Q3 PIMG Commentary: Inflation and Interest Rates

The third quarter delivered some familiar headwinds to financial markets. A resurgence of inflation and stubbornly strong employment were enough to send bond and stock markets lower. The battle with inflation is proving difficult and central bankers are determined to do their job despite the obvious consequences of increasing interest rates. To many, the economy appears quite strong with restaurants full and vacation prices pushing ever higher. However, higher interest rates are undoubtedly taking their toll as Canadian GDP continues to flounder. As long-term investors we see lots of opportunity as yields on bonds and valuations on certain stocks reach levels we have not seen in decades.

Despite inflation numbers continuing to trend lower, the Bank of Canada has not quite reached its long-term objective of an annual reading between one and three percent. August data presented a surprise uptick to 4% and this was enough to cause bond markets to price in another round of interest rate increases. What is most frustrating is that the largest contributor to the August inflation reading was the shelter component which came in at 1.7% month-overmonth. Shelter prices are calculated from several inputs, but a major component is interest expense and rent. With mortgage rates being pushed higher by higher interest rates and rents moving higher because of higher mortgage costs, a lot of the reason for the recent increase of inflation can be attributed to central bank policy. A not so virtuous cycle.

Where this inflation story ends is yet to be written. On the anecdotal side, we have seen some evidence of continued softening. Tesla announced more price cuts on several of its best-selling models while Disney announced discounts on some of its ticket pricing. Oil prices have rolled over and the price per gallon in the Vancouver region is well below $2 per litre again. We don’t expect inflation to move materially higher from here and as such believe that most interest rate increases have been completed.

Equity and bond markets will likely continue to take their cues from inflation readings. The recent drop in equities is not unusual as we do expect these types of moves about once a year. As equity investors, this is the short-term risk premium we pay to earn higher returns over time. As the quarter ended, equities traded down to extremely oversold conditions. These extreme sentiment readings often represent a turning point for the markets. Additionally, from a seasonality perspective, we are now entering the historically strongest period for equity markets which lasts from October to April.

Over the quarter, company and sector performance largely reflected associated debt levels. Consumer discretionary and real estate companies soldoff more than defensive sectors such as healthcare, consumer staples and financials. Energy was the leading sector with oil prices trading around $90 U.S. per barrel. This divergence of sector performance speaks to the ongoing recessionary fears and the impact that higher rates will have as we head into the new year. The higher cost of capital (borrowing) will be a significant headwind for those that are highly levered. Recent Canadian GDP data highlighted those sectors most sensitive to interest rates had weakened the most over the past year. Housing, construction, and wholesale trade, which make up approximately 30% of GDP, were all negative over the past quarter. Conversely, retail trade, mining, oil and gas and durable manufacturing were all positive contributors to GDP growth and are tracking at greater than three percent annualized rates. This speaks to the resilience of the consumer, an improvement in supply shortages, a tight labour market and strong population growth. The net result is what we believe to be a more balanced state for the economy as we head into 2024.

Client portfolios did experience some negative performance in the back half of the quarter, but downside was minimal relative to broad indexes. This reflected our focus in bellwether businesses such as Intact Financial, Alimentation Couche Tarde, and Sun Life. Energy producers such as Suncor also did well, and uranium has become an emerging story with Cameco a standout performer. In the US, large cap tech names like Amazon, Google and Microsoft continued their strong recovery while financials such as Chubb, JP Morgan and MetLife were also positive. Capital intensive companies with larger debt profiles like Telus and Algonquin Power contributed negatively to performance. Cash flow from dividends and interest payments continue to provide dependable sources of returns while adding additional stability and reinvestment opportunities through this volatile period.

Tactically, our portfolio management was active throughout the quarter harvesting gains in select positions while also reinvesting that cash in companies that presented more attractive valuations. On that front, we trimmed some of our position in Apple as well as Cameco which have traded around all-time highs. We reinvested the proceeds from those trims in more shares of Telus and BCE which have traded near multi-year lows. We added shares of Fortis to our Canadian portfolio and Westrock to our US portfolio. While Fortis is no doubt familiar, Westrock is likely a new name. Westrock is one of the largest cardboard box manufacturers in the world. They will have an even larger global market share after combining with Irish based Smurfit Kappa. This combination will create the largest paper/cardboard company in the world with offices in 42 countries. Notably, the new entity expects to realize synergies of $400M. We like when strong businesses trading at attractive valuations pursue value enhancing transactions.

The third quarter showed that financial markets continue to work through the issues that were largely created as a response to the COVID induced economy. There is still too much demand and not enough supply. Until this imbalance is fully rectified, we can expect markets to be driven by interest rate expectations and corresponding rhetoric from central bankers. Fortunately, equity markets have already priced in most of the inflation we expect to see and have historically done well through similar periods. When we do ultimately see inflation numbers fall within the one to three percent target range, we should expect to see markets stage a meaningful recovery.

Your Plena Wealth Advisory Team

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