As hard as it is to believe, we have already arrived at the second long weekend of the summer (well, at least for those of us not in Newfoundland, Quebec or Yukon). These next three days will provide a welcome reprieve from what has been an unusually non-sleepy number of weeks. That said, we enter August with a noticeably different tone to financial markets than back in the second quarter and this has served as a reminder that having a strategy and staying the course pays off.

 

Let’s begin with the state of North American equity markets. As of Thursday, the S&P500 was on track to deliver a total return (change in price plus dividend reinvestment) of minus 1.8% since the end of May. The index is still down close to 15% since the start of the year, but the recent performance highlights just how much damage was baked into most of the first half. This is also better than what we have experienced in Canada, as the TSX is down about 7% since the end of May, for a total return of roughly minus 6.6%. This isn’t a major surprise considering that commodity prices have deteriorated this summer on prospects for either a mild economic slowdown or outright recession.

 

Clients will recall the discussions that Ally and I had back in the second quarter, on the need to start trimming back on the broad Canadian equity sector in favour of US and tech. That is playing out today. If we take the NASDAQ 100, it is now showing a small positive total return (0.3%) since the start of June. Contrast that with a negative 18% total return for the TSX materials sub-index and minus 9% total return on the energy patch.

 

The evolution of a recessionary rhetoric among investors has created the pivot between commodities and tech by fading some of the anxiousness around mega rate hikes.  Yes, the Federal Reserve followed through on its talk of a 75-basis point increase this week; but in removing future guidance it has put itself on the seat next to all of us in this macro theatre. We just don’t know which the way the plot is going to develop.

 

Bond traders have a good idea, however, and that is why have seen a continued decline in yields and corporate spreads since mid-June. Even with the Fed funds target returning to the peak we saw prior to the pandemic, the 10yr yield has now fallen almost a full percentage point to around 2.6%. The Government of Canada yield has followed suit. And, while both curves remain inverted (adding to the line-up of individuals calling for recession), there has also been some relief in short-dated yields. Canada’s 2yr fell below 3% this week for the first time since early June and the US 2yr note is just a few basis points from its July 5^th low of 2.82%.

 

I know that a lot of Canadian investors have become confused by the activity in recent weeks.  How can it be that more economists are predicting recession, more indicators are coming in negative, yet stocks are going up? Indeed, we saw a second consecutive contraction in US real GDP as the second quarter print came in at minus 0.9%. This is often viewed as the technical definition of a recession, though a recession in the US is only truly labeled when a group called the National Bureau of Economic Research (NBER) says so. Instead of simply looking at whether the official GDP statistic comes in negative for two or more quarters, the NBER examines a host of other indicators. These include employment, personal incomes, the level of production and consumer spending. Since none of these have shown a persistently contraction, a recession is not going to be called for a while.  If you want some precedent, consider that the pandemic-driven recession in the first half of 2020 was only called by the NBER in July 2021.  Yes, a year after it was over. This is also a very hot political potato given that we are heading into the US midterm elections in November and Republicans and Democrats are already battling over whether there is a recession or not.

 

Investors should not get engulfed in this debate. The volatility that we saw in the markets in the first half is being reflected in a more volatile set of economic reports. We have talked about this in terms of commodity prices and housing. In just four months, home prices sunk like a stone in some places, and this is affecting spending decisions and thus inflation patterns. In this environment, it is better to take the pulse of business and now that we are more than halfway through the quarterly earnings season, we are discovering that things are not as terrible as some feared. Revenue and profit growth rates are slowing, which they should, but not on a steep glide path.

 

Source: Bloomberg Financial LLC

 

Of the 498 companies in the S&P500, over 260 have already reported, as indicated in the Bloomberg table above. Of that total, 60% have reported sales numbers that have beaten street estimates and 73% have come in ahead of expectations on earnings.  The only two groups where a majority have come in below estimates on sales are communications and financials, however, not one sector has done so in terms of earnings.

 

On the Canadian side, we are a little young in this earnings season relative to the US, with only 67 of the TSX300 companies reporting so far.  Still, of those reporting, over 70% have come in above consensus on revenues and there has the percentage of companies beating on earnings is close to 60%. There is definitely a more mixed picture so far and we don’t get third quarter Canadian bank earnings until next month and those are going to be the main focus in terms of assessing credit demand in the wake of higher rates. If the activity in housing is anything to go on, we are likely to see a significant break on mortgages, though many households are probably dipping into revolving credit to meet higher borrowing costs and non-discretionary price inflation.

 

There are a number of takeaways for investors as we prepare for this weekend. First, the apparent dichotomy between corporate earnings, market performance and observable economic activity is going to persist. There will also be a convergence at some point – either because economic activity recovers alongside the rising valuations in stocks, or that stock valuations fall backward in the event that the economy continues to weaken. This latter situation is going to be determined by central bank actions beyond July. The Pyle Group has been advocating for remaining fully invested according to individual mandates, while remaining tactical. This strategy has enabled us to experience losses that are below indexes in either bonds or equities, while maintaining the ability to participate in the recent upside. That doesn’t mean we are in cruise control and circumstances may dictate a more defensive positioning ahead of the US mid-terms. Eyes on the road and hands on the wheel – something we will all be practicing this weekend.

 

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.