Global conflicts rage unabated. Donald Trump was elected the 45th President of the United States—during his campaign he promised to spend lavishly and would likely run up national debt by trillions of dollars. Let’s see. In Canada, the all-important residential market faces an uncertain future, even as the Bank of Canada has cut rates. You might think this would all make investors worried. And yet, as the team at leading Canadian institutional investment management firm Canso Investment Counsel Ltd. points out in their latest Market Observer newsletter, stock and bond markets have been soaring. What’s behind the market’s enthusiasm for risk? Here is a summary of Canso’s analysis:
To read the full October 2024 Market Observer, click here.
From bad to worse
The Canso team began the most recent Market Observer by noting that in their previous newsletter, they had wondered how financial markets were moving ever upwards in price while so much bad news was mounting on the global stage. But through the third quarter, the current newsletter noted, “things have gotten much worse.”
As Russia updated its nuclear strategy, the war in Ukraine has showed no signs of abating. Nor has the conflict between Israel and Hamas, which in fact expanded to include Hezbollah in Lebanon and, to a still-uncertain extent, Iran. In the U.S., meanwhile, Donald Trump was elected the 45th President of the United States.
“Clearly,” the Canso team wrote, “there’s a lot to worry about if you want to worry, but the ‘Risk Markets’ continue to climb this veritable wall of worry, as bull markets frequently do.” They added, however, that this bull is behaving in an “abnormal” way.
Driven by mania for AI stocks, equity prices have risen in 2023 and 2024 despite the decline in 2022 as rates rose and inflation nagged. Meanwhile, the bond market, “drooling over Federal Reserve (Fed) rate cuts galore,” soared through much of the third quarter, as investors clung to their “dream outcome of back to almost zero interest rates on any weak economic data,” the newsletter noted. Of course, any positive real-world economic news is interpreted as negative for bond markets. The Canso team pointed out that after a stronger-than-expected September jobs report, U.S. bond yields shot up.
So, what’s going on? The Market Observer pointed to two factors. First, the U.S. economy is in pretty good shape. And second, “the huge increase in money supply during the pandemic … is still being thrown at investment opportunities.”
All of this is occurring while “political and social angst over the recent high inflation” continues in Canada and the States, where inflation and the economy remain top of mind, according to the Canso team. They lay the blame for that firmly at the feet of central bankers, who opened the money taps during the pandemic and then acted too late when prices began to soar. “Their hubris was rewarded by inflation soaring to the highest levels in 40 years,” noted the newsletter, adding that central bankers’ eventual success in curbing inflation has come at the cost of their reputations and well-kept public images.
“They did blow it,” the Canso team wrote, “in spectacular fashion.”
Canada’s mortgage unease
One of the casualties of monetary policymakers’ belated fight against inflation has been the Canadian residential housing market, which has outsized importance to the country’s overall economy. The Bank of Canada has been lowering rates, and now “the fervent hope of Canadian real estate agents, homeowners and politicians is … that lower mortgage rates will reignite the bonfire of the pandemic residential housing prices,” the Market Observer noted.
Canso thinks they might be disappointed.
The problem, the team wrote, “is that tomorrow’s mortgage rates might not be much different than today’s.” They pointed to the fact that the real yield on the five-year Canada bond—a useful indicator for fixed mortgage rates—is already hovering around the long-term historical average, even though it is “higher than the negative real yields during the Zero Interest Rate stupidity that followed the 2008 Credit and 2011 Euro-Debt crises,” the newsletter observed.
If the Bank of Canada brings short-term rates down towards three per cent, that means fixed mortgage rates may not have very far to fall going forward. And while the Canso team noted that variable mortgage rates would fall precipitously, they have doubts that Canadian homeowners have much appetite for variable after the experiences of the past three years. They also question the bond market’s hopes for more drastic cutting from the Bank of Canada “after the post pandemic inflation debacle.” Unless there is a severe recession, they added, “we don’t see the BOC taking short-term interest rates to the extremely negative levels of the Zero Interest Rate Policy period from 2011 to 2019.”
So, according to Canso, one potential scenario is very much in play for Canada: “a double whammy of a weakening housing-dependent economy and higher rates biting into disposable cash flow for consumers with mortgages.”
Partying like it’s 1999
And yet the financial markets keep on rolling. During the third quarter, U.S. stock indexes hit multiple record highs (through Oct. 21, the S&P 500 had notched 47 of them since the start of the year), and new bond issues were snatched up with glee. “Investors are desperate to put their money to work and not be left behind,” the team wrote, and “few professional forecasters … provide caution when their compensation depends on the continued irrational exuberance of their clients.”
How irrational? The Canso team, which previously raised concerns about private debt, pointed to a recent surge in “financial innovation”—high-risk products marketed directly to retail investors. Some of these, they noted, come in the form of derivatives-derived exchange traded funds (ETFs) and meme stocks promising outlandish returns. “The financial markets, as Estee Lauder used to say about cosmetics, are now selling dreams, not investment products,” the team wrote.
They added that market enthusiasm for risk is being driven by excess money in the economy, which is also giving working people’s pocketbooks a boost. Wage growth in both Canada and the U.S. seems to have settled in the four to five per cent range—well above pre-pandemic norms—and some unions have won far higher increases. For instance, Air Canada pilots recently received a wage increase of 26 per cent.
Meanwhile, the next president of the United States is likely to ensure that the money taps stay wide open, since both candidates have promised massive spending that would add trillions to the national debt. Notably, the Republican party, the newsletter remarked, has abandoned any semblance of fiscal conservatism, and Trump’s musings about interfering with U.S. Federal Reserve monetary policy and implementing across-the-board tariffs “would be very inflationary,” in Canso’s view. This situation “should scare bondholders,” the team wrote, “but they’ve been busy buying bonds to avoid missing the bond market rally as the Fed eases policy and lowers interest rates.”
Be fearful when others are brave
In this money-fueled atmosphere, where “nobody seems to care about deficits or inflation,” Canso’s approach is to proceed with caution. “Our rather simple take on things is that when nobody cares about risk, usually risk investments don’t pay enough to be attractive,” the team noted. Credit spreads are tight even on lower-grade bonds, and Canso suspects that the bond market rally is running out of steam. Barring a return to ultra-low rates, which the team thinks is unlikely, “we think investors will soon be regretting many of their current holdings,” they wrote.
They are also generally cautious this time of year and pointed to the autumnal market collapses of Black Monday in 1987 and the Credit Crisis of 2008. “Just when a good quarter has been booked,” the Market Observer concluded, “things can be very different in just a few weeks!”
This story was created by Canadian Family Offices’ commercial content division on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.