Andrew Pyle
May 13, 2022
Sometimes markets advise us as much as worry us
Someone once told me as I made the transition from the Bay Street trading desk to advising retail investors, that this role isn’t as simple as providing recommendations to multi-billion dollar institutional investors. You had to not only be a portfolio manager and financial planner, but an educator, psychologist, and counselor as well – characteristics that bartenders have aspired to for generations.
Considering the developments of the past two years, these aspects of the job have been put to the test for sure. There is a sense of disbelief in the financial system that I have not seen since the financial crisis, but this extends to the geopolitical stage as well. Nobody in 2021 expected the disaster in Ukraine that is taking place now, nor would anyone here have thought it likely that the central bank chief’s job tenure be called into question. In short, Canadian investors need to be forgiven for thinking that 2022 has created a seemingly bottomless pit of woe; and that is where the counselling comes in. Before I get started, just a schedule update. We will be hosting our monthly conference call on Monday evening at 7pm ET, the details can be found at the end of the newsletter.
This week, stocks continued to slide on various factors – from continued concern that central banks would have to raise interest rates to a point that would choke off economic growth, to the shutdowns in China, to a prolonged war in Ukraine. We tend to think of markets as reactionary and prognosticating beasts. They take information, revise projections and ultimately set a new pricing of securities that corresponds to that information. Information will move markets, but markets will also move on their prediction of where that information will go next and, sometimes, create a new path for that information. Today, it is hard to know whether markets are just reacting or performing their role as forecaster.
Take the first concern – interest rates. The bond market has worked itself into a lather over the possibility that the Bank of Canada and Federal Reserve would have to get even more aggressive on interest rate hikes. A quarter-point increase wasn’t enough, so they shifted to half-point moves, but maybe that would not be enough. Hence, the increased banter over a 0.75% rate hike – all aimed at crushing inflation. Unfortunately, some officials have fueled this speculation by offering sound bites that such a large-scale interest rate hike wasn’t off the table. Of course not. Nor is a pause off the table if the economy starts to show signs of stumbling. Still, the reinforcement by said officials of a possible larger increase in rates has led to the continued erosion in stock market valuations and, yes, even crypto valuations.
Central banks listen to every heartbeat of the market, so it wasn’t a surprise that the Fed Chair himself came out today to quell the drums of a three-quarter point move and suggested the Fed could simply follow a series of half-point moves as a means to reducing inflation. Let’s remember that at the end of last year the consensus view was for only quarter-point increases done in a gradual manner. In response to Powell’s comments the stock market recovered on Thursday. What is interesting is that the market has actually gone through a conditioning. Rate hikes were always going to cause some concern for bonds and equities, but when the view shifted to major hikes, both markets corrected in a sizable fashion. All the Fed Chair did this week was to simply paint a picture of heftier increases than seen in 20 years, but not as bad as seen almost 30 years ago. And the market bought it.
That’s just part of the counseling – that even something that is not conducive to the economy (like rising interest rates) can still be constructive for stocks simply because it possibly won’t be as bad as what we originally feared. Last week, we started picking away at government bonds as yields on 10yr paper hit 3%. Yields have since retreated for a couple reasons. First, more economists expect a significant slowdown in growth or recession. Second, a slowdown will likely cause central banks to not push ahead with the degree of tightening once expected. Yields have calmed down in the past week in response to developments and, while they may still edge higher, our belief is that we are closer to the top in yields (i.e., bottom for the bond market) than the opposite.
But what about the stock market? On Thursday, the S&P500 fell to an intraday low of 3859 – representing a decline of 19.9% from its January 4th high. In other words, we came within a tenth of a percent of calling this a bear market for the index. Looking back over the history of markets, we know that declines of 5-10% are normal and fairly frequent. By contrast, major corrections of 50% are relatively rare. So, where we are now is right in the middle, and that requires a step back to see whether this market correction is an appropriate prediction of what may come.
At first glance, the decline in the major indices do portend at least a slowdown in economic growth, but not necessarily a recession. The bears would argue that a recession is likely and that we would normally see stocks fall more than 20% in such an instance. Historically, that is true; but we are not yet seeing recessionary storm clouds in North America. Europe is different but that region is dealing with an invasion. China is also different, though it is hard to comprehend Beijing allowing the Chinese economy to implode because of the virus. And, in the case of Europe, there is going to be substantial re-building once the Ukraine situation is resolved.
Our take remains that investors should not be panicking in this situation. Yes, Bitcoin and other crypto currencies had a meltdown this week and it was linked to a general exodus from risk assets. That said, I would not lump crypto and stocks into the same camp. The latter asset class can be linked to fundamentals, where crypto is still searching. And if folks are dumping their crypto assets out of fear of continued correction, where are they going? Perhaps they are building cash reserves, or maybe they are buying bonds. Either way, this becomes an argument for staying invested in both bonds and stocks, as opposed to throwing in the towel. Likewise, it doesn’t mean betting the farm on a market rebound. Watching the valuations of stocks and bonds, relative to fundamentals, is the best counselling today and making sure your portfolio remains aligned with your objectives, your ability and willingness to take risk is still the best counsel.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew
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These are the personal opinions of Andrew Pyle and may not necessarily reflect those of CIBC World Markets Inc.