What Did We Just Hit?

Sometimes, you are driving along nicely, and suddenly, your car is jolted as you hit a pothole. Well, the market just did that… or maybe it’s a sinkhole. It was not that long ago that markets were making new highs as inflation cooled, the global economy was improving, and it seemed like a Goldilocks environment. When we say not that long ago, the TSX made a new all-time high last Wednesday (July 31), yet it is now down about 4-6% over the past couple of days. So, what just happened?

We could highlight that softening economic data over the past few months was viewed as good news. It was good news because it meant the path of inflation was likely going to continue in the downward direction. This helped bond yields come down, too, which allowed for the market to trade at a higher multiple. But then the economic data crossed an invisible line in the sand, and that softer economic data is now too soft. Nobody is talking about inflation. Instead, the recession talk is rising up. Silver lining bonds are working as a partial portfolio stabilizer.

In our opinion, this does look and feel like a long overdue corrective phase, albeit a very abrupt start. Markets have been going up since last fall, with just a brief dip in the second quarter. True, the economic data has softened, but it's way too early to get excited about the recession risk. Given that many flows look like risk-off behaviour, that is common during plain vanilla corrections. The duration or depth remains unknown, but likely, a few days is not the end.

The general rule is that corrections are buying opportunities unless there is a recession nearby. Now, a couple of days does not make a correction – they usually do take longer to work themselves out – but this could be the beginning of one. So we could be seeing the development of a buying opportunity unless there is a recession. There is no denying that the economic data has softened and continues to do so.

The data has actually been softening for a bit, and it has just become too much for the equity market to ignore. The bond market was listening for a while. The chart above shows the Citigroup Economic Surprise indices, which turned slightly negative more than a month back and have gradually been softening. Some softness does not mean recession. In fact, while our market cycle indicators have weakened a little, the cycle does appear reasonably intact.

The market cycle indicators, which total over 30, are an equal-weighted basket of forward-looking economic, sentiment, fundamental, and rate signals. This helps provide a more rules-based approach to measuring the health of a market cycle. It does not provide hints on corrections; instead, it provides information as to the health of the overall cycle, trying to avoid those big bear markets. So, if the signals hold up during a correction, we feel more confident that it is a buying opportunity. And today, it remains decently healthy.

September and October are seasonally the months that see a spike in volatility and often a period of market weakness. But in an increasingly impatient world, maybe August is the new September/October.

Duration Dance

Years ago, when bond yields were 1-3%, it was an easy call to be underweight and carry lower than market duration. As bond yields rose over the past few years, we gradually altered our views, increasing the weighting and increasing duration. Today we are about market weight in bonds and carrying a duration of about 5.2. And now it is anything but easy.

There are some clear reasons to have a good allocation to bonds in a portfolio today. Yields are higher now than many years past, which translates into a higher forward return expectation. It's best to push down the painful memories of how we got to these higher yields, as they may cloud your judgment about the future. Yields are attractive today.

Other bond-friendly positives include inflation cooling. Sure, it's not a straight line, but the trend globally is to cooling inflation. And the global economic data, which was stronger earlier in the year, appears to be losing momentum. Perhaps even in the coming months, folks will start talking about recession risk again (we wrote this section on Tuesday, and it would appear recession talk has already started). A good thing for bonds. 2022 reminded (or taught) investors that when inflation is a big risk, stocks and bonds move down together. But when recession is the risk, bonds work really well as a diversifier. So, this recent rise of recession talk is clearly positive for bonds.

BUT don’t get too excited about bonds. Inflation is cooling, yet there are a number of longer-term trends that will keep it higher than in years past. On average, at least. Demographics are becoming less disinflationary. Global trade is slowing, and we are creeping towards a more polarized world. Supply chain diversification trends continue, as near shoring, also adding to inflation. And don’t forget all those labour wage gains during the past few years; this will keep inflation a bit higher than normal. Higher average inflation than the previous couple of decades will put a bit of a floor under bond yields.

And then there is the elasticity of yield demand. That is a mouthful, and we will devote a future publication to this concept, but in the meantime, here is the synopsis. Bond buyers are a very diverse group, comprised of governments, banks, pensions, institutions, funds/ETFs, and, of course, everyday people. During the previous decade, a higher proportion of bond buyers didn’t care what the yield was.

Rising global trade would result in foreign central banks accumulating U.S. dollars, often through Treasuries, not caring about the yield. Now we have global trade slowing and many foreign central banks diversifying their holdings away from Treasuries. Domestic U.S. banks had been parking increasing amounts of excess capital in Treasuries, caring more about their capital ratios than the yield. As yields rose, though, these banks are now sitting on large unrealized losses, which contributed to some bank failures in 2023. Rest assured, this cohort is much less of an enthusiastic buyer of Treasuries today. And, of course, the biggest bank, the Fed, has changed from quantitative easing to quantitative tightening. These are all buyers who would buy bonds and never care if they yielded 0.5%, 2% or 5%. Their demand is inelastic to yield, yet all of these buyers have diminished in size over the past number of years.

But bond auctions have not gone unsold, as different cohorts have filled the void. Investors, like you, me, clients, etc., have been enticed by higher yields in money markets or even along the spectrum of maturities. Money flow into cash vehicles has been very strong, as has flows into bond funds/ETFs. Unlike the previously mentioned groups of bond buyers, this group is very sensitive to changes in yields. This raises the question: will the flows continue if yields fall from 4.5% to 3.5%? Maybe, but probably slower. And at 3.0%?

Because the yield-sensitive group of bond buyers is now likely a larger component of demand compared to the folks who don’t care about the yield, we believe the elasticity of yield demand has risen. This means if yields fall too much, demand should soften, thus arresting how far lower yields can go.

Moving from the demand side to supply, well, there is no shortage of supply. Given how corporations binged at the debt trough during the past decade of low rates and too much liquidity, the maturity walls will continue for years to come. And with governments running deficit levels more applicable to recessions or wars, there is no shortage of supply. That, too, will keep yields higher than the previous decade.

If you add all this into your mental model, yields are unlikely to come back down or go way up. Welcome to the rangebound bond market, in our view. As a result, we believe being a bit more tactical with bonds and duration will add value over time. Add this to healthy yields, and you have a decent combination. So, with yields falling over the past couple of months, we would be more inclined to trim bonds or reduce duration a tad.

Elections and Markets

2024 is an election year, just about everywhere. Already behind us are India, the UK, France, and Mexico (to name a few), and the big U.S. showdown is coming up in a few months. Not surprisingly, this creates the most often-asked question: “How should we position a portfolio ahead of the election?” The challenge, of course, is you never really know who is going to win, and even if you had a good idea, how the market reacts or what policy is actually implemented are two other big variables. It is like a bunch of coin flips.

Just look at the Mexican market drop and lack of any recovery after electing the party often viewed as less business friendly. While in India, when Modi lost his clear majority, markets dropped for a day, then recovered and have continued to move higher over subsequent months. France’s CAC 40 has not enjoyed their election process. But the UK market seems to like the labour party winning results. The only constant is some level of volatility, but even that seems pretty random.

We would also be cautious about listening too much. Even if confident about the result, can you take their intended policy statements made during the campaign period as rock solid? How many times have we seen promises for “no new taxes” amount to nothing? Campaign talk has the objective of winning votes and doesn’t always translate into real policy.

And then how the market reacts is a big variable. When President Trump won in 2016, markets dropped hugely in overseas trading. Markets never like surprises. But they had largely recovered by the open in NY and finished up on the day. Global markets went on to rise for the next year. The S&P 500 in 2017 only had 4 days that it dropped more than 1%, and it never fell more than 2%. It was one of the smoothest upward-trending rides in market history.

One could easily let confirmation bias kick in and attribute the great market to the new president. Not so fast. The market started trending higher before the election, likely thanks to synchronized global growth for the first time since before the financial crisis. After 2008, we had this kind of rotation of problems globally. The U.S. and Japan were doing fine, but Europe was suffering. Then, when Europe started to improve economically, Japan stumbled. When Japan was getting back going, the U.S. slowed. But in early 2016, they all started humming along nicely.

It's the economy, silly. It does matter more than who sits in which seat. In fact, looking at past elections and which side won in the U.S. leads to really no clear winner regarding market performance. A great analysis by the U.S. Bank Asset Management Group found a very weak connection between election outcomes and the market. But a stronger connection between economic growth and inflation trajectory and the market. If you look at market performance with improving or deteriorating economic activity, well that paints a much more clear picture compared to who wins the election.

Or, for some other evidence, under President Joe Biden, the S&P 500 energy sector is up 196% while the Wilderhill clean energy index is down 75%. This is probably not what one would have expected.

We are not saying to ignore the elections; they have the chance of adding a lot of volatility to markets and injecting a good amount of uncertainty or surprises. And remember, markets usually don’t like surprises. Outside perhaps adding a bit toward volatility management, it is probably best not to meddle with your portfolio construction based on elections.

Market Cycle

Market cycle indicators have remained decently on the bullish side, albeit with some softening during the past month, mainly in the U.S. economic data. Fundamentals remain encouraging. If we see a dramatic drop in more signals, that would contribute to potentially changing our mindset, but for now, this could simply be the start of a corrective phase.

From an asset allocation tilt perspective, we remain mildly or moderately defensive. We hold a bit more cash, a lot more bonds, and less equity. The bond allocation is more conservative with less credit exposure. Diversifiers are also focused on volatility management strategies. Our higher cash balance is considered dry powder, so if this does grow into a more interesting correction, we may be enticed to do some buying.

Final Thoughts

If this does develop into a full-on correction, it might actually be a healthy development. The market was extended and overly concentrated. Some recalibrating could help with the longevity of the cycle. While we would expect economic recession talk to grow louder, so far, the data is only moderating. Given all the data, this looks more like we hit a pothole (albeit a big one) than a sinkhole.

Authors: Craig Basinger , Derek Benedet , and Brett Gustafson

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Sources: Charts are sourced to Bloomberg L. P.

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