To say that this month’s corrective activity in stocks and bonds was anticipated would be an understatement. Bears on both sides of the asset teeter totter have been pounding the table all summer for some jolt to happen. Maybe it would be an economic stall-out from the Delta variant, or an inflation scare that would drive bond yields up. In this case, it was just a bunch of partisan-driven folks in Washington that play with debt ceiling limits like kids play fortnight. Arbitrary vote deadlines, ominous comments from a former Federal Reserve Chair (and now Treasury Secretary) was all the excuse sellers needed. Yet, there is nothing startling about the moves we have seen in either market.

 

Before we examine the extent of the retracement in stocks and bonds this week and month, let’s first recognize that the so-called teeter can in fact break, as it has now. In other words, we typically expect bonds to do well (yields fall) when stocks sell-off, and vice versa. This is because a shock causes investors to run from risk assets, either because the economy is faltering or there is some geopolitical or policy issue at play, usually pushes them to safe-havens. That would include government bonds. This week, we saw the S&P500 lose close to 4%, but the iShares US Treasury Bond ETF lost around 1.5% as well. The investment grade corporate bond market was knocked more than 2% lower.

 

 

The reason why bonds sold off, despite a mini-correction in stocks, is a mixture of Capitol Hill drama and a lack of real fear among equity holders. If you really think that the US government debt ceiling won’t be raised before the current ceiling ($28.4 trillion) is breached, then it makes sense to unload those securities that are going to mature between now then, which analysts peg at around October 18th. That could mean anything from T-bills to bonds. If you poll market participants, however, the majority believe that Congress will pull a new ceiling out of the hat just in time.

 

The other reason is really a lack of conviction behind the sell-off in stocks. Yes, there was a tick higher in volume on the S&P500 on Thursday when the index lost 1.6% but, outside of the spikes of September 17th and June, we didn’t see anything higher than the peak volumes through the summer. This was no exodus and therefore there wasn’t a lot of fuel for low-risk assets like government bonds to feed on. That’s not entirely fair, since the long end of the US curve did see better buying in the last two days of the month.

That still leaves the 30yr US bond above 2% by a handful of basis points. Does that make the third quarter a disaster though? Considering that the bond ended the second quarter at 2.08% after a huge rally in the last two months of that quarter, I would have to say no. If people are really afraid of inflation and a debt default in the largest bond market in the world, it sure doesn’t look like it. That doesn’t mean yields can’t and won’t go higher. In fact, they should in an environment where the economy is recovering closer and closer towards full employment. I believe we will return to this year’s yield highs on the US 30yr bond (just above 2.4%) by year-end.

 

 

That view isn’t based on a government default, but simply a continued grind higher in US and global economic activity. Yes, embedded in this outlook is some optimism towards supply constraints, both labour and inputs, but I do think we are moving in that direction. The key takeaway is that a higher bond yield forecast, based on stronger economic growth, doesn’t mean that stocks have to buckle. The roughly 5% decline in the S&P500 as of Thursday is, of course, a disappointment for investors. It turned what looked like a 5% incremental gain for the third quarter into a flat quarter. From the end of April and through the virus-induced hiccups in May and July, it still paid off to be invested. The question is whether this 5% drift in stocks morphs into something more significant?

 

 

Remember, a 5% decline in valuations is normal and viewed as healthy in a bull market. Likewise, a 10% downdraft would be normal after the third quarter of a year when stocks are up double-digits. As I mentioned the other week, I would be viewing these pullbacks as opportunities to add to areas in the portfolio where you are light against the backdrop of still strengthening economic fundamentals. In the case of the TSX, we have definitely seen materials, health care and consumer discretionary stocks lag during the quarter. Staples, industrials and real estate have outperformed. I still like the materials sector and with the sub-group looking to make a triple-bottom around 2700, I think adding exposure makes sense. Teck Resources has paid off this quarter, but a little defence in gold and silver looks appropriate at current valuations.