Economic Update Q3
When central banks get involved!
Throughout the summer, economic conditions continued on the path seen during the first part of the year. Following a massive vaccination effort leading to a decrease in cases, Covid-19 restrictions have been virtually eliminated. Household consumption has remained strong thanks to savings set aside during the pandemic. Labour and supply problems in some sectors have not yet been resolved. Inflation and policy rates have continued to soar. Fears of a recession in the spring, which seemed to fade during the summer, are becoming very tangible this fall, resulting in volatile equity and bond markets offering low returns.
In the next few paragraphs, we will provide an overview of the current economic situation, while analyzing what brought us here and what role central banks have played. We will present what is important to keep in mind for fall 2022 and the adjustments made to our portfolio management to protect your investments and add value in these uncertain times.
 We will use as a reference the US Federal Reserve or Fed, which represents the world's largest economic power, the United States. It also influences other central banks such as the Bank of Canada (BoC) since they are financial allies and neighbouring countries.
Are markets really efficient?
In order to better understand what happened, we must go back to March 2020, the beginning of the pandemic in North America. At the time, there was a global panic as we found out about a highly contagious virus that affected the population and for which no one had a cure. Having never experienced a similar case in the modern era and fearing a serious economic crisis, in addition to the humanitarian and social crisis that was emerging, most central banks decided to lower their key rate, with the Federal Reserve cutting from 1.5% to 0% within a month. Was it the right decision? At that time, probably yes since it was necessary to dispel fears of a possible global recession to come but, given the current situation, it would have been wiser to take a step back rather than react quickly to a problem with a great many unknowns.
The various restrictive health measures used to prevent the spread of the virus resulted in some economies being shut down for weeks or even months. The main impacts were a drastic drop in international trade and productivity, creating supply problems at all levels as well as a labour shortage thereafter. The culminating effect of these decisions has now been seen in recent months with the massive surge in inflation. There is a lack of products and service workers, so the prices of what is available have increased significantly. Central banks have therefore decided to stimulate the economy by deploying several rescue plans to help consumers with their cost of living.
Today, the causes and effects of the pandemic are better known and controlled. Central banks must now tighten monetary policy by repatriating money back into their coffers while controlling the growing inflation problem. Unfortunately, simply raising interest rates will not bring down inflation without causing further damage to the economy. Inflation is present because international trade has not recovered to pre-Covid levels and there are still supply and labour problems. At the moment, many countries are trying to produce different goods and services that they used to import, but unfortunately the production costs are higher because they do not have the raw materials, expertise and skilled labour to do so. It will take a long time before everyone can produce on their own and is competitive. As such, inflation will take time to return to where we want it to be.
The current strategy of central banks to counter inflation by raising policy rates will simply reduce consumption. Prices are high and interest rates are rising rapidly so the cost of borrowing is getting higher, meaning we will consume less. As such, if the pace of rate hikes is mismanaged, we could see a recession looming in 2023 as economic growth turns anemic. If central banks had not set policy rates at 0% in 2020, the current intense increases would have had less impact on the economy since they would have been of a lesser magnitude. At this rate, North American policy rates will be above 4% in December 2022. We have a hard time understanding why central banks want to raise rates so quickly without giving the market the opportunity to absorb them. Stock exchanges are currently less efficient since it is central banks that are influencing prices through their decisions. Many investors wait for the release of the previous month’s inflation figures in order to analyze the economic outlook and the likelihood of an upcoming recession.
Important dates to remember this fall
To help you keep track of economic developments this fall, Table 1 summarizes the important dates for data releases with a major influence on the economy: inflation and central bank meetings to decide whether or not to raise policy rates.
It should also be noted that October 3 is the day of the provincial election in Quebec and that mid-term elections in the United States take place on November 8. The first date will have little or no influence on stock markets, but the second could bring its share of volatility.
Impacts on portfolio management
A good metric to see if the stock market is expensive or a bargain is to analyze a company's price-to-earnings ratio. The higher this ratio, the more expensive a company’s stock is relative to its earnings. Conversely, if the ratio is low, it means the company is undervalued for the profits earned. Moreover, it is important to compare this ratio for companies in the same sector and with a similar market capitalization. During the pandemic, this ratio rose above 35 for S&P 500 companies, which meant that shares in publicly traded companies were changing hands at 35 times their profit, the highest level in the last decade. This meant that the stock market was overbought. Historically, since 1917, the average of this ratio has been 16 times price/earnings. Right now, we're around 19.5 (see Table 2), which seems to mean that the equity market is cheaper than it was last year, when it peaked, but it can still go down and normalize, especially if a recession is approaching. In Table 3, you can see how this ratio has moved since the 2000s. Depending on the current situation and what could happen, it is likely that this ratio will decrease further for a few weeks or months. After that, we will remain on the lookout to invest in companies that will benefit from the recovery and a new phase of growth.
S&P 500 price-to-earnings ratio
Source: S&P500 PE Ratio. (September 16, 2022). Retrieved from : https://www.multpl.com/s-p-500-pe-ratio
S&P 500 price-to-earnings ratio versus historical average since 2000
Source: Current Market Valuation - S&P500 P/E Ratio vs Historical Ave Since 2000 with +/- 2 standard deviations. (September 16, 2022). Retrieved from: https://www.currentmarketvaluation.com/models/price-earnings.php
When interest rates rise rapidly, the cost of borrowing impacts many companies, which drives stock markets downwards. In summary, equities and bonds are the asset classes that perform worse in this type of situation. My team and I have experienced such situations before, so we know what to do. Here are some important actions taken by our team to enhance performance in the current situation:
Buying securities with a low beta (relative volatility compared to a benchmark), many of them also offer solid dividend yields.
Purchase securities with low implied volatility and a price/earnings ratio below their peers.
Eliminate positions in securities that are not making a profit or are in debt.
Avoid securities in sectors where real inflation has a major impact.
Increase the duration of our bond holdings.
Renew bonds by choosing those with a high credit rating and a more attractive yield to maturity.
Ensure the liquidity of all investments.
Keep a sufficient portion of holdings liquid and increase it as risk management reaches pre-established levels.
Bonds in each of the risk profiles will be increased gradually in order to take advantage of higher interest rates (with higher yields, the asset class becomes more attractive), to the detriment of equities (oversold asset class when rates rise and as a possible recession approaches).
At the moment, we are dependent on central banks, because they are the ones who set the tone. Nevertheless, we have already identified how we will take advantage of this situation in order to improve our performance while protecting your capital. We know 2022 has been a challenging year, but our experienced team is working hard to minimize the impacts of a possible coming recession. We are available at all times to answer your questions and listen to your comments. We would also like to take advantage of this economic update to sincerely thank you for your continued confidence through these uncertain times.
 Canadian CPI Release Schedule. Retrieved from: https://inflationcalculator.ca/cpi-release-schedule/
 CPI Release Schedule. Retrieved from: https://cpiinflationcalculator.com/cpi-release-schedule/
 Banque du Canada. (July 29, 2022). Bank of Canada publishes its 2022 schedule for policy interest rate announcements, the release of the Monetary Policy Report and other major publications. Retrieved from: https://www.bankofcanada.ca/2021/07/bank-canada-publishes-its-2022-schedule-policy-interest-rate-announcements-release-monetary-policy-report-other-major-publications/
 Federal Open Market Committee (August 17, 2022). Meeting calendars, statements, and minutes (2017-2022). Retrieved from : https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm
Investing (July 27, 2022). U.S. Fed Funds Target Rate. Retrieved from : https://ca.investing.com/economic-calendar/interest-rate-decision-168
The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. The opinions expressed do not necessarily reflect those of NBF. I have prepared this report to the best of my judgment and professional experience to give you my thoughts on various financial aspects and considerations. The securities or sectors mentioned in this letter are not suitable for all types of investors and should not be considered as recommendations. Please consult your investment advisor to verify whether the security or sector is suitable for you and to obtain complete information, including the main risk factors. Some of the securities or sectors mentioned may not be followed by the analysts of NBF.