Q3 PIMG COMMENTARY: THE IMPACT OF LOWER RATES
Gains in financial markets over the last three months were broad-based across assets classes and geographies. Although markets experienced a hearty, albeit short-lived, correction at the start of August, the third quarter provided a steady climb higher. For now, asset prices seem to be looking beyond the slowing global economy, as lower inflation and interest rates are proving to be a more powerful force.
Canadian and U.S. equity markets experienced another strong quarter with growth of indexes coming in close to 10 per cent in Canada and around five per cent in the U.S. International market performance was similarly strong and even the long-beleaguered Chinese markets produced noticeable upside. Perhaps most appreciated by more conservative investors was the notable performance of fixed income. With the U.S. central bank now joining Canada’s decision to lower interest rates, bond markets reacted quite strongly with five per cent gains across most indices. This is a big move in an area of the market that has been very frustrating since interest rates started rising in 2021.
Impressively, amidst this strong quarter of performance, equity markets also experienced a correction of over 10 per cent. As referenced in past commentaries, corrections of around 10 per cent should be expected by equity investors on an annual basis. The cause of this correction was largely blamed on an increase in U.S. unemployment and the obscure Sahm Rule being violated. This rule, which essentially reflects the trend of unemployment, suggests that when the three-month rate of unemployment breaches a positive 0.5 per cent, a recession is to follow. Statistically, this rule has had a perfect record at predicting the start of a recession. It is maybe worth pointing out here that another market signal with a perfect record of predicting recessions, the inverted yield curve, has now gone some two years since inverting without following through on its promise. Perhaps a recession will come, and both of these indicators will be proven valid once again. That outcome remains to be seen but the breadth of deteriorating global economic data continues to confirm that business activity and consumption are indeed contracting.
The August correction lasted a mere few trading days, as investors quickly embraced the notion that higher unemployment would mean lower interest rates, which could in turn spark more economic growth. Perhaps central banks will be able to lower rates just enough to fend off a recession, keep labour markets intact and avoid reigniting inflation. History would suggest the odds are against them and some level of economic decline will take hold. On the other hand, maybe this economic cycle, that is the result of extreme measures taken during the pandemic, will continue to break the norms. Remember, by definition, we are always headed toward a recession. While investors should continue to adjust their investments to best account for macro trends, staying invested through the ebbs and flows of the business cycle should continue to produce good outcomes.
During the quarter, we continued to invest in companies that can generally be described as defensive. Most of these companies have been underperformers over the last few years because of higher-than-average amounts of debt on their balance sheet along with being slower-growth businesses. These types of companies have been out of favour the last few years and their valuations reflect very little optimism.
In Canada, we bought shares of Riocan Real Estate Trust. Riocan is the second largest real estate trust in Canada with over 33 million square feet of leasable area. They focus on mixed use properties, which increasingly means their properties are livable spaces with a mix of retail, office and residential. There’s a good chance the new tower in your area with ground floor retail from the likes of Loblaws and Dollarama is a Riocan-owned property. Higher interest rates pushed the valuation of shares from an average of 13x funds from operations to where we bought them at 9x FFO. With a 5.5 per cent dividend that we expect to grow each year, we are happy to patiently wait for the discounted valuation to narrow.
In U.S. portfolios, we added shares of Verizon. The company, the largest U.S. telecommunications company by users, has also been the victim of higher interest rates. The telco business is very capital-intensive, which has resulted in the accumulation of significant debt on their balance sheet. Higher interest rates have translated into less free cash flow for equity holders and resulted in a stock price some 50 per cent off of its recent highs. They recently announced the acquisition of Frontier Communications, which should act as a catalyst for growth, as they will now be the largest provider of broadband services in the country. As interest rates trend lower, the reversal of that higher debt burden should allow Verizon to pay down more debt and continue to grow their attractive six per cent dividend yield.
As mentioned, bond prices also appreciated nicely this quarter. Many bonds that were bought in client portfolios less than a year ago are reflecting unrealized capital gains of over 10 per cent. While many bond issues are still trading under par value, the passage of time and any additional interest rate reductions will continue to push bond prices closer to par. Going forward, with interest rates closer to long-term averages, we expect fixed income allocations to once again provide stable cash flow and an offset to equity market volatility.
We would be remiss not to mention the upcoming U.S. election. On November 5th, Americans will determine the next president as well as which party will control the House and the Senate. These elections always serve as opportunities for investors to lose sight of long-term objectives. We would like to remind everyone that both equity and fixed income markets have rewarded investors who have stayed invested through every permutation of government. There will be some winners and losers on the margin but the companies we are investing in will continue their efforts to grow shareholder value with plans that stretch far beyond the incoming administration’s term.
Hopefully the last quarter of the year will be a continuation of the first three with anticipation of future growth outweighing concerns of near-term weakness. With inflation now seemingly under control, central banks stand ready to do what they can to limit the downturn of the business cycle. Long-term investors should be looking for politically-related selloffs as buying opportunities if they present themselves.
Your Plena Wealth Advisory Team