In this edition we discuss how the loonie measures how independently the Bank of Canada can act, why index investors might get uncomfortable in the coming weeks and outline a great resource for bookworms.
A screen on the trading floor at the New York Stock Exchange (NYSE) display a news conference with Federal Reserve Chair Jerome Powell following the Federal Reserve rate announcement, in New York City, U.S., September 18, 2024.Andrew Kelly/Reuters
REITs
‘Yield taker’ economy leaves Canadian investors subject to Fed policy
The S&P/TSX Real Estate Investment Trust index jumped 30 per cent, including distributions, for the third quarter and sentiment for the sector climbed along with it. Desjardins real estate analyst Kyle Stanley reflected the newfound optimism this week by publishing Welcome to the pivot party! He argues that the rally in REITs will continue as central bank interest rate cuts occur for the rest of the year and into 2025.
Morgan Stanley’s outlook for U.S. interest rates, however, might complicate things. Morgan Stanley’s economists believe that equity and bond prices reflect more Federal Reserve rate cuts than will actually occur. Markets are expecting the Fed to cut rates as if the U.S. economy was in recession – as if it had already suffered a hard landing – rather than the more likely soft landing where GDP growth continues.
The domestic economy is much weaker than the U.S. In fact, according to purchasing manager surveys (PMIs), Canada has the weakest economy in the developed world. In theory, this would mean the Bank of Canada will cut rates much more than the Fed, boosting income-generating sectors like REITs.
But it’s not that simple. The reality is, the bank will cut if it can.
Canada is a yield taker economy, not a yield maker. This means that to a significant extent we absorb Federal Reserve monetary policy rather than completely tailor borrowing costs to the domestic economic context.
Canadian bond yields will stick close to U.S. yields whether the economic circumstances warrant it or not. In practical terms, the difference between domestic and U.S. five-year bond yields has averaged a scant 13 basis points over the past two decades, despite pandemic-related volatility.
The Bank of Canada’s freedom to cut rates will play out in currency markets. Lower yields and accompanying weak growth rates (relative to the U.S.) discourage foreign investment. They limit the number of global investors that are exchanging local currencies into loonies to buy Canadian assets. So, if the Bank of Canada cuts rates deeper than the Fed, the currency is likely to weaken significantly.
Ok, so back to domestic equity income sectors. The outlook will remain bright as long as the Federal Reserve and the Bank of Canada cut rates together. If, as Morgan Stanley expects, the Fed stops cutting sooner than markets think – a higher for longer scenario – then the fun starts. The Bank of Canada will continue to cut rates to stimulate the economy as long as they are comfortable with weakness for the loonie.
Andrew Kelly/Reuters
The downside of expanding market breadth
The equal weighted S&P 500 has significantly outperformed the conventional, technology-dominated S&P 500 in the past three months and this will signal a major change in market returns if it continues.
The equal weighted S&P 500 index has climbed 8.7 per cent since July 7, well ahead of the usual market cap-weighted benchmark’s 2.7 per cent. The trend signals a broadening of market leadership beyond AI-related tech favourites Microsoft Corp., Alphabet, Nvidia Corp., Meta Platforms Inc., Amazon.com and Apple Inc.
The expansion in market leadership is good news for investors as a whole but might cause some consternation for index-oriented passive investors. One of legendary Merrill Lynch strategist Bob Farrell’s 10 rules of investing is “markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names” - indicating that the market rally is more sustainable now with more stocks pushing the benchmark higher.
The conventional market cap-weighted S&P 500’s recent underperformance means owners of ETFs that track the benchmark are also underperforming more portfolios than usual (even some active fund managers!). Smaller stocks that are helping move the equal weighted index higher have very little effect on the orthodox large-cap driven benchmark.
Research tells us that passive index investors are far more likely to outperform more active portfolios over the long term, so they should just wait this out. I’m interested in seeing if new sector leadership emerges in the coming months.
Diversions
Recommendations for every reader
A great place to find new books to read is the Five Books site. It features expert recommended lists in every genre you can think of. The Best Novels of 2024 (the “so far” is understood, it’s a literate crowd after all) page is the one I scan most often. The first lists are, in order, best historical fiction of 2024; the best novels in translation: the 2024 International Booker Prize shortlist; notable new novels of summer 2024; the best sci-fi and fantasy novels as chosen by fans: the 2024 Hugo Award; recent fiction highlights: the 2024 women’s prize shortlist; and the best mysteries of 2024.
Each recommendation includes a reasonably detailed description to help guide reader choices. All in all, a very helpful inclusion to the internet.
The essentials
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Globe Investor highlights
The dollar just had its best week in two years, showing once again how dangerous it can be to bet against the U.S. currency if the rest of the world just won’t let it drop
Definitive numbers on how much you can save with ETFs compared to mutual funds
Wider U.S. deficits, inflationary trade policies threaten bond outlook, says PIMCO
Why bitcoin has been distinctly listless in the past three months after starting the year with a bang
What’s up next
Friday is the big day for domestic data with the release of employment for September (27,500 net new jobs expected). The unemployment rate is forecast at 6.7 per cent and the increase in hourly wages for permanent employees is anticipated to be up 4.7 per cent year over year).
The third quarter Bank of Canada business survey is also coming out Friday.
Consumer price numbers for September are out next Tuesday. A non-seasonally adjusted decline of 0.2 per cent month over month is forecasted, and a year over year jump of 1.9 per cent is predicted for the ex-food and energy component.
See our full economic and earnings calendar here (You can bookmark the page - it gets updated weekly)