Rates, Higher for Longer?
A renewed rate hiking cycle has increased probability of a higher for longer interest rate environment.
Equity market breadth has been weak, but there’s been encouraging signs lately.
The first two months of the second quarter of 2023 saw a continuation of a dynamic we highlighted in our April edition, which is that coming out of the Silicon Valley Bank collapse towards the end of March, the overall breadth of the equity markets in the US would weaken significantly.
We saw significant strength and price gains in only a few mega cap technology names, as the twin dynamics between a flight to safety and balance sheet security given the banking issues and a new hype cycle driven by excitement around the potential emergence of artificial intelligence saw significant flows into the names at the top of the equity indices. Given the significant weightings these names hold in popular indices such as the S&P 500 and the Nasdaq, these strong moves have led to headline index return numbers that appear incredibly strong.
As you can see in chart 1 below, the US led the way in equity returns, with the Nasdaq and the S&P significantly outperforming the TSX, Europe and emerging markets. Given how narrow the breadth of the market has been for the majority of 2023, these strong returns at the index level are not indicative of the experience for most equity investors.
In charts 2 and 3 below, you can see some illustrations of this assertion. Chart 2 shows the S&P500 versus the S&P500 equal weight index. The equal weight index assigns each constituent of the index the same weight, and therefore is a far better proxy for how the average equity in the index is performing. As you can see from the chart, beginning in March the red line, which is the difference line between the market cap and equal weighted indices, began to rise significantly. This rising line indicates that the market cap weighted return was outpacing the equal weighted index return and can be used as a proxy for the overall breadth of the market. Remember, the breadth of the market means that there are more companies participating in upward momentum and signifies a stronger overall market environment.
Moreover, Chart 3 illustrates the disparity between the S&P 500 ETF, and the S&P Dividend ETF, which is a basket of equities that have paid and increased their dividends for at least 20 consecutive years, largely known as dividend aristocrats. That ETF on a total return basis was slightly negative for the first 6 months of 2023, versus the S&P 500 up over 15% for the year.
June saw a change in the dynamics of the market. The green line in Chart 2 shows the equal weighted S&P 500 move from being flat to slightly negative to the end of May to up almost 6%. This indicates to us that there has been a move towards a broadening equity market, and this is a positive sign moving forward. There are many possible reasons for this, from concerns over the stability of the banking system receding as we move past the turmoil of a few months ago, to the initial excitement and novelty of tools such as ChatGPT 3 fading. This is undoubtably a positive for the sustainability of the equity market recovery from a tough 2022.
Chart 1- Global Equity Snapshot
Chart 2- S&P 500 Market Cap Vs. Equal Weight
Chart 3- S&P 500 versus S&P Dividend ETF
Interest Rates & Central Bank Policy
The other significant area of focus during the second quarter of the year was interest rates, central bank policy, and the possibility of a higher for longer interest rate environment. In North America, we saw both the US Federal Reserve and the Bank of Canada end their brief pause of rate hikes with a continuation of their respective hiking cycles. Both the US & Canada have raised their policy rates to over 20-year highs, as seen in Chart 4 below.
Chart 4- North American Policy Rates & Curve Spreads
Why have central banks continued to raise rates? Because in their objective function, inflation measures continue to be persistently higher than their targets. Chart 6 below shows the trend of year over year changes in inflation for the G7 economies of the world. Europe continues to face higher overall inflation than the US & Canada, led by the UK in the second column from the right, where headline inflation continues to run hot.
A risk we have mentioned in previous editions and that continues to remain present for North America is that while inflation is higher than targeted, it is decreasing, and that it is possible that the hikes from 2022 are just now fully making their way through the economy and are curbing aggregate demand as intended, and that these fresh hikes have the potential to cause more economic harm than good. The bond market would appear to share that concern and continues to price in that interest rates are going to come down, as evidenced by the inverted yield curves depicted in Chart 5. However, while the yield curves remain inverted, they are beginning to price in the possibility that interest rates are going to be higher for longer, as you can see that the longer end of the yield curves have risen from a year and 5 years ago.
Chart 5- US & Canada Yield Curves
Chart 6- G7 CPI trends
This higher for longer environment has been our baseline forecast for quite some time. Given the ongoing geopolitical uncertainties around Russia and Ukraine, and China and the US, the reversal of aspects of globalization, to the political and societal push around transitioning the global energy economy, these large macro and secular forces are going to continue to put pressure on inflation and interest rates globally, resulting in a higher steady state interest rate environment then has been experienced by the developed world over the past two to three decades.
Conclusions & Portfolio Considerations
The possibility that interest rates will be higher for longer has significant implications for global economies, governments, and investors. Having higher interest rates on cash and/or “risk-free” assets should change the market dynamics that have been in force for well over a decade, where zero-interest rate policies provided investors with little choice but the equity markets in a search for growth and income, stretching valuations and exposing investors to risk.
The ability to generate a respectable level of income and return from assets such as cash and fixed income will continue to rebalance the global financial system to a more sustainable structure and allow us to construct better risk-managed portfolios for our clients. Within fixed income, as shorter duration bonds mature, higher rates on the back end of the yield curve reduces the re-investment risk of rolling that capital into new bonds with father maturities and provides a more sustainable income and return expectation from our fixed income.
Within equities, we continue to own high-quality businesses with strong cash flows and clean balance sheets. The risk for companies that over-levered during the zero-interest rate environment of the past decade is that if they need to roll their maturing debt obligations at these new interest rate levels, they will run the risk of being unable to service their debt. As such, our focus on strong balance sheets is critical. A broadening equity market should include participation by the quality dividend paying businesses that we invest in.
A couple of sectors in particular that demonstrate some of these characteristics and that remain attractive is health care and energy. Energy valuations continue to look very attractive, with very low debt levels and strong free cash flows that allow companies to pay out growing dividends and retain upside exposure to higher commodity price levels.
Areas in commodities and real assets that have strong inflation protection characteristics continue to look attractive here. As we continue to push on with an economic and energy transition strategy, there remains upside for commodity prices from this fiscal impulse. The fact remains that many commodities globally have been underinvested in given the depressed commodity market, and that significant resources will need to be spent to procure and produce the commodities necessary to build new infrastructure.