Market participants have learned to expect an increase in volatility during the months of August through October, and this year didn’t disappoint. While many indicators haven’t worked as well lately, seasonality seems to be working out well as an indicator.
This year hasn’t gone to the script many had expected back in January. But instead of those predictions being completely offside, perhaps they were just early. The difference between wrong and early isn’t very much, but it's worth paying attention to. The ‘bear’ case to start the year was focused on a coming earnings recession, as the combination of higher rates and the removal of COVID stimulus would slow the economy and margins. These fears are just now beginning to show up as a stronger-than-expected American consumer, and healthy payroll numbers got many companies through the first half of the year without seeing much of an impact on earnings.
But this autumn, we are now beginning to see things slow. The rise in interest rates is having an impact on mortgage payments and the housing market, which is having an effect on consumers. Companies are also starting to slow their new orders as they would rather run through excess inventories than finance them at higher rates. At the same time, unions are becoming more aggressive in extracting higher wages. These ingredients all contribute to a risk of weaker earnings.
Companies that have been able to pass along cost increases to consumers have been able to maintain margins. But it appears that period may be behind us, and in the next few quarters, we may finally begin to see the slowing that had been predicted earlier this year.
The sector that first saw the impact of the higher rates was the banks. While the US regional bank crisis that took down SVB and several others earlier in the year seemed to be quickly forgotten, we are now hearing the larger banks in both Canada and the US speak of a slowdown in their businesses and loan growth. As many market watchers say, ‘you can’t have a bull market without the banks,’ and with many banks off over 20% on the year without them turning around, it's tough to be very optimistic about markets.
The other area of the equity market, which has seen major headwinds due to the higher yields, has been in the defensive sectors. Groups such as REITs, Utilities and Telecom are usually thought of as ‘safer’ by investors due to their higher dividends. But with a combination of higher debt levels and the traditional purchasers of these securities finding different opportunities to earn income (i.e. money market funds), many companies in this area are off over 20%. Without the banks and the defensives, any strategy tilted towards value is having a difficult year.
Given so many of the recent headwinds in the market are so closely tied to higher interest rates, a potential source of relief would be in lower yields. Lower yields can come in a few ways, but really, it comes down to either a slowdown in inflation or a recession. In some parts of the economy, we are finally seeing inflation pressure begin to subside and with corporate earnings under pressure, central bankers appear to be ready to call an end to their aggressive rate tightening. On the recession call, Canada may be on the verge of entering one already, while the US continues to push back those fears.
The month of October also witnessed the unfortunate beginning of another conflict in the Middle East that no one wants. This shouldn’t have much of an impact on markets unless we see a serious disruption in oil supply, which so far has not happened. Yet, it is another event that will add to the uncertainty in markets and may keep volatility elevated in the near term.
On the positive side, if the seasonality holds, we are exiting the worst stretch of the calendar, and the month of November is the strongest of the year. The factors are all in place for, at minimum, a relief rally that has the potential to last into year-end and may be underway. Investor sentiment is washed out, and many systematic investment funds are at extremely low levels of investment. Bond yields also look stretched to the upside, and a pullback will give relief to the equity market.
It's always darkest before the dawn, and we all could use some positive headlines after the last few months. With many now out of the market, the ‘pain trade’ is higher, and right now, one of the riskier trades to put on is to be short the market. It may be more of a tactical trade as next year will remain tricky, but any relief rally would be welcome to investors.
— Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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