Higher for longer

By Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 02/24/2023

Economic data

February hasn’t been a kind month to investors as they’ve adjusted to Federal Reserve Governors’ repeated statements that the institution hopes to raise rates further and hold them there for an extended period of time. Investors fought this for all of last year, with the futures market continuously ratcheting higher its expected terminal rate (final resting place for Fed Funds when it pauses). Now, the futures market has its terminal rate a bit higher than where the Fed has been guiding us.

This week’s events helped cement those expectations. The latest minutes from the Federal Open Market Committee (FOMC) showed that the governors all wanted to hike at least 0.25%, and that they saw sticky inflation as a continued risk that would justify holding rates higher for longer. The revision to 4th quarter GDP showed inflation was a bit higher than previously estimated, with GDP a bit lower, owing to softer consumer spending. Personal income and spending was a mixed bag, with incomes less than expected, but spending is holding up nicely. The bigger concern was that the Fed’s favoured inflation indicator, the personal consumption expenditures (PCE) deflator was higher than expected with the all-in and core rates increasing on a year/year basis.

In Canada, our inflation report was a bit softer than expected, but the core rates remained high. There was nothing much in that report that should move the Bank of Canada off of its ‘on hold’ posture with respect to raising interest rates further. In fact, core inflation (excluding food and energy) was up by only 0.1%, and is up 4.9% year/year, with the 3-month trend now only 3.1% on an annualized rate basis. Our retail sales report showed that spending held up, but the core rate that excludes autos printed in the red for the 2nd straight month. The volume of sales were quite positive, and StatsCan’s flash estimate for January estimates another good gain. The bad news from the report was that housing-related retail sales are slumping, which comes as no big surprise. Spending did remain buoyant on vices like alcohol and cannabis; it seems Canadians won’t let a potential recession get in the way of having a good time.

Bond market reaction

January’s rally in government bonds evaporated this past month, as both Canada and the U.S. saw their 10?year benchmarks post fresh year-to-date high yields. The skittishness in bonds reflects a growing mindset amongst investors that central bank interest rates, at least in the U.S., will continue to move higher and stay there for longer than previously expected. So investors pushed back on the 10-year Treasury yield staying below 3.5%, given the futures market keeps moving the terminal yield higher. Regardless, the yield curve remains inverted, flashing warning signals for a recession that many don’t see coming, given the growing belief that a ‘soft landing’ or ‘no landing’ is possible. Those are rare events, remember, with recessions a much more likely outcome.

Credit spreads moved up modestly this week in the investment grade sector, with the high yield sector seeing a more meaningful move higher in sympathy with the hit on the stock market this week. However, credit spreads remain lower than where they started the year, so if a recession does materialize, it will likely be met with credit spreads moving higher still.

Stock market reaction

After a surprisingly strong start to the year for equities, reality seems to be setting in as the lagging effects of “higher for longer” interest rates take their toll. Both the S&P500 and S&P/TSX were down about 1-2% during this holiday-shortened, yet news-heavy, week. Between the U.S. and Canada, there were over 100 companies reporting earnings, including bellwethers such as Nvidia, Walmart, GFL, Loblaw and Home Depot. One theme that seems to be recurring has been the resiliency of top-line revenue in the face of weaker margins and lower earnings. While the almighty consumer continues to spend, the problem has been higher costs from labour, logistics and interest payments, and therein lies the clearest rationale for recent market weakness. In company specific news, Teck Resources kicked off the week with a bang, announcing a spinoff of its metallurgical coal business and the pathway to collapse its dual share structure. These two points taken together likely lead to the renamed Teck Metals either rerating higher as a pureplay base metal producer, or else becoming a potential takeout target by a super major. And finally, CIBC reported better than expected results this morning. Capital levels were slightly above expectations, provisions for credit losses were less than expected, while operating leverage was slightly negative due to higher legal expenses. Net-net, it was a decent bounce back quarter for CIBC, especially given the current low valuation bar.

What to watch next week

We will get Canada’s December GDP report next week, along with building permits and productivity. The U.S. will see the release of durable goods orders, house prices, consumer confidence, purchasing manager surveys, vehicle sales, unit labor costs and productivity.?

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 Thursday, and equity data, which is as of mid-day Friday. 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.