- The S&P 500 finished the week 3.3% lower compared to last Friday, snapping a strong run in the back half of October.
- Sector-wise, energy led the few areas that managed to remain in positive territory, though they were handily offset by big declines in telecom, tech and consumer discretionary.
- The TSX also declined, but to a lesser extent, dipping 0.1% from last Friday’s close, supported in part by renewed strength in oil prices (WTI surged above $92 for the first time in about a month) and the government’s moderately positive fall fiscal update.
It came as no surprise last week when the U.S. Federal Reserve (the Fed) opted to raise interest rates by 75 basis points—we expected as much. Initially, there was a small rally as investors interpreted the press release to mean the Fed may pause rate hikes and give earlier increases more time to dissolve into the economy. But then Chairman Powell highlighted that inflation has been much stickier than previously imagined, and rates may need to go higher than what the market had been expecting. Equity prices dropped significantly as a result. We feel this goes back to what we’ve been saying for months: investors must listen very closely to the Fed. Since Jackson Hole, the central bank has said clearly that they will continue to raise interest rates until inflation is brought under control, even if that means a higher-than-expected terminal rate. Markets have gotten this calculation wrong multiple times in 2022—whenever inflation dips slightly, they believe that the Fed will choose to plateau rates. But as Chairman Powell made very clear in his speech, that will simply not be the case.
Bottom Line: Without ‘peak interest rates’, markets no longer have a silver lining against negative news on the earnings side.
What we saw in mid- to late-October was a strong equity rally based on the assumption that the Fed was going to pivot to a less hawkish stance. That optimism has to come off now. During that period, we also saw the Dow 30 outperform the S&P 500 and the Nasdaq, which in essence showed that Value continued to outperform Growth—a trend we’ve been observing all year. We also saw disappointment on the earnings front, though the missed performance only impact the particular names and not the broad market. Over the next few months, investors will be watching the Fed speeches closely for any changes in language. But barring any shifts in policy, we should still see heightened volatility in markets. Stock-specific stories will continue to matter in this environment, however. You want to keep an eye on earnings and valuations, because if rates will continue to move higher then those multiples still have more room to come down though companies with lower valuations have less space to drop.
Bottom Line: Subpar earnings have not significantly impacted valuations, but with the Fed remaining hawkish, equity markets could still move a leg lower.
Yields on 10-year Treasuries temporarily dropped beneath the 4% threshold last week before moving higher again – staying above an important psychological barrier for investors. Typically, if you expect interest rates to rise, you can reasonably assume that yields would go higher as well. Though this did happen the magnitude was not in lockstep. What we saw was the short end of the yield curve compress, as investors fell into a risk-off sentiment and rushed into short duration bonds. What is that telling us? It’s saying that bond markets sometimes have a different perception of the overall outlook than equity markets. It’s saying that there’s still risk aversion in the market, and that yields for near-term debt may actually plateau somewhere between 4% and 5%. Because as rates go up, the economy weakens. And as the economy weakens, equity markets tend to sell off, creating the conditions where 4% yields may look increasingly attractive to investors. While we believe the Fed will continue to go higher on interest rates, the road to ‘peak rates’ is still uncertain. Though we cannot be sure of an exact terminal rate we are starting to see the upside in bonds again.
Bottom Line: The outlook for fixed income is slightly more optimistic than for equities.
We initially thought that missed earnings from heavyweights such as Microsoft, Alphabet and Netflix would kickstart large declines in the broad index. Instead, when one of the mega cap companies reported bad results, the fallout was isolated to their share price alone. There was no contagion, even after four or five large names had missed their targets. As valuations move a leg lower, we have raised our asset class view of equities from bearish to slightly bearish, and have started to use some of our cash reserves to take advantage of opportunities that are emerging. Regionally, we have moved positive on the U.S., remained overweight Canada, stayed neutral on Emerging Markets, and held firmly to our negative outlook on Europe. And though our position on fixed income is generally unchanged, we do currently favour investment grade credit over high-yield bonds and emerging markets debt. We have also preserved our tilts toward Value and Quality factors as opposed to Growth, and confirmed sector biases to Energy, Healthcare and Consumer Staples. You can find more commentary and analysis on these calls in our Monthly House View report, which will be published on November 14.
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