Market Musings
By: Erik & Guillaume
A little hard to accept that another summer has passed by, and winter is just around the corner. A new year will be soon upon us. The year 2022 has been a difficult one, considering what we have experienced over the first 10 months. We believe that we should expect a continued volatile environment with the ongoing instability and insecurity to persist into 2023.
With the world bank ‘s prediction of GDP one per cent for the U.S. 1.5 per cent for Canada and 0.5 per cent for Europe in 2023, the emergence of a recession (if we are not already in one) is eminent in our minds.
When will the call be made? It is anyone’s guess. The recession call is insignificant, as it will undoubtedly be the typical call that we have been in recession for X months (by the time the economists declare it). What is significant is what it means for you, our clients, and the financial health of your savings and portfolios. We will try to address that in what follows.
First, let us look at how this recession will affect individuals or who will be affected how. Indeed, the answer is not the same for all, as it depends where you are in the life cycle.
For those who are past the accumulation phase, or those in retirement, the effects of this recession will be felt differently than those in earlier cycles.
Why? Due to interest rates. Rates peaked in 1981, and have been falling ever since, at least until relatively recently. Certainly, there were periods of hikes that ended just before previous recessions, but on the whole, interest rates were not as impactful as they currently are. Due to inflation, or in preparation for the next contraction, the central banks have increased rates significantly, both relatively and absolutely. In combination with other factors related to recessions (such as job security should the economy slow down enough, etc.), this can have a significant impact on the accumulation generation. Employment risks in conjunction with higher borrowing costs can influence affordability of large purchases such as homes. Therefore, for those in the accumulation phase, this can present immediate challenges. If you take the longer view, affordability can become more attractive, as is the case recently in residential real estate sales numbers in large centres like Toronto, where prices and captivity for listings have waned.
However, certainly, in the short term, recession presents a challenge for accumulators, or early phase individuals.
Conversely, in some respects, retirees, with accumulated portfolios, are experiencing something different: higher rates for their savings. A recently as a year ago, the best rates were in and around one to two per cent on fixed income. Available on year rates were about 0.75 of one per cent. This meant that for those wanting fixed income previously, it was a capital erosion strategy. If you bought fixed income over the last years, you actually lost purchasing power. The only benefit was liquidity. Today, for 12 months, cashable, 3.5 per cent or better (non-cashable GIC, 12 months are at five per cent). We have not been able to find garden variety fixed income for five years at current rates for over 10 years. This means that fixed income is no longer a capital erosion strategy, but is actually a fixed income strategy. There is also the longer-term benefits of these securities. It now makes sense to buy for five years.
So for some, this looming recession offers an unseen benefit.
Nevertheless, it does not end there. Economic slowdown has a significant impact of equity values, as you have witnessed or experienced since January 2022. What has occurred thus far in 2022 can be magnified by the risk of a policy mistake by the Federal Reserve: tightening too much, too fast. This is a statistical reality. It has occurred a number of times in the past. Should the powers that be raise rates too high or too quickly, this can lead to a market correction and drive stocks down to their nadir. This is why we are somewhat under exposed to equity in most cases and are holding a little more cash than usual. How far below the recent lows could the index drop? It’s very hard to tell. The S&P500 could easily reach the 3,300 level on an increasing level of uncertainty (coming from Russia? China? North Korea? The real estate market?, etc.) or about 10 per cent lower than where we are now or six per cent lower than the October lows.
Back to central banks and rates for a moment: the expectation was for the Canadian central bank to raise rates by 0.75 per cent on October 26. In somewhat of a surprise move, the governor of the Bank of Canada raised the rates by 0.50 per cent. This could signal a slowing, which may protract the current situation for somewhat longer. The U.S. Federal Reserve kept the same tightening pace on November 2 when it increased rates by 0.75 per cent for the fourth time in a row.
In cases of economic stagnation or significant slowing down, the Federal Reserve should be prompted into action in an effort to “kick start” the economy. Interestingly, the conditions that may have prompted the shock (higher rates too fast) permit for the remedy. To restart the economy, the Fed will likely cut rates, to encourage the consumer. As we have mentioned in the past, roughly two third of GDP in any G30 nation is consumption. You need a healthy consumer to grow. This means putting disposable cash in the consumer’s hands. This can be done in three ways by the government:
1- Full employment (we already have that),
2- Cut taxes (deficits are simply too big), and
3- Cut interest rates (which requires rates to be significantly above zero, where they now are).
There is, of course, a number of other inputs to consider:
When will all of this transpire? We do not have a crystal ball and, as such, remain cautious at times like these.
How high will rates go? A very good question. The Fed being data driven, and data being backward looking make that impossible to tell. Some narket prognosticators are suggesting five per cent or another one per cent hike. Time will tell.
When will rates reach their peak, and when will the Fed pivot? Impossible to tell for the reasons above. But we would expect over the first two quarters of 2023.
Although uncertainty reigns currently, our combined experiences are telling us that the turn is near. While we are not unscathed, we are confident that this too, as other such incidents, will pass and become a distant memory, like in 1987, 1994. 1998, 2000 and 2008. Not all of these were recessions, but all had a fairly frightening impact on investors’ psyches and portfolios. However, none had lasting effects.
And having the opportunity to buy a well-managed, solid blue chip equity that has a history of growing its dividend, that is trading at a 35 per cent discount to its high, is very appealing to us.
We look forward to capturing some of these opportunities for you over the next few quarters.
As always, we welcome your comments and questions, and thank you for your confidence and trust.
Erik and Guillaume
Disclaimer
Erik Moisan isand Guillaume Desjardins-Tessier are Portfolio Managers with Raymond James Ltd. The views are those of the authors, and not necessarily those of Raymond James Ltd. Investors considering any investment should consult with their Investment Advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decision. Raymond James Ltd. is a Member - Canadian Investor Protection Fund. Commissions, trailing commissions, management fees and expenses all may be associated with mutual funds. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.
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