High Valuations, Rising Yields, and Policy Shifts | November 19, 2024

Navigating the complexities of political shifts, inflationary pressures, and market volatility, this week brings both challenges and opportunities for investors.

This week, markets are dealing with both political shifts and persistent inflation challenges. The election results have heightened expectations of fiscal changes, but concerns over stubborn inflation and interest rate uncertainty loom. Global equities mostly gave back gains from recent rallies, while some markets like Canada showed resilience due to specific sector strength. Meanwhile, the bond market continues to adjust to shifting central bank policies, and commodities saw mixed movements amid concerns over supply and economic growth.

Economic Environment and Policy Outlook

The broader economic landscape is undergoing significant shifts, driven by evolving political dynamics and persistent inflationary pressures. This section will delve into how these changes are impacting various aspects of the market.

• U.S. Market and Policy Uncertainty: The outcome of the U.S. election has prompted shifts in market sentiment. U.S. equities gave back some of their recent gains, driven by profit-taking and uncertainty surrounding the incoming administration's policies. The S&P 500 dropped by 2.1%. The Nasdaq shed 3.15%. Investors were also discouraged by comments from Federal Reserve Chair Jerome Powell, who signaled that rate cuts would proceed cautiously due to economic strength. The bond market reflected this sentiment, with the yield on the 10-year U.S. Treasury rising to 4.44%, up 14 basis points for the week.

• Global Markets and Tariff Concerns: European and Chinese equities also retreated as investors weighed the implications of a potentially tough U.S. trade policy. European markets were affected by weak earnings and higher bond yields, while Chinese markets were down amid caution over trade uncertainty and slowing demand. Investors in these regions are closely monitoring the incoming administration's stance on tariffs, particularly in relation to Europe and China.
• Persistent Inflation and Rate Uncertainty: The U.S. inflation data showed a 0.2% month-on-month increase in CPI, pushing the year-on-year rate to 2.6%. Core inflation remained steady at 3.3%, signaling that inflationary pressures are persistent. Retail sales data for October exceeded expectations, adding to the notion that consumer demand remains resilient. As a result, market participants are adjusting their expectations for future rate cuts, with many expecting the Federal Reserve to maintain higher rates for longer to control inflation.
• Canada's Resilience: In contrast to the broader market retreat, Canadian equities managed to post gains of 0.5%, led by a strong performance from the technology sector, notably Shopify. The TSX was also buoyed by positive earnings results in energy. The Canadian dollar, however, continued to weaken as policy divergence between the Federal Reserve and the Bank of Canada drove adjustments in interest and exchange rates.

Sectoral and Geopolitical Insights

• Technology and Bitcoin: The technology sector faced a pullback as the market adjusted following the election rally. Meanwhile, Bitcoin surged past $90,000, driven by speculation that the new U.S. administration would loosen regulations around cryptocurrencies. However, the announcement that the new government may end tax credits for electric vehicle (EV) purchases caused EV stocks, including Tesla, to pull back after an earlier surge.
• Energy and Commodities: Energy stocks managed to stay positive, but the broader commodities market showed weakness. Oil prices fell nearly 5% on the week amid rising concerns about excess supply and weaker demand from China. Conversely, natural gas prices surged, driven by concerns over potential supply disruptions caused by Hurricane Rafael.
• Financials and High Yield Bonds: Financial stocks outperformed due to expectations of deregulation and merger activity under the new U.S. administration. In the bond market, high-yield bonds continued to attract investors seeking yield, while investment-grade bonds declined as rising yields reduced their attractiveness.

Key Market Moves:

• U.S. Treasury Yields: The U.S. 10-year Treasury yield climbed to 4.44%, indicating a shift in expectations towards higher long-term rates. This rise reflects a market consensus that rate cuts will proceed more slowly amid ongoing fiscal stimulus and inflation pressures. The chart also shows a continued upward trajectory since September, highlighting increased investor caution around long-duration bonds.

• Equity Performance: The S&P 500 pulled back from recent highs, with the technology sector leading the decline. Both cap-weighted and equal-weighted indices showed weakness, reflecting broad-based profit-taking across the market. Meanwhile, the Russell 2000 index remains below its previous peak, indicating limited participation from small-cap stocks in the broader rally. Investors should be mindful of high valuations in these markets, especially given the recent volatility.

• Retail Sales and Inflation Trends: Retail sales continued to show resilience, with October data indicating a 0.4% month-on-month increase. This suggests that consumer spending remains strong despite rising prices. Core inflation held steady at 3.3%, with housing inflation remaining a key driver. The charts demonstrate that while inflation has moderated from its peak, certain components, like shelter and rent, remain persistently high, complicating the Fed's efforts to bring inflation back to target.
• Commodity Price Movements: Oil prices fell nearly 5% on the week, driven by concerns over excess supply and weaker demand from China. Conversely, natural gas prices surged, as shown in the charts, reflecting fears over potential supply disruptions from Hurricane Rafael. This divergence within the energy sector indicates varied market responses to supply and demand dynamics.
• Fixed Income Spread Trends: High-yield bond spreads narrowed, indicating continued investor appetite for risk despite rising benchmark yields. Investment-grade bonds, however, showed widening spreads as rising yields made them less attractive. Our research that investors are seeking higher returns in riskier debt, but caution is warranted given the current interest rate environment.
• Global Market Divergence: Our research also shows a divergence between developed and emerging market equities. While European and Chinese markets pulled back due to trade and tariff concerns, Canadian equities showed resilience, driven by strong sector-specific performances. This divergence highlights the importance of geographic diversification in navigating current market conditions.

Investment and Portfolio Implications

Equity Allocation:

• Maintain a diversified exposure to equities while being mindful of valuation levels, especially in technology and small-cap stocks.
• The pullback in the S&P 500 and Nasdaq suggests potential buying opportunities in sectors that may benefit from fiscal policy changes, such as financials and energy.
• Exercise caution as valuations remain elevated, and the risk of further volatility is high.

Fixed Income Positioning:

• With the 10-year Treasury yield continuing to rise, reduce exposure to long-duration bonds.
• Focus on shorter-duration and high-yield bonds that offer better risk-adjusted returns in a rising rate environment.
• Given persistent inflation, maintain some exposure to Treasury Inflation-Protected Securities (TIPS).

Sector Opportunities:

• Financials, energy, and infrastructure are sectors to watch.
• Financials are likely to benefit from expected deregulation, while energy may see support from higher fiscal spending.
• Infrastructure equities, particularly those linked to essential services like data centers and utilities, offer attractive opportunities given their stable cash flows and resilience to inflationary pressures.

Emerging Markets and Commodities:

• With rising geopolitical risks and tariff uncertainties, emerging markets remain challenging.
• Select opportunities exist in consumer-oriented sectors and infrastructure.
• Commodities, especially natural gas, may offer tactical opportunities, but remain cautious given the volatility in oil and other raw materials.

Conclusion

The week ahead will be shaped by evolving political and economic dynamics. The markets are digesting the outcome of the U.S. election, inflation trends, and central bank policies. Investors should stay vigilant and consider balancing growth opportunities with defensive positions, especially in sectors poised to benefit from fiscal changes. While optimism remains in some corners of the market, the risk of elevated valuations and persistent inflation should not be underestimated.

Looking forward, investors should monitor upcoming economic data releases, particularly inflation and employment figures, as well as any policy announcements from central banks or the new administration that could further impact market dynamics.