At the start of the third quarter, there was widespread optimism that inflation had peaked and that slowing economic activity would allow monetary policymakers to limit further tightening and perhaps pivot toward lower interest rates sooner than expected. This sparked a rally across asset classes into late August, at which point U.S. Federal Reserve Chair Jerome Powell brought investors back down to earth with comments at the Jackson Hole Economic Symposium reasserting the Fed’s resolve to lower inflation. The U.S. Fed and the Bank of Canada raised overnight interest rates and indicated that further rate increases should be expected.
Financial market volatility and U.S. dollar strength stemming from central bank “hawkishness” accelerated in late September, when very generous fiscal policy announcements in the UK triggered a collapse in British government bond prices and the British Pound Sterling. Markets would eventually stabilize after parts of the stimulus plan were cancelled. Prime Minister Liz Truss – who held the office for a record-setting period of only 50 days – would resign shortly thereafter.
The MSCI All Country World Index decreased 4.7% in local-currency terms (-0.6% in Canadian dollars), driven by the usual suspects – high inflation, aggressive monetary policy tightening, and the heightened potential for recession. Emerging markets equities underperformed their developed market peers, with the MSCI Emerging Markets Index posting a -8.0% return (in local-currency terms).
The Canadian equity market also dropped. After posting a 1.4% loss for the quarter, the S&P/TSX reached a level 15% lower from the all-time high reached on April 4th, putting it firmly in correction territory. To make matters worse, defensive sectors – which are also among the most interest rate sensitive sectors – did not outperform their more cyclical counterparts. Communication Services, Utilities, and Real Estate were among the weaker performers during the third quarter.
In the commodity space, gold responded negatively to the prospect for higher real interest rates, and the price of crude oil dropped by 25%. Both areas are important to the Canadian economy and capital markets.
In the bond market, the story – and harbinger of doom, according to some – was the deep inverting of the yield curve: short-term bond yields increased dramatically and reached levels higher than mid and long-term yields. Even moderate inversion has been a reliable sign of pending economic weakness. From an investor’s perspective, the FTSE Canada Universe Bond Index eked out a 0.52% increase over the quarter.
Globally, over 80% of central banks are raising interest rates, which is the most synchronized interest rate tightening cycle in the past four decades. While the authorities speak to the public of engineering “soft landings”, it is curious that any decent economic data point is being seen as bad news for markets, as if further tightening may not actually be a good idea. If that’s not contradictory enough, this aggressive tightening path is seen by many analysts as both needed and dangerous at the same time. Ominously nicknamed “operation break stuff” by central bank critics, the extent and impact of this tightening cycle is clearly a key storyline to watch in the coming months.