William McChesney Martin Jr., the Chairman of the US Federal Reserve from 1951 to 1970 famously said, “The job of the Federal Reserve is to take away the punch bowl just as the party gets going”. In other words, start the interest rate hike cycle as soon as the economy is back on track after a recession.
The economic growth on both sides of the border was quite robust during 2021 (+4.6% in Canada and +5.7% in the US) and is forecasted to stay healthy during 2022 (~+4.0%). Unemployment levels have also dropped closer to the pre pandemic levels. As a side-effect of a strong economy, inflation has risen and to levels (+4.8% in Canada and +7.0% in the US) that have made the Central Banks (Bank of Canada and the US Federal Reserve) increasingly uncomfortable and unable to continue to hold low interest rates. Higher interest rates make it costlier for consumers to borrow and consume, which reduces demand. As demand falls more in line with supply, inflation falls as well. The Central Banks’ challenge is to determine the optimal pace and magnitude of interest rates hikes. Going too slow and low would mean inflation continues to run high and if it becomes entrenched in expectations, the Fed might be forced to raise interest rates even higher and faster later. Going too fast and high has its own problems as this throttles the demand more than required and leads to an economic slowdown or even a contraction, i.e., recession.
Both central banks have indicated that a rate hike cycle is imminent starting in March, however, have used language that suggests they have given themselves enough room to adjust the course of the policy depending upon the economic data. As Central Banks turned decisively hawkish in January, the stock markets have been hit with turbulence and witnessed a sharp sell-off. Given the flexible approach adopted by the central banks, we believe markets will be guessing at their next move and this will give rise to more volatility with the ebb and flow of expectations – the takeaway: diversification is key to mitigate volatility.
We note the recent sell off was more pronounced in growth stocks that typically have a higher valuation multiple (see graph). A stock price can be explained as a function of a ‘valuation multiple’ and ‘earnings’. Valuation multiples tend to contract when interest rates rise and thus lead to fall in share prices. Given that the trajectory of interest rates remains upwards, we believe the macro environment remains challenging for companies with high valuations. Therefore, the burden of returns will now fall on earnings – the takeaway: skew portfolios towards names trading at a low valuation and that are generating good earnings.
Policy error remains a risk to the markets, however, given that the GDP growth and corporate profits are expected to grow at a healthy rate which makes the case for a constructive outlook on the North American equity markets remains intact.
January in Review
The North American stock markets started the year on a cautious note with the S&P 500 index and the Technology sector heavy and the NASDAQ entering correction territories (defined as >10% drop from peak to trough).
Investor concerns were fanned by Federal Meeting minutes on the 5th January that indicated in addition to hiking interest rates, some policy makers also favor the start of a shrinking of the Federal Reserve balance sheet.
After the Federal Open Market Committee (FOMC) meeting on January 26th, the Federal Reserve indicated that it would start raising interest rates soon and confirmed that it expects to start the process of shrinking its balance sheet after the liftoff has begun.
Against market expectations of a rate hike, the Bank of Canada held the interest rates at current levels after its first policy meeting for the year, however, indicated interest rates will need to increase to control inflation.
The Bank of Canada expects inflation to stay around +5.0% for the first half of the year and thereafter declining to ~+3.0% by year end.
The headline inflation number for December came in at +7.0% for the US and +4.8% for Canada.
The unemployment rate declined to 5.9% in November from 6.0% in December in Canada and declined to 3.9% in December from 4.2% in November in the US.