Key tactical changes
- We increased our equity exposure and brought it closer to neutral levels with a slight preference for U.S. equities. We see relative strength in U.S. equities over international equities
- We reduced our overweight position to Canadian government bonds as we optimized our overall fixed income to a neutral stance
- We are underweight risky credit within fixed income as we see default rates rising in the face of tighter monetary policy
The euphoria that defined the beginning of Q3 this year for U.S. equities largely disappeared at the end of September. Earlier during the quarter equities rallied on hopes that U.S. technology stocks would greatly benefit from artificial intelligence. Markets also expected the U.S. Federal Reserve (the Fed) to bring down inflation to its target level of 2% without sacrificing employment and output.
To some extent, resilient economic data confirmed the market’s optimism for the economy. The Fed’s fastest interest rate hiking cycle in decades caused borrowing costs to rise to over 5.5% from near 0% levels in just 18 months. This brought down inflation to 3.7% in August 2023 from 9.1% in June last year. For a while, markets seemed to ignore the potential impact of higher interest rates.
But midway through the quarter, markets started to suffer from the Fed’s tight monetary policy. The yield on the 10-year U.S. Treasury note, which dictates interest costs for everything from housing to cars for consumers and business funding costs, swiftly rose from 3.6% in mid-July to 4.8% in late-September. This rapid rise in yields is likely due to the resilient economy and concerns about debt-fueled deficit spending in the U.S.
As yields on relatively risk-free short-term government securities rose above 5%, risky equities suddenly seemed expensive, and this triggered a sell-off in equities. Both the S&P 500 Index and NASDAQ Composite Index lost around 3% in Q3 2023. Bond market volatility also jumped to its highest level since May. Losses on some long-term U.S. Treasury bonds approached over 40%.
Despite financial tightening and higher yields, the U.S. economy seems resilient. The U.S. unemployment rate remained near historical lows at 3.8% in August and September jobs data was healthy. However, the rest of the world is feeling the impact of higher U.S. borrowing costs. Canada’ s economy, which is already slowing down due to its own tight monetary policy, is further feeling the pressure of higher U.S. yields. As well, the strong U.S. dollar is challenging several emerging economies.
In our view, markets are finally coming to terms that interest rates will stay at relatively elevated levels for a longer time. While markets expect the U.S. to avoid a recession, our base case scenario is one of a meaningful slowdown for the U.S. in the face of higher yields.
Despite this, we expect the U.S. economy to relatively outperform developed Europe and emerging markets. For instance, our research shows that manufacturing activity, while still in the contraction phase, is stabilizing in the U.S. In addition, earnings in the U.S. are showing signs of rebounding compared to other developed markets such as Canada and Europe.
In Europe, we expect Germany to face challenges as China, its key export market, continues to fight deflationary conditions. While incoming Chinese data has been encouraging, we feel it is too soon to be optimistic about the country’s prospects. For this reason, we are also cautious about emerging economies that are dependent on commodity exports.
