Financial Letter - Second quarter 2023

As we headed into 2023, the global equity risks were numerous, and most investors were pessimistic about the year to come. Even so, the first half ended with attractive gains. 

  Sources: FTSE International Limited, S&P Dow Jones Indices LLC and MSCI Inc.

  Sources: Bank of Canada and Fundata

Throughout the second quarter, the global stock markets were in the grip of opposing forces. On the one hand, the possible slowdown in the U.S. economy weighed on the global growth outlook, and the U.S. debt-ceiling negotiations in May added to the uncertainty. Moreover, the continued hawkish rhetoric from central banks bent on curbing inflation heightened concerns about the effect on the economy once again.

On the other hand, the frenzy over the artificial intelligence sector pushed technology stocks higher. The global equity markets also posted strong gains at the end of June, buoyed by slowing inflation and hopes that the rate hikes were coming to an end.

Source: Trust National Bank

Results and comments

The Canadian fixed income market ended the second quarter with negative results, as measured by the -0.7% return on the FTSE Canada Universe Bond Index.

Its performance was due mainly to a readjustment of interest rate expectations and a rise in the yield curve in Canada, particularly in May. The market was expecting the Bank of Canada (BoC) to cut interest rates by the end of 2023. But the Canadian economy has proven particularly resilient in recent months, complicating the BoC’s efforts to control inflation. The Canadian economy grew at an annualized pace of 3.1% in the first quarter of 2023, well above the BoC’s forecast of 2.3%.

Faced with these higher-than-expected results, combined with inflation that is still too high in the long term and the strength of the labour market, the BoC opted to raise its key rate once more by 25 basis points at the end of the quarter, taking it to 4.75%. 

Outlook

Inflation in Canada hit a two-year low with a 3.4% increase in May on an annualized basis. Even though this news is encouraging, the decrease is due to several factors, and not all of them are equal. 

The first factor is the vitally important baseline effect, which can be defined as the impact that the choice of a point of reference can have on the outcome of a comparison. In this case, the comparison uses the May 2023 price level and that of May 2022, when a sharp increase in prices was recorded. To cite a glaring example, let’s take the gasoline price, which spiked after Russia invaded Ukraine and peaked in early June 2022. Much of the decline in inflation is, therefore, due to the baseline effect.

Next, some key components of the Canadian CPI still show strong increases from last year and remain well above the BoC’s target of 1% to 3%. For example, grocery prices rose by a very robust 9.0% in May, while the cost of restaurant meals accelerated further to 6.8% on an annual basis according to Statistics Canada. Not surprisingly, the mortgage interest cost component also increased, rising 29.9% from the previous year as a result of interest rate hikes.

We have to ask whether Canada’s key rate is restrictive enough to bring inflation back to the target. The market seems to think not, since at the time of writing, it still expects at least one more rate hike from the BoC between now and year-end. 

Even so, as stated in the previous Financial Letter, it’s conceivable that the vast majority of the increases are behind us. It appears that the unfavourable impact of higher interest rates on fixed income prices will, therefore, be less pronounced than in 2022.

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Results and comments

The Canadian stock market returned 1.1% in the second quarter, as measured by the S&P/TSX Composite Index. This return, which is relatively modest, especially in relation to the U.S. market, is due mainly to the market’s readjustment to potential rate hikes, but also to the composition of the Canadian market. It is highly exposed to the Financials, Energy, Industrials and Materials sectors. But it was the Information Technology sector that recorded the best quarterly return, driven by enthusiasm over artificial intelligence. That being said, this sector represents only about 8% of the S&P/TSX Composite Index. This situation is the opposite of 2022, when the more defensive sectors outperformed. 

The BoC’s decision to raise its key rate once again caused the Canadian dollar to appreciate during the quarter against many currencies, including the U.S. dollar, the euro, and the Japanese yen.

Outlook

As already stated, the Canadian economy grew at a fastest pace than expected in the first quarter. The recession narrative thus gave way to discussion about the resilience of Canada’s economy. There are a number of reasons for this unexpected growth, such as excess household savings, companies that have kept their workers on and less friction in the labour market as a result of online recruiting of skilled workers.

In the coming months, the outlook for the Canadian market will remain closely linked to the BoC’s decisions, the release of economic data and the impact of rate hikes on the economy. 

Results and comments

The U.S. market posted a second consecutive quarter of strong returns, despite the uncertainty surrounding the U.S. debt-ceiling negotiations in May. The S&P 500 Index returned 6.3% in Canadian dollars, although the gains were reduced by our currency’s strength against the U.S. dollar.

The divergence in returns across sectors was pronounced. Information Technology alone accounted for more than 50% of the return, driven by the frenzy over the development of artificial intelligence (AI). Consumer Discretionary and Communication Services, which include some of the Big Tech stocks, such as Alphabet, Amazon.com and Meta Platforms, also ended the quarter with returns that significantly outperformed the rest of the U.S. market. We note that the mega-cap tech and AI stocks are the reason for the S&P 500’s performance since the start of the year.

Outlook

The fact that a handful of companies is driving the U.S. stock index is not healthy, and this concentration of growth implies an increase in risk for the U.S. market. Some investors are even starting to wonder whether the recent price movements of certain companies, particularly tech companies, reflect the start of a bubble at a time when the market is still facing the risk of recession.

U.S. inflation remains stubbornly above the 2.0% target set by the U.S. Federal Reserve (Fed), even though it is showing signs of slowing. The monetary tightening cycle started by the Fed in 2022 is not necessarily over, even though the Fed decided not to raise its key rate at its latest meeting in mid-June. Fed chair Jerome Powell reiterated during his testimony before Congress at the end of the quarter that rates could remain high for longer, or even that further increases could be expected.

Recall that the Federal Open Market Committee (FOMC) is responsible for setting the Fed’s monetary policy. The committee comprises seven members and the 12 presidents of the Fed’s regional banks. At each meeting, these 19 people vote on the level of interest rates so as to indicate where the key rate should be in the coming months and years – a concept that is called forward guidance and serves to promote market stability by managing expectations. 

The graph below shows the changes in these forecasts between the March and June meetings. We can see the median curve of the forecasts as well as the votes of each (the points on the graph). It should be noted that some members abstain from voting. At their last meeting in mid-June, the FOMC members opined that a further 50-basis-point increase would be needed in 2023, bringing the key rate to 5.5% by year-end. 

Thus, it is likely that the U.S. market will face further rate hikes, and the impact on the economy is still uncertain. It remains to be seen whether the U.S. market’s expectations will align with the Fed’s.

Results and comments

International and emerging markets equity returns were especially mixed in the second quarter. The results were positive in local currencies, but the Canadian dollar’s strength sharply reduced the gains and even led to losses. European equities suffered from their sensitivity to global industrial activity and lack of exposure to artificial intelligence. In Asia, Japan stood out during the quarter, but China’s slow recovery after it lifted the Covid-19 restrictions still weighed on the region. 

Finally, the MSCI Europe Index ended the period with a return of 0.8% in Canadian dollars, while the MSCI All Country Asia Pacific Index and the MSCI Emerging Markets Index ended the quarter with returns of -0.8% and -1.2%, respectively, in Canadian dollars.

Outlook

The risk of recession, inflation and rate hikes will continue to be a major concern in Europe. Germany, one of the main drivers of growth in the euro zone and Europe in general, entered a technical recession after its GDP contracted in the fourth quarter of 2022 and the first quarter of 2023. In addition, monetary tightening by the European Central Bank is expected to continue. In the United Kingdom, inflation continues to be at particularly high levels, and the market expects the Bank of England will also keep raising rates between now and year-end. Finally, geopolitical tensions will also remain a vitally important issue.

In Asia, China’s disappointing recovery remains a big question mark and raises new concerns about the global growth outlook. The data show that consumer spending on services has increased after months of lockdown, but manufacturing is lagging. In fact, a weakening global economy and interest rate hikes by the country’s major trading partners are reducing demand for Chinese-made goods. Even so, valuations in Asia and emerging markets are attractive, and there are many opportunities. 

Even though we are repeating ourselves, we have to point out that the risks cited in our recent newsletters – inflation, interest rate hikes and recession – are still present.

Even so, the markets’ performance since the start of the year, the enthusiasm over advances in artificial intelligence and the relative decline in inflation, particularly in North America, are creating hope that the economic situation is improving. The market appears to be pricing in a soft landing, even to the point of suggesting we could avoid a recession. And yet the consensus is quite clear: an economic slowdown, or even a recession, seems inevitable. But are these risks properly reflected in the market? 

The second half of the year will be crucial for an assessment of the impact of rising rates on global economies. Second-quarter earnings announcements, for example, will be a key component of any assessment of economic conditions and overall sentiment. 

If it turns out that the global economic situation is improving, or at least not getting worse, Canadian, European and Asian equities could stand out from the U.S. market. In the event of deterioration, the U.S. dollar could once again become a safe haven for investors.

The global economic environment is complex, and market expectations are volatile. Nevertheless, the market presents many opportunities, even though some stocks seem particularly overvalued. In fact, the themes out of favour one year are not necessarily the same the following year. The same applies to sectors and regions. Over the long term, the various components complement one another and reduce stock market risk. 

In closing, a long-term perspective, sound diversification and a balanced portfolio adapted to your risk tolerance and needs are key principles for navigating more difficult economic environments and achieving your goals.