Andrew Pyle
December 16, 2022
Switching games
On this week’s conference call (playback details can be found at the end of the commentary), I talked about how equity markets have responded to recent monetary policy decisions by the Bank of Canada and Federal Reserve. Up until Thursday, the reactions looked surprisingly nonchalant. Where you would think that a commitment to continued rate hikes (and higher probability of recession) would send stocks into the tank, instead we saw resilience. It’s almost as though market participants are still playing an old game of inflation and rates and have not yet read the playbook for the next game – how companies do in recessions.
Let’s start with a few obvious points. First, I cannot recall a time when equity markets hit a bottom before a recession got underway. Prior to this week, there was a growing chorus of investors who believed that the lows seen in October were in fact the trough for this bear market. Now, to be fair, this view has also been predicated on the belief that there will not be a recession in the US or Canada. The Federal Reserve also believes this as they gave us all their updated economic predictions for 2023 and only showed a moderation in GDP growth to half a percent. The problem is that if the Fed thinks the economy has some underlying resilience to it, then the job of getting the inflation genie back in the bottle is not over yet. Hence, the median voting member forecast of where the fed funds target rate will top out is up north of 5%, compared to this week’s rate of 4.5%.
The second important point is that the recovery in the broader market from October to December was not that much different than what took place from June to August, after the second quarter sell-off. From the intraday low on June 17th to the high on August 16th, the S&P500 rallied about 19%. From the low on October 13th to this Tuesday’s high, the index had rebounded 17.5%. The summer rally failed to stick and after yesterday’s 2.5% drop in the S&P, this one looks like it might disappear as well. For institutional funds that were anticipating a prolonged Santa rally and an opportunity to salvage something respectable from an otherwise dismal year, may be looking to unwind long positions in an effort to not lose another few percent before the books are closed.
Based on Thursday’s close of 3890, we are now only 10% above the intraday low set in October – a target that we would not dismiss as unreachable at some point in the first quarter. When we hit that low, the S&P had declined approximately 25% from its record high set in late March. Had a recession developed in the second half of this year, this decline would have been close to the average that we have seen for recessionary periods in the past. Yes, we have seen heavier hits, like 50% in 2008-09 and 35% in March 2020, but if the recession was already under way, we could have had a constructive debate as to whether October could be a bottom.
Even though more indicators are pointing to a recession developing, the statistical evidence doesn’t support there being one starting in the fourth quarter. More recent data, however, does suggest that the next quarter could start off quite weak. This week alone we saw manufacturing sentiment in NY state crumble (Empire index falling to minus 11.2 in December from plus 4.5 in November), and a further contraction in industrial production of 0.2% in November after a 0.1% drop in October. US retail sales for the month of November also came in below expectations, with the headline down 0.6% and the control group falling 0.2%.
Note, these come after some strong gains in October and those provide a positive base effect to the fourth quarter – which is why I don’t believe you will see the first negative GDP print this quarter. If retail remains weak in December, the opposite will happen and the first quarter base effect will be negative. While we have seen stocks sell off without a pullback in consumer spending, we have rarely seen stocks resist a correction when there has been one.
What of Canada? Up until the last couple of weeks, the TSX looked in better shape technically than the US market after it broke well above its August highs and looked set to retest the best levels of early June, which was up around 21,000. The outperformance has come despite poorer signs from Canada’s jobs market in the past few months and a generally anemic commodity environment. Foreign investors have warmed to the weaker Canadian dollar, but that same factor is also a negative in terms of where we see monetary policy. Since a decline in the value of the Loonie can put upward pressure on imported prices, it can make the Bank of Canada’s job of lowering inflation a little more difficult. The pace of wage and salary inflation in Canada has also shown no sign of turning around after hitting 5.6% last month and, similar to the problem facing the US, higher wages are going to make services inflation even sticker.
Right now, there is a gap of a quarter point between the Bank of Canada rate (4.25%) and the Fed funds rate (4.5%) and both central banks have been moving pretty much in lockstep this year. The BoC did appear to blink at its October meeting, when it raised rates only 50bps instead of the expected 75bps move. It stuck to its half point stance last week, which was matched by the Fed. What the BoC cannot do is allow the policy rate gap to widen, as it did back in 2017-19. To do so would probably send the Loonie down to 70 cents and that would compound the Bank’s problems on the inflation front. Therefore, if the Fed is going to tack on another half a percent on rates, I would suspect the Bank will follow and that means even more pressure on households in this country.
The outperformance that we saw in Canadian stocks this year vis a vis the US and other regions was really the product of the first quarter, when commodity prices fueled two of the three main engines of the TSX. After March, the TSX pretty much followed the broader US market. Some may make the argument that commodities are about to stage a resurgence in 2023 and that will again help the Canadian equity landscape shine relative to its peers. I beg to differ. Recessions have never been that friendly to commodity demand and unless you want to bet the farm on a sustained Chinese covid re-opening, it’s a stretch. Canadian stocks will help in providing income support to the portfolio, but one has to be very selective going into the next quarter.
Ally and I believe that the market is coming to grips with the new game that is about to be played, as evidenced by Thursday’s sell-off. That said, we find ourselves caught between believing the Fed and Bank of Canada and believing the bulls that don’t believe in recession. Central banks are going to premise the need for further tightening on the fact that economic fundamentals are sound, which also means inflation is going to be harder to beat. However, we all know that if a recession does develop, it is unlikely that central banks will be able to maintain a restrictive monetary stance. Bulls are correct in assuming there will be a pivot in central bank policy from tightening to easing, but that only comes if we get a meaningful contraction in the economy and stocks aren’t set up for that first part of the game in our opinion.
On behalf of the Pyle Group, have a wonderful weekend.
Andrew Pyle
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