If there was an excess of euphoria in financial markets during the first half of 2023, it appears to be getting skimmed off the top at a rapid pace during these initial sessions of July. Investors indeed may be scratching their heads as to what has changed and they would be forgiven if they couldn’t find much. The North American economy continues to chug along, central bankers continue to repeat their message that the inflation fight is not over, and people are being paid to be defensive. This begs the question of whether this week’s pullback is the start of a more substantive correction, or simply a brief pause for the market to catch its breath?

 

At the start of the year, stocks had just come off a disappointing December retracement after bottoming in October. In the first three trading sessions of January, the S&P500 had dropped by 0.8%, but things stabilized and by the end of the first five days, the index was up 1.4%. Here at home, the TSX actually gained 0.6% in the first three days and had a delivered a 2.5% lift after five sessions. Contrast that to what we were seeing as of Thursday this week, where the S&P500 was down 1.3% and the TSX was down 1.8%. A similar loss was seen for the NASDAQ. In itself, these three days aren’t spectacular and we saw a similar performance just a couple of weeks ago, when the S&P was down 1.4% and the TSX was off 1.8% in a 3-day period. We also saw worse performance back in May and, of course, March.

 

 

 

The erosion on Thursday was created by the same thing that has spooked equity bulls for the past year and a half and that is the threat of a higher interest rate regime. A much stronger-than-expected US ADP payrolls report (showing a gain of 497K jobs in June, or almost double the consensus forecast) added fuel to the fire sparked by Wednesday’s release of the last FOMC meeting minutes. There was also a better than predicted report on the services sector, where the ISM services PMI showed a gain of almost 4 points in June, led by employment and new orders. Given that the services sector in the US represents the majority of economic activity, these numbers painted the picture of an economy that was not only not in recession, but was perhaps still very much in growth mode. Either way, this supported the contention by Fed officials that further rate hikes would be required. Again, this should not have been news.

 

 

 

Not only should the market have not been surprised by the fact that the economy isn't falling off a cliff mid-year, and that rates are not going to drop any time soon, but there also didn't seem to be a lot of thought given to what the ADP figures were actually showing. Yes, having almost a half a million net new jobs in month was a shocker, but this report has been understating the health of the labour market for quite some time. For example, with the June increase, the cumulative gain during the last six months has been about 1.58 million. Even with this morning’s weaker-than-expected non-farm payrolls headline (and downward revision to May), non-farm payrolls had increased by 1.67 million. If we take the analysis over the last 12 months, the difference is even more stark, with the ADP headline increasing 3.2 million against a 3.8 million gain in non-farm payrolls.

 

If you really are placing your bets on what the ADP report is saying, then the market should still be comfortable with the view that things are weaker. The problem is that investors went in the other direction. If the June headline was a more accurate depiction of what was going on, then ADP was playing catch up to non-farm payrolls. Furthermore, even though the 6-month cumulative gain in payrolls of 1.8 million is still a deceleration from what we saw in 2022, it is higher than any point between the financial crisis and the start of the pandemic. It’s when this cumulative gain drops below a million that we know the economic cracks are getting wider. That is an unlikely development until we get towards the end of this year, if then. Which brings us back to the robustness of the U.S. economy and the implications for monetary policy and bonds.

 

 

 

As much as this has been a disappointing start to the month for equities, it has been quite rough for those in the fixed income market. Using the Bloomberg USAgg Index, there was a drop of 1.3% in the first three trading days – in line with the S&P500. This is when you know that a retracement in stocks is being caused by rate expectations and not a deterioration in the economy. The above chart shows the S&P500 against the first contract of the U.S. long bond future.

 

We typically think of bonds and equities moving in opposite directions. If the economy is strong, then stocks are bolstered by underlying fundamentals, while bonds have to deal with nasty things like inflation and central bank tightening. If the opposite is true, then bonds will tend to outperform or, in fact, improve as stocks falter. During most of 2022, there was positive correlation between stocks and bonds because they were both being driven by the same dominant force – interest rates. Bonds fell because of the most aggressive tightening phase in decades and stocks dropped because of fear this tightening would create a recession and because high-growth companies in the tech sector were going to get a valuation haircut.

 

This week, we saw the U.S. long bond future come within a couple of dollars of its March low and about 5% from its cyclical low from October (which was the worst level seen since 2010). The S&P500, on the other hand, is way above its March trough and more than 20% higher than the “bottom” of last October. If the Fed is going to take these latest economic datapoints as a cue to follow through with its rhetoric of one or two more rate hikes, then the bond market is pricing this view appropriately. Indeed, these pullbacks in bonds on head-scratching economic data should be used as buying opportunities in our opinion. Equities appear to be out of touch with the reality of higher rates for longer and the rubber-band impact this could have on economic activity and profits.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew Pyle

 

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The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.

CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. Insurance services are available through CIBC Wood Gundy Financial Services Inc. In Quebec, insurance services are available through CIBC Wood Gundy Financial Services (Quebec) Inc.

 

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