Canso releases its Market Observer for January
Investors are becoming more optimistic, but there’s plenty of reason for caution
Article content
Financial markets ended 2023 with a strong rally in both bonds and equities. But will the good times keep rolling in 2024? In their January 2024 Market Observer newsletter, the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. look at investor optimism over inflation, interest rates and A.I. – and find plenty of reason for caution.
Click here for the full Market Observer.
—
Markets ended 2023 in a state of euphoria, confidently digging their rose-coloured glasses out of storage amid widely expected rate cuts in 2024. Yet, any investors inclined to question the current wave of optimism need to look no further than 2023 — when markets proved themselves anything but reliable forecasters. As the Canso team remarked in their most recent newsletter, “Investor psychology and even human physiology means that there’s no wisdom in investment crowd behaviour.”
Remember that at the start of 2023, financial markets were in the doldrums as investors, market-watchers and economists were pretty much convinced that a recession was looming. Yet the recession never came. And when officials from the U.S. Federal Reserve hit pause on interest rate increases in June and then in the autumn started talking up possible rate cuts in 2024, bonds staged a remarkable rally, sending yields down. Equity markets also surged. The Canso newsletter succinctly put it this way: “Go figure.”
The thing about momentum is that there’s no point in fighting it. “When there’s a lot of money being made, traders are biologically on a testosterone fueled bender and assume massive risks,” the Canso team wrote. A case in point: the market fervor for anything smacking of artificial intelligence, despite the reality that cash flows for A.I.-related companies are still “unknown and indeterminant.” In Canso’s view, the A.I. craze is clearly a bubble that “will not end well” — it is “pure and utter momentum investing. Enjoy it while it lasts.”
It wasn’t just investors who managed to end 2023 on a winning note, however unsustainable those gains may prove to be. The newsletter noted that amid persistent inflation, workers demanded higher wages and largely got them. In fact, wage growth outpaced inflation and workers’ standard of living rose for the first time in years.
The roots of error
This is a long way from the recession so many economists predicted. How could they have been so wrong? To the Canso team, the unpredictability that marked 2023 — even if it ended to the upside — has its roots in central bank policy, in particular the massive amount of money policymakers created during the pandemic. The experience of the pre-pandemic years, when central bankers expanded money supply without sparking inflation, led them to believe that they could print any amount of money without consequences. “In a generation,” the team wrote, “central bankers went from the monetarist orthodoxy of ‘Only Money Matters’ to believing that money supply didn’t matter anymore.” Of course, they were proven wrong. ZIRP (zero interest rate policy) and massive bond buying programs by central banks (even of junk bonds), at levels that far exceeded those seen during the financial crisis of 2008-09, finally had the inevitable effect and “eventually ended up as an inflationary shock,” the newsletter noted.
But what economists might not have fully accounted for is the lag effect of monetary policy moves. It took several months before unprecedented increases in M2 money supply created a surge in inflation; it is also taking longer than expected for all that stimulus to dissipate. In other words, it was still propping up the economy in 2023, which explains why recession prognosticators were wrong. The “differences in the timing of monetary expansion and the lag in inflation/CPI have confounded central bankers and the market alike,” the Canso team wrote.
Expecting a miracle
By January, the rally in the bond market had reversed the yield rises that occurred in 2023. Clearly, investors were expecting central bankers to relent on further rate hikes. But the Canso team noted that a key question remains: Is the war on inflation won?
Maybe not. As the newsletter noted, the Break Even Spread (BES) – the difference between nominal Canada government bonds and inflation — adjusted Real Return Bonds (RRBs) — ended 2023 below 2 per cent, about where it was before the pandemic. “That suggests that current bond market consensus believes that inflation is under control and … at or below the 2 per cent target,” the Canso team wrote. As a result, “there are few calling for caution in the bond market after the powerful rally we’ve just seen.”
But perhaps caution is warranted, in Canso’s view. The team pointed out that the current long Canada bonds’ real yield — the difference between yield and experienced inflation — stood at a mere 0.3 per cent. That suggests investors expect “an immediate drop to 2 per cent inflation.” Yet inflation seems to have levelled out at around 3 per cent, and average hourly wages have risen by well more than 4 per cent. The newsletter also remarked that it’s unreasonable to expect deflation in 2024 to rival the extreme price contraction seen in the wake of the 2008-09 financial crisis — when long Canada bond yields were higher than they are now.
In Canso’s view, that makes long government bonds look expensive, particularly if inflation and interest rates revert back to the levels of the pre-ZIRP era. In short, the team argued, “enthusiasm for low inflation should be tempered.”
Treading carefully
That note of caution extends to the corporate bond market. Bond investor optimism over an expected central bank course reversal and fear of missing out drove “a huge rally in credit spreads” at the end of 2023, the newsletter noted. That has made the team wary that corporate yields are not providing enough compensation for risk and “the scramble to ‘get invested’ has resulted in too much narrowing of credit spreads.”
It’s a similar story in high-yield bonds. Tight spreads during the easy money period of 2011 to 2019 might have been acceptable, as “easy financing terms and low yields kept a lot of dodgy companies afloat,” but corporate defaults have been creeping up in the higher-rate post-pandemic period. “Recently, we have seen lower credit spreads with higher defaults in speculative issuers,” the Canso team wrote. “That suggests a lack of caution from investors.”
As welcome as the rally in bonds and equities might have been for investors, it might turn out to be a red flag. For its part, Canso is focusing on improving portfolio quality and is sitting firmly on the sidelines of the current financial market mania. After all, “few forecasters believed the economy would escape recession in 2023 and absolutely nobody predicted the massive rally in equity markets.” Now, momentum has turned up and almost no one is predicting a recession or a bad year for financial markets. “And that,” the Canso team wrote, “has got us worried.”
This story was created by Content Works, Postmedia’s commercial content division, on behalf of Canso Investment Counsel Ltd. which is a member and content provider of this publication.