- Equity markets rallied strongly this week, ending the run of three consecutive weeks in the red despite a wave of hawkish talk and action by central banks.
- The S&P 500 rose 3.6%, led by strong gains in consumer discretionary, banks and materials, while energy lagged.
- Meantime, the TSX added 2.6% as broad-based gains outweighed a 0.6% slip in energy as oil prices ended the week little changed.
Over the past couple of weeks, markets have been re-evaluating the current environment, and we’re seeing some pessimism. The U.S. Federal Reserve has reiterated that it’s going to keep its foot on the gas pedal, taking interest rate hikes further than many investors were expecting. In essence, they’re saying that while inflation may have peaked, it isn’t going away any time soon. That ongoing concern means that the Fed now seems to consider a recession and some labour market weakness to be acceptable outcomes in its effort to cool rising prices. The Bank of Canada has mirrored the Fed’s stance. Last week, it raised interest rates by 75 basis points and emphasized that we still need to keep an eye on inflation—even with the decline we’re seeing in housing prices. In this environment, defensive positioning makes a lot of sense. On the Financials side, higher rates mean that we’ll have to closely examine the shape of the yield curve—if it inverts further, then Financials will lag the broader market. Sectors like Health Care and Energy make more sense, as they can be expected to hold up relatively well in a downturn—with the caveat that a long and painful recession would be bad for oil and gas. But we don’t consider that to be the most likely scenario.
Bottom Line: Stocks have room to decline further, because central banks are more concerned about inflation than protecting markets.
The US dollar has been incredibly strong of late, almost reaching parity with the British Pound Sterling—a possibility that seemed nearly unfathomable in 2021. But what’s behind this dominance? There are a couple of main drivers. One, North American central banks have been faster to raise interest rates that other countries, which means that the U.S. economy is in better shape than many others around the world. And two, we’re still in a risk averse environment. As much as we’ve seen some bear market bounces, markets are still down significantly from the beginning of the year. With the US dollar considered something of a safe haven, it’s not surprising that money is flowing to the greenback in this environment. Looking ahead three-to-six months, we see no reason why this strength won’t continue. That doesn’t necessarily mean that the USD will appreciate more from here. But we also don’t expect it to depreciate against other currencies.
Bottom Line: In the long term, the US dollar will come down, but in the short term, expect continued strength.
Given the latest interest rate hike, how much more pain can we expect in the Canadian housing market? It’s a complicated question. By all measures, the Canadian housing market is overvalued, and homes have become increasingly unaffordable because of rising rates. This is especially true in Victoria, Vancouver, and the GTA. But the other important factor is that sales activity has dropped off. This concerning trend may well continue, and with no end in sight to interest rate hikes, our evaluation is that there is room for the situation to get worse. The big question is whether this will mean years of pain or only months. Unfortunately, that answer remains unclear. When the market does get back to fundamentals, continuing immigration will help with demand, and supply will slow down because construction will adjust to the new environment. But construction can’t stop overnight—that kind of shift will likely take a couple of years.
Bottom Line: The Canadian housing market may well go lower before it gets better.
In terms of positioning, we’ve been spending a lot of time thinking about short-term rallies, like the one we saw late last week. Is it time to take some more risk off the table? Looking at the current environment, we expect September and October to be a bit more challenging for markets, and we still believe that the earnings picture is not quite as rosy as many investors think. The consumer continues to weaken, the labour market is likely to slow down, and inflation is not likely to come down as quickly as some are expecting. When you put all that together, we think taking off some more risk makes sense, at least for our most conservative portfolios. We’re also trimming our Technology exposure, as we expect that it may come back down due to rising interest rates and potential pressure on the consumer.
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