- Equity markets slid this week as trouble in the banking sector pushed the Fed, Bank of Canada and economic data to the background.
- The S&P 500 fell 4.5%, with all sectors in the red.
- The banks were thumped 11.5%, with some even larger spills in the smaller regional bank group.
Last week, Fed Chairman Jerome Powell’s hawkish remarks to the U.S. Senate—which indicated that the terminal interest rate may now be in the 6% range—prompted a selloff in markets. There’s no question that his comments came as a surprise to investors. Why? There are a few factors. We’re not surprised that inflation has been sticky; we’ve said all along that it will be a bit of a grind, with certain parts of inflation coming down faster than others. For the most part, the supply side of inflation has been improving, while the demand side looked like it was getting better before popping up again, and that’s an issue. The Fed has consistently said that inflation will likely stay higher for longer than expected. This was confirmed by the latest inflation numbers, and that’s really what surprised markets. When the Fed talks about being “data dependent,” this is what they mean—the inflation numbers weren’t as good as hoped, so Chairman Powell left the door open for a 50bps rate hike, which is a reversal of previous expectations. Our evaluation is that at least two or three more rate increases are in the cards, with the magnitude of those hikes still to be determined. The Fed will need to see multiple months of weakening employment and cooling inflation before they consider a rate-hiking pause. However, the recent collapse of Silicon Valley Bank (SVB) Financial probably puts more pressure on the Fed to slow down until the full ramifications are known.
Bottom Line: For now, the risk is on the side of higher-than-expected interest rates, not lower—but the SVB Financial situation throws a wrench into that equation.
Bank of Canada
Meanwhile, north of the border, the Bank of Canada held interest rates steady at 4.5%, following through on its previous announcement of a rate-hiking pause. Does this mean that we’ve reached a plateau that will continue for the remainder of 2023? It’s a difficult situation to read. The first thing for investors to know is that the inflation picture looks different in Canada than it does in the U.S. We’re seeing inflation dropping in Canada, which is why we think the BoC’s pause was the correct decision. The BoC also has to be more careful than the Fed when it comes to balancing the goal of reducing inflation with the health of consumers, who have greater household debt and are affected more by mortgage rates and the housing situation than their American counterparts. (Remember that housing impacts both Canadians’ net worth and consumer confidence.) The BoC clearly wants to follow through on their promised pause, as last week’s announcement shows. But we can’t say with 100% confidence that rates won’t move higher at some point. If inflation spikes, hikes will be back on the table. The other consideration is the exchange rate. The USD continues to strengthen versus the CAD because of the divergence in their interest rate policies. Will the BoC let the CAD get so far from the USD? That remains to be seen.
Bottom Line: Rate increase could be in store for later in the year, but the bar to change course is high, because the BoC wants to avoid having egg on their face.
Tensions between China and the U.S. are continuing to increase, particularly with respect to technology. Investors may well ask—is there a way to access China’s economic rebound while managing this risk? When you invest in Emerging Markets (EM), you do so knowing that it’s a riskier asset class, in part because of geopolitical issues. In our evaluation, every time tensions flare up and markets pull back, it creates an opportunity to buy at a discount—as long as you still believe that growth in China will be much stronger than in North America, which we do. We’ve recently increased the allocation to EM in our portfolios based largely on China, which isn’t being afflicted by the high inflation and interest rates of North American economies. We see recent issues like the balloon incident as likely short-term stories, whereas China’s reopening is a long-term tailwind, with China being in a similar situation to North American and Europe a couple of years ago but with even more horsepower behind it. This isn’t to minimize the potential for further tension—there are some significant concerns about the relationship between the two countries, and this flare-up has been bigger than previous ones. What we’re watching to see is if China retaliates against specific companies. To take Huawei as an example: despite all the restrictions levied against it, China didn’t retaliate against Apple—Huawei’s biggest competitor and a company that does a lot of business in China. Why? Perhaps because they don’t want to risk derailing their own fragile economic recovery.
Bottom Line: Even with the potential for geopolitical hiccups, we still expect China’s recovery to be the best story this year.
We’ve just completed our monthly review and overall, we’re remaining relatively balanced. We do, however, see some risk in the near term—we don’t know what inflation will look like over the next month, and markets could react quicky if anything changes. Also, we recently became aware of the first bank in North America collapsing since the financial crisis and the fallout of this is still to be determined. This will obviously cause some additional risk aversion. There is no change to our equity and bond allocations, and we are continuing to prefer bonds to cash due to attractive yields and additional volatility we are seeing in the markets. Geographically, we’re now slightly underweight the U.S. due to inflation and interest rate uncertainty, and we’re bullish on Emerging Markets, largely because of the China reopening story and the discounts available compared to a couple of months ago. We also remain slightly underweight Canada and neutral on international markets (EAFE). No changes on the fixed income side—we’re overweight Investment Grade bonds and neutral on High Yield, EM debt, and duration. At this point, we don’t feel the reward of lower grade credit is sufficient to justify the additional risk, and while we will look to increase our duration exposure down the road, we’re not quite there yet. On the style front, we’re still slightly bullish on Value, and while we are getting less hesitant on Growth than we were previously, we’re remaining Neutral for now because inflation and interest rates could put pressure on valuations in the near term. And finally, in terms of currency, we’ve come down to neutral from slightly bullish on the CAD—as previously mentioned, the divergence in the Fed and BoC’s interest rate policies will likely increase the gap between the CAD and USD in the short term.
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