Paving Way for Opportunity?
As interest rates continue to move higher, market pullback has caused increased opportunity.
Higher interest rates contribute to weaker financial markets in Q3
The third quarter of 2023 saw a strong start in July, before equity markets weakened over the course of August and September, with the S&P 500 pulling back just under 7% from its summer highs, while the Nasdaq 100 and TSX Composite pulling back 8% and 6% respectively.
The main catalyst for the weakness in financial markets stemmed from the steepening of the interest rate curve, signifying a belief that interest rates are going to be higher for longer. In the chart 1 below, we show the yield curve at the end of September (pink line), compared to the curve at the end of June (green line), a year ago (red line), and 5 years ago (orange line).
It is worth noting that as of the end of the second quarter of 2023, the longer end of the rate curve (5 years and beyond), was consistent with the equivalent rates at the end of September 2022. This is to say that the steepening of the yield curve, where the long end rises more than the short end, occurred during the third quarter of 2023, with the US and Canada 10-year yield rising to 4.5% and 4% respectively.
As we enter the final quarter of 2023, as previously noted, the headline market cap weighted US indices continue to paint a far rosier picture of financial market performance in 2023 than the reality. In chart 2, we provide a snapshot 2023 year to date total returns in Canadian dollars for the following:
- S&P 500
- Equal Weight S&P 500
- S&P US Dividend Aristocrat ETF, which is comprised of companies that have increased their dividend for 20 consecutive years, which is a good indicator of business quality.
- TSX Composite
- TSX High Dividend ETF, which is comprised of 30 of the highest yielding Canadian companies
- Canada Universe Bond ETF
Chart 1- US & Canada Yield Curve
Chart 2- Snapshot of 2023 Year to Date Returns
As we can see, when looking past the headline index returns, 2023 has continued to pose a challenge to global investors. Given the global economy continues to digest and adapt to this changing interest rate regime that began in 2022, this is not a surprising outcome. Of particular interest, the equal weighted S&P 500, which can be thought of as the return of the average equity in the index, is up 1.47% to the end of September, far less than the market cap weighted S&P 500. Even more eye-opening is the weakness of very high-quality businesses that comprise the Dividend Aristocrat universe.
All of this is to say, that with interest rates rising and staying higher, this has resulted in significant market revaluations and relatively broad weakness through 2023. Now, with the top-heavy equity indices exhibiting weakness and overly pessimistic positioning and sentiment into the final quarter of the year, this has begun to provide some opportunities for deploying capital into quality businesses at better valuations.
Under the surface, pullback has provided some more compelling opportunities for capital deployment.
As we head into the remainder of 2023 and into 2024, we are beginning to find more compelling opportunities both within our existing equity universe and portfolio companies, as well as in new companies to deploy additional capital in portfolios.
2024 is an election year in the United States, which has historically been accompanied with stronger equity markets, as presidential candidates lay out their election platforms and promises to the electorate. We expect inflation and geopolitics to be front and center heading into this election cycle.
At a broad level, we are seeing aggregate earnings expectations rise, as shown in Chart 3. The pink line (1 month moving average) has been rising for the US and Global Indices since March, while Canada looks to be in the process of bottoming in August. Rising earnings expectations can be overly optimistic at times but do signal that underlying corporate fundamentals are recovering.
We are seeing opportunities across sectors and industries and remain focused on businesses with quality balance sheets and cash flow profiles. With our base case of rates higher for longer, balance sheet quality continues to be a core focus for us, as businesses will need to be able to weather rolling over existing debt at higher interest rates than during the last decade. Businesses that have over-extended themselves risk significantly curbing their profitability or viability if they have to roll over excessive debt and higher rates, and don’t have the ability to either retire some or all of their debt and deleverage. As such, selection matters.
While economic headwinds remain a concern, our ability to deploy capital into quality companies at more attractive valuations heading into 2024 provides us with optimism heading into the final quarter of 2023.
Chart 3- Equity Earnings
The Upside to Higher Interest Rates- Bonds command an expanded role in portfolios
As rates have continued to rise, more recently in the longer end of the curve, the role of bonds in our portfolio continues to increase in value. The steepening of the interest rate curve has afforded us the ability to lock in attractive rates of return for a longer period from the bond portfolio. This is especially true where we can buy these bonds at a discount to their maturity value. From a tax perspective, this enables us to produce a tax advantaged return in the form of a portion of the total return of the bond will come from capital gains at maturity, versus entirely from the coupons of the bond, which are fully taxed as interest income.
Another benefit to owning bonds with a longer maturity is that when interest rates do come down, there exists the ability to benefit from capital appreciation as those bonds yields come down (bond price rises) to compensate for the lower interest rate.
As a result, our bond sleeves in our client portfolios have a contracted return stream that is further into the future than 3 months ago, benefits from a more tax-efficient return due to buying at a discount, and an increased ability to exhibit capital appreciation from lower rates in the future. Having an expanded role for bonds in portfolios is a positive outcome of this new interest rate regime and provides a far more robust portfolio construction toolkit.
As always, asset allocation and selection of assets is paramount.