Global Equity Weekly

September 29, 2022 | 16:31

Pounded

Economist

Senior Economist and Director
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Robert Kavcic

Senior Economist and Director
Economics

Robert has been with the Bank of Montreal since 2006. He plays a key role in analyzing regional economic, fiscal... (Read more)

Markets continued their wild ride this week, with last week’s hawkish Fed announcement pressuring yields higher and stocks lower, while a crisis broke out in the U.K. The action provided some stark reminders on the conduct of fiscal policy and the pricing of assets.

The U.K.’s not-so-mini budget, which included more than £100 bln in tax cuts and energy price relief, was delivered by policymakers clearly unable to read the room. The pound slid to a record low against the dollar early in the week, while 30-year Gilt yields surged above 5% at one point for the first time in 20 years. The severity of the move in the latter added serious stress to the market, raising liquidity concerns in the pension system that uses long-dated Gilts as collateral, prompting the BoE to step in and promise bond purchases on whatever scale necessary. This, of course, at a time when inflation is raging and the central bank is raising policy rates.

Table 1 - Market Performance

Source: BMO Economics, Bloomberg

The lesson here is that, after rolling with blank cheques through the pandemic, fiscal policymakers are not free to do whatever they want, whenever they want. In Canada, financial results continue to come in ahead of expectations across both federal and provincial jurisdictions, and there is an appetite for direct support spending. While the measures to date are proportionally much smaller than the package unveiled in the U.K., they are inflationary and lean against what the Bank of Canada is trying to do. The loonie was under pressure as well this week, alongside a broad risk-off trade, but it doesn’t look like the market is imminently going to turn on Canada, as it did in the U.K. or here at home in the mid-1990s. That’s in part because of more wiggle room in the budget, and the fact that, while they can be fleeting with oil prices, the country is stringing together current account surpluses (deficits in the U.K. recently, and in Canada during the 1990s, topped 3% of GDP). Let’s just say that after this week’s warning shot, allowing the surge in revenues to rebuild fiscal capacity would be a very wise move at this juncture.

Meantime, U.S. Treasury yields pierced the 4% level for the first time in over a decade. After more than 2½ years pinned below 2%, the lesson here is that valuations across a wide spectrum of assets need to be reset. In the equity market, almost all the bear-market drawdown to date has been valuation-driven, with the forward price-to-earnings multiple on the S&P 500 falling almost step-for-step with the rise in yields—more specifically, real 10-year yields. Bears would read this as though any earnings recession has yet to be priced in. Elsewhere, real estate values are adjusting to higher mortgage rates. Gone are the days of 1.5% financing in Canada (rates across the spectrum will be closing in on 5% soon), while U.S. 30-year fixed rates are moving toward 7% in the largest year-over-year increase on record going back to 1990. We can talk at length about demographic demand and supply-side constraints, both of which are real issues, but a market simply can’t absorb such a sudden increase in the cost of capital without some meaningful repricing—which is well underway. In commercial real estate, cap rates that had compressed to around 3% in some sectors suddenly don’t make sense when risk-free returns are available at equal or higher levels.

All told, it looks like we’re quickly headed back to a world that used to make much more sense. One where managing a country's purse was a job to be done carefully, and with consequences; and one where asset valuations really mattered.

Major Index Performance

North American Sector Performances

(% change over period)

Table 2 - S&P 500 Sector Performance

Source: BMO Economics, Bloomberg

Table 3 - 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