By Scott Blair
This is what volatility looks like for sure. Up, down, all around! The two questions are:
- What’s happening and why, and
- Do we expect any downward trend to continue?
What’s Happening and Why?
In recent weeks we have seen a number of developments. The two most pressing have been the increase in the U.S. Treasury yield and, in tandem, a fear of rising inflation. Since the low of 0.65% yield on 10 year treasury bonds in September, we have seen a recent jump to as high as 1.63% on March 9th. That is a big jump. Some of that was driven by the Saudi’s refusal to play ball and increase oil production which drove the price per barrel up to its recent high of US$68 on March 8. Higher energy prices are inflationary and pose a threat of rising interest rates. Couple that with a dovish (read do-nothing) stance of the Fed to combat inflation and, all of a sudden, equities come under fire. The thinking there is “well, if I can get 1.5% on a risk free treasury bond and only half a percent more for the average S&P 500 stock dividend, why would I take the risk?” The gap has closed, and indeed interest rates have ticked up.
In this environment, it favours those stocks that do well in a rising rate environment like banks. These are called cyclicals because at that part of the rate cycle when rates are rising, they do better. These also happen to be value oriented stocks meaning higher dividends, lower price to earnings ratios but generally don’t have a lot of growth potential. This explains a couple of things we’ve seen recently. First the selloff in growth stocks like large tech (no dividends). It also to a degree explains the sell off in the “stay at home” trade which propelled growth stocks like Zoom, Docusign and, believe it or not, Tupperware. It also explains in part the tick upward in value stocks.
There’s a lot going on here but when you put together all the pieces of the puzzle it begins to make sense so you sort of get that “ahh, I get it” sensation.
Do We Expect This Downward Trend to Continue?
Let me begin by using the old standby disclaimer that no one really knows BUT, if you were to ask for our opinions, the answer would be no. We expect that we will continue to see a bumpy ride, but we do believe that the general direction from here will be positive and for the following reasons:
First, let’s address the inflation bogey man. Inflation currently is about 2%. The long term average is about 2.5% so we’re still below. True, inflation and interest rates have ticked up this year, but that is a good thing given that 6 months ago the greater fear was a fear of deflation. Deflation is really bad for an economy because it means if you wait to buy something, it will be cheaper later so nobody spends. We appear to be a “Goldie Locks” inflation period: Not too high, not too low but just right. Keep in mind that a bit of inflation is a good thing because it is a sign of a robust economy where businesses thrive. Too high is a bad thing but we are nowhere near that.
A second thought about the inflation and interest rate environment we have now is that “real” interest rates or the difference between interest rates (currently 1.5% 10 yr) minus inflation (2.0%) is negative. Historically negative real rates in a rising inflation environment is very good for equities. Think of it this way, if you are going backwards by owning a bond then the only other place to look is equities. Hence, YTD the TSX is up 7%, the S&P is up almost 4% and the DOW just hit another all time high and this is even after the pull back of the last couple of weeks. The other thing about rising long term yields versus the near stagnant shorter term yields is that it causes a steepening of the yield curve, also a good leading indicator for equities. So, yes, we are bullish on a go forward. The US$1.9 trillion in stimulus cheques in the US doesn’t hurt either. When those low to mid income people get those cheques, they’ll spend them which is an immediate boost to the U.S. economy.
One final note is on Canada. Let’s call it the “Go Canada” trade. Remember what we were saying above that we are moving to a more value-oriented market than growth oriented? If you think about it that’s kind of all we have here in Canada. Value sectors are financials, energy and telecoms. Yay, we have those. It means that or at least appears that Canada could outpace the US for the first time in a long time as per above YTD TSX 7% S&P 4%. It does not mean a wholesale swing but more a bit of a heavier weighting in Canada.
Sorry, this has been a lot of info for one go-around and we recognize we may have lost many of you half way through but in turbulent times and particularly in a pullback when we know people are nervous its our responsibility to answer those two questions at the top.
We hope we have succeeded but as always, if you have questions or want to talk about it, don’t hesitate to give us a call.
Photo by Photoholgic on Unsplash