The U.S. Federal Reserve’s ongoing tightening of the economy and its commitment to reducing inflation has markets reeling after a strong summer rally. Still, bond investors were not able to benefit from the rate hikes, yet. With Fed Chair Jerome Powell leaning back toward a more hawkish tone recently, the U.S. dollar held its position of strength against other major currencies, including the loonie, which was put on the defensive by the renewed slide in equity markets. The euro and the pound meanwhile continue to be susceptible to high inflation and slow growth, driven by rising energy prices. Gross domestic product growth shows the economy is cooling into the third quarter but not anywhere close enough to slow the Bank of Canada’s rate hike moves.
Scotiabank analysts and economists weigh in on how economic indicators and trends are influencing equities, currencies and interest rates right now.
Equities
- The U.S. Federal Reserve’s tightening phase explains why financial markets are reeling. Fed Chair Jerome Powell’s speech at the Jackson Hole meeting last Friday was short and crystal clear, indicating that the Fed’s “overarching focus is to bring inflation back down to the 2% goal.” Hopes that he would adopt a somewhat balanced tone in the face of decelerating growth were obliterated. “Reducing inflation is likely to require a sustained period of below-trend growth ... bringing some pain to households and businesses,” Powell said. With inflation running well above target, a Fed pivot will require much weaker macro data, in our opinion. As long as the ISM Manufacturing Index (currently at 52.8) runs above 50 and the unemployment rate (3.5%) stands below 4%, it’s unlikely the Fed will pause. Fed fund futures now peg the exit rate this year between 3.75% and 4.0% (currently at 2.5%). Oversized rate hikes may soon come to an end, but the tightening phase is likely to extend, with the pace of quantitative tightening doubling on Sept 1.
- The hawkish Fed tone likely put an end to the strong summer rally as investors reassess valuation metrics in light of more tightening to come, as well as growth and earnings prospects. On the valuation front, still pricey Growth equities were hit the hardest last Friday. The MSCI USA Growth index, which was trading at 26 times forward earnings before the meeting (vs a LT avg of 20.4x; median 18.7x), fell slightly more than 4%. Quality lost 3.9%, while the Value, Minimum volatility and Momentum indices performed better, slipping 2.8%, 2.6% and 2.1%, respectively. Top performing sectors were Energy, Utilities, and Staples — in line with our current positioning. Tech (-4.3%), Discretionary (-3.9%; TSLA/AMZN), and Communication (-3.9%; NFLX/GOOG) were the laggards.
- Bond investors were unable to benefit from the risk-off tone last Friday, with the Bloomberg US Treasury index gaining a paltry 0.05%. We believe long-term bond yields should continue to trend higher, pushed by more tightening and elevated inflation, until macro data becomes much weaker, and a recession becomes very apparent.
- Investors are facing one of the most challenging environment in decades, with both U.S. equities (-14.0% TR) and Treasuries (-9.0%) suffering heavy declines this year. The last time both stocks and bonds ended down over a calendar year was in 1969. We still believe volatility will remain elevated in the back half of 2022 and capital preservation should be top of mind.
— Hugo Ste-Marie, Director Portfolio & Quantitative Strategy; Jean-Michel Gauthier, Associate Director, Portfolio & Quantitative Strategy
Foreign Exchange
- The U.S. dollar (USD) retains a firm undertone against its major currency peers following comments last Friday by U.S. Fed Chair Powell, emphasizing the Fed had more work to do to curb inflation. His remarks were broadly in line with speeches from other Fed officials recently but sounded a little more hawkish than his remarks after July’s policy decision. In July, Powell suggested that policy had reached neutral, which markets interpreted as a signal of a “dovish pivot.” As a consequence of last week’s remarks, U.S. short-term rates remain firm and swaps pricing has factored in the risk of the Fed policy rate nearing 4% in the first half of 2023, some 150 basis points above the current target rate. Markets, however, remain undecided on the near-term outlook for Fed policy, with pricing wavering between a 50 or 75 bps hike on Sept. 21. Last Friday’s US Non-Farm Payroll report may help shape Fed rate expectations next month. Job growth is expected to slow but a sharp deceleration, which is the inevitable consequence of higher interest rates at some point, may shift expectations to a moderate rate hike, dampening the USD.
- Central bankers are tending to sound more hawkish as inflationary pressures persist. Among the major central banks, only the Bank of Japan is pledging to maintain an easy policy stance. The Reserve Bank of New Zealand has indicated it may be near the end of its tightening cycle. However, tighter monetary policy is coming in Europe despite obvious and significant economic headwinds — the surge in power prices in the Eurozone and the related cost-of-living crisis in the United Kingdom — that raise the risk of recession. European Central Bank policy-makers are actively discussing a 75 bps rate increase for its Sept. 8 policy decision, while the Bank of England is likely to lift rates at least 50 bps at its policy decision meeting the following week. Even marginally more supportive interest rate differentials may not underpin either the euro or the pound for now, with both currencies liable to remain susceptible to the negative economic outcomes (high inflation, lower growth) that are a result of the jump in energy costs.
- The Canadian dollar (CAD) ended August on the defensive near 1.31 against the USD, reflecting the general bid for the USD and the renewed slide in equity markets, which typically weigh on the CAD’s performance as a high-beta currency. Markets continue to overlook relatively firm economic domestic data and Bank of Canada (BoC) messaging that points strongly to another “forceful” rate increase next month. We expect a 75 bps increase in the Bank’s key rate; market pricing currently points to the risk of something even stronger.
— Shaun Osborne, Managing Director, Chief FX Strategist, and Juan Manuel Herrera, FX Strategist
Economy
- Canada’s gross domestic product (GDP) in the second quarter marginally disappoints. The economy is fitting our narrative of cooling momentum into the third quarter as super-charged growth in the first half of the year was likely brought forward at the expense of the second half. That’s not going to be anywhere close enough to being meaningful to the BoC, which is expected to hike the interest rate by 75 bps next week and keep the door open to further tightening thereafter as determined by data.
- The economy grew 3.3% quarter over quarter at an annualized rate in Q2. That was less than anyone in consensus anticipated. The median call was 4.4% with Scotia at the low end with 4.2% and the high end was 4.8%. The BoC’s July MPR had anticipated growth of 4%. The economy has not grown over the past three months after May’s GDP was flat versus the previous month, June’s rose only 0.1% month and preliminary flash guidance for July points to a small dip of -0.1%. What this does in terms of the math is bake in 0% growth for Q3 over Q2.
- None of this matters for the BoC heading into next week’s statement-only decision sans forecasts or presser. It’s inflation all the way for the bank. GDP remains more than 2% higher than pre-pandemic and the supply side remains damaged. The BoC would probably see the need for the gap to go significantly negative in order to dampen inflationary pressures. In other words, there is a need to open up slack whether through below-potential actual GDP growth or an outright and meaningful contraction in the economy. We are nowhere near that point.
— Derek Holt, Vice-President and Head of Capital Markets Economics
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