In our view, the capital market outlook for the rest of 2023 continues to be clouded by the worrisome levels of inflation, deteriorating corporate earnings, hawkish central banks, and ultimately how the economy digests the fastest interest rate increases in US history. There is simply too much debt, particularly government debt. As a result, there will be more stress on the economy as the higher interest rates on that debt become payable.
Although we could see a continuation of the relief rally in stocks over the next few months, we do not believe it is worth trying to time this rally in the short term due to the current high valuations and a potential recession within the following year.
Rising interest rates are a major concern, especially as they have increased at an unprecedented pace over the past year, with the Fed taking the policy rate from 0% to 4.75%. The recent troubles faced by banks, such as Silicon Valley Bank, Signature Bank, and Credit Suisse, are indicative of the broader problem that high rates have caused and may be a “canary in the coal mine.” Time will tell, but if history is a guide, one should not be surprised if other cracks appear in the system.
Before issues bubbled to the surface with the three banks mentioned, financial institutions were already tightening lending standards. They will become even more stringent now. Lending conditions lead commercial loan growth by about a year and are an excellent leading indicator of a recession. The first signs of credit tightness are now appearing, with bond defaults increasing, bank non-performing loans picking up, and high-yield bond spreads widening. This often leads to recessions as opposed to a “soft landing.”
Interestingly, despite these challenges not seen in years, the S&P500 is positive year-to-date and is off only 15% from its historical peak. The Fed and other central banks are expected to cut rates and rescue the markets at the first signs of trouble. This scenario has been referred to as the “Fed put” and the “don’t fight the Fed” mantra. Unfortunately, the market over the past 20 years or more believes that the “don’t fight the Fed” term only applies when economic softness occurs. They have forgotten that the term can also apply to other circumstances. The Fed has been quite open about its determination to subdue inflation. This means that monetary policy should remain hawkish until Central Banks truly get inflation under control. The problem today is that inflation remains sticky, with month-on-month US core PCE inflation still running above the Fed’s 3.5% year-end projection, never mind its 2% target. Until those reverse, we do not see the Fed coming to the market’s rescue anytime soon. Even if they do, it may be too late.
It is essential to recognize that the impact of monetary policy on economic activity takes time to work its way through the economy. On average, it takes ten months after the first rate cut before an easier policy brings a recession to an end. However, a cautious approach to public equities is warranted in the current challenging market environment: it takes approximately 12-18 months for the first-rate increase to impact the economy negatively – and that first-rate increase was in March 2022.
Regardless of the direction of the capital markets, Kinsted believes its clients will be more insulated, given the diversification of their portfolios. Public equities and bonds are no longer the only investments that makeup client portfolios. We have significantly diversified into private assets with higher risk-adjusted-return profiles, such as private equity, private credit, private infrastructure, private real estate, and agriculture. As a result, Kinsted clients will be more isolated from day-to-day volatility inherent in the public markets than most Canadian investors without sacrificing long-term returns.