Global Equity Weekly

October 06, 2023 | 16:28

The Adjustment to Higher-for-Longer Continues

Economist

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with BMO Capital Markets since 2006. He plays a key role... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with BMO Capital Markets since 2006. He plays a key role... (Read more)

Equity markets were mixed this week alongside still-rising yields and a rock-solid U.S. payrolls report. The S&P 500 added 0.5% with gains in communication services and technology offset by deeper declines in energy, utilities and consumer staples. Ten-year Treasury yields pushed to 4.8% to end the week, the highest since 2007, with the weekly selloff capped by a juicy 336k increase in U.S. payrolls in September. The TSX was down 1.5% on the week, and continues to struggle more under the weight of higher yields.

Expectations of higher-for-longer interest rates are strengthening, and markets are facing the reality that the neutral level of rates beyond this cycle will be higher than in the past. This will be an adjustment for those that got used to a decade of suppressed borrowing costs since the Global Financial Crisis. Meantime, we’re already seeing some areas where the adjustment is well underway:

Equity valuations: The spread between the forward earnings yield on the S&P 500 and the 10-year Treasury yield has compressed to less than 1 ppt, something we haven’t seen since the aftermath of the tech bubble in the early-2000s, while the forward p/e ratio sits around 18. During the 2010-to-2020 era of ultra-low rates, that spread averaged roughly 4.5 ppts with a forward p/e ratio of just under 16. During the post-tech bubble/pre-financial crisis era of more ‘normal’ interest rates (2003-07), the spread averaged 2 ppts, also with a forward p/e ratio of just under 16. The index has already moved sideways for more than two years now as yields have risen off the floor, and it looks like valuations are still finding the new normal through some combination of price stagnation/declines and earnings growth. For what it’s worth, Canadian stocks have been hit harder in recent months, leaving the yield spread and p/e ratio already cheaper than pre-financial crisis norms.

Real estate as an asset class: Real estate investment simply doesn’t ‘pencil’ at current interest rates and prices. In the Toronto condo/multifamily sectors, for example, cap rates have historically sat 1.5-to-3.5 ppts above 10-year GoC yields. But, the abrupt backup in bond yields has eliminated any meaningful spread. If history is a guide, cap rates that shrunk to around 3.5% at the market peak are likely in the process of resetting higher, to around 5% or more, based on our current interest rate outlook. This can come quickly through price declines, or more gradually through robust rent growth—both are playing out right now. From a similar perspective, a new income property investor would be deeply cash-flow negative with 20% down at current prices and mortgage rates, and a 25-year amortization, making investment difficult until prices/rents adjust.

GICs back in fashion: Canadian households are now presented with safe savings vehicles that haven’t been on the radar for the past decade—high-interest savings accounts and GICs. The latter are now readily available in the 4.5%-to-6% range for 1- and 2-year terms. Indeed, personal term deposits on Canadian bank balance sheets have surged by 75% since the end of 2021. The return of GICs as a more viable option further illustrates the valuation pressure on other asset classes—after all, it’s all relative.

Government finances: In the decade leading up to the pandemic, 10-year Government of Canada yields averaged 2%, and the Bank of Canada’s policy rate averaged just under 1%. That effectively gave fiscal policymakers free will to spend and borrow—inflation averaged 1.7% during that period, so real borrowing costs were similarly suppressed. That steadily pulled down federal debt service costs from 14% of revenues before the Global Financial Crisis (2007), to below 6% by 2021. That tide is now shifting. In the latest 12 months, debt service costs have risen to nearly 9% of total revenue, and not because the latter has fallen off. Ottawa estimates that every sustained 1 ppt increase in borrowing costs along the curve would add $4 billion to expenses in the first year, and about $7 billion per year by year five. While we’re still looking at a modest impact this fiscal year because yields only really took off late in the summer, if the neutral level is reset higher (let’s say 2.75% for the BoC rate and 3% for 10-year yields), that could mean an impact of closer to $10 billion per year down the road for Ottawa’s finances.

Pension funding: One silver lining is that defined-benefit pension plans are seeing their funding positions improve substantially now that future liabilities are discounted at a higher rate. If the past decade of low rates was the exception, not the norm, that’s good news for many plans in Canada. According to Mercer, the median solvency ratio across pension plans jumped to roughly 125% as of the end of Q3, up from around 110% a year ago and norms of less than 90% during the pre-pandemic era of low rates. Improved funding positions means less pressure (e.g., contributions, retirement ages, etc.) to make up actuarial shortfalls.

Major Index Performance

North American Sector Performances

(% change over period)

Table 1 - S&P 500 Sector Performance

Source: BMO Economics, Bloomberg

Table 2 - TSX Sector Performance

Source: BMO Economics, Bloomberg

TSX Relative Sector Performance

(relative to the index, year-ago = 100; dashed line = 200-day m.a.)

S&P 500 Relative Sector Performance