Eight is enough?

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 02/03/2023

Economic data

The much anticipated Federal Reserve rate decision was announced this week and without much surprise, the overnight rate was increased for the 8th consecutive time to 4.75%. Even though the pace of increase was lowered to 25 basis points (bps), Governor Powell stuck to his guns and stressed that the fight against inflation is still not over. In his own words: “We need substantial more evidence to be confident about inflation returning to 2%, in particular as we see core non-housing services still running at 4% annualized with no progress there.” While the message seemed pretty clear, markets did not believe a word of it. In fact, risk assets rallied on the news and during the press conference that followed, as many consider that the current level of rates is sufficient to achieve an economic soft landing and to swiftly bring inflation back to the 2% target. While the Fed expressed that there was no rate cut in their playbook if the economy evolved according to its projections, futures markets were still expecting the central bank to reverse course in the later part of this year. Let’s remember that we need to be careful in drawing conclusions based on market expectations: no later than last July, futures markets were expecting the Fed to cut rates at this very meeting. Finally, it seems like this fight between central banks and financial markets is going global as we saw the same situation develop on Thursday, when both the European Central Bank (ECB) and Bank of England (BoE) delivered their expected 50 bps hike along with hawkish talk, which was then followed by a rally in bonds and equities. It seems a lot of market participants are choosing to ignore the old adage: “Don’t fight the Fed.”

The data early in the week gave central bankers some comfort as we saw the manufacturing data from the Institute for Supply Management (ISM) going further into contraction territory and unit labor costs slow down. Both are a sign that higher rates are doing the job of slowing the pace of growth on the economic and inflation fronts. Things turned around on Friday as once again the employment number came out very strong. Nonfarm employment came out at an astounding 517,000, much higher than the expected 188,000. The unemployment rate dropped to 3.4%, a number not seen in decades. Average hourly earnings did decrease from the previous month, but came out slightly higher than expectations on a year over year basis. Such an outsized result will definitely reprice Fed actions for later this year.

In Canada, we saw the November GDP report and the flash release of the December estimate that leaves Q4’22 GDP on track to slightly exceed the Bank of Canada’s estimate. Building permits plunged in December, with both the residential and non-residential sectors seeing material pullbacks.

Bond market reaction

It was quite a volatile week in rates. We saw yields drop earlier in the week as hawkish central bank talk was met with market disbelief. Unfortunately, we got a fresh dose of reality as the U.S. employment report showed that there might be more work to do to cool this economy down. After the dust settled, we ended up with a 10?year Canada bond yield relatively unchanged on the week. But as we know, markets do not stay unchanged for long.

Corporate bonds are definitely taking part in the global risk rally. Credit spreads have been performing well for many months now, but notable this week was the appetite for new issues. New issues were well oversubscribed and the ensuing spread compression resulted in the secondary market overperforming as well.

Stock market reaction

U.S. equity markets had one of their best weeks after the Fed announcement, especially with technology and growth stocks looking beyond monetary tightening. The Nasdaq was up nearly 6% in two days! Earnings season is well underway with companies giving useful nuggets of information about consumer sentiment, supply chains, and general economic conditions. Large cloud providers including Microsoft and Amazon are cautious on 2023 growth for their cloud businesses as customers rationalize their technology footprint after spending aggressively over the last few years. While this doesn’t translate into large budget cuts, some investors are nervous simply on decelerating sales momentum. Across other sectors, common themes holding up corporate earnings include energy costs coming under control, rational cost cutting, stronger than expected pricing power, and a tailwind to demand from China reopening. While this statement is a generalization, it’s certainly holding true to many companies where earnings expectations were dire: 2023 is evolving to be slightly better than expected.

What to watch next week

The economic calendar will be lighter next week, as the University of Michigan sentiment index will be released in the U.S. Canada will provide us with the always volatile employment number on Friday and the latest trade balance.

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Disclaimer

Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

The views expressed in this document are the views of CIBC Asset Management Inc. and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. Certain information that we have provided to you may constitute “forward-looking” statements. These statements involve known and unknown risks, uncertainties and other factors that may cause the actual results or achievements to be materially different than the results, performance or achievements expressed or implied in the forward-looking statements. This document is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this article should consult with his or her advisor. All opinions and estimates expressed in this document are as of the date of publication unless otherwise indicated, and are subject to change with the exception of bond data, which is as of end of day the previous Wednesday, and equity data, which is as of mid-day Thursday. CIBC Asset Management and the CIBC logo are trademarks of Canadian Imperial Bank of Commerce, used under license. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc.?