The U.S. Federal Reserve (Fed) signalled on Nov. 3 it will commence tapering its bond purchases by US$15 billion per month, and global markets are now grappling with the realities of a gradual withdrawal of much of the liquidity that has underpinned the asset price recovery taking place over the past year.
The Fed’s decision follows a faster-than-expected inflation recovery that—boosted by unexpected disruptions to the global supply chain —has forced policymakers to shorten their timeline to stimulus withdrawal and eventual interest rate hikes.
The Bank of Canada (BoC) in October sent ripples through the market as it announced it would end its pandemic bond-buying program and signaled it could raise rates as early as the first quarter of next year, bringing forward its own timeline by several months.
The anticipation of these announcements had already had a significant impact on two-year bond yields, especially in Canada, Australia and the UK, due to the clear signs of tightening central bank policy over the coming several months.
“The key issue for the market right now is how quickly the Fed raises rates,” says Robert Fournier, Managing Director, U.S. Equity at Gluskin Sheff.
For central banks, the challenge is how to turn down the liquidity taps in a manner that keeps inflation in check while not choking off economic growth and alarming investors who have seen markets fall during previous tightening campaigns.
For Fournier, a key issue is whether the Fed’s previous messaging that the recent spike in inflation is largely transitory in nature proves to be true.
The S&P 500 has to date held in well despite the signals of monetary tightening, rebounding from a mid-September swoon to again touch all-time highs even as U.S. stocks continue to trade at higher price-to-earnings multiples than markets in Europe and Japan.
“A good scenario would be some degree of transitory inflation that slowly rolls over in the next 12 months, and the Fed manages through this with one or two rate hikes next year. The market seems priced for that and could likely manage through it,” he said.
“But if we dislodge from that because inflation is too high for too long and the Fed feels like their backs are against the wall and they need to communicate a lot more hawkishly, then to me that could lead to several points of multiple contraction in the U.S.”
That scenario could also lead to a prolonged period of higher inflation, which could squeeze corporate margins and negatively affect earnings. However, Fournier said the U.S. equity strategy is better positioned for that potential outcome as it is focused on companies with less exposure to sectors such as materials or industrials that can be vulnerable to inflation, and higher exposure to companies that act as inflation pass-through mechanisms and can often benefit from inflation.
“Consumer spending has been strong, and margins in the U.S. are a lot higher than the rest of the world, and it’s a lot easier to pass on higher costs when your margins are higher,” he said.
Mark Grammer, Managing Director, Head of International Equity at Gluskin Sheff also sees the potential for a contraction in multiples as a result of rate increases, though he noted markets in Europe and Japan, where the international strategy is focused, have not seen valuations rise to the same degree as they have in the U.S.
Nevertheless, the strategy has been trimmed of some if its higher-multiple holdings in preparation for the liquidity drawdown, he said.
“We’ve gone through the strategy to look at the impact of inflation and we feel pretty comfortable with our names,” he said. “The bulk of the portfolio companies have pretty decent pricing power, particularly in our large-cap holdings. Additionally, we have also added some exposure to energy and materials that tend to benefit from inflation in order to protect the overall strategy to a degree.”
In Asia, the bulk of the strategy’s holdings are in Japan and largely in value stocks, which tend to be buoyed by economic growth and are less susceptible to a contraction in multiples than growth stocks.
One issue that could factor into international markets is whether central banks will feel compelled to adjust their tapering plans in response to an aggressive Fed action, said Grammer.
“The European Central Bank (ECB) has maintained they will continue with loose monetary policy. But if the U.S. tightens and inflation in Europe is around the same as in the U.S., can they maintain that stance?” he asked.
While the Bank of Canada has also pulled forward its projected path for interest rate increases, the bank is likely to err on the side of caution, says Shelagh Lemke, Managing Director, Head of Fixed Income at Gluskin Sheff. However, fighting inflation is not something the Bank of Canada has had to deal with over the past decade.
“Central banks have been using non-traditional tools to deal with deflation over the last decade,” she said. “Now they will need to revert to more traditional monetary policy to address the inflationary environment. This transition could result in a policy error.”
Also significant is that Canadian household debt is considerably higher than U.S. household debt, due largely to mortgages. This means that a significant upwards move in rates will hit many Canadians directly in the pocketbook and could have a chilling effect on home prices, which is something the central bank must also be wary of.
“The consumer did not de-lever in Canada as they did south of the border because we didn’t really have a financial crisis here,” said Lemke, referring to the economic effects of the COVID-19 pandemic.
It’s also important to keep in mind that, while there are risks associated with rate hikes, monetary tightening represents not a departure from the normal but a return to it, says Alkarim Jiwa, Managing Director, Head of Canadian Equity at Gluskin Sheff.
“They’re increasing the overnight lending rate because the economy is strong, so we don’t think it’s a bad thing. Jobs numbers are now higher than pre-pandemic levels, and the overnight rate is abnormally low, so they’ve got a long way to go to reload the gun,” he said.
So far, the central bank’s communications have actually benefited the Canadian equity strategy, which is tilted towards sectors that are helped by a strengthening economy and away from those which are rate sensitive.
“The risk you run into is if the economy is running too hot and the central bank has already raised rates several times, you can get to a point where they overshoot and derail the economy, but we’re a long way off from that being something to worry about,” said Jiwa.