EQUITIES COMMENT - Declining Bond Yields Lift Stocks - Can This Continue?
Declining bond yields were the drivers of stocks during the first quarter. The TSX Composite gained 5% while the S&P 500 was ahead 7% in Canadian dollar terms. The S&P 500 outperformed the TSX due to a larger weighting in Technology and lower exposure to Energy. Over the past year, Canadian stocks are down 5% and U.S. stocks are unchanged.
Even though the Bank of Canada and Federal Reserve raised short term interest rates during the quarter, bond yields fell. Central banks are still reacting to inflation that is well above their 2% target. Resilient employment growth has provided confidence for them to boost rates. (The Bank of Canada has indicated it is now on hold with rate increases.)
Bond yields are reacting to future expectations for lower economic growth and quite possibly, a recession. In that case, inflation and employment are likely to fall; central banks would start cutting rates. Bottom line: declining bond yields had a positive effect on stock prices, particularly those with high p/e multiples like Technology.
Last year’s loser was this quarter’s winner – Technology - and last year’s winner was this quarter’s loser – Energy. Technology stock prices are very sensitive to bond yields. When yields fall, this has a positive effect on the stocks. You can see from the graph that yields did not fall very much, about .30% in Canada. However, investors expect bond yields to decline further, particularly if the economy enters a recession. The Technology companies are generally not that sensitive to the economy so their businesses should hold up reasonably well in a weak economic environment.
The price of oil slid modestly during the quarter due to fears of lower demand if there is a recession. In early April, OPEC+ (includes Russia) met and agreed to reduce production. This has since given a boost to the price of oil. By managing supply, OPEC+ hopes to limit the decline in price and sustain revenue.
When you look at the sector returns chart, it is somewhat surprising to see Financials had a slight positive return in Canada and were only down 3% in the U.S. given recent news headlines. Looking deeper into the Financials group, the following charts show the performance of the bank subsectors for the TSX and S&P 500. In March, two U.S. banks failed due to a 1930’s style “run on the bank”. Customers wanted to withdraw their deposits and in order to come up with the funds, these banks were forced to sell assets at losses. In short order, their capital ratios fell below regulatory requirements and they had to close.
Based on the information we have to date, here are our observations:
These appear to be special situations and are not representative of the U.S. banking industry as a whole.
U.S. policymakers have taken steps to boost confidence in the banking system which we believe will be effective.
The Canadian banking system is very different from the U.S. Our industry is much more concentrated and tightly regulated so we do not see similar issues arising among Canadian chartered banks.
The end result of this turmoil could result in “tighter” lending standards. When it’s harder for businesses or consumers to get bank loans, the economy tends to suffer.
Higher interest rates contributed to the failure of Silicon Valley Bank and Signature Bank. There will likely be further negative repercussions from the rapid and extensive interest rate increases of the past year.
Are rate increases soon to turn into rate cuts? The answer is yes according to some investors. They believe that the economy is about to slow substantially and as a result, central banks will cut rates. Now there is a likelihood of tighter lending standards, this scenario could indeed come to pass sooner rather than later. On the other hand, if inflation remains well above 2% and the economy continues to expand, rate cuts could be further ahead in the future. This might cause both bonds and stocks to retrace some of their recent gains.
The next question is, will rate cuts cause stocks to rise? Declining rates could boost stock p/e multiples but, if the economy is struggling, corporate earnings will be under pressure. Earnings for the past year are now falling for both the TSX Composite and S&P 500. At this time, there is quite a wide range in forecasts for earnings in 2023. Generally in a recession, corporate profits drop significantly and this is not incorporated in current estimates. (We are taking a more conservative view.)
Forecasts for 2024 are for double digit gains in profits. This seems optimistic if the downturn is mild. However, should bond yields fall further on the back of rate cuts and current earnings forecasts come to pass, then stocks could rise further as p/e multiples increase. In this uncertain environment of recession/earnings risk, still high inflation and signs that higher rates are starting to bite, we are maintaining our targets of 21,600 for the TSX and 4,300 for the S&P 500 at year end 2023. By that time inflation should be lower, monetary tightening ought to be behind us and markets will be anticipating faster economic growth in 2024.
