The global economy has proven to be much more resilient than most investors had expected at the outset of 2023, on account of pent-up consumer demand, the remanence of pandemic related stimulus and durable corporate earnings. Nevertheless, the possibility of an economic slowdown remains high given lingering inflation, tightening credit, and of course the highly fraught geopolitical landscape. Central banks’ policy of hiking rates to reduce inflation has created a complex backdrop for both investors and policymakers, however despite challenges, certain markets have thrived widening the proverbial runaway for an economic ‘soft-landing’.
At the end of 2022, the global economy looked to be losing momentum as economic activity in most OECD countries was contracting. Also, recall Europe was facing serious energy issues, while China was engaged in a zero Covid policy both of which acted as a drag on activity. The outlook was grim, and a global recession seemed inevitable.
Fast forward six months, and the opposite has come to pass. All OECD countries have a manufacturing PMI over 50 (indicating expansion), while global service PMIs sit at an 18-month high. The risks in Europe and China have also reversed course with the energy prices in the EU falling to near term lows after a mild winter, while in China the lifting of COVID zero policies allowed for a rebound of consumption and capital expenditures.
The labor market has been an interesting bright spot during the economic expansion. In the U.S., over 1.5M net new jobs have been added since the beginning of the year, while in the EU, the unemployment rate sits at all-time lows. Improved participation rates have been supported by job growth, while employment levels have returned to pre-pandemic levels.
However, aging demographics have resulted in structural limits on the labor supply, with the participation rate of adults fifty-five and over depressed, reflecting an aging baby boomer generation that seems increasingly absent from the workforce. A tight labor market has contributed to wage inflation, which according to the Atlanta Fed wage growth tracker increased by 6% in May, down from 6.7% the prior year. While declining, the level remains high.
Inflation has fallen sharply from its peak last year of 8.1% in Canada and 8.9% in the U.S., to 3.4% and 4.1% in May of this year, respectively. Much of the decline can be attributed to energy prices, which have come down significantly. However, core inflation (minus food and energy) remains stubborn.
The ‘hot spots’ that have contributed to higher prices look to be turning down as supply chains are restored and pent-up consumer demand peters out, helping prices ease across core categories.
Similarly, shelter, once the largest contributor to the jump in inflation, has also started to ease as Owner’s Equivalent Rent and associated interest rates (read: mortgage rates) reach their peak.
Given the strength of labor markets and wage growth, inflation’s decline to the 2% goal could be elusive in the short term. Central bank policy is having an impact, but policymakers are not claiming victory quite yet and are maintaining a hawkish tone. As long as interest rates remain elevated, credit conditions will tighten providing the headwinds central banks are looking for, but also giving rise to remote risks that are difficult to account for such as the regional banking crisis experienced at the end of Q1.
Global equities continued their move higher with the MSCI All Country World Index returning 4.0% (CAD) for the second quarter, furthering its impressive year-to-date return of 11.6% (CAD). Stocks were propelled higher by the optimism that inflation might be moderating, better than expected economic data, and central banks signaling that they were nearing the end of their rate hiking cycle. While the rally in Q1 was broad across markets, performance in Q2 varied more by geography and sector, suggesting that diverging paths of growth across the global economy might be emerging.
Canada’s S&P TSX produced a 1.1% return compared to the S&P 500’s 6.3% for the quarter (both in CAD), highlighting the difference in the sector weightings in each index. While mega-tech companies pulled the U.S. market higher, Canada’s banks delivered lackluster Q2 earnings and Energy and Material stocks were flat to down due to falling oil and base metal prices as concerns increased relating to the strength of China’s economic recovery following the country’s reopening.
In the US, the increase in the second quarter was highly concentrated amongst a narrow set of U.S. mega-cap technology stocks, driven by excitement around artificial intelligence and investors’ preference for companies with solid balance sheets in the face of higher borrowing costs. In fact, if the top ten largest stocks by market capitalization were removed from the S&P 500, the index’s return would have been closer to flat for Q2. Similarly, growth stocks outpaced value stocks in the quarter, with the S&P 500 Growth Index up 10.2% compared to the S&P 500 Value Index finishing up 6.1% (both in USD). Put simply – large cap growth stocks were clearly the big winners in Q2.
Japan’s equity market, the Nikkei, was the strongest of the developed markets, finishing up 18.5% (¥) for the quarter, hitting its highest level in 33 years. Recent strength can be attributed to the successful application of pressure from domestic and international investors on management teams to (finally) undergo major reforms in corporate governance, while consumer activity propelled Japan’s GDP growth to a relatively robust 2.7% in Q1.
The Eurozone also posted a positive return, with the MSCI EAFE finishing the quarter up 3.2% (USD), albeit masking wide variations between jurisdictions. The MSCI UK lagged, returning -1.6% (GBP), as higher than expected inflation increased expectations of more interest-rate hikes and threatened to further slow the U.K’s already lackluster growth. Conversely, Spain and Italy both had strong quarters, with the MSCI Spain and MSCI Italy posting 3.6% and 5.3% (EUR) respectively.
Emerging market equities finished the quarter positively, as the MSCI Emerging Markets returned 0.9% (USD). In China, equities were sharply lower with the MSCI China finishing the quarter off -9.9% (CNY) due to the possible stalling of the economic recovery, continued restructuring efforts within the real estate sector, and ongoing geopolitical tensions between the US and China. Much of that weakness was offset by strong equity returns in India, with the MSCI India finishing the quarter up 12.2% (INR),where macroeconomic data seemed to be responding positively to accommodative monetary policy.
Thus far, companies have effectively safeguarded profit margins, displaying a commendable level of resilience. Nevertheless, with the current level of stagnation in earnings growth, profit margins might be exposed if the economy tips into recession or if inflation persists. However, as different sectors have exhibited divergent performance, favorable opportunities may arise when market performance broadens out to a wider range of sectors.
The relentless move up in bond yields over the last two years on account of central banks’ aggressive monetary tightening was put on pause during Q2 as yields traded largely range bound throughout the quarter.
In response to the regional banking crisis earlier in the year, investors shifted away from risk assets to mitigate the perceived increase in uncertainty along with the prospect of the Federal Reserve pivoting to an accommodative stance as a means to minimize the possible fallout. The result was not only strong bond performance for Q1, but also a lower starting point for yields at the outset of quarter.
As central bankers maintained their current policy direction, and both economic growth and inflation came in higher than expected, yields shifted higher. During the quarter, the Canadian and U.S. 10-year government bond yield moved from 2.90% and 3.02% to 3.27% and 3.68%, respectively. Strong corporate balance sheets coupled with earnings resilience and the diminished risk of contagion contributed to corporate bonds outperforming and spreads reducing.
The broadly higher yields translated to negative returns for the broad bond indexes, with the FTSE Canadian Bond Universe and Bloomberg U.S. Aggregate Bond Index both returning -0.8% (in their respective currencies). The prospect of more rate hikes placed pressure on the short end of the curve, with the FTSE Canadian Short Term Bond Index outperforming the FTSE Canadian Long Term Bond Index 0.2% to -0.8% respectively, pushing the yield curve to its most inverted state since 1981.
With systemic risks across the banking system seemingly under control, policymakers were able to renew their focus on higher-than-expected inflation and tight labor markets. Except for the Bank of Japan, all major central banks raised rates at some point during the quarter. The Fed in the U.S. took a hawkish pause, in June, the Bank of Canada ended their ‘conditional pause’ after inflation ticked up to 4.4% after nine straight declines hiking rates 25bps. The unexpected strength in the economy has thrown expectations of when central banks will reverse the current course of tightening into question.
As U.S. economic activity continues to surprise to the upside, a ‘soft landing’ has increasingly become the market consensus. However, given monetary policy’s commonly regarded ‘long and variable lags’, this may be presumptuous. Such a dull policy tool takes time to fully diffuse through the economy, so its outcome is hard to completely anticipate. The current levels of inflation may continue to require higher interest rates, which could run the risk of overtightening, potentially exacerbating vulnerability like that currently detected in the commercial real estate sector. And if the defaults are significant enough the impact could provoke broader instabilities across the economy.
The prospect of a recession seems to have been pushed out to 2024. And while the equity markets took a decidedly positive view of the investment landscape, the future continues to remain uncertain with major risks still lingering.
Our strategy continues to focus on a well-diversified portfolio of actively managed high-quality assets. Prior to the current rate hiking cycle, yields sat close to zero for well over a decade, pushing investors into long duration higher risk assets as low-risk assets resulted in marginal aggregate returns. With the yield on cash sitting near 5%, investors have viable alternatives.
At a global level, growth and policy differences are beginning to emerge, as further conveyed by diverging performance across equity markets. While valuations in the U.S. are trading above their historical value, opportunities in Europe and emerging markets offer compelling valuations. As for fixed income, the sharp rise in bond yields has made bonds a viable contributor to investment portfolios, not just as a ballast to equity market volatility, but also as a generator of yield.
As we look ahead to the second half of the year, it is evident that the investment landscape has undergone significant changes from just six months ago. Uncertainty continues to surround several important factors, including monetary policy, corporate earnings, geopolitical and recessionary risks. Furthermore, higher for longer interest rates suggest an environment of higher macro and thus market volatility, which may create worthwhile investment opportunities through dislocations, stressing the importance of employing an active approach that focuses on quality.