As winter gave way to spring we began to hear more and more that the tightening effect of higher interest rates is showing up in various parts of the economy. There have been reports of weaker markets for consumer durable purchases (appliances, cars, …). Also, there are reports of consumers downgrading to cheaper alternatives as noticed by basic goods stores like Walmart, fast food restaurants, and credit card companies. All point to consumers being under strain. The restaurant feedback is one of the first clues that service spending is following in the path of goods spending.
Meanwhile inflation rates and other economic indicators tend to be bouncing higher and lower from month-to-month so the trend and pace of decline is challenging to pinpoint. I would say this is not unlike past cycles of economic easing. It is never a crystal clear smooth, steady path.
Bonds and Interest Rates
In the spring I wrote that “the plateau in interest rates is starting to break.” Indeed we have now seen a couple rate cuts by the Bank of Canada but thus far the US Federal Reserve has held off on rate cuts, wanting to see a clear path of inflation rates converging on 2%, rather than the “down one month, up the next” gyrations they are seeing. It makes sense that Canada’s economy would be cooling off quicker than the American economy because in Canada our house mortgages tend to lock in rates for no more than 5 years whereas many mortgages in the US lock in rates for the entire amortization (payoff) period of the mortgage. Hence when rates rise, the new higher rates roll through the entire Canadian base of homeowners in a matter of 5 years whereas in the US the rate increases have a far more gradual impact. Also the US has likely been more positively impacted by the Artificial Intelligence craze than Canada.
Fig. 1: Bond ETFs: Gov’t:XGB, Corp:XCB, High Yield:XHY, US 20-yr:TLT–2 yr –Yahoo Finance
You can see from the chart above that long term bond prices bottomed around October 2023 (bottoming prices imply peaking interest rates), rose into the year-end, and then declined somewhat in the first half of 2024. We see them bottoming again now (and interest rates peaking) as it becomes increasingly clear that there will be no need to raise interest rates further.
Now the question is more about how far interest rates should fall and how fast. There is some view amongst market pundits that a Trump presidency would be more inflationary whereas a Harris presidency would not and so interest rates would have less tendency to fall if Donald Trump wins the presidency and more tendency to fall if Kamala Harris wins.
In terms of our bond strategy, I don’t think the political outcome will matter too much because I feel the path of bond prices is clearly flat-to-higher, it is just a matter of degree. The notion of bond prices falling significantly from here does not seem in the cards with either presidency.
Currencies
With some countries starting to drop interest rates before others (Canada being one of the first major economies to begin the interest rate descent), their rate moves compared to the US will impact their currency moves relative to the US. Recall from above that the US Federal Reserve has not started its interest rate cuts yet.
Fig. 2: US Dollar Index (green) and USD vs CAD (blue) – 2 years – Yahoo Finance
You can see in the chart above that from December 2023 the blue line has steadily increased (CAD weakening. In December it traded at almost 1.32 CAD/USD (76 US cents per CAD) and is now trading in the ballpark of 1.38 CAD/USD (72 US cents per CAD). It may fade slightly in the next couple months but once the US Federal Reserve starts cutting rates alongside the Bank of Canada, I don’t see much more weakening in the CAD. By that I mean that if the CAD fell below 70 US cents, I think it would only be brief, perhaps for a matter of months.
We still have significant exposure to the US dollar, through our US stock and bond positions but if there were a brief drop down in the CAD, we would consider the possibility of some rebalancing of that currency exposure.
Stock Markets
As shown in the chart below, Major global stock markets took a breather in April from their winter acceleration and then once May arrived markets parted ways. The US (purple) and Japanese (red) markets rose into the summer while the UK and German markets did not move much and the Canadian market actually declined slightly. The unique performance of the US and Japan can be chalked up primarily to two factors: in the US the AI craze pushed tech stocks higher and these have grown to really dominate the stock market (not good from a diversification perspective). In Japan, there has been a sense that after decades of struggling the Japanese economy is once again on more solid ground and in position to do well going forward. As such there has been some crowding into Japanese stock markets, pushing them higher.
Fig. 3: Equities: US-purple, Can-blue, Jpn-red, UK-yellow, Germany-green – 2 yrs – Yahoo Finance
After the end of the quarter, July experienced (not shown) a pullback in the US index due to a pullback in tech stocks. Meanwhile, stocks in other sectors tended to do better. It is not clear if this is the end of the tech frenzy but I would say it is a lot closer to the end than to the beginning.
Just after the quarter’s end we purchased meaningful positions in Emera, a utility company where we owned a small position in the past. Emera’s profitability in the past few years has been challenged by increased costs as it gradually wound down old coal-fired power plants. Now they are almost all closed and the remaining few are slated for closure in the next few years as Emera builds the new electrical generation capability to move away from coal. Emera is building renewable facilities at a blistering pace and also increasing its ability to tap into the Labrador hydro facilities through increased transmission capacity. Hence, with all this expenditure behind it, Emera should see stronger days ahead. And to boot, the company is currently paying a dividend yield of over 5%. Emera seems to have a solid future ahead of it and we continue our search for other businesses with the same.
Respectfully submitted,
Paul Fettes, CFA, CFP, Chief Executive Officer, Brintab Corp.
Leave a Reply