The bigger question to us is why the economy has been so resilient thus far despite the sharp rate increases.  The main reason is that the unique structure of the 2022 economy blunted the power of the central banks’ tools.  Years of low interest rates, dating back to the aftermath of the 2008-09 financial crisis, had allowed for a transformation of much debt, both household and corporate, away from variable rates that rise as the central bank tightens policy to low, long-term fixed rates.  That meant that even as central bankers raised interest rates over the past year, households and corporations were slow to feel the impact.  Another reason that spending has remained strong so far is that the most immediate beneficiary of higher interest rates has been savers, who are suddenly getting much larger returns on the savings that had risen during the pandemic when their spending on services such as travel and entertainment was constrained by the shutdowns.  This provided another leg to continued consumer spending.  Finally, while the Fed, the ECB and the Bank of Canada, among others, have all been aggressively raising interest rates, two of the largest global central banks, the BOJ (Japan) and the PBOC (China), have both remained in easing modes.  The result is that Global Liquidity has still been expandingand the aggressive interest rate hikes of the past year appear to be having a limited impact on spending and economic growth thus far.

But we are now seeing the traditional paths of slowdown; interest sensitive sectors such as housing rolled over first; businesses then saw a slowdown, as evidenced by the layoffs in both the technology and financial sectors.  The last pillar to fall is the consumer; that hasn’t happened yet because employment has remained strong due to labour shortages held over from pandemic and the massive government stimulus provided during 2020-21.  Economic growth has also benefitted from pent up demand for services related to the pandemic.  In addition to lower energy costs, rising real wages and ongoing employment growth, the consumer has not yet depleted the excess savings built up during the pandemic.  But those economic tailwinds are all now fading and we saw evidence of that in the earnings of the giant retailers.  Savings are dwindling.  Consumer debt is piling up.  The post-Covid spending splurge is over.  As a result, several big retailers tried to pump the brakes during earnings season by issuing sales guidance for this year that disappointed Wall Street.  Lowe’s, Best Buy, Home Depot and Target Corp. all see the potential for revenue to decline this year.  There is a sense among retailers that the consumer has been defying gravity for quite some time, and they are expecting the music to stop.  The savings rate has dropped below 5% for the first time since 2009, when the economy was in recession following the financial crisis.

The Yield Curve doesn’t lie. There are plenty of decent recession indicators out there to alert you to a slowdown before it happens, but one of the most reliable over many cycles has been the ‘shape of the yield curve.’  Normally longer-term interest rates are higher than short-term rates.  It is actually the basis of the banking system in that they take in shorter-term deposits at lower rates and then lend it out longer-term at higher rates.   However, when inflation starts to rise later in the economic cycle, central banks are compelled to raise interest rates to try to slow down growth and reduce those inflationary pressures.  As the economy slows down, the entire rate structure shifts lower, but longer-term rates fall sooner and more quickly.   When long-term rates drop below short-term interest rates, we refer to it as ‘an inverted yield curve.’  The chart below shows the spread during the last 55 years of 10 year government bonds versus 3 month treasury bills.  For most of that time, the spread has been positive (i.e. a ‘normal’ yield curve).  On all of the occasions when it went negative, the economy entered into a recession (shaded areas) less than a year later.  The current drop has been one of the sharpest in decades.  It’s hard to see how we don’t go into recession based on that signal!

So why aren’t we ‘running for the hills’ in terms of stock market exposure with all these economic risks and banking problems in front of us?  One big reason is that, when this recession finally does arrive, it will have been the most widely anticipated downturn in history!  Many sectors, such as autos and financials, are already reflecting largely recessionary conditions.  Bearish sentiment remains high, with the recent Association of Individual Investors bearish sentiment index increasing to 45%, well above the 31% historical average.  Bearish sentiment and ongoing analyst and strategist calls for further declines in U.S. stocks actually provide mreo support as these sentiment indicators generally hit such high levels closer to market bottoms than tops.  It seems that, in many ways, anyone who has wanted to get out of stocks has gotten out!  While stocks have never started a new bull market before a recession has actually begun, we do believe that we already saw the lows for this cycle last October.  Stocks will most likely remain in this ‘trading range’ of S&P500 Index 3700-4200 for the rest of 2023, the bias for the next major move is probably to the upside, especially with extremely bearish and defensive positioning that could unwind at any time, driving an upward rally.

The biggest question for investors, of course, is always what asset mix and which sector and individual stocks will yield them the best ‘risk-adjusted return’ in 2023?  In terms of asset mix for clients, we recently took profits on our U.S. Treasury Bond trade and reduced our overall bond exposure closer to our benchmark weight of 40%.  With the U.S. Fed still planning to hold firm on short-term interest rates near 5%, we see little room for longer-term U.S. bond yields to fall much further from their current level of around 3.5%. 

In terms of stock exposure, we went into March with an equity weight of about 40%, right at the bottom end of our normal 40-65% range.  We used the weakness from the banking crisis to add back some stocks and move that weight back to around 45%.  We added some Canadian and U.S. bank exposure over the past week, but that was from a position of almost no holdings in the sector, and we still remain underweight the group until we see how the current crisis unfolds.  Our preference is for the major players in both markets, including Bank of America, Citigroup, JP Morgan, TD and Bank of Montreal.  In terms of overweight sectors, we have been adding to energy stocks on the recent weakness.  Oil prices are supported by low inventories, reduced production in the U.S. and a bump in demand from the re-opening of the Chinese economy.  Meanwhile, the valuation of these stocks is exceptional, with free cash flow yields of over 20% at the current WTI oil price of US$70 and cash flow multiples of under four times.  Most energy companies are also returning more of their excess capital to shareholders via stock buybacks, increased dividends and debt re-payment.  Top names include Cenovus, Crescent Point and Baytex Energy.  We also still like the pipeline stocks for their moderate valuations and high dividend yields.  Ditto for the Telecom Sector (BCE, Rogers and Telus) where they also have continued growth from data services. 

Within growth sectors such as technology and health care, we continue to hold slight overweight positions.  Growth stocks rallied in March on expectations that interest rates are near their cycle peaks and will start to fall in 2024.  While these companies have become such a large part of the overall economy that their earnings can no longer be ‘immune’ from economic cycles, they also have inherently higher organic growth rates than most other industries and are also large generators of free cash flow.  We continue to hold positions in the major ‘cloud’ players such as Alphabet and Microsoft but have also been adding some mid-sized software players in payments (PayPal, Nuvei and Lightspeed) and continue to be players in the semi-conductor names (AMD, Qualcomm and the Semi ETF, SMH).    In health care, we like CVS and Pfizer for their exceptionally low valuations and continue to maintain exposure to the biotech stocks through the large company ETF, ticker IBB. 

While we are seeing more opportunities in stocks on the recent selling, we are still underweight equities in general and carrying a larger cash position than normal, particularly since cash returns have risen so much.  Of course, a few more volatile months like March and we might have to re-assess this outlook.  For now, we still see economic weakness ahead and expect North America to be in recession before year end.   Stocks are already reflecting a lot of potential bad news, so we think the downside risk from here is limited to the lows of last October, but are still reluctant to jump fully back into stocks until see clearer evidence that interest rates are coming down and that the worst of the growth slowdown has been priced into stocks.

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