Q3 2023 Market Review
ECONOMIC COMMENTARY
Supported by strong quarterly earnings and uplift in 2024 earnings guidance, equity markets started the third quarter on a positive note, but the travails of China, the world’s second largest economy, and the FED’s persistently hawkish discourse took their toll, and the markets posted negative returns for the quarter ended on September 30th. Specifically, the MSCI All Country World Index (US$)[1], the S&P 500 Index, and the S&P/TSX Composite gave back -3.40%, -3.39%, and -2.20%, respectively, during the quarter. Unlike the first semester where only a handful of issuers were responsible for the bulk of the major indices’ positive performance, during the third quarter, performance dispersion broadened. Even within the group commonly referred to as the Magnificent 7[2], dispersion increased with Alphabet (Google) and Meta Platforms (Facebook) posting strong returns while Apple and Microsoft lingered and Amazon and Nvidia went sideways. Anecdotally, equity factor (or equity style) exposure did not play a significant role in performance attribution in the quarter. From a sectoral standpoint, it was a different story. On the bright side, the energy sector nicely outperformed the market as the extension of the Saudi Arabia-led production cuts provided support. On the downside, global financials generally continued to suffer from deeply inverted yield curves and growing loan defaults. Similarly, dispersion was significant across regions. To this point, North American equity markets did better than their European counterparts as China was again a distant laggard.
The macroeconomic situation in China is intriguing. Expectations were high following the re-opening of the country post-Covid, but most of the trade (imports and exports), industrial output, retail sales, and capital formation indicators paint an underwhelming growth portrait. Curiously, monetary policy action in the form of liquidity injection by the People’s Bank of China (“PBOC”) is yet to come. This contrasts with the recent history of China’s decision makers to extend massive stimulus response when confronted with a growth slowdown. We are not certain why they remain so timid this time around, but there are few possible explanations. It could be driven by the fear of seeing inflation spiraling out of control. It could be because they perceive that there is limited room for further money easing when monetary tightening is taking place elsewhere in the world. It could be because they believe that said stimulus will not be effective, or lastly, they may want to avoid risking further renminbi depreciation against major trade partners, including the US. It can be all the above but whatever the motivation, it may reflect a permanent change in the way Chinese decision makers view the relationship between GDP growth and capital investment. It is important because if a review of China’s growth model at the highest government level is underway, it could have severe implications for growth globally. Naturally, this is something we are monitoring closely.
Fixed income markets were again broadly negative during the third quarter. Specifically, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate Index returned -2.89% and -1.63%, respectively. In Canada, the decline of the ICE Bank of America Canada Broad Market Index was even more pronounced at -3.85%. Importantly, in the United States, the decline has been extending across all market segments into October as the combination of runaway fiscal deficit and Federal Reserve accelerated balance sheet reduction has been proven to be a nasty recipe. We highlight that the global equity markets have declined in four quarters since the beginning of the Federal Reserve’s tightening cycle in the 1st quarter of 2022: Q1-22, Q2-22, Q3-22, and Q3-23. As it turns out, fixed income markets were also down in each of these quarters. Given that an allocation to fixed income is generally thought to provide diversification benefits, let’s just say that this outcome has been less than stellar. Nevertheless, we believe that the prospects for fixed income instruments have changed quite dramatically since the first quarter of 2022. To this point, on December 31, 2021, the yield to maturity on the ICE Bank of America Global Broad Market Index stood at 1.11% and its duration[3] stood at 7.6 years. This implies that a 1% increase in interest rates over the next 12 months would have translated into a 6.6% loss, roughly speaking[4]. At the same time, had interest rates remained the same over the next 12 months, the return would have been 1.1%. It is only if interest rates were to decline further, even though they were already negative across Europe, that a return of more than 4% was possible. Fast forward to October 20, 2023, the yield to maturity on the ICE Bank of America Global Broad Market Index stood at 4.59% (3.48% more) and its duration[5] stood at 6.4 years (1.2 year less). This means that a 1% increase in interest rates over the next 12 months would result in a loss of 2% (4.6% better than the same scenario two years ago), while unchanged interest rates over the next 12 months would translate into a return of 4.59%, roughly speaking. Last but not least, should a decline of 1% in interest rates occur during the next 12 months, the return would be around 11%. It is even more compelling for investors who are focusing on North American markets as the yield to maturity exceeds 5.5%. The same way we found difficult to justify ultra-low yields across the curve two years ago, we’re finding it difficult to justify 5% US 10-year treasury yields. We believe there are technical factors at work which do not make the current situation sustainable. As a matter of fact, we do not think it is logical for the Republic of Greece, which defaulted on loans owed to the International Monetary Fund eight years ago, to be able to borrow for 10 years at a lower rate than the US Government, irrespective of how dysfunctional Congress seems to be and how weak Joe Biden’s presidency is turning out to be.
For all these reasons, we have been actively looking for ways to take advantage of higher current yields and potentially lower future yields in the configuration of our fixed income model portfolio.
THE ANT AND THE CICADA
The title of this section refers to a fable attributed to the Greek philosopher Aesop[6]. Its origin goes back over 2 000 years. It tells the story of a cicada which spends the summer singing and dancing while its neighbor the ant is busy seeding and harvesting a field so that it wouldn’t starve during wintertime. When the cicada comes begging the ant for food with its fiddle under the arm as the weather gets cooler, the ant sends the foolish cricket off, telling it to sing and dance the winter away. There have been many adaptations of this story over the centuries, including one by the 17th century French poet and moralist Jean de La Fontaine[7]. The objective here is not to debate the respective virtues of the protagonists in the tale but to simply argue that actions have consequences and that we find striking parallels between Aesop’s famous tale and present times, parallels which complicate the decision-making process of central bankers.
The idea is that summer is over and that the cicada could be viewed as a hypothetical household that has been enjoying a frivolous and leisurely lifestyle through incremental borrowings made possible by a decade of ZIRP[8]. In contrast, the ant could be viewed as a cautious mortgage-free and consumer debt-free household that has endured a lengthy period of financial repression during which its savings did not offset inflation. As winter approaches by way of higher interest rates, the fortune of the two households is turning. To this point, while higher interest rates are bringing significant hardships to our indebted household as its purchasing power is eroding, more elevated interest rates are proving a boon for our mortgage-free household which income from savings is improving.
This example highlights that the effects of the more restrictive monetary policies implemented by central bankers globally since 2022 have not been uniformly distributed. While the implementation has worked, on average, when it comes to taming inflation, this may not mean much to many. For instance, for some households, central bankers’ efforts have succeeded in reducing the cost increases for certain goods but have indirectly caused higher cost increases for others, like mortgage payments. For some other households, central bankers’ efforts may only have succeeded in boosting discretionary spending capacity. In the end, monetary policy is not a panacea. In fact, when considering the burden that higher interest rates impose on cicada-like households, the tightening may have reached the limits of its usefulness. For overly indebted households, we believe that more targeted fiscal policies will have to be considered to provide some relief because they are not able to sing and dance the winter away.
LET’S TALK ABOUT CASH!
One of the questions we most frequently get asked by families nowadays is whether it is worth investing in anything other than cash. After all, the reasoning goes that cash currently pays upwards of 5%, which is more than the current inflation rate, more than the yield to maturity of government bonds with more than a couple of years left before maturity and, since this summer, more than the earnings yield on most equity markets indices[9]. While this makes intuitive sense, we outline below a few reasons why we do not think it is a good idea.
The first reason is that while sitting in treasury bills, non-credit oriented money market instruments or high interest savings accounts enable investors to collect a risk-free 5% annualized return that might only be true for a few months. To this point, an overwhelming majority of macroeconomic datapoints suggest that central banks are nearing the end of their interest rate hiking cycle. This means that future cash returns might very well be lower than current cash returns, which means that the longer an investor stays in cash, the lower the average yield might be. This risk of not being able to reinvest proceeds at a rate that is equivalent or higher than the current rate upon the expiry of an investment is called reinvestment risk. For instruments such as cash, which mature overnight, this risk is particularly high.
The counter argument to the above that some clients put forward is that they will have plenty of time to re-engage with the markets later, when overall conditions have improved. The problem with this view is that by the time investors deem that conditions have improved sufficiently to justify reinvesting again, if history is a guide, the prices of financial assets will have already compounded at a much higher rate than the safe returns earned on cash during the waiting-for-better-conditions period. This risk of missing out on superior opportunities by staying in cash is called the risk of regret.
All things considered, our view is that it is not when cash is yielding more than both fixed income and equity markets that investors should be considering it as a viable alternative. Instead, it is when cash is earning nearly nothing with a view that it will go up fast in the future because in doing so, it will tend to negatively impact the value of both fixed income and equity investments. In fact, this is what happened since the beginning of 2021, with cash returns effectively crushing fixed income markets and large swaths of the equity markets. Ironically, we believe that while cash is providing the highest spot returns in decades, it is at this very moment that its prospects are the worst when the time dimension is accounted for. In contrast, the derating that fixed income and equity instruments have suffered in the past few years has rendered them more attractive in the long term, relative to cash. Furthermore, JP Morgan Asset Management estimated in its most recent outlook that a dollar invested in cash will be worth, after inflation, $1.04 a decade from now, whereas a regularly rebalanced portfolio comprised of 60% equities and 40% fixed income instruments would grow to $1.54 after inflation, which represents 50% more[10]. Had the authors of the report factored in taxes, the difference would be even larger since most fixed income instruments bought on the secondary market or via mutual funds trade at a discount to par value. As such, future returns on those instruments will certainly include a good portion of capital gains, thereby making fixed income more tax efficient than cash.
[1] Unless specified otherwise, index performance references total returns denominated in local currency terms.
[2] Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms
[3] A measure of sensitivity to a variation in interest rate.
[4] Ignoring convexity and complex curve movements.
[5] A measure of sensitivity to a variation in interest rate.
[6] Aesop's Fables. A new translation by Laura Gibbs. Oxford University Press (World's Classics): Oxford, 2002
[7] La cigale et la fourmi
[8] Zero-Interest-Rate-Policy
[9] The earnings yield is the inverse of the price-to-earnings ratio.
[10] JP Morgan Asset Management – Portfolio insights - 28th annual edition 2024 Long-Term Capital Market Assumptions Time-tested projections to build stronger portfolios