2022 Q3 Review:

by Vittorio Ciccone | B. Com. | Investment Analyst at Ciccone McKay Financial Group

 

In fighting inflation, central banks take the lead

2022’s third quarter started with a slight tease. A summer rally took hold. Treasuries hoped to continue the good-news trend, as equities erased some losses and yields moved higher.

What a difference a month makes. The end of July saw declines across equity asset classes (S&P down roughly 25% from January) and yields touching 4%. The sell-off was a continued catalyst for the US dollar, which gained 4%.

The volatility continues, with inflation and interest rates continuing to dominate the investor mindset. With markets moving — some might say gyrating – investors wonder just how much central banks will tighten further to get inflation back under control. No doubt the expectation of higher inflation soured investor sentiment in Q3.

The biggest Q3 news hit in September. Boris Johnson was out as the United Kingdom’s prime minister; Liz Truss was in. Unfortunately, PM Truss couldn’t celebrate her new job for long. Global investors disliked, to put it mildly, her party’s new fiscal package, i.e., several tax cuts added to a large bill to help with rising energy prices. The UK had already been struggling with higher levels of inflation compared to the US and Canada, thanks in large part to its energy issues.

Gilts, i.e., UK government bonds, and sterling sold off dramatically, sending waves throughout the market. This forced the Bank of England (BoE), which had been first in raising interest rates, to delay the selling of bonds. Instead the BoE bought long-dated gilts.

The change in stance from quantitative tightening to quantitative easing (LINK to BLOG), was intended to save the distressed UK pension industry from liability-driven investing. The BoE gave pension funds a deadline to restore balance. As of Q3’s closing, the market expects the BoE to get back on track with rate rises.

Outside the UK and all its drama, other central banks continued the tightening and rate increases. This, despite widespread belief that a recession is either near or already happening. Everyone’s watching for additional rate hikes to come from the US Federal Reserve, Bank of England, European Central Bank and the Bank of Canada.

Bank of Canada (BoC) Governor Tiff Macklem continues to follow the hawkish tone of Fed Chair Jerome Powell, which leaves the door open for an additional 75 basis-point (BP) rate rise; however, RBC is assuming that the rate will be dialed back to only 50 BP.

Meanwhile, the Royal Bank of Canada (RBC) reports that global gross domestic product (GDP) forecasts for 2023 have been coming in at 2.7%. According to RBC, this seems overly optimistic – we can’t help but agree.
As shown in its September dot plot, i.e., graphical representation of future rate hikes, the Federal Reserve is probably not going to halt its tightening plans. In fact, the Fed may raise rates an additional 75 basis points (bps), or as RBC believes, 50 bps in December. The US dollar has appreciated versus other currencies, so such a rate raise would be tough on other countries and make their fight against inflation even harder.

Canada

Over the first half of the year, data showed the Canadian economy outperforming that of the US. However, there were some cracks in the underlying data. For example, RBC notes that employment has declined in three of the past four months.

Canada’s monthly core inflation ticked lower in September (something the BoC naturally likes to see), but rate hikes are clearly taking a toll on the consumer. Home sales are down more than a third over the past year, and the price corrections in the real estate market continue nationwide. The Canadian economy is greatly exposed to housing and higher levels of household debt versus its US counterparts, meaning falls in housing data will have a greater impact on our overall GDP outlook.

Based on the Canadian economy losing steam, and with interest rates moving higher, RBC predicts the jobless rate will reach 7% from 5.2% in September. As well, RBC forecasts a recession in the first half of 2023.

In terms of Canadian equities, our Partnered Portfolio Manager Mathieu Roy from Louisbourg Investments says:

“Canadian equities were not immune, but perhaps partially vaccinated against the weakness that spread across equity markets. Investors became more concerned with the lack of progress on inflation late in the quarter, which led to a -1.4% return for the S&P/TSX. This was still notably better than the performance of its US and international peers, given the Materials exposure and greater defensiveness across many of its sectors.

“As suggested, Materials (+3%) provided an off-setting tailwind but so did Industrials (+4%), Consumer Discretionary (+4%) and Consumer Staples (+3%). Industrials (rails, waste) and Consumer Discretionary (discount stores, quick service restaurants) do share defensive characteristics. All other sectors posted negative returns with Communications (-8%), Real Estate (-6%), Health Care (-6%) and Energy (-5%) performing the worst. Energy was the most painful,given its importance in size within the benchmark in Canada.”

 

The United States

Since its August meeting, the Federal Reserve has maintained a hawkish tone. The Fed has even signalled further tightening to combat inflation. Its dot plot points to an additional 125bpsincrease over the next two meetings and into 2023. The US yield curve is likely to flatten further as the long-term yield comes down from the weakening economic backdrop and the hoped-for fall in inflation. The Fed’s hawkishness will keep the front end of the curve higher.

In terms of equity performance, here’s Mathieu Roy again:

“US equities experienced a good start of the quarter on strong corporate profits. However, the enthusiasm soured alongside inflation persisting and finished the quarter down 4.9% in USD. The strength of the US dollar more than offset the loss, with US equities ending up 1.3% in Canadian dollars. Looking on a sectorial basis, there are really four sectors that stood out. On the positive side, Consumer Discretionary (+4%) performed well, driven by Amazon and Tesla who both reported stronger financial results than expected. Energy (+2%) also stood out with stocks remaining resilient despite the pullback in the commodity price.

“On the negative side, Communication Services (-13%) remained under pressure, as concerns around ad spending cuts (Google & Facebook) and the increasingly competitive environment between telcos [telephone companies] intensified. Real Estate (-11%) also had a difficult quarter, as the surge in interest rates cooldown earnings prospects for the sector.”

 

Final thoughts from Mathieu Roy

“Elevated inflation continues to be fought by central banks, which is leading to monetary conditions getting tighter. Companies are already dealing with rising costs and supply disruptions. Revenues growth will also slow alongside economic deceleration, putting pressure on corporate earnings. Canadian company earnings do a get nice offsetting tailwind of rising commodity prices. Given the downdraft in equity prices, we now feel that these increasingly difficult conditions are more properly discounted by the market.

“The risk-reward of equities is also being helped by the anticipation of significant rate hikes necessary to bring inflation under control. We believe that the quick escalation in the cost to finance consumption and run businesses will eventually have the desired impact of cooling activity and inflation in the process. As investors begin to see some progress on that front, they will anticipate a softer tone regarding monetary policy and be more encouraged with risk assets. Valuation multiples have compressed to attractive levels that can handle some earnings disappointment.

“Given this backdrop, we feel that the overall risk-reward for equities is becoming more attractive. This leads us to advocate a neutral overall equity position versus the benchmark policy of a client, with an emphasis on Canadian equities given their relative tailwinds and valuation level. “

 

Further reading:

• The Royal Bank of Canada
• Mathieu Roy, CFA - Louisbourg Investments - Answering some key questions about the current economic and investment landscape and shares why he thinks these are exciting times for equity investors.

 

If you would like to learn more about the information in this article, please do not hesitate to contact us: info@ciccone-mckay.com and/or 604-688-5262.