Market Packs it’s Schoolbags as Economic Vacation Comes to an End

It is likely that for each of us, our childhood memories of summertime were of bliss. The structure and discipline of the school year is thrown aside for two glorious months as problem sets shift from studying for math or spelling exams, to who is hosting the next sleepover or pool party. It’s a time to reset and be care-free, even if only for a time. The notion that this environment is short and seasonal, while acknowledged, couldn’t be further from thought. But, like all good things, it comes to an end as children face the reality that a return to structure, lessons, actions and consequences is inevitable. As they organize their binders for their new class list, they’re filled with apprehension to see the same subjects they’d struggled with so much last year. The dreaded subjects never really went away, they were just ignored, and it is now time to pick up right where they left off.

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After a long, pandemic-era period of low rates, near zero inflation and easy access to credit, the subjects we’re picking right back up on include:

• Rising and persistent inflation, just as it had tripled in Canada from June 2017 through July 2018
• An interest rate hiking cycle last attempted from 2017-2018
• A return to the U.S. – China tensions that dominated headlines in 2019

It’s crucial, now as always, to remember that the market is a cranky toddler that the economy is trying to 'parent' - they are not one and the same.? Just like a toddler, the 'market' has a short-term memory, often displays erratic behavior and mood swings, and engages in gross exaggeration and fixation.? Reason and logic are often not always the best approach when dealing with a toddler (and the market) and it’s best not to try and predict short-term behavior. The parenting economy can attempt to provide the right environment and warning signals when market behavior is likely to lead to adverse consequences, but at the end of the day, this toddler may not listen and may take their sweet time coming around. So, while the economy flashed signs of recession, the market continued whimsically through it’s economic summer with the S&P500 (USD) posting 17.4% gains and Canada posting 4.7% gains year-to-date (YTD) through to August 31st. Not necessarily a recession avoided, but certainly one postponed.

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An important distinction to make is that when we talk about 'risk of recession', that’s an economic term understood to describe two back-to-back quarters of weakening real gross domestic product (inflation adjusted GDP). On the other hand, a 'bear market' describes a stock market decline greater than 20%. There is a link between recession and bear markets, but one does not always lead to the other; the economy is not the stock market. Worse yet, economic guidance that should influence market behavior is slow to arrive and slow to have an impact. Even the Bank of Canada states that it takes 18-24 months for a rate policy change to impact price levels. Measured from the start of their policy hiking cycle in 2022, that timeline takes us to right about now, so we’re only beginning to see the economic impacts of the first instances of those hiking decisions. Inflation, like unemployment, is what we call a lagging indicator - the last shoe to drop. Unemployment is the natural response to a slowing economy and lack of demand, and as such, many indicators flash red before any employment impact is felt. Separating indicators into “Leading”, “Coincident”, and “Lagging”, we believe our economic scorecard for North America looks like this:

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Clearly, the only positive economic indicators are those that are trapped in the past, and all of our leading and current data points are either negative or deteriorating. It may seem at first glance that the market is gleefully ignoring daunting economic reality, but when you pop the hood on U.S. market performance this year, there’s a different story. To June 29th, 2023, the S&P500 was up over 14.0%. When you exclude the top 10 AI stocks in that market, year-to-date gains were only 1.2%. That’s a gap that doesn’t indicate widespread optimism on market or economic growth, just a strong belief in one sector of technology. Without it, U.S. market growth has been stagnant.

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In Canada, pessimism continues to prevail as both Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) missed profit expectations this week, both citing provisions for credit losses. This is not a new theme as the big Canadian banks have been aggressively setting aside money to cover bad loans, and reasonably so. A Q2 2023 report from credit monitor Equifax Canada showed that, versus last year:

• Missed debt payments (non-mortgage) are up by 175,000 (18.8%).
• Insolvencies are up 28.5%. Consumer proposals are up 36.5%.
• New mortgage originations are down 42%.
• Non-mortgage debt delinquency has increased 25.3%. In BC and Ontario, that’s over 31%.

That’s the bad news.

The good news is that recessions come in many different forms and causes, and an inflationary recession is one where policy tools exist to set the economy back on track: the rates. High interest rates, while unpleasant in the short term, act as “dry-powder” to be able to cut and stimulate the economy in the event of a recession, particularly one driven by inflation. In fact, the largest contributor to May's 3.4% inflation rate in Canada was increased mortgage interest cost, a direct result of high rates themselves. When artificially high rates are the largest driver of the inflation problem you’re trying to correct, cutting provides both relief to an already-defaulting consumer as well as a disinflationary pressure. At present, Canadian money markets have priced in a probability of 77% that rates will have dropped -1.25% by this time in 2025. Absent of any further economic disruption and while inflation remains the primary concern, it is our team's view that the market impact of a Canadian recession would be immediately met with substantial rate cuts, limiting the drawdown. We also believe that weakening U.S. economic data would further allow for greater cuts in Canada without currency disruption. With rate targets in Canada now at 5% and the U.S. bound between 5.25%-5.5%, we haven’t had this much dry powder in 15 years.

As we approach our September Gold Seal Financial Group quarterly asset mix meeting, we’ll be carefully evaluating our shorter term, tactical positioning to reflect some of the more near-term risks in North America and abroad. While some positioning changes are likely to appear defensive in nature, we are always careful to moderate our convictions and maintain flexibility in our client portfolios for evolving conditions. After all, this toddler market may take its time coming around.

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