Aug 2, 2023
In this Episode, James Parkyn & François Doyon La Rochelle review the Market Statistics as of June 30,2023 and update their listeners on Inflation.
Market Statistics – June 2023 : Market Statistics - Statistiques de marché (pwlcapital.com)
Read The Script:
François Doyon La Rochelle:
You’re listening to Capital Topics, episode #55!
This is a monthly podcast about passive asset management and financial and tax planning ideas for the long-term investor.
Your hosts for this podcast are James Parkyn and me François Doyon La Rochelle, both portfolio managers with PWL Capital.
In this episode, we will discuss the following points:
- For our first topic, we will review and comment the market statistics for the first half of the year.
- And for our next topic, we will give you an update on inflation.
- Please note before we move on to our topics that we will take a summer break. We will be back for our next episode on September 28th.
2) Mid-Year Review of Markets:
François Doyon La Rochelle: I will start today with a review of the market statistics as of June 30, 2023. So, after a very difficult year in 2022 when pretty much all asset classes posted big losses, I’m sure our listeners will be relieved and happy to hear that in the first half of 2023 stocks and bonds are generating positive returns. These positive returns are across the board as all the asset classes we follow, except for one, are in positive territory. As a reminder, you can find our Market Statistics report on our Capital Topics website in the resources section or on the PWL Capital website in our team section. We will provide the link for the market stats on the podcast page.
James Parkyn: Indeed François, after the historical devastation where both stocks and bonds were hammered with double-digit negative returns, investors should be quite pleased with the returns so far this year.
François Doyon La Rochelle: Totally James, particularly given the fact that most market pundits were skeptical about the outlook for markets entering the year. Many of them were forecasting a recession that has not yet materialized.
James Parkyn: Correct it has not materialized yet, GDP growth continues to be positive, personal consumption remains stubbornly strong and jobs are still being created at a strong pace both here in Canada and the U.S. Market Pundits are however expecting GDP growth to slow and even contract in the coming months on the back of the historic interest rate tightening cycle imposed by the central banks. As a reminder to our listeners, to tame inflation that had risen to multi decades highs last year - 8.1% here in Canada and 9.1% in the U.S., the Bank of Canada increased its overnight rate from 0.25% in March 2022 to 5% in July 2023. In the U.S., the Federal Reserve increased the Fed fund rates from 0.25% to 5.25% over the same period.
François Doyon La Rochelle: I must say that this tightening cycle had the desired effect on inflation since it has come down here in Canada and the U.S. to 2.8% and 3% respectively which is close to the long-term target of 2% set by both central banks. This said, the tightening cycle caused collateral damages particularly in the U.S. regional banks as the sharp interest rate increases left some banks in delicate positions prompting the intervention of the Federal Reserve.
James Parkyn: Regional banks were not the only worry for the markets in the first half of the year, there was, yet another debt ceiling political crisis in the U.S. that dominated the headlines for several weeks until an agreement to raise the debt limit was reached in June.
François Doyon La Rochelle: Despite all this noise, the stock markets have had a strong first half, particularly in the U.S. and the internationally developed markets. Those equities are now in the bull market territory and have risen more than 20% from the lows reached in October 2022. We will look at the details a bit later, but the S&P500 Index in the U.S. is up, in U.S. dollars, by 27.5% since the lows, and the index for internationally developed equities, the MSCI EAFE (Which is the acronym of Europe, Asia and the Far East) is up roughly 32.8% since the lows. Here in Canada, we are not yet in a bull market since the S&P/TSX Composite is up only 12.8% from October’s 2022 lows.
James Parkyn: This may be surprising for some investors who are still emotionally caught up in the recency bias of last year. Capital market history teaches us that strong bull markets most often follow painful bear markets.
François Doyon La Rochelle: Absolutely James and there is a good chart from Dimensional in their mid-year review that shows, based on data from the Fama/French Total US Market Index extending from July 1926 to December 2022, that historically, after a market decline of 20% or more, the average return one year later is 22.2%, the cumulative average return after 3 years is 41.1% and the cumulative average return after 5 years is 71.8%.
James Parkyn: Yes, this data is very powerful as it is a stark reminder that you need to stay disciplined in bear markets by staying invested and sticking to your long-term plan. You can’t afford to be out of the market when it turns positive.
François Doyon La Rochelle: Despite this nice rally from last year’s bottom, it must be mentioned that the main indexes have not fully recovered to where they were at their all-time highs.
James Parkyn: Effectively, the S&P500, the MSCI EAFE, and the S&P/TSX Composite are still between 5% to 7% off their previous peaks as of June 30th.
François Doyon La Rochelle: With this being said let’s now look at the market statistics as of June 30th. Let’s start with the Canadian fixed income. 2022 was a historically difficult year for bonds as it was the worst year in many decades. Canadian short-term bonds in 2022 were down 4.04% and the total bond market, which holds longer-dated maturities was down by a whopping 11.7%. Year-to-date as of June 30th, despite an increase in the interest rate of 1% by the Bank of Canada, the Canadian short-term bonds are up 1.01% and the Canadian total bond market is up 2.51%.
James Parkyn: It’s nice to see positive numbers in the bond market again, however, the performance you are quoting Francois is total return numbers, which includes interest income. If we look at bond prices, remember bond yields and bond prices move in opposite directions, short-term bonds on a price basis were down slightly. Longer-duration bond prices were up a bit.
François Doyon La Rochelle: You are right James, bond prices are down but especially in the short end because of the impact of the latest interest rate increases from the BOC. As an indication the yield on the benchmark Government of Canada 2-year bond was 3.82% at the beginning of the year and it now sits at 4.21%, so the price went down. The yield on the Government of Canada 10-year bond was 3.30% at the start of the year and it was 3.26% on June 30th, so the price went up.
James Parkyn: For those looking for the safety of GICs, there are some juicy rates available now. For example, you can get over 5.5% for a 1-year GIC and about 5.2% for a 5-year.
François Doyon La Rochelle: Now let’s look at equities, stock markets around the globe were up everywhere year-to-date. Canadian equities were up by 5.70% led mainly by growth stocks since the large and mid-cap growth stocks had a performance of 8.1% versus 4.0% for large and mid-cap value stocks. Small-cap stocks also delivered a positive return with a performance of 3.0% year-to-date as of June 30th. In the U.S., the total stock market is up 16.2% in USD but because the Canadian dollar gained relative to the US dollar the performance in Canadian dollars was 13.5%. Year-to-date, large and mid-cap growth stocks vastly outperformed value stocks with a performance in Canadian dollars of 26% versus only 2.7% for value stocks. Small cap returned 5.6% in Canadian dollars with small growth again outperforming value with a performance of 10.9% versus 0.1% for small value.
James Parkyn: This is a complete reversal of what happened last year when large and mid-cap growth stocks were down significantly more than large and mid-cap value stocks. What is significant this year, is that a handful of mega-cap stocks are dominating the returns in the U.S. stock market. According to Morningstar, as of May 31st, 97% of the return on the Morningstar U.S. Large and Mid-Cap Index, which performs closely with the S&P500 Index, came from the 10 largest stocks in the index. This means that only 3% of the return came from all the over 700 stocks.
François Doyon La Rochelle: Yes, year-to-date performance in the U.S. market is very concentrated in a few stocks and a few sectors. Just looking at the top 5 holdings of the S&P500, which includes Apple, Microsoft, Amazon, NVIDIA, and Alphabet (Google) they have a performance year-to-date as of June 30th ranging from positive 36% for Alphabet to a whopping 189% for NVIDIA. In terms of sectors, 4 out of 7 sectors are experiencing negative returns in the first half. The sectors that are performing well are the technology, communication services, and consumer discretionary sectors. According to an RBC Global Asset Management report, since January 1st, 2020, only seven stocks in the S&P500 Index have produced more than half its cumulative return and these stocks are Meta, Apple, Alphabet, Microsoft, Amazon, NVIDIA and Tesla.
James Parkyn: Wow, this is impressive, but it means that if you are a stock picker and you did not hold any of these stocks in your portfolio you probably did poorly compared to the index. Remember there are thousands of stocks in the U.S. market and even more globally and research shows that most stocks, over very long periods, underperform one-month U.S. Treasury bills. This capital market history fact comes as a major surprise to most investors.
François Doyon La Rochelle: That’s correct and that’s one of the reasons why stock pickers have trouble beating indexes and why we use broadly diversified portfolios to make sure we have the winners in our clients’ accounts.
Finally, looking at internationally developed equities, large and mid-cap stocks were also up year-to-date, they were up by 12.1% in local currency. In Canadian dollars, international developed equities were up 9.1% since the Canadian Dollar appreciated against the basket of currencies included in the MSCI EAFE Index. Here again, large and mid-cap growth stocks have outperformed value stocks with a performance of 11.5% in Canadian dollars compared to 6.7% for large and mid-cap value stocks. Similarly, in the U.S. and Canada, the small-cap stocks trailed large and mid-caps with a performance of 3.1%, that’s also in Canadian dollars.
To conclude, emerging markets lagged compared to developed markets with a year-to-date performance of 2.6%, and contrary to developed markets' value and small-cap stocks fared better than growth and large-cap stocks.
So this wraps up the review of what happened in the Markets during the first half of the year.
3) Update on Inflation:
Francois Doyon La Rochelle: Our Main Topic today is an Update on Inflation. We have covered Inflation a lot since the spring of 2022. James, maybe we can start with a summary of where are we at now with Inflation Rates?
James Parkyn: Francois, Inflation cooled last month to its lowest pace in two years. As indicated earlier in the podcast, in the U.S., the consumer-price index or CPI climbed 3% in June from a year earlier, sharply below the recent peak of 9.1% in June 2022. The index for core inflation, which excludes volatile food and energy prices, in June also posted its smallest monthly increase in more than two years. The annual rate of inflation is now at the lowest it has been in just over two years. While the rate of inflation in the June CPI report remains above where the Fed wants it to be, the data suggests clear progress in getting price pressures down toward more acceptable levels.
François Doyon La Rochelle: In Canada, the news was even better. The latest Inflation number came in at 2.8% in June. What about Europe and the UK James?
James Parkyn: In Europe, inflation has eased to 5.5% in the 20 countries using the euro and to 7.9% in the U.K., but that’s still far above the Central Banks’ 2% target.
François Doyon La Rochelle: Does there appear to be a consensus among economists? Can Central Banks declare victory over Inflation?
James Parkyn: Nick Timaros in the WSJ reported in a recent article that: “Some Fed policymakers and economists are concerned that the easing in inflation will be temporary. They see inflation’s slowdown as long overdue after the fading of pandemic-related shocks that pushed up rents and the prices of transportation and cars. And they worry underlying price pressures could persist, requiring the Fed to lift rates higher and hold them there for longer.” So their biggest fear François is about whether wages and price growth can slow enough without an economic downturn.
François Doyon La Rochelle: Karen Dynan, an economist at Harvard University is quoted in that article. She states, “While things seem to be heading in the right direction with inflation, we are only at the start of a long process”. So, James, what are economists on the other side of the debate saying?
James Parkyn: Nick Timaros goes on to state: “Other economists say that thinking ignores signs of current economic slowing that will gradually subdue price pressures. They also argue inflation will slow enough to push “real” or inflation-adjusted interest rates higher in the coming months. That would provide additional monetary restraint even if this week’s rate increase is the last of the current tightening cycle”.
François Doyon La Rochelle: So, the debate is really around wage inflation. The first camp of economists is nervous that there is too little slack and too much demand in the economy. They are not confident that inflation will return to the Fed’s 2% inflation target in the coming years.
James Parkyn: Exactly. Many of these economists worry that wage growth is too strong. Without a recession, they see a tight labor market pushing up core inflation next year. Since an overheated labor market is likely to show up first in wages, many see pay gains as a good proxy of underlying inflation pressure. The thinking is that 3.5% annual wage growth would be consistent with inflation between 2% and 2.5%, assuming productivity grows around 1% to 1.5% a year.
François Doyon La Rochelle: According to the U.S Labor Department’s employment-cost index, wages and salaries rose 5% in the January-to-March period from a year earlier. The Fed watches this index closely because it is the most comprehensive measure of wage growth.
James Parkyn: The second camp of economists believes there is ample evidence that the labor market is cooling, in turn reducing inflationary pressures. They point out that the amount of time it takes unemployed workers to find new work has been growing. Increases in hours worked by private-sector employees have slowed along with the number of unfilled jobs. Benjamin Tal, the deputy chief economist at CIBC World Markets, is quoted in the Global Mail that: “He expects the economy to be bleeding vacancies as opposed to jobs. Namely, companies will not be hiring but not be firing.”
François Doyon La Rochelle: The encouraging news about inflation falling is that it has created space for the Central banks to be more patient and take their time about any further rate hikes.
James Parkyn: To support that point François, the Fed in the U.S. last month held its benchmark federal funds rate steady in a range between 5% and 5.25%. This was the first pause after 10 consecutive increases since March 2022, when officials raised it from near zero. As a reminder for our audience, the conventional thinking is that Interest-rate increases slow the economy through financial markets by lowering asset prices and raising the cost of borrowing. As we can see by what has happened in the financial markets and the economy, this has yet to transpire.
François Doyon La Rochelle: On July 27th, the Fed increased the Fed Funds rate by 25 Basis points to a target range between 5.25% and 5.50%. This was widely expected by the markets. This matches the prior peak reached over 2006-07. You’d have to go back to 2001 to find a period when rates were higher than today. The speed and size of the hikes (over 500 basis points in 16 months) are unmatched by any Fed tightening campaign since 1980. That said, CPI inflation is getting close to the Fed’s 2% target. What are Central Bankers saying about the latest inflation numbers James?
James Parkyn: They are all staying on message insisting the pain will only get worse if inflation slips out of control. The governor of the Bank of England Andrew Bailey was quoted in the Financial Times: “Our job is to return inflation to target, and we will do what is necessary. I understand the concerns that go with that, but I’m afraid I always have to say – that it is a worse outcome if we don’t get inflation back to target.” Despite the risk of recession François, I feel the central bankers are emphasizing that they expect to keep rates at their peaks for some time – likely longer than stock and bond markets expect. They also appear to me to be very synchronized.
François Doyon La Rochelle: I agree James. The Bank for International Settlements (or BIS), the Switzerland-based global organization of central banks appears to agree as well. In a recent report, the BIS highlighted that since early 2021, almost 95% of the world’s central banks have raised rates. Even more than during the inflationary oil price shocks of the 1970s. The BIS called it “the most synchronized and intense monetary policy tightening in decades.”
James Parkyn: I think there is increasing acknowledgment that Policy mistakes were made during the Pandemic. That in turn requires that interest rates be normalized at much higher levels than the ultra-low rates in effect during the pandemic.
François Doyon La Rochelle: James, what are economists saying about the impact of fiscal policy or government spending on Inflation?
James Parkyn: David Parkinson writing in the Globe & Mail recently, asked the following question: “How much of Canada’s nagging inflation problem can we blame on government spending?” In his article in the wake of the Bank of Canada’s latest interest-rate increase, he highlights the fact Governor Tiff Macklem noted in the bank’s latest economic projections, government spending growth is running at about two percent. This is on par with the estimated rate that the economy’s potential output is growing. This implies that the government’s contribution to the economy’s supply-demand balance is neutral. In other words, it’s not helping the excess demand problem that continues to fuel inflation pressures, but it’s not compounding the problem, either. But he also goes on to make the case that if you compare government spending to pre-pandemic levels, fiscal policy is stimulative.
François Doyon La Rochelle: Intuitively, governments could also help fight inflation by reducing deficit-funded spending to cut demand. This would lower the pressure on Central Banks to raise interest rates further.
James Parkyn: To that point Francois, Gita Gopinath deputy executive director of the International Monetary Fund, in a speech at the European Central Bank’s (ECB) annual conference in Sintra, Portugal, last month argued “Some side effects of fighting inflation with monetary policy could be reduced by giving fiscal policy a bigger role. Indeed, economic conditions call for fiscal tightening,” She went on to say: “Given the economic conditions we have, both because of high inflation and record high debt levels, the two would call for a tightening of fiscal policy. If you look at projected fiscal deficits for many G7 countries, they look too high for far too long.”
François Doyon La Rochelle: She also warned and I quote her: “Central banks must accept the “uncomfortable truth” that they may have to tolerate a longer period of inflation above their 2 percent target to avert a financial crisis.” James, is there good news for Investors with lower Inflation?
James Parkyn: Yes, I believe there is good news for Investors in rates staying higher for longer. I also think that the real news is that we are now starting to get positive Real Interest rates. Finally, many Economists are forecasting lower Central Bank rates as early as 2024 and as far out as 2025. Morningstar chief economist Preston Caldwell stated in a recent report that “Inflation is now showing broad-based signs of deceleration,” says “The Fed is still likely to hike in its July meeting, but today’s CPI Inflation report supports our view that the Fed will pivot to aggressive cutting in 2024 after inflation falls.” François, we now know that the Fed effectively increased their Fed funds rate after July’s meeting.
François Doyon La Rochelle: For investors who have been avoiding fixed income because they’re afraid of rising rates, now is the time to revisit their fixed income portfolio. Investors are getting compensated on a real basis, meaning after inflation, from their bond investments, and that hasn’t been the case for quite some time.
James Parkyn: The perfect example is we are now getting much better rates on GICs. Recently, the GIC rates were 5.5% for 1 year, and about 5.2% for 5 years. These rates are significantly higher than our Estimate for Expected Return on Bonds of 4.26%. Our listeners can find our latest PWL Financial Planning Assumptions paper published on our PWL Website. Despite rising bond prices generally, yields are now higher than they have been for most of the past decade.
François Doyon La Rochelle: Right now, you’re getting a good income out of a fixed income. Rates look attractive. On a “real” basis, rates also look attractive when compared to inflation expectations for the coming years. For example, the PWL estimate for inflation is 2.2% a year, meanwhile, an investor buying a 5-year GIC, like you mentioned James, would get 5.2% or a real yield of 3%.
James Parkyn: In Conclusion Francois, the key for Investors is that even if the Fed raises rates a bit further, the end of the current cycle of increases is on the horizon unless there is a dramatic resurgence in inflation. As we have said many times, we do not preach market timing about stocks AND bonds. Specifically for bonds, don’t try to time the peak in interest rates.
I want to share with our listeners an interesting quote from Dimensional in their Mid-year Review report: “What investors do know is that markets will continue to quickly process information as it becomes available. A long-term plan, one focused on individual goals and built on confidence in market prices, can put investors in the best place for a good experience, whatever may be in store”.
François Doyon La Rochelle: In other words, James, don’t try to guess the end of the hiking cycle. As a reminder to our Listeners, our discipline is to invest with “The Investor Mindset, focused on the long term”. We don’t want to be led astray by short-term noise in the financial media and recent financial market volatility. This challenge is daunting and applies to all Investors including us Professionals. We have said it often on our Podcast: “It is simple to say but not easy to do: We must always be cognizant that we can fall into a trap of trying to “Forecast the Future”.
François Doyon La Rochelle: Thank you, James Parkyn for sharing your expertise and your knowledge.
James Parkyn: You are welcome, Francois.
François Doyon La Rochelle: That’s it for episode #55 of Capital Topics!
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Enjoy your summer and see you soon!