CIO at SLGI Asset Management Inc. urges caution on strong bear market rally as leading indicators flash yellow
After a months-long streak of stubborn increases in inflation, investors in Canada and the U.S. had seemingly resigned themselves to a long spell of increasingly aggressive rate hikes by central banks. But as data in June reflected early indications of economic softening, markets have started to price in central bank rate cuts in early 2023 in response to slowing growth indicators.
But Chhad Aul, Chief Investment Officer and Head of Multi-Asset Solutions at SLGI Asset Management Inc. believes it’s too soon to get excited, especially since there’s yet to be a sustainable downtrend in inflation.
“In the last few weeks of July and heading into the first week of August, we’ve seen optimism and calm in markets,” Aul says. “But we fully expect volatility to return as we get into the fall, if not sooner. There are lots of questions still to be answered on the central banks' fight against inflation.”
Everyone is hoping for a soft landing, with the economy slowing down just enough to rein in inflation without falling into a severe slowdown or recession. But as the Bank of Canada and the Federal Reserve started their respective campaigns from behind the curve, the priority of the day is to throttle inflation back toward their target range of 2%. In other words, the more likely forecast is for more uncertainty and difficulty as inflation works its way through the markets.
“Ultimately, I think they're willing to accept softness and growth to achieve that end, which makes the hard landing scenario with recessions, far more likely,” Aul says. “The question is just really, how deep and how much will it have to affect the labour market, which is the one part of the economy that's showing the most strength.”
In an environment of rising rates, housing – which represents an estimated 10% of the total economy, Aul says – is likely to show the most sensitivity. Canadians also hold much of their net assets in their residential properties, which means a weakening of housing prices can trigger a negative wealth effect that could hamstring consumption.
Based on the leading indicators SLGI Asset Management Inc. is monitoring, the housing market is well on its way to weakening. While there have yet to be signs of considerable weakness in manufacturing, it’s also a fairly rate-sensitive component of the economy; if that domino falls – which Aul says is likely at this point – it’s liable to bleed into corporate profits and earnings.
“Job cuts typically come later in the recessionary phase of a normal economic cycle,” Aul says. “Since we’re starting with such a tight labour market today, we can expect even more of a lag in this case.
“You can view it as a blessing or a curse,” he adds. “If you’re bullish, you can expect the strong labour market will put a floor under how bad the economic damage could be. But if you have a more bearish view, it’s a support for inflation, which increases the amount of shock therapy that’ll have to be done to ultimately cool off the market.”
SLGI Asset Management Inc. reads the currents in financial markets today as a strong bear market rally, which creates opportunities for portfolios to be shifted to a more defensive stance. Within equities, they see a lot of sense in downplaying exposure to cyclical sectors. From a factor perspective, quality and growth would be their odds-on favourites over value, specifically in the slowing environment they see the world drifting towards.
More broadly, Aul suggests an incremental rotation toward bonds and lowering equity exposure. Within the bond portfolio, he recommends moving up to higher-quality bonds, and shifting away from riskier parts of the credit market.
“It’s about making the portfolio more resilient,” he says. “I feel there’s a lot still to be done on the inflation side, and lots to figure out in terms of what the economic damage we may have to take. Ultimately, we don’t believe a dovish pivot in policy is necessarily coming as the market seems to have expected lately.”
The last few bear markets have culminated in very sharp, V-shaped recoveries, which Aul argues is due to how aggressively policies were shifted to the dovish side in response to economic challenges. This time is different, as conditions don’t lend themselves to the same quick pivot to growth concerns.
“I think we have to temper expectations for a very quick solution to the market that we’re in,” Aul says. “It's not surprising that markets have been somewhat trained to expect that … but this time around, unfortunately, it looks like it will be a tougher climb.”