It's all about inflation (3)

At a CFA Institute annual conference in the 1990s, one of the speakers mentioned that if his economic crystal ball allowed him to predict just one thing, he would choose inflation.

Indeed, inflation - or more precisely, investors' anticipation of inflation - has a direct impact on the price of the two major asset classes that constitute the balanced portfolio: bonds and stocks. For bonds, the cause effect relationship is rather simple: investors will agree to pay less for a bond maturing in 10 years if they anticipate that inflation will have eaten away a significant part of the capital at maturity.

The impact of inflation on the performance of major stock indices is less direct, but still fundamental. Empirical data indeed shows that stocks tend to generate better real returns (after inflation) when the inflation rate is under control - generally between 2 and 3%.

Growth stocks (especially technology) are more sensitive to inflation - and the interest rate increases it causes - since inflation erodes the present value of the company's future profits, which underpin it's stock market value. A bird in the hand is better than two in the bush!

If we analyze the performance since of stocks and bonds since the start of 2022 from this angle, we can clearly see the evolution of investors' inflation expectations.

Inflation is not transitory!

It is in the first quarter of 2022 that we definitively buried the notion that the current surge in inflation would be "transitory" and that it would dissipate along with the problems of the supply chain (remember the stock shortages and huge bottlenecks at major seaports!).

We then understood that the fight against inflation would be long and arduous, and that it would require a marked increase in interest rates by central banks, potentially leading to a recession. In a nutshell, inflation expectations changed, and bonds and growth stocks were immediately impacted. This explains the poor performance of the balanced portfolio in 2022: stocks and bonds fell down in tandem.

The hope of a soft landing

The period from autumn 2022 to summer 2023 was characterized by the hope that central banks would succeed in beating inflation - by raising interest rates - without inflicting too much damage on the economy and, above all, avoiding provoking a recession. This is what we call a soft landing. Stocks had the wind in their sails, and the S&P 500 index rose by around 27% during this period.

The rate on US 10-year bonds also fell to around 3.2% last April, due to lower inflation expectations.

The problem with soft landing is that it is often predicted, but very rarely happens, as the graph below shows.

Dashed hope?

The first cracks in the most recent soft landing scenario appeared in spring 2023. Signs that inflation is more persistent than hoped have been accumulating since. The war in Ukraine, the rise oil prices and the decoupling of the supply chain - against a backdrop of economic war between the United States and China - are all factors that could complicate the task of central banks in the fight against inflation.

As is usually the case, the bond market was the first to react. 10-year rates started to rise again, to reach more than 4.5% in the ^3rd quarter. Other factors are at play - like the gigantic fiscal deficit, and the threat of yet another government shutdown and the downgrading of US debt by a rating agency - but the increase in 10-year rates is largely caused by the rise in inflation expectations.

Canadian and US stocks, meanwhile, are down nearly 7% since their July 31st peak, which could indicate in creased fears of a recession on the part of investors.

If the hopes of a soft landing are once again disappointed and the economic world experiences a recession, we will be vindicated in having kept the bonds that cause so much pain since 2022, as they will help protect our portfolio.

Market Review

Canadian stocks: the rebound of oil

The Canadian stock market closed the quarter down 2.2%, despite excellent returns from oil companies.

The price of a barrel of oil increased by 29% during the quarter, thus putting an end to its decline that began in the summer of 2022. This inscrease follows the announcement, by Saudi Arabia and Russia, that they will extend their production cuts until the end of the year. The energy sector benefited from this, closing the quarter up 8.9%.

Despite a decrease of 7.6% during the quarter, the technology sector remains the best performer in 2023, up 36.2%. Shopify's stock - up 57.7% since the start of the year - explains by itself around 2/3 of the increase in the Canadian stock index. This is only a return of the pendulum, as in 2022, conversely, it alone caused for around 2/3 of the drop in the index!

The good performance of 13.8% in the health sector is almost entirely attributable to the cannabis company Tilray Brands (+57.6%), which wishes to continue its acquisitions in the field of alcoholic beverages. However, this sector weighs too little to have a notable impact on the performance of the overall index .

US stocks: too expensive?

The S&P 500 index fell by 3.3% over the quarter, bringing the increase for the year to 11.7%. Although the US economy is showing resilience, inflation has not yet been brought under control, and interest rates will therefore remain high for longer than expected.

The communications sector has been the best performer since the start of the year, up 39.4%. Meta and Google - which together make up more than half of the sector - closed the quarter up 4.6% and 11.0% respectively. Their integration of artificial intelligence, combined with results, that beat expectations explain this performance.

Energy stocks stood out with an increase of 13.3%, but unlike in Canada, they make up a small part of the index (only 4.7% of the S&P 500).

With bonds once again offering attractive yields, high-dividend stocks have lost their appeal. Although this is not the only factor explaining their underperformance, the three sectors with the highest dividend yield - utilities, consumer staples and real estate posted the worst returns, both for the quarter and for the year.  

In addition, for the first time since 1997, S&P 500 earnings yields (expressed as the inverse of the price/earnings ratio) are below the 3-month Treasury bill rate - a sign that US equities are expensive.

International equities: Japan continues to perform

The MSCI international (EAFE) index was down 1.6% (in CAD) over the quarter.

The good performance of Japanese stocks continued during the quarter, up 1.9%. They have thus retrained the 1st of world stock exchanges since the start of the year, up 24.5%. However, adjusting for the 12% depreciation of the Yen against the CAD, the return on the Japanese stock market for the Canadian investor is 0.9% for the quarter and 9.9% year-to-date.

The UK stock market, led by the energy sector, was among the best performers during the quarter, up 2.4%. However, like Japan, the British pound has depreciated, resulting in a return of 0.4% for the Canadian investor.

On the continental Europe side, the consequences of the energy crisis caused by the war in Ukraine are still very present. The Euro zone is showing anemic economic growth while inflation remains at a very high level. The MSCI Europe index was down 2.5% over the quarter.

Emerging markets: India stands out

Emerging markets were flat during the quarter, in Canadian dollars.

Among the major emerging stock markets, India stood out as the only one to offer a positive return (+7.0% in CAD over the quarter). The economic outlook continues to be encouraging.

An economic recovery well below expectations, in particular because of the real estate crisis, hitting the counrty and trade tensions with the United States continue to beset Chinese stocks, down 2.1% over the quarter.

The economic slowdown in China has also affected South Korea and Taiwan. Their stock markets are down 3.2% and 2.5% respectively for the quarter.

Bonds: rates keep rising

Let's be frank: the performance of bonds since spring 2022 is enough to test the patience of even the most disciplined investors.

After a return of around -12% in 2022, one might have thought that the worst was behind us when the rate (yield to maturity) on US bonds maturing in 10 years fell to around 3.3% in the spring. Unfortunately, as the fight against inflation proved more difficult than the market expected at the time, the yield to maturity on 10-year bonds (which reflects inflation expectations) rose to 4.6% as of September 30th, and the return for the year-to-date is negative, at -1.5%. In Canada, the yield to maturity of 10-year bonds rose to 4.0%.

Despite all this, it is important not to throw in the towel on our bonds. When the economic downturn occurs, thosde same bonds will protect the value of the balanced portfolio. In the meantime, we find solace knowing that we can now invest contributions to portfolio at the highest rates since 2007.