Market Update - November 2021



Let's start with some facts about Remembrance Day:


  1. Jozef Kowalski of Poland was the last World War I-era veteran. He died on December 7, 2013, at the age of 113!

  2. Of the approximately one million Canadians who fought in World War II, Veterans affairs Canada estimates that roughly 39,700 remain.

  3. The average age of a World War II veteran is 94.

  4. Remembrance Day was first observed in 1919 throughout the British Commonwealth. It was originally called “Armistice Day” to commemorate the armistice agreement that ended the First World War on Monday, November 11, 1918, at 11 a.m.

  5. From 1921 to 1930, Armistice Day was held on the Monday of the week in which November 11 fell. In 1931, Alan Neill, Member of Parliament for Comox–Alberni, introduced a bill to observe Armistice Day only on November 11.

  6. The United States used to commemorate Armistice Day on November 11. However, in 1954 they changed the name to Veterans Day.

  7. The legion says it raises about $20 million from its poppy campaign each year, with the funds going directly toward supporting veterans.

  8. Veteran’s Affairs Canada estimates the total veteran population to be 629,300.


Heading for an energetic year-end


Equity markets opened the final quarter of 2021 with strength, posting particularly solid gains in North America, while an appreciating Canadian dollar helped the S&P/TSX extend its year-to-date lead over its peers. On many levels, October was a reflection of the first 9 months of 2021: the various segments of the North American stock markets (cyclical/defensive / value/growth) fought hard for a place on the podium, foreign equities lagged behind, and bond prices fell slightly (chart below).


The release of better-than-expected corporate earnings is a key factor behind the strong performance of stocks in October. Indeed, 82% of the 276 S&P 500 companies that have reported Q3- 2021 earnings thus far have beaten estimates, pushing expected year-over-year quarterly earnings growth from 30.6% to 39.5% since the start of the earnings season (chart below).


Going forward, there is little doubt that earnings growth is bound to slow. However, the good news is the 12-month outlook has begun to stabilize just below a healthy 10%. Surprisingly, for now, most companies seem to be able to maintain their profit margins (chart below) – which stand at record highs in the U.S. – despite inflationary pressures and supply chain issues.


Clearly, one cannot take for granted that rising input prices will eventually lead to lower profit margins for many firms. With respect to major commodity prices, trends diverge. However, one development that has caught the markets' attention in October is the persistent rise in oil prices (chart below).



Energetic Inflation?


Buoyed by a perfect storm of strong demand (stemming from the recovery in global economic activity following the Delta wave, coupled with an energy crunch in Europe and Asia) and relatively limited supply (OPEC+ refusing to provide additional production), oil prices have recently reached a 7-year high. This trend has added to concerns about the future path of inflation and economic growth.


Inflation is never a matter of any single factor. But, in the case of energy prices, this is likely due in part to the fact that our economies are far less dependent on oil than they once were. The oil intensity of global economic activity (a measure representing the number of barrels of oil consumed per unit of GDP) has dropped by half over the past 40 years. In addition, unlike the 1980s/90s, the correlation between stock markets and oil prices has generally been positive since the turn of the millennium, suggesting that rising crude oil prices are more symptomatic of a strong economy in search of equilibrium than a threat to growth at this juncture.


What can we conclude from all of these nuances? In short, although inflationary pressures are proving to be stronger than expected and are likely to continue for several more months, they should ultimately stabilize at levels that are more sustainable and consistent with the Fed's ambitions, as the post-COVID economy finds its equilibrium. Recall that in August 2020, the Fed changed its inflation target to 2%, on average. Details surrounding this new policy remain ambiguous. However, it is clear that the Central Bank is seeking, in part, to make up for the cumulative shortfall caused by nearly a decade of below-target inflation. In this regard, despite the strong inflation trend of the last few months and that currently expected by markets going forward, we see it will still take a little less than 2 years for the core PCE Index and 5 years for the overall PCE Index (the Fed's actual target) to catch up to the 2% trend (chart below).


While this framework is not perfect, it does help illustrate why the Fed is willing to tolerate higher inflation in the short run. To be sure, it will nonetheless have to start to gradually reduce monetary policy accommodation (reducing asset purchases and increasing interest rates) sooner rather than later. And, that is indeed what is in store for the coming months.


Time to Taper


At a conference in late October, Fed Chairman Jerome Powell left little room for ambiguity regarding his intention to begin reducing the pace of asset purchases in November, by saying, “I do think it's time to taper.” This process should lead to the end of the asset purchase program by the middle of next year. However, he made sure to add, “I don’t think it’s time to raise rates.” With still 5 million fewer jobs than before the pandemic, one can understand why the Fed, whose mandate is to ensure maximum employment in addition to price stability, is not rushing to raise rates (Chart below).


It’s a different situation on our side of the border, where not only has employment returned to pre-pandemic levels (Chart 14), but the overall economic recovery is proving to be the strongest of the G7 countries, in nominal terms (Chart 15). This reflects, among other things, the sharp rise in the terms of trade associated with the increased prices of many commodities which Canada exports.



Under the circumstances, the Bank of Canada, whose mandate is centred on maintaining stable and predictable inflation, announced the immediate end of its asset purchase program and opened the door to rate hikes in the second or third quarter. Specifically, our colleagues on the NBF Economics and Strategy team are now projecting the first-rate hike as early as next April (as opposed to July, previously) and a total of 4 hikes in 2022. In the U.S., the first hike is projected for Q3-2022 (as opposed to Q4-2022 previously) (Chart below).


Such a divergence between the interest rate outlook between our two countries combined with a rise in oil prices is a traditionally positive backdrop for the Canadian dollar, which did indeed appreciate by 2.2% during October. In theory, this environment should continue to support the Loonie over the next few months, although the upside potential does not seem as high as suggested by the historical relationship between these variables, which has been visibly weaker since 2019 (Chart below).



The Bottom Line


Our base-case scenario of decelerating global growth and more modest equity out performance remains unchanged. The key issue for markets remains inflation, which is likely to be strong for several more months, potentially reaching a new year-over-year high in December (Chart below). This will continue to put pressure on central banks, which should not significantly alter their intentions, as long as long-term expectations remain consistent with their objectives. For 10-year Treasury yields, after rising sharply in recent months, it will probably be more challenging to break through the technical level around 1.70% (pre-pandemic level and peak in early 2021). A brief period of consolidation is likely, but the trend should ultimately remain upward as central banks normalize their monetary policies.


Against this backdrop, we are keeping our asset allocation – slightly overweight in equities and cash at the expense of bonds – unchanged.


As always, if you have any questions about your investment planning our individual portfolio questions – please feel free to reach out to me or any of our other team members.


- Your Creed Capital Management Team

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