Powell’s Pause or Powell’s Pit Stop?

Weekly Commentary

Market Recap

• Equity markets rallied this week, with the AI-powered tech and communication services names still driving the gains. The S&P 500 rose 2.6%, with technology leading the pack up 4.4%. Not to name names, but the blowup in valuations for a select group of companies has now powered technology 41% higher this year, while communication services are not far behind, up 36%.
• Meantime, the TSX continues to lag, up 0.4% on the week as gains in consumer discretionary and technology were partly offset by declines in utilities and energy.
• It’s no secret that the Canadian index has been stuck in a range all year (+3% so far in 2023) even as the S&P 500 has broken out above last summer’s high (+14.8% in 2023). From a simple valuation perspective, at around 13x forward earnings versus 19x-plus in the U.S., Canada has rarely looked this cheap on a relative basis.

Fed Pause

Last week, the U.S. Federal Reserve followed through on its much-anticipated pause on rate hikes, declining to raise interest rates for the first time in 15 months. The pause had been widely anticipated, but a rate hike could have also made sense based on the underlying data—the decision to pause was dovish, but the dot plot was quite hawkish. In his comments, Fed Chairman Jerome Powell hedged, emphasising that the dot plot is based on today’s expectations and not necessarily representative of what tomorrow will bring. He was also asked why the Fed doesn’t just raise rates now if the dot plot is pointing toward two or more additional rate hikes down the road; his response was that it’s no longer about getting rate hikes into the economy quickly but rather about the final destination. Pausing has the dual benefit of giving previous rate increases a chance to filter through the economy and giving the Fed a chance to see which way the data is trending. Still, the decision is somewhat confusing, as Powell reiterated that inflation remains stubbornly high while GDP and employment numbers are holding up better than expected. In our view, it’s possible to interpret these comments just about any way you’d like. Markets’ reaction seemed to reflect uncertainty, selling off right after the announcement and then rebounding during Powell’s comments, ending up in neutral or slightly positive territory depending on which market you were looking at. Ultimately, we don’t think this is necessarily going to be a long pause; rather, it’s a pit stop, with the Fed likely thinking that they’ll need to do more, but wanting to take some time to examine the situation before committing to further increases.

Bottom Line: The Fed’s pause is not necessarily the end of the rate hiking cycle, and it’s increasingly unlikely that there will be rate cuts in 2023.

Housing

How will the Fed’s move affect the U.S. housing market, and where does it leave consumer? It’s no surprise that on the consumer front, people were hoping for rate cuts. That’s not likely to happen any time soon, so this does put more pressure on consumers to tighten their belts. In good news, the supply side is improving and inflation is coming down, so people will get some relief from that. But the cost of borrowing is still going to be expensive. If this isn’t the end of the rate hiking cycle, there’s still the chance that U.S. consumer debt levels could go up, and that mortgage rates could rise. We do expect to see the U.S. housing market starting to bottom out if the Fed only has one more rate hike left this year, but two or more increases could cause it to move another leg lower. In Canada, the household service debt ratio is increasing, as is the debt-to-income ratio, with rate increases still a possibility. That’s certainly not good news, but it’s still manageable for the consumer because of the abundance of savings they can tap into. It’s also worth remembering that in both Canada and the U.S, the supply of available housing is limited because if you sell, your options aren’t great—you either pay a fortune in rent or you buy a new home at today’s mortgage rates. At your current rate, you might be able to afford a million-dollar home, but at higher rates, you might only be able to afford a home in the $700,000 range. There’s no win there for the consumer.

Bottom Line: With interest rates already around 5%, one more hike isn’t likely to have a huge affect on the housing market, but more than one could change the situation.

Playing Defense

When it comes time to circle the wagons, which sector makes the most sense for defensive positioning? Let’s look at Consumer Staples vs. Consumer Discretionary as an example. The conventional thinking is that investors should consider tilting toward Staples rather than Discretionary because the economy is weakening, inflation is high, and job losses are occurring. Consumers will tighten their belts and shift their spending to Staples—or so the reasoning goes. We agree that this kind of trade will make sense when a recession is nearer. But this cycle is different because of consumers’ reservoir of personal savings from the pandemic. This creates a buffer for Consumer Discretionary that didn’t exist in past recessionary cycles. As a result, Discretionary is holding up much better than one might have expected, and it’s an exposure that is worth maintaining for the time being, especially with China’s reopening boosting demand. U.S. Consumer Discretionary is interesting in that it includes companies like Amazon, which isn’t really discretionary in the conventional sense, and also includes some Tech exposure. In a slow-moving downturn, you don’t have to be completely defensive—you can still play a little offense and maintain some measure of balance. When we see more negative news, like massive job losses, that’s when it will be time to move to Staples. But we’re just not seeing that yet. The recession has already been punted to 2024, and there’s no reason it can’t be pushed out further. In our view, investors should only pivot to defensive sectors like Consumer Staples when the recession is about three months away.

Bottom Line:As long as the consumer continues to hold up fairly well, we wouldn’t recommend a massive tilt to Consumer Staples.

Positioning

A detailed breakdown of our portfolio positioning is available in the latest BMO GAM House View Report, titled Know When to Hold ’Em.

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Originally Posted June 19, 2023 – Powell’s Pause—or Powell’s Pit Stop?

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