maybe, maybe not. Typically, markets don’t start to really move until after the Labour Day weekend. It is worth noting, however, that the VIX index briefly popped up to the 16-17 range in the first week of August before coming back to around 15. In our view, it would have move even higher for this to herald a true market correction.
In terms of cash, we may not be at a peak in short-term rates just yet, but we’re certainly closer to the top than the bottom. If we see headline inflation pop back up, that could make markets a little more nervous.
We remain neutral (0) on U.S. markets, as the economic backdrop and job picture continue to demonstrate resilience. The only issue that prevents us from going slightly overweight is valuation multiples, which we believe are approaching fully valued. Only a small handful of companies—the so-called ‘Magnificent Seven’ Tech names—have been leading markets higher, and while we’ve started to see a bit of a rotation to other companies, that narrow market breadth has pushed some of the U.S. indices higher than others around the world.
This month, we’ve moved to slightly bullish (+1) on EM and neutral (0) on Canada, reversing our ratings from last month. This doesn’t represent a major shift, but rather a re-evaluation at the margins. We still like Canada, but we simply like EM a little more, based largely on our belief that investors have become a little too pessimistic on China following an underwhelming economic re-opening. Of course, we’d like to see Beijing be a bit more proactive in terms of stimulus. But even with that being the case, EM simply looks oversold.
The big story of the month in fixed income has been the U.S. government’s credit rating being lowered by Fitch. This move reflects concern about the growth of government debt and the ability of Congress and the Biden administration to control spending. We have already seen financial markets experience some volatility as a result of the downgrade, and that may continue in the short-term. But the main takeaway is that bonds issued by the U.S. treasury remain among the safest investments on the market, and treasury yields may even rise as a result of the downgrade. It is important to consider that there are three main rating agencies for U.S. bonds: Standard & Poor’s (S&P), Fitch, and Moody’s. S&P downgraded U.S. credit from a AAA rating to AA+ all the way back in 2011, while Fitch just made the same move, and Moody’s has yet to do so. Like the 2011 decision, we expect this downgrade to have minimal long-term impact—in short, we don’t think it’s as significant a story as some news outlets have made it out to be.
With economic data remaining fairly strong, we’re staying slightly bullish (+1) on Investment Grade (IG) credit and slightly bearish (-1) on High Yield. We are also holding firm at neutral (0) on EM debt. Our one significant change this month has been bringing Duration back to neutral (0) from a previous rating of slightly bullish (+1). A potential recession continues to be pushed down the road, which in turn has pushed back the timeline for interest rate cuts. In that environment, a neutral rating on Duration makes sense. There will come a time when investors will want to have Duration in their portfolio, but now is not that time.
Style & Factor
With the softening of the U.S. dollar (USD) slowing, we remain neutral (0) on the CAD while continuing to like Gold as a long-term hedge.
There are no significant changes in our implementation this month. Interest rates creeping back up is likely a positive for the USD—it had been softening earlier in the year, but that has slowed down a bit. We haven’t implemented any hedges in our portfolios, so we’re not taking big stances either way.
Meanwhile, we remain slightly overweight (+1) Gold. We view it as great long-term hedge. It’s currently stuck in a trading range, but if we do see an upside surprise on inflation, it will be nice to have in our portfolios.
1 As of August 11, 2023.
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