A sign board in Toronto displays the TSX close on March 16, 2020.Frank Gunn/The Canadian Press
This is the week that the stock market finally woke up to the realization that policy makers will not have its back forever. The shock of that belated discovery could linger for a while.
Fast-growing tech companies, which rocketed higher over the past two years on the back of locked-down economies and near-zero interest rates, are suddenly feeling the tug of gravity. Meanwhile, the stodgy also-rans of the recent boom – banks and value stocks – have a new strut in their step.
A couple of the Toronto Stock Exchange’s leading issues – Shopify Inc., the online e-commerce giant based in Ottawa, and Royal Bank of Canada, the long-time heavyweight champ of Canadian financial services – demonstrate how the abrupt shift in sentiment is playing out.
Shopify shares dived this week, extending a string of losses over the past month for the one-time stock market darling. In contrast, boring-but-reliable Royal Bank stock celebrated the start of 2022 by continuing to climb. Since early October, Shopify shareholders are down 18 per cent while Royal Bank investors are up 11 per cent.
RBC and National Bank earnings fall short as revenue stalls
Shopify’s pandemic growth decelerates as its ecosystem investment delivers profit
The reversal of these two companies’ fortunes reflects the ominous outlook for interest rates, which is the downside of encouraging medical news suggesting that the Omicron variant of COVID-19 is not quite as vicious as its predecessors. If Omicron is indeed less lethal, new lockdowns will not derail the global economic recovery for long and central banks will no longer have to coddle sick economies. They can be more aggressive in raising interest rates to tamp down inflation.
The prospect of higher rates is particularly painful for tech stocks such as Shopify because most of these companies’ profits still lie far in the future. Rising rates reduce how much those distant earnings are worth today.
In contrast, bank stocks are less affected by tighter monetary policy because more of their profits are in the here-and-now. Banks might even benefit if higher rates allow them to increase the wedge between the rates they pay on deposits and the rates they charge for loans. Banks have therefore enjoyed a mostly pleasant week. So have value stocks, which have the virtue of being cheap and should therefore be better able to weather harsher market weather.
So far, so transparent. The surprise, though, is that the market has been so surprised. You can blame this week’s ruckus on minutes from the latest meeting of the U.S. Federal Reserve, published Wednesday, that showed policy makers striking a hawkish tone. Really, though, the Fed wasn’t saying anything it had not said before.
“Duh, has anyone been listening?” fumed Joel Naroff of Naroff Economics in a note. “Central banker after central banker has been speaking about how inflation was now a concern and that rates would be going up … yet when the Fed put into print that it would be doing what it has been signalling it would be doing, investors suddenly got worried.”
To be fair, central banks have been less than definite in their pronouncements. They have left themselves lots of room to manoeuvre and most still seem to think inflation will fade in the second half of this year. Still, the violent reaction to the Fed minutes shows that many investors had not fully factored in the probability of higher rates ahead.
The question now is how far and how fast the increases will come. The 10-year Government of Canada bond yield has already soared from 1.43 per cent at the start of the week to 1.72 per cent on Friday – a huge move in bond market terms. Its U.S. counterpart has followed a similar trajectory and now sits at 1.77 per cent. Ten-year yields will likely edge higher over the rest of the year, rising to 1.8 per cent in Canada and 2 per cent in the United States, according to Capital Economics.
What is an investor to do? Optimists claim that stock markets usually fare fine when central banks start to tighten policy, because policy makers typically raise rates only when corporate profits are strong and growing. Pessimists gesture to lofty valuations in tech stocks and U.S. stocks in general and suggest this time could be different.
David Rosenberg of Rosenberg Research pointed out in a note Friday that Wall Street’s epic surge over the past three years was built on one-fifth earnings growth and four-fifths multiple expansion. In other words, corporate earnings climbed but what really drove the market’s gains was investors’ willingness to spend more for each dollar of those earnings. The result is a price-to-earnings ratio that is now at lofty heights and vulnerable to a correction.
Canadians may want to ponder the merits of sticking close to home, or at least reducing exposure to the U.S. market. Data compiled by S&P Capital IQ show how dramatically the P/E ratio of the U.S.-based S&P 500 has diverged from that of the Canada-based S&P/TSX Composite over the past decade.
Say what you will about the relative merits of the two markets, but it is clear investors are paying far more to participate in the U.S. market than in its Canadian counterpart. At a time of rising interest rates, this does not seem like a brilliant move.
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