Investors continue to receive confusing signals from markets, policy-makers and the economy through the midpoint of 2023.
Inflation rates have dropped in most regions but remain higher than the targeted ranges of around 2% embraced by most central banks. Economic growth has slowed, but not as much as was expected in the wake of central banks’ aggressive policy rate hikes of the last 18 months. The Bank of Canada (BoC), having paused its efforts to tighten monetary policy earlier this year, resumed rate hikes in June and July with the aim of slowing growth so that inflation doesn’t become entrenched. Bond markets have continued to wrestle with the future path of monetary policy, resulting in higher-than-normal yield volatility.
Despite these headwinds, equity market indexes have shown strength year-to-date. For much of the first half of the year, this strength was quite narrowly focused, with mega-cap technology and consumer discretionary stocks contributing almost all the gains in the S&P 500. Into the early summer, gains broadened to many other sectors, contributing to a growing hope that the U.S. economy will achieve a soft landing and avoid a recession in the months ahead.
So, what should we expect in these coming months?
The recent market optimism for a soft landing hinges on the idea that inflation will return and stay close to the 2% target, allowing the Federal Reserve and BoC to begin reducing their policy rates early next year. Additionally, service sector inflation rates, which include shelter costs, must continue to fall for overall inflation rates to trend lower than the current 3% level.
And despite higher inflation, consumer demand has been stronger than expected, buoyed by continuing strength in demand for labour, and because households have used excess savings accumulated during the pandemic to support spending. Those savings balances have been significantly reduced this year, but, without sufficient softening of the employment and wage trends into year-end, the Fed and BoC are more likely to keep policy rates at or slightly above current levels into 2024 to constrain aggregate demand.
While we may be close to the end of the rate hike cycle, investors should expect a period of steady policy rates to follow rather than a quick turn to rate cuts.
Looking ahead, investors should recognize that financial conditions have tightened and will remain on the tighter side into year-end. Interest rates on debt for consumers and businesses alike are a larger economic hurdle now, and prospective mortgage and loan refinancings will boost their debt service costs. Even for many well-run companies, this requires a somewhat more cautious approach as they adjust to both higher financing costs and inflation of input prices.
On the other end of the spectrum, default rates in high-yield bonds have begun to rise from low levels, signalling that some weaker businesses are succumbing to their debt burdens. As a result, expect corporate default rates to gradually increase into 2024.
Earnings growth should also slow into 2024. Profit margins have deteriorated somewhat, albeit from extremely high levels as corporate profits have been very strong so far in 2023. Globally, expectations of 12-month forward earnings growth have turned slightly negative after a period of significant strength from 2021 to 2022. Across individual countries, however, the earnings story is more mixed. For example, commodity-oriented countries, such as Canada, may experience a weaker forward earnings trend, while some Euro-area countries may see earnings tick higher.
Combined with the second-quarter increase in many developed economies’ stock market valuations, the earnings picture suggests maintaining a small degree of caution over the near term. Balanced portfolios should tilt slightly toward bonds and away from equities into the end of the year, or until equity risk premia improve.
The bond markets offer portfolios attractive yields today, and bond market volatility has begun to normalize from recently high levels. The investment-grade corporate bond market in Canada is yielding in the area of 5%–6%, which comes at a much lower level of volatility than equities. Holding a slight overweight in the portfolio to corporate bonds allows investors to ride out a period of economic uncertainty while keeping portfolio liquidity high.
Although timing markets is always difficult, portfolio diversification can help build resilience to market uncertainty. So can setting the portfolio’s strategic long-term asset mix to reflect a client’s level of risk tolerance — a primary consideration on the path to good portfolio construction.
Steve Locke is chief investment officer, fixed income and multi-asset strategies, with Mackenzie Investments.