Market Watch: August 2023

Global financial markets experienced a decline in August as the US economy revealed a revised 2.1% annual growth rate in the second quarter, driven by consumer spending and business investment. Unemployment unexpectedly rose to 3.8%, while inflation remained at 3.2%. Fitch Ratings downgraded the US default rating to AA+ due to fiscal concerns. Traders speculated the US Federal Reserve might pause interest rate hikes. In Canada, the economy contracted in Q2, leading to doubts about the Bank of Canada’s rate hike strategy. The labor market showed signs of weakness, and inflation remained above target. China experienced deflation, risking economic slowdown, while the UK faced challenges in achieving its inflation target. The Eurozone had moderate economic growth, but uncertainty persisted, and inflation remained high, raising concerns for the European Central Bank.

The S&P/TSX Total Return Index was down 1.37 percent in August as Canada’s economy contracted in Q2, raising doubts about the Bank of Canada’s interest rate hike strategy.

Canada’s economy faced unexpected setbacks in Q2, witnessing a contraction in its GDP. The country’s economy stagnated during this period, contracting at an annualized rate of 0.2 percent, a sharp contrast to the 0.6 percent expansion in the year’s first quarter. The primary factors contributing to this economic slowdown were a persistent decline in housing investment, with a significant 2.1 percent drop marking the fifth consecutive quarterly decrease, and a substantial 8.2 percent decline in new construction. Renovation spending also declined by 4.3 percent. Lower inventory accumulations, decreased exports, and a slowdown in household spending further contributed to the economic stall.

Canada’s job market remained relatively stable, with a slight uptick in the unemployment rate to 5.5 percent in July. Notably, worker compensation saw a significant increase, with average hourly wages growing by five percent, following similar gains in May and June. However, the Canadian economy experienced a loss of 6,400 jobs, leading to the third consecutive monthly increase in the unemployment rate as the demand for employment from the growing population outstripped job creation, contrary to economists’ expectations of a 25,000 job gain.

Canada’s July inflation figures exceeded expectations, staying above the Bank of Canada’s target and increasing the probability of additional monetary policy tightening in September. The Consumer Price Index (CPI) headline inflation rose to 3.3 percent year-on-year in July, up from 2.8 percent in June, mainly due to a slower decline in energy prices. Core CPI, excluding food and energy, dipped slightly to 3.4 percent year-on-year in July from 3.5 percent in June.

On monetary policy, Canadian markets are preparing for the Bank of Canada’s (BoC) policy rate announcement scheduled for September 6, 2023. This announcement follows two consecutive 25 basis points (bps) interest rate increases in June and July, which raised the overnight lending rate to 5.0 percent, its highest point since 2001. Throughout 2023, Canadian interest rates have shown a consistent upward trend, with the 5-year Government of Canada rate climbing by more than 100 bps since late March 2023, briefly crossing the 4.0 percent threshold – a level not seen since 2007. Market indicators suggest strong confidence among bond investors that the gradual monetary policy tightening phase has concluded. Economists anticipate that the BoC will keep its policy rate at 5.0 percent.

The S&P 500 Total Return index was down 1.59 percent in August as US Q2 growth was revised to 2.1 percent, unemployment rose to 3.8 percent, and Fitch downgraded the US credit rating.

Official revised estimates revealed that the US economy expanded at a 2.1 percent annual rate in the April-June quarter, a slight adjustment from the initial estimate of 2.4 percent. This growth, which marked a modest acceleration from the 2 percent rate in the previous quarter, was propelled by increased consumer spending and business investment. Economists had anticipated a stable assessment of the GDP, with this revision still representing an improvement from the 2 percent growth in the first quarter.

The US economy saw an unexpected increase in unemployment to 3.8 percent from July’s 3.5 percent in August, marking the highest rate since February 2022, contrary to the anticipated stability at 3.5 percent. The US economy added 187,000 jobs, surpassing the expected 170,000, though revisions to the July and June job reports revealed 110,000 fewer jobs created during those months than initially reported. Over the past year, job gains have averaged 271,000 per month, with the economy exceeding this hiring pace only twice in the last nine months. Furthermore, average hourly earnings experienced a 4.3 percent year-over-year increase.

July’s inflation rate in the United States increased by 3.2 percent compared to the previous year, signaling a potential easing of inflation’s grip on the economy. The month saw prices rise by 0.2 percent seasonally adjusted, aligning with Dow Jones estimates. Although the annual rate fell slightly short of the forecasted 3.3 percent, it was higher than June’s figures, marking the first yearly increase over a year. The core CPI also rose by 0.2 percent for the month, matching estimates and resulting in an annual rate of 4.7 percent, the lowest since October 2021. The annual core rate was slightly below the Dow Jones consensus estimate of 4.8 percent.

Fitch Ratings downgraded the United States’ default rating from AAA to AA+ due to concerns about expected fiscal deterioration over the next three years, erosion of governance standards, and a growing government debt burden. Fitch cited the impact of repeated debt-limit political standoffs and last-minute resolutions on confidence in fiscal management, with a consistent decline in governance standards over the past two decades, despite a recent bipartisan agreement to suspend the debt limit until January 2025. The agency also noted a rising general government deficit, expected to reach 6.3 percent of GDP in 2023, and expressed concerns about potential economic challenges, including a “mild” recession in late 2023 and early 2024 due to tightening credit conditions, weakened business investment, and consumption slowdown. The White House disagreed with the downgrade, emphasizing the strength of the US economic recovery. This downgrade by Fitch follows Standard & Poor’s downgrade of the US credit rating from AAA to AA+ in 2011.

On monetary policy, Traders are betting that the US Federal Reserve will pause its interest rate hikes. Futures tied to the Fed’s policy rate initially indicated a minimal chance of a rate increase this month and now reflect a reduced probability of any further policy tightening by US central bankers this year, dropping from 45 percent to around 38 percent after the latest jobs report. The job report is likely prompting the Fed to hold off on rate hikes in September, potentially marking the end of the rate hike cycle amid easing inflation pressures. Cleveland Fed President Loretta Mester remains hawkish, suggesting the need for further rate increases. Still, the overall market sentiment means the Fed will remain on hold until at least April 2024, with potential rate cuts in May.

The MSCI ACWI Ex-US Total Return Index was down 4.50 percent on global economic concerns in August as China faced deflation, UK inflation surged, and Eurozone growth remained sluggish.

The Chinese economy experienced its first deflation in July in over two years, with the CPI dropping by 0.3 percent year-on-year, slightly surpassing the -0.4 percent year-on-year consensus forecast. This deflationary trend encompassed reduced food, transportation, and household goods costs.

Simultaneously, the PPI recorded its tenth consecutive decline, contracting by 4.4 percent year-on-year in July. This deflationary environment heightens the risk of both consumers and businesses postponing their expenditures, potentially resulting in slower economic growth, slimmer profit margins, and increased unemployment. Given the concurrent decline in CPI and PPI, Beijing is anticipated to implement further easing measures to bolster economic growth.

The UK inflation and labor data has heightened the Bank of England’s challenge in achieving its 2 percent inflation target, prompting the expectation of a 25-basis point rate hike in September. The BoE’s policy decisions depend on three key factors: labor market tightness, private sector wage growth, and services inflation. Concerningly, July’s data showed services inflation rising to 7.4 percent year-on-year, surpassing the central bank’s 7.3 percent forecast, while headline prices moderated to 6.8 percent year-on-year. Regarding labor market dynamics, June’s data presented a mixed picture, with a slight uptick in the unemployment rate to 4.2 percent and a decrease in job vacancies to 1.02 million, suggesting easing hiring pressures. However, private sector pay growth, reaching 8.2 percent, its highest level on record outside the pandemic, raises deeper concerns for the BoE.

Eurostat’s GDP estimate for Q2 2023 reported a 0.3 percent quarter-on-quarter growth in the euro area, though economic growth was moderate. The tight labor market was evident, with a record-low unemployment rate of 6.4 percent in June. Despite this, uncertainty looms over the economic future, with the August composite PMI hitting 47, the lowest level since 2012, excluding the Covid period. Inflation in the Eurozone was surprised by remaining stagnant at 5.3 percent year-on-year in August, while core inflation dropped slightly from 5.5 percent in July to 5.3 percent in August.

The weaker-than-expected data raises the likelihood of an ECB pause at the upcoming September meeting. Still, it highlights a concerning issue: increasing sector input cost inflation due to wage pressures. Although not the baseline scenario, the recent surge in inflation expectations might lead to further ECB tightening beyond 3.75 percent. In the bond market, real yields have risen since July 18, primarily driven by increasing inflation expectations. Given its efforts to combat inflation, this development is worrisome for the ECB.

The Portfolio Management Team