Housing IS the Business Cycle – September 2007 NBER Working Paper

Central banks are beginning to restart and accelerate their monetary tightening cycles. The Bank of Canada (BoC) surprised markets by increasing interest rates by another 25 basis points (bps) in June. In the BoC’s Summary of Deliberations, there was a robust debate on the reasons behind the unusually resilient consumer spending. The Governing Council discussed the role of excess savings, strong job and population growth and even statistical factors such as seasonal adjustments.

It is worth noting that a 2007 paper from the National Bureau of Economic Research (NBER) suggests that residential investment is the best early indicator of an impending recession. If this still holds true, then it would appear that we are currently in a recovery phase rather than experiencing stagnation. Home resales saw a consistent increase for four consecutive months to May, with home sales transactions up 1.4% from a year ago. This marks the first time since mid-2021 that home sales have shown positive annual growth. The increase is observed across various regions in Canada, with more than 75% of local markets experiencing growth compared to last year.

One of the contributing factors to this trend is the limited housing supply. New listings have declined by 13.6% over the past year and remain around 16% below the pre-COVID average. As a result, current market conditions favour sellers (see Chart 1). Many households seem hesitant to list their homes due to concerns about potential price decreases since their purchase, the inability to port a low-rate mortgage or the availability of rental properties in a strong rental market. Overall, this is a remarkable outcome, especially considering the nearly 4 percentage point increase in the posted 5-year mortgage rate. It seems housing, like the economy, is unusually resilient.

Chart 1: Low number of listings imply a return to sellers market

Source: CREA, Macrobond

In this respect, Canada is not unique. House prices in other global developed markets such as Australia, the US and South Korea, are also seeing a stabilization in house prices. This can be attributed to strong household finances and a structural preference for more living space as many continue to work from home. Thus, central banks are engaged in crucial debates surrounding the all-important question.

Are interest rates sufficiently high?

Canada’s economy has a particularly high proportion of sectors sensitive to interest rates, about 25% versus 21% in the US (see Chart 2), primarily due to the housing sector’s importance in Canada (see Chart 3). In addition to the global factors noted above, Canada has a number of unique factors that further bolster housing activity.

Chart 2: Canada has higher share of rate sensitive sectors vs. the US…

Source: NBF Economics and Strategy

Chart 3: …and relative to other countries

Source: OECD, Macrobond

Firstly, population growth has been consistently strong for the past three years, supported by immigration and an increase in non-permanent residents attending school or working on visas. Moreover, borrowers have been extending mortgage amortizations to delay the impact of higher interest payments that accompany rate increases. Even so, interest servicing costs have risen to historic highs, accounting for 15% of personal disposable income (see Chart 4). In its latest Financial System Review, the BoC noted that over a third of mortgages had already been reset or affected by higher interest rates as of May this year. Looking ahead, its modeling shows that this figure will rise to 47% by the end of this year. Furthermore, due to the influx of homebuyers during the pandemic, this will apply to nearly everyone between 2025 and 2027 (see Chart 5).

Chart 4: Canadian debt servicing costs are back at their highs

Source: StatCan, Federal Reserve, Macrobond

Chart 5: Nearly all mortgage payments will increase over the next 3 years

Source: BoC

Consequently, debt service costs are almost certain to rise for the 35% of households that own their home and have mortgages.

While the adjustments will undoubtedly be challenging, we believe the worst outcomes are likely to be avoided. Homeowners will have built some equity and household net worth has surged to $15.7 trillion, a 27% increase since the end of 2019 (see Chart 6). As a result, debt levels as a proportion of assets remain manageable (see Chart 7). Indeed, new mortgages were stress-tested to ensure affordability with mortgage rates near current levels of 5%. The excess savings that emerged from limited spending and extensive fiscal support during the pandemic were substantial. Although diminishing, excess savings are estimated to be around $25 billion, with a significant portion redirected into term deposits and other assets like equities. Perhaps most fundamentally, both employment and real household incomes have grown materially, by about 5% since 2020.

Chart 6: Household net worth has surged

Source: StatCan, Macrobond

Chart 7: Debt levels are high, but asset values have also grown

Source: StatCan, Macrobond

However, the Canadian household sector diverges starkly from the US. While high housing demand has led to a similar increase in housing starts, household balance sheets differ. Effective mortgage rates paid by US households have remained relatively flat due to the prevalence of 30-year fixed-term mortgages, leading to lower debt and debt servicing costs (see Chart 4 again). Nevertheless, a short-term risk arises from the recent Supreme Court decision to reverse student loan forgiveness, implying that this cohort of consumers will face resumed loan repayments. A recent survey indicated that 40% of respondents were unaware of this ruling and unprepared to resume payments. Estimates suggest that interest on student loans amounts to between $64 billion and $96 billion annually, which would reduce total after-tax incomes by approximately half a percent.

The stability of housing markets has been remarkable, defying the conventional wisdom that a more indebted country like Canada would be more vulnerable to higher interest rates. While savings, employment, asset values and immigration demand have all supported the real estate market to date, they will not fully offset the impact of rising debt servicing costs as excess savings dwindle. We still believe a recession still lies ahead, with the potential silver lining that the BoC may have less work to do going forward.

Capital markets

Following a strong and volatile first quarter in asset markets, the second quarter was calmer. Market enthusiasm seen in the first half of the year reflects the view that economic activity will be sustained as inflation eases. Resilient economic data played a role in supporting corporate earnings. Notably, asset value gains became more narrowly-driven by specific themes, particularly the growing enthusiasm in artificial intelligence (see June Outlook). This resulted in market leadership being centred on large-cap technology stocks, which significantly outperformed the broader equity market. Thus, while the S&P 500 Index rose by 8.7% in Q2, the tech sector accounted for the majority of this gain, surging by 17.2%. On the other hand, the Canadian equity market lagged its global counterparts due to its relatively limited exposure to technology companies. Still, cyclical stocks, such as consumer discretionary, industrials and financials outperformed defensive sectors. Indeed, the breadth of the equity rally has been better in Canada this year, as the S&P/TSX outperformed the S&P 500 in six of the eleven major GICS sectors year-to-date. Commodities were largely flat, but oil prices were down for the second consecutive quarter.

Global fixed-income markets were caught off guard as central banks resumed or accelerated rate hikes in response to resilient economic activity and persistently high inflation. The BoC raised its target overnight rate by 25 bps to 4.75%, and both the BoC and the Federal Reserve indicated that rate hikes were not yet over. Bond yields increased significantly in the second quarter, led by shorter-term yields, resulting in yield curve inversions reaching levels not seen since 1990. Even with tighter credit spreads that were helped by low supply and strong demand, the FTSE Canada Universe Bond Index fell -0.69% in the second quarter.

Portfolio strategy

While the cyclicality of housing lends itself well to predicting economic cycles, various financial flows and consumer preferences have prevented housing markets from experiencing the full effects of higher interest rates, which has posed a challenge for central banks. Indeed, Canada’s economic resilience is particularly noteworthy considering high household debt levels. However, the link between higher rates and an economic slowdown, although delayed, is unlikely to be eliminated. Historical trends show that unemployment rates tend to remain low until the onset of a recession and even a 0.5 percentage point increase can trigger a recession. The renewed efforts by central banks to further raise rates at this stage of the tightening cycle, while suggesting the need for sustained high rates, increase the risk of a hard landing. 

As a result, we anticipate declining profit margins as wages continue to add pressure and pricing power diminishes. Consequently, we maintain a cautious outlook for equities and expect weaker earnings in the upcoming quarters. In Canadian equity portfolios, we favour companies that are likely to consistently deliver earnings in a low-growth environment. At the same time, we continue to search for companies whose valuations reflect the anticipated slowdown or align with our secular themes, such as rising business capital expenditure. The latter includes companies involved in rebuilding supply chains and advancing the transition to green energy sources.

In fixed income portfolios, we have started to position for a broader steepening of the yield curve while maintaining an underweight exposure to credit. Both of these positions should benefit portfolios as we approach a recession. Our balanced portfolios remain underweight equities and fixed income, with a preference for cash. While the economic stability has been welcomed, market optimism suggests that it will continue. In our view, the downside risks are gathering pace.

An Apple (plus FAMNNGT*) a day keeps the doctor away.   

Recession talk has given way to discussions on the resilience of economies and the reasons behind it. The reasons include excess household savings, companies holding on to workers, reduced labour market friction with the ability to source skilled workers remotely and still obliging fiscal support. Equity markets, especially in the US, have broadly cheered the economic stability. As growth defies expectations, the S&P 500 Index has risen 11% year-to-date (YTD), which lags the even more buoyant European and Japanese equity markets. The upbeat sentiment was helped, at least until mid-May, by interest rates that took a breather to start the second quarter following a turbulent first quarter. This equity market resilience has come despite the counterpart to economic strength: inflation. Both the US core PCE Deflator and the Federal Reserve’s (the Fed’s) “supercore” measure, which follows underlying services prices excluding shelter costs, are struggling to fall below 4.5% year-on-year.

The equity market enthusiasm has been supported by strong fundamentals compounded by a new bullish narrative surrounding anything related to artificial intelligence (AI). Indeed, there has been a rotation in market leadership since early in the year from energy, materials, financials and industrials to the technology juggernaut. To be sure, our fundamental outlook is supportive of the significant opportunities arising from AI-induced productivity enhancements. It is also aligned with our secular theme of the coming capital spending boost, that to date had encompassed building resilient and redundant supply chains, alongside greening of energy sources and now investments incorporating AI.

More recently however, equity market leadership has become extremely narrow. One way to see this is in the performance of the S&P 500, where constituent weights float with the market capitalization. The S&P 500 is up 10% YTD as of the end of May. However, when each company in the Index is given equal weight, the Index has slightly negative performance for the same period, creating a gap of a hefty 10 percentage points (see Chart 1). Another way to illustrate this is by splitting the S&P 500 into the top eight performers and the remaining 492 companies (see Chart 2). The market value of these eight megacap tech stocks as a share of the Index has surged from 22% in January to 30% in June.  

Chart 1: Largest capitalization stocks driving gains
Indexed at 100 on 12/30/2022

Source: S&P Global, Macrobond 

Chart 2: Megacap tech stocks have surged
Indexed at 100 on 12/30/2022

Source: S&P Global, Macrobond 

Only a handful of companies driving the Index’s is not healthy. When market breadth is broadly based, it is a signal of broad-based growth across various industries and the overall economy. In contrast, the increased concentration of market leadership implies rising risk and scarcity of growth. Evaluating the premium valuations of these high-flying stocks becomes challenging, as their prices become disconnected from fundamental historical relationships. Indeed, if AI is a ‘gamechanger’ in terms of the way companies will operate, productivity benefits should accrue broadly, and not only within the immediate AI-winners. We do not disagree with the potential upsides to come from the AI revolution, but this current market rally appears fragile, despite a recent improvement in market breadth in early June.

Short-term hazards remain

There is growing evidence of credit contraction (see April Outlook), and a recession continues loom closer. While the latest earnings season provided better-than-expected earnings, corporate profits are set to decline during an economic downturn. The vast majority of companies in the S&P 500, the “S&P 492,” may not be buoyant, but they have also not yet fully priced in the economic slowdown, as earnings forecasts remain optimistic. Interest rates are once again on the upswing as central banks reassess whether current levels are sufficiently restrictive (see May Outlook, as well as recent moves by the Reserve Bank of Australia and the Bank of Canada).

More immediately, the resolution of the US debt ceiling gridlock has buoyed sentiment, but also presents a potential market risk. While the US Treasury was prohibited from borrowing after hitting its limit, it had to deplete its chequing account held at the Fed, known as the Treasury General Account. The balance of this account stood at approximately US$39 billion at the end of May and needs to be replenished to about $600 billion. In addition, the Treasury was unable to issue bonds since hitting the debt ceiling. Now that issuance has resumed, this new bond supply comes at a time when banks are being asked to raise cash reserves to avoid further bank failures. Coupled with ongoing quantitative tightening, elevated recession risks and already high valuations, liquidity will be withdrawn from the markets, posing short-term risks.

Capital markets

Apart from the enthusiasm over AI-fueled tech stocks, markets were generally weak during a month with no shortage of headlines. Most notable were the US debt ceiling negotiations, which created significant stress on US one-month T-bills, causing their yields to surge to 7% at one point. However, the resolution and the smooth passage in the House of Representatives and Senate were welcomed by markets. The month also saw consistently higher-than-expected inflation readings and decent momentum in economic activity, which led to interest rate hikes from both the Fed and the European Central Bank (ECB). Additionally, there were renewed concerns over US regional banks earlier in the month, as First Republic Bank, the third bank to fail, was acquired by JPMorgan.

While the tech sector exhibited remarkable strength, equity markets saw little upside elsewhere. The Nasdaq Composite Index headed up the leaderboard with a 5.9% gain, with megacap tech stocks also helping the S&P 500 stay positive. Elsewhere has been marked by sell offs. Commodity prices have been declining, due to a weaker-than-expected economic reopening in China and a contraction in German GDP. Energy prices continued to slide as WTI fell 11.3% in May and metals such as copper declined by 6%. As a result, the materials and energy sectors were among the worst performers.

In Canada, bank earnings releases were below consensus expectations, putting downward pressure on the financial sector. Consequently, financials, in tandem with energy and materials, pulled down the broader Canadian equity market. The S&P/TSX Composite Index declined 4.9% in May, with only the information technology sector delivering a positive return.

Economic releases, including inflation data in both Canada and the US showed strength, with inflation notably rising due to contributions from services and an unexpected increase in goods prices. This put upward pressure on interest rates. The Fed raised its target interest rate by 25 bps to over 5%, and is now in a range consistent with the Fed’s March projection of its terminal rate. Bond yields climbed across the yield curve, with two-year yields up 52 bps in Canada and 33 bps at the 10-year term. Credit performed well as demand rebounded, providing support for spreads. The FTSE Canada Universe Bond Index declined 1.69% in May.

Portfolio strategy

Key indicators of jobs and growth are broadly positive, although there is conflicting data across various economic indicators, including manufacturing surveys and leading indicators. During the late stages of business cycles, it is common to see volatile and contradictory data as different sectors experience the lagged impact of higher interest rates at different times. The full effects of the rate hikes over the past year have not been fully felt by the economy, and certain factors, such as extended amortizations for some variable-rate mortgages in Canada, are mitigating the direct impact of monetary tightening. Nonetheless, tighter lending standards by banks and central banks’ resolve to control inflation suggest that a recession is likely within the next year.

We maintain a cautious outlook for equity markets, anticipating declining profit margins, sticky wages but diminished pricing power, and further negative earnings revisions in the coming quarters. Thus, balanced portfolios remain underweight equities. Fundamental Canadian equity portfolios remain focused on stability and own companies with resilient earnings and dividend profiles. Fixed-income portfolios are underweight corporate and provincial bonds. While the equity market has demonstrated remarkable resilience to date, it is becoming increasingly evident that risks to equities persist beneath the surface. We are therefore taking a more cautious approach to portfolio positioning.

*Acronym for the current largest capitalization technology stocks (Apple, Facebook/Meta, Amazon, Alphabet/Google, Microsoft, Netflix, Nvidia, Tesla).

Cautionary signs from abroad.

The Bank of Canada (BoC) began tightening policy in March 2022, ahead of most major central banks and has recently been among the first to pause. However, there have been some surprising developments in other countries over the last month, and it is worth examining whether they have any implications for Canada.

For instance, the Bank of England began raising rates even before the BoC. Like Canada, the UK is sensitive to interest rate increases, particularly as mortgage interest rates are typically fixed for two to five years. Despite Brexit reducing mobility overall, the UK saw a net migration inflow over the past year, leading to a 0.65% population gain. Although slightly higher than pre-pandemic levels, this growth is far from the 2.7% population increase seen in Canada. Furthermore, the UK economy has slowed but is facing the highest inflation rate in Europe and one of the highest inflation rates among developed markets, with the CPI annual rate stalling at over 10% year over year (y/y) in eight of the last nine months (see Chart 1). Core inflation is at 6.2%, not far from its 30-year highs of last summer. The implication that inflation is difficult to wrestle is potentially concerning, yet UK inflation has remained high in no small part due to extended supply pressures emanating from Brexit and more rigid trade rules.

Chart 1: UK inflation highest among developed peers

Source: Statistics Canada, Australian Bureau of Statistics, UK Office for National Statistics, Statistics New Zealand, Macrobond

In early April, the Reserve Bank of New Zealand (RBNZ) surprised the market by increasing the Official Cash Rate by 50 basis points (bps) to 5.25% due to concerns over higher near-term inflation readings. Supportive fiscal policy combined with rebuilding after recent storms may add fuel to upside pressures. The RBNZ has matched the Federal Reserve (Fed) for the largest cumulative rate hikes and may still increase rates further.

In Australia, the central bank paused in April, but quarterly inflation reports for both headline and its core metric of trimmed CPI, while modestly lower than expected, still exceeded the central bank’s targets at 7% y/y and 6.3% y/y, respectively. In early May, the Reserve Bank of Australia surprised the markets with a 25-bps rate hike, taking the target cash rate to 3.85%, citing high services prices as a concern. It noted that inflation may take “a couple of years” to return to the top of its target range. 

Are higher rates a material risk?

Canada is, like many other countries, currently adjusting to past rate hikes. On the surface, the country has appeared resilient in the face of short-term adjustable rate mortgages, high sensitivity to interest rate increases because of large debt, and its broad exposure to the cyclically-sensitive commodities sector. In spite of these factors, there have been no banking stresses, fewer mass layoffs and no sharp rise in mortgage delinquencies. But as with countries elsewhere, at least for the near term, we should not underestimate the potential for a surprise on the side of further policy tightening. Indeed, the April BoC Summary of Deliberations showed that the discussion leaned towards whether rates needed to rise again. There are reasonable arguments for this.

While it may be too early to call it a trend, the Canadian spring housing market appears to be picking up steam. New listings to start the spring season were the lowest for any March over the past 20 years, and demand from natural household formation and new immigrants has been strong. This has coincided with a peak in mortgage rates as the BoC stopped hiking rates. Five-year mortgage rates have fallen from last October’s peak of 5.88%, with the latest 75 bps of BoC rate hikes having little effect. As a result, house prices in major cities have risen for the last two months.

Fiscal policy is adding stimulus, with provincial governments adding about $6 billion in new support measures and tax reductions and the federal government more than doubling that to $13 billion. These support measures are delaying a material slowdown and working against tighter monetary policy. Perhaps the most important lesson we take from other countries is that overall inflation is still at risk of remaining above target, particularly with Canadian economy-wide average hourly wages running at over 5% (see Chart 2).

Chart 2: Strong Canadian wage growth risks above target inflation

Source: Statistics Canada, Macrobond

While we view the most likely scenario to be no further rate hikes, the longer inflation is above the explicit target, the more extrapolative expectations become, making it harder to bring inflation under control. So even if the BoC does not surprise with more rate hikes, there is a risk that monetary policy will be held tighter and rates higher for longer. This is not being priced into markets. The implications for asset prices are material; the longer rates are held high, the more stresses build and the harder it is to push problems down the road.

Capital markets

After three of the largest four US bank failures in history, it is surprising that April was one of the calmest months in markets. Volatility indices for both bond and equity markets eased, evidenced by the daily and monthly change in prices. Two areas stood out: US regional bank stocks continued to fall, led by First Republic. Secondly, the quiet world of US T-bills reflected anxieties surrounding the US debt ceiling limit. Investors kept purchases below one month to avoid debt ceiling default risk, pushing yields down and the spread to 3-month T-bills to historic wide levels.

Bond yield changes were subdued in Canada over the month, while corporate credit spreads tightened, leading the FTSE Canada Universe Bond Index to rise 0.98%. A decent corporate earnings season contributed to the sanguine market sentiment and equity markets recovered from the March upheaval. The MSCI ACWI Index gained 1.4%, led by developed markets. The S&P 500 Index rose 1.6%, although breadth was narrowly concentrated in the technology sector, which was buoyed by lower interest rates that helped boost valuations. In Canada, the S&P/TSX Composite Index outperformed, rising 2.9%. Commodities were generally weak in April, except for oil prices, where the OPEC+ group cut output at the start of the month, leading WTI to hit a peak of US$83/bbl. This was short lived and prices eased back to close the month nearly unchanged.

Portfolio strategy

Similar to other economies, Canada’s late cycle environment presents risks that are not one-sided, and central banks are unlikely to intervene aggressively in a slowdown. While recent economic releases suggest momentum is slowing, consumers are gradually using up their excess savings and businesses are exercising restraint in spending, which is a process that takes time. Meanwhile, inflation remains stubbornly high and we do not anticipate significant interest rate cuts in the near future. Our outlook indicates that a recession is the most probable scenario for the latter half of 2023.

In our fundamental equity portfolios, we continue to look for companies with strong fundamentals that can navigate slower aggregate economic growth. Our portfolio positioning emphasizes defensive strategies, with earnings stability a crucial theme at both the sector and security level. However, we are also exploring opportunities to invest in oversold cyclical companies that will likely perform during an economic recovery. Our fixed-income portfolios follow a similar theme, focusing on corporate bonds while we remain patient in our macro positioning given the possibility of tighter lending during a recession later this year. Our balanced portfolios maintain an underweight position in equities in favour of cash. We continue to assess both domestic and global data and seek out opportunities in both calm and volatile markets.

Averting crisis, but anxious about credit.

The US Federal Reserve (Fed) and Bank of Canada (BoC) have raised their overnight rates at the fastest pace since the 1980s. As we passed the one-year mark since the start of this rate hiking cycle, the economy and financial system appeared stable and even resilient, and markets bore the scars as higher rates led to declines in valuation multiples throughout 2022. While there have been some signs of strain, such as UK pensions, the Bank of England’s (BOE) rapid response curtailed negative outcomes. Additionally, the collapse of cryptocurrency exchange, FTX, was less related to interest rates than fraud. However, this past month’s failure of three banks: Silicon Valley Bank (SVB) and Signature Bank in the US, followed by Switzerland’s Credit Suisse being forced into a merger with its long-time domestic rival, UBS, marked somewhat of a turning point.

In comparison to prior crises, today we are at a better starting point. Issues with US regional banks are not the same as during the Great Financial Crisis (GFC), when banks held assets that were complex, massive, interlinked and then severely impaired. The legacy of those problems was a shift to tough regulatory requirements for large global banks. They now have deeper capital bases that can better withstand inevitable recession-induced asset write-downs. However, recent instability is reminiscent of more classic problems, such as outflows of deposits from banks when the rates paid do not rise in line with policy rates, combined with an inverted yield curve that impacts bank margins.

Over the weeks surrounding the stresses on the US regional banks, data releases showed depositors moved more than US$400 billion out of bank deposits (see Chart 1), with two-thirds of the outflows coming from small and mid-sized banks. Most of those flows went into financial assets that now yield higher returns than bank accounts (see Chart 2), notably money market funds. This outflow of deposits is forcing banks to sell assets and recognize losses in bond holdings due to the rise in interest rates. The Fed has taken steps to prevent the situation from worsening. Banks are now borrowing at the Fed’s discount window or using the newly established Bank Term Funding Program that was created to provide banks with a liquidity backstop. Although the rate of borrowing at the discount window remains elevated, the exodus of bank deposits slowed by the end of March and the problems have become less acute. This turmoil will require banks to bolster deposits. One way to do that is to raise interest paid on deposits, which may result in a higher cost of funding and pressure on profitability.

Chart 1: Deposits have been leaving banks at a rapid clip

Source: Federal Reserve, Macrobond

Chart 2: Deposit rates not keeping up with policy rates

Source: Federal Deposit Insurance Corporation, Federal Reserve, Macrobond

Following the banking instability, central banks seemed to face a choice between price stability (raising rates to combat stubbornly high inflation) or financial stability (injecting stimulus to save a precarious financial system). Separating out tools to deal with these two problems, they have continued to raise rates even in the face of the bank failures. What has made this whole situation a turning point, however, is that this turmoil has brought markets into a position where they are now working with the Fed rather than against it. The Fed has persistently stated that inflation remains high and financial conditions will need to tighten, and markets rallied and credit spreads stayed tight allowing for the economy to remain supported rather than constricted. Now, markets appear to be heeding the warning signs. Credit markets have seen decreased issuance and wider credit spreads.

It is worth noting that a key link in the transmission of central bank actions and the economy is through bank lending. The Fed’s Senior Loan Officer Survey shows that banks have been tightening lending standards for months now (see Chart 3). Given concerns about liquidity, outflows of deposits into money market funds, costlier sourcing of funds, net interest margin pressures and weakening demand, banks are likely to pull back further on lending activity in coming quarters. This will directly dampen prospects for business investment and consumer spending to varying degrees. One sector that may be particularly impacted is commercial real estate lending. While shifting demand for office space is one factor, it is notable that smaller US regional banks with assets under US$250 billion hold about three-quarters of total commercial real estate loans. While this segment represents approximately one quarter of overall loan books, the combined supply and demand pressures imply a vulnerable sector. Overall, the message is clear: lending will be scarcer economy-wide, and an economic slowdown to recessionary levels is now looking increasingly likely.

Chart 3: Lending standards tightened to levels typically preceding recessions

Capital Markets

Both riskier equities and safe-haven bonds have performed well over the past six months, benefiting from a sharp repricing of short-term interest rate expectations. However, this does not necessarily signal that all is well as there has been considerable volatility in the interim. Persistently high inflation led Fed Chair Powell to assert in March’s semi-annual congressional testimony that the Fed may increase the pace of rate hikes, resulting in expectations of a 50 basis-points (bps) move that pushed yields to a high of over 5% and the endpoint of rate hikes to 5.69%. After the recent bank events unfolded, expectations flipped. Two-year Treasury yields posted their single-largest, one-day drop since 1982 with Canadian yields closely following suit. For March overall, two-year yields declined by 48 bps and 10-year yields by 43 bps. This helped the FTSE Universe Bond Index rise 2.16%.

The flight to safety that was triggered by the US bank run similarly helped gold prices surge by 7.8% and silver prices by 15.2% in March. Meanwhile, energy prices declined, especially oil prices, which fell by 7% for the quarter. Natural gas prices experienced a sharp retreat, especially in Europe despite strong economic activity data and the reopening of China’s economy. The softening in energy prices was short-lived as oil rebounded within the first days of April due to OPEC’s surprising announcement of a material cut in supply.

Risk assets posted strong performance in March, with the MSCI ACWI Index up 2.5% and the S&P 500 Index closing up 3.7% in local currency terms despite regional bank stocks plunging 35.6%. Notably, even though the epicenter of the bank failure was in California’s Silicon Valley, the tech-heavy Nasdaq Index was up 9.5% in March as tech stock valuations benefited from the fall in rates. On the other hand, the S&P/TSX Composite Index was nearly flat, declining 0.2% during the month. The large weight of banks and energy in the Index was a drag on overall gains.

Portfolio Strategy

In light of the continuing effects of aggressive tightening by central banks over the past year and the recent turmoil in the US’s and Switzerland’s banking sectors, we anticipate even tighter lending standards than already posted in the second half of 2022. An economic downturn seems now more a question of “when” rather than “if”. Even as we approach the period of recession, the equity risk premium (ERP), which is the additional return demanded above lower-risk bond yields, has remained surprisingly unchanged despite recent events. While the ERP is holding in at recent average levels in Canada, it remains low in the US. As the ERP rises in response to slowing economic activity, valuation multiples will be pressured lower, compounding lower earnings. As a result, we maintain an overall underweight position in global equity markets in our balanced portfolios. We also have a modest underweight position in fixed income and are overweight in cash. In our fundamental equity portfolios, we continue to favour companies that offer stability with resilient earnings and dividend profiles.

The recent volatility in fixed-income markets has reflected a high level of uncertainty, with narratives that oscillate between expectations of further central bank rate hikes, or rate cuts mid-year. Our fixed-income portfolio decisions have been guided by valuation forecasts in line with our unwavering outlook for a mild recession, and our belief that central banks are nearing the end of their tightening cycles, although we do not foresee interest rate cuts in the near term. We remain underweight credit and have a modestly short duration position.

We anticipate that contracting lending standards will support central bankers’ goals of slowing the economy. We will closely monitor and assess the conditions around the economic slowdown to gauge what the recovery may look like and position portfolios accordingly.