A Reluctant Hawk
Since our last update, the most important developments for the North American markets have been the monetary policy announcements from the Bank of Canada and the US Federal Reserve. Bank of Canada raised policy rates by 25 basis points to bring them to +4.50% and announced its intention to pause the further hikes. Tiff Macklem, the governor of Bank of Canada, said that the pause was contingent on the economy evolving in line with expectations, including inflation dropping to ~+3% by mid-year. The US Federal Reserve also raised policy rates by 25 basis points to bring policy rates in the US to +4.75%.
The US Fed chair, Jerome Powell, maintained the message that their work is far from over, as the current inflation readings remain high and the job market is still very tight. Further, the FOMC (Federal Open Market Committee) expects a couple more hikes before considering a pause. Notwithstanding the hawkish message, the US Fed Chair acknowledged that the disinflationary process has begun, and was not very forthcoming to pushback on the recent easing of financial conditions driven by run up in capital markets. Overall, Mr. Powell’s stance of a reluctant hawk, i.e., the impression of lack of conviction to keep monetary conditions tight, was read by the market participants that a change in policy stance is likely nearby, in our opinion.
Year-to-date, the capital markets have been off to a good start on expectations of a policy pivot as inflation readings have continued to cool off their highs. The inflation reading for Canada fell to +6.3% in December (reported in January) from +6.8% in November (reported in December) and in the US fell to +6.5% in December (reported in January) from +7.1% in November (reported in December). This, put together with a lack of any pushback from the US Fed chair and the indicated pause in the policy rates hikes by Bank of Canada, has fanned the risk-on sentiment among investors. However, it is noteworthy that the year-to-date rally has been concentrated on the companies that were hit the hardest during the year 2022 (See Figure 1).
Figure 1:S&P 500 Index Members, Price performance 2022 vs Year-to-date
While several of these companies are still down significantly from their highs during the last year, indicating recovery potential on a return to normal, we believe the macro environment of 2023 warrants a selective approach. As the high inflation and policy rates narrative gradually fades, growth narrative will begin to take over and therefore companies will have to deliver on revenue and earnings growth expectations to sustain the stock price performance. Given that the impact of high interest rates has just begun to work its way through the economy, many of these companies could find it difficult to meet their revenue and earnings expectations.
Furthermore, the latest readings on the unemployment rate in the US unexpectedly falling to +3.4% from +3.5% and the ISM Services PMI (Purchasing Managers Index) jumping back to expansion territory (55.2 in January) from contraction territory (49.6 in December) could force Central Banks to rethink any potential change in policy stance. Though the recent change in Central Banks’ tone is positive and strengthens the case for adding risk-on exposure, we believe investors need to be mindful of bumps in the road ahead.
