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THIS WEEK WITH SADIQ

A Bond Market in Limbo

October 23 to 27, 2023

THIS WEEK WITH SADIQ

A Bond Market in Limbo

October 23 to 27, 2023

Commentary

Market Recap

  • Equity markets struggled this week alongside the relentless selloff in Treasuries. The S&P 500 fell 2.4%, with weakness in consumer discretionary, banks and technology weighing heaviest.
  • The index is again flirting with the 200-day moving average as it drifts down from above.
  • Meantime, the TSX was down 1.8% on the week, with gains in materials and energy lending some support as WTI pushed back above $90 at one point.

Interest Rates

Just when the macroeconomic picture begins to show weakness, one or two positive data points pop up to challenge that story. Overall, the general trend is toward weakening, but it’s not definitive in the sense that it will necessarily lead to a recession. From the perspective of the U.S. Federal Reserve (Fed), a slowing economy should ease inflation and, in turn, allow them to stop raising interest rates. Higher-than-expected inflation prints, Energy prices, and resilient employment numbers, however, make that decision more difficult. The question the Fed is asking itself is: if we stay at this level of interest rates, is it simply a matter of time for inflation to come down? Or will rates at this level be unable to tame the beast? If it’s the latter, then they will have no choice but to continue to push interest rates, while if it’s the former, they can safely pause. There are two options on the table for the Fed: raise rates one more time and monitor the effects, or continue pausing and see what happens. We continue to believe they likely have one more rate hike left in them. For the Bank of Canada (BoC), it’s a different story. They’ve seen bigger cracks in the economy, and they also know that the impacts of higher interest rates on the housing market and broadly on the consumer are likely to play out in the coming years. As a result, they’re likely closer to a terminal rate than their American counterparts.

Bottom Line: Both the Fed and BoC are still waiting for more economic data to guide them, but the possibility of another rate hike is higher in the U.S. than in Canada.

Bonds

How are investors responding to higher interest rates? They’re moving to the short end of the curve. Just for sitting on cash, investors are currently able to get a yield of over 5%. That’s extremely attractive in the short term, but it’s not a sustainable, long-term answer. There are risk factors in the market, but not necessarily enough of them to allow the Fed to stop raising rates. If and when the Fed signals a hard stop on rate hikes, that’s likely to cause the yield curve to uninvert. If equity returns improve, that could also cause bonds to normalize; as I’ve discussed in previous weeks, September and October are typically not great months for stock markets, which has allowed bonds yields to look good in comparison to equities. That said, we believe we’re getting close to a level where bonds will look very attractive. Once a rate-hiking pause and eventual rate cuts take effect, bonds could potentially have years of positive returns.

Bottom Line: As the interest rate outlook improves, investors are likely to jump back into bonds.

China

We’ve seen better growth data coming out of China of late, as well as several other potential tailwinds: the long-term Belt and Road initiative (a global infrastructure and development project), a savings rate in decline, reports from global companies that their China earnings are improving, and an increase in travel, which should help boost demand. On the other hand, however, is the ongoing crisis in the country’s most important sector: Real Estate. It’s a situation that cannot be resolved overnight, and it may not even be entirely fixable—but if they can at least get it under control, that should improve consumer confidence. For now, investor sentiment on China is negative and outflows have been high. But in our evaluation, that makes for a good opportunity for investors—as long as they’re in it for the long haul. That why we remain slightly overweight Emerging Markets (EM).

Bottom Line: For long-term investors, there are still significant opportunities in China

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled An Economy at a Crossroads.

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