Soft landing?

So, here we are at last: central banks have declared mission accomplished in the fight against inflation and have initiated interest rate cuts. The Bank of Canada was the first of the G7 to cut its key rate in June, but it was the US Federal Reserve's rate cut that the market was waiting for. The Fed granted investors' wishes on September 18 with a 0.5% cut in its key rate to 5.0%. Further cuts will follow, which could bring the Fed Funds rate - which influences the majority of interest rates in the US and, by extension, around the world - below 3% by 2026.

A consensus is now emerging on the markets that central banks have achieved the rare feat of curbing inflation without triggering a recession - a soft landing. In such a scenario, the economy and profits will continue to grow. This was all it took for equities to resume their upward trend on most markets. Skeptics seem confounded!

Of course, consensus does not mean certainty. Financial markets may consider a soft landing to be the most likely scenario, but other less pleasant scenarios are possible. Rising protectionism and tensions between China and the United States, conflict in the Middle East that is likely to spread, and budget deficits in the United States and elsewhere in the world that will have to be addressed sooner or later are all threats to the global economy.

In fact, since the 90s, all but one of the Federal Reserve's interest rate cut cycles have been accompanied by recession and significant declines in equities.

Rate cuts and the equity market

Faced with such risks, prudent investors resist the temptation to put all their eggs in one basket and make sure to keep a sufficient portion of their portfolio invested in government bonds – a safe haven – according to their risk tolerance. One indication that many investors are indeed exercising such caution is the good performance of bonds over the quarter; their price is rising because people are buying them.

Another scenario – less likely but just as unpleasant – is a resurgence of inflation. We will talk about this at greater lengths if necessary.

In the meantime, let's take advantage of the excellent returns that the market offers us!

Market Review

Canadian Equities: buoyed by lower rates

Up 10.5% (17.2% year-to-date), the S&P/TSX index closed its best quarter in four years. This momentum in Canadian equities is attributable to optimism about a soft landing for the US economy and the Bank of Canada's easing of interest rates.

Lower rates benefited several sectors of the Canadian economy, including finance (+15.8%), technology (+14.0%), utilities (+15.3%) and real estate (+16.3%).

The materials sector remains the best performer since the beginning of the year, up 25.8%. Faced with the freeze on Russian assets imposed by the G7 countries, several central banks, including China's, replaced part of their foreign currency reserves with gold. Growing concerns over the Middle East conflict also stimulated demand for gold. This strong demand has propelled the precious metal to new heights, with an increase of 30.4% in 2024.

The energy sector treaded water during the quarter, with the price of a barrel of oil now at $68.17, down 11.5% over the period.

U.S. Equities: not tech stocks for once

U.S. equities had another good quarter, up 4.5% in Canadian dollars, bringing their year-to-date return to 24.9%.

What stands out in the last quarter is that the "old economy" sectors, often referred to as value stocks, have done particularly well after being in the shadow of technology stocks for almost two years (or even a decade). Among the best-performing sectors were utilities (+18.5%), real estate (+16.3%), industrials (+11.2%) and financials (+10.2%). Rate cuts also benefited small-cap yields, indicating that optimism is spreading throughout the US economy.

Although they remain the leaders in terms of year-to-date performance, the technology and communications sectors underperformed this quarter, each recording an increase of 1.4%. This slowdown coincides with the first signs of weakness in companies that have benefited from the artificial intelligence boom, such as Nvidia (-1.7%), Google (-8.8%) and Microsoft (-3.7%). Although they reported good financial results, concerns are emerging about their high valuations.

International Equities: big in Japan

The international equities portfolio generated a return of 5.8% in CAD terms over the quarter, up 15.6% on the year to date.

The Japanese stock market endured a tumultuous quarter, particularly in early August, when the Nikkei 225 index plunged by over 10% in a single day - an event unseen since 1987 - and by almost 20% in three days. The reason for the plunge was a below-expectation US employment report, combined with a significant appreciation of the yen, which raised concerns about the impact on Japanese exports. Investors seemed to overreact, as Japanese equities quickly regained some of their losses, ending the quarter down 4.9%. Given the yen's appreciation, Canadian investors achieved a positive return of 5.6%.

The MSCI Europe index gained 1.8% over the quarter. As in the case of Japan, the currency effect benefited Canadian investors, who achieved a return of 5.5%.

Emerging markets: China's comeback?

The MSCI Emerging Markets index returned 6.9% (in Canadian dollars) for the third quarter of 2024.

Struggling with a problematic real estate sector and a slowing economy, China was on track for another negative quarter. The scenario took a completely different turn as the Chinese stock market rallied over 21% in the final days of the quarter in response to supportive measures, including monetary easing, regulatory adjustments and fiscal stimulus by the Beijing authorities.

India returned 8.1% on market expectations of strong economic growth in 2024 and 2025. India's prosperity is fueled by stable macroeconomic indicators, which are attracting the attention of global investors. The inclusion of India in JP Morgan's Emerging Markets Government Bond Indices last June served as a further catalyst, enabling foreign players to engage more widely with Indian financial markets.

Taiwan posted a return of -2.4%, mainly due to uncertainty in the artificial intelligence sector, particularly regarding the timing of high-end product launches and the scale of growth expected in this area.

South Korea, whose economy relies on exports, recorded a 9.9% drop, its stock market remaining vulnerable to external uncertainties. New export orders fell due to a slowdown in demand for computer chips.

Bonds: a strong quarter

The bond market has begun to anticipate central bank interest rate cuts in the spring of 2024. This process accelerated this summer: from 3.9% at the end of April, the rate on 10-year Canadian government bonds had fallen to 2.9% by September 30.  

Lower rates mean higher bond prices, leading to a 4.7% return for the quarter.

A rather technical but still significant phenomenon, the rate on US 10-year bonds is now higher than the 2-year rate. The yield curve - which had inverted in the summer of ²⁰²²¹ - has therefore begun to normalize, even if 3-month rates are still higher than 10-year rates. In the past, such normalization of the yield curve has often coincided with the onset of a recession, although it is not clear that there is a causal relationship.

If there is indeed a recession, bonds will continue to serve us well. If not, we'll have to make do with interest income.

Note

[1] An "inverted" yield curve means that short-term interest rates - 3 months to 2 years - are higher than interest rates on bonds maturing in 10 years or more. When the curve is "normal", long-term rates are higher to compensate for the higher risk on a long-term loan/investment.