Middlefield Market Commentary
Marco Update
by Dean Orrico, President & CEO and Rob Lauzon, Managing Director & CIO
Equity markets continued to slide in September with the TSX Composite, MSCI World and S&P 500 Indices generating total returns of -3.3%, -4.3% and -4.8%, respectively. A sharp increase in bond yields drove stock markets, with U.S. 10-year treasury yields increasing nearly 50 basis points in September.
Although 10-year yields have risen to sixteen-year highs, they are still in-line with the 40-year average of 5%. Markets are adjusting to a more typical rate structure as we exit the extremely low interest rate environment of the past decade. We are not overly concerned by the current level of yields, as equity markets have historically produced good returns in similar rate environments. What is striking is the velocity at which rates have moved higher over the past two years, and the speed at which markets have had to recalibrate their cost of capital assumptions.
Much debate is taking place as to why bond yields have moved higher in recent weeks. Normally, moves in yields are tied to monetary policy and market expectations concerning central bank rate-setting moves. Instead, the narrative has shifted towards fiscal policy and the supply/demand mismatch for sovereign debt. The concern is that escalating federal budget deficits will require more government borrowing thereby creating a supply of bonds exceeding demand. As a result, higher yields are required for investors to absorb the increased supply of bonds.
While concerns about government deficits have been raised for years, it appears that “Bond Vigilantes”, a term coined by Ed Yardeni in the 1980s, are sending a signal to the market that the situation is becoming untenable. The amount of total public debt outstanding in the U.S. has doubled to $33.4 trillion over the past ten years and, as of August 2023, it costs over $800 billion per year to service that debt.
While Bond Vigilantes may have driven the Treasury market in recent weeks, and fiscal spending concerns are warranted, we maintain the view that monetary policy will ultimately determine the path forward for rates and equity markets. We are optimistic that inflation will continue trending lower in the US, especially with shelter costs decelerating. Economic indicators tied to the health of the consumer have started to deteriorate as credit card delinquencies rise while intentions to travel have decreased as indicated by the recent sales on Disney Park vacations. While we acknowledge that the economy is starting to show signs of slowing, these developments match our base case of a soft landing in the US. This, in turn, should allow the Federal Reserve to soften its hawkish stance. Indeed, we believe the Fed may be done with rate hikes altogether supported by the fact that the bond market is pricing in only a 30% chance of a hike (as of October 6th) at the upcoming November 1st meeting.
Much of the interest rate risk in the market has been priced in, and we see an attractive entry point for multiple sectors. Rate-sensitive businesses, such as real estate and utilities, are currently screening as deeply oversold and are positioned for a near-term rally. The S&P 500 has declined 8% since its July 31st high leaving it right around its 200-day moving average. Over the same period, its forward price-to-earnings multiple has declined from 20x to 18x, which is below its 5-year average of 19x. We view the recent pullback as a healthy correction within a broader bull market and are optimistic for a strong finish to 2023. Considering the growing body of evidence that suggests the economy is beginning to slow, we favour companies that possess defensive growth attributes – high free cash flow, low capital expenditures and strong balance sheets.
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