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Spooky Times

It was Halloween month for investors as expectations of higher interest rates and for longer led to continuation of spike in bond yields across the US yield curve, with yields rising relatively higher at the long end than the short end. The month started with economic data tracking somewhat better-than-expected, exacerbating the narrative, and resulting in the US 10-year bond yield touching the 5% mark at one point. Like the fixed income asset class, the equity markets bore the brunt of rising yields too and closed the month in red. The Canadian fixed income investors had some respite as yields dropped at the short end of the curve. The rise in geopolitical tensions after the conflict in the middle east added to investors’ concerns. However, the sliver of hope returned around the actual Halloween when reports of softer economic data suggested the centrals banks are probably done hiking interest rates in this cycle.

The Institute of Supply Management’s (ISM) US Purchasing Managers’ indices (PMIs) for Manufacturing and Services were both higher than expected for the month of September (reported in early October). The Manufacturing PMI index was at +49 (expected +47.9) and the Services PMI Index was at +53.6 (expected +53.5). However, the indices for the month of October (reported in early November) showed deceleration with Manufacturing PMI at +46.7 (expected +49) and the Services PMI at +51.8 (expected +53). The unemployment showed increase on both sides of the border with the US unemployment rising to +3.9% in October from +3.8% in September and Canada unemployment increasing to +5.7% in October from +5.5% in September. The Sahm Rule Recession Indicator signals start of recession if the three-month average unemployment rate is +0.50% above its low in the previous 12 months. Given that the low reading of unemployment in Canada was at +5.0% and in the US was +3.4% during the previous twelve months, the indicator suggests the much-anticipated recession might be around the corner (See figure 1).

Figure 1: Sahm Rule Recession Indicator and US Recessions

Source: Bloomberg

As per Statistics Canada, the Canadian economy stalled for the month of July and August at +0.0%. Preliminary estimates suggest the GDP might contract for the month of September, i.e., the Canadian economy might be on track for contraction in the third quarter of 2023 after having contracted by -0.2% in the second quarter. Two consecutive quarters of GDP contraction meets the definition of a technical recession. Bank of Canada and US Federal Reserve kept the policy rates steady in their latest policy meetings. This put together with the more recent reports of softer economic data in the US fueled the narrative that the Central Banks are done hiking rates. Recessions are disinflationary and reduce the appetite of central banks to increase interest rates and cause more economic pain.

The initial reaction of these developments has been a return of risk-on sentiment in the markets. We would like to highlight that the story of year 2023 thus far has been that of flipping narratives between hope and despair with broader markets largely trading range bound. We think a more decisive constructive move in the markets will follow when investors are confident that they can begin to peek towards the other side of the cycle. The recent developments suggest such a point is approaching, however, is not here yet.

We think the markets still need to navigate through two risks in the near-to-medium term. First, the risk of policy error - central banks drew a lot of flak being stuck on the transitory inflation narrative for too long and therefore let inflation go out of control before starting the rate hikes. While unemployment has started to increase in recent months and consumer confidence is on a decline, suggesting the higher interest rates are perhaps beginning to bite, we think central banks are likely to err on the side of caution before indicating any pivot on the policy front. This increases the risk of policy error, i.e., keeping financial conditions tight for too long. Second, the reset of earnings expectations – a recessionary period is likely to coincide with corporate earnings downgrades, which is generally a headwind for stock markets in the short term. Nevertheless, we think broader markets already reflect a lot of caution and therefore maintain our cautiously optimistic stance on the back of our expectation that we are closer to the end of policy rate hikes.

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