Commentary October 2024 – Wobbling Toward a Cooler Economy

Reblogged from Brintab

 

In the July letter I noted that the transition of economic cycles between growth and recession is rarely a smooth path and that was evident that last month.  Note that I am often primarily referring to the US economy because it is so dominant in driving what happens all around the world.  In late summer we saw signs of things slowing down in the US economy, on the other hand we got September signals of slightly higher than expected inflation and a strong “non-farm payroll report.”  This led to the knee-jerk reaction among some that the recession has been averted and the US economy is back in growth mode.  The way I see it, we are definitely not out of the woods yet.

Bonds and Interest Rates

As the US central bankers started signalling the intent to decrease interest rates, long duration bond prices started rising (remember, when interest rates fall, bond prices rise).  I have included a longer-term trend chart here to help get a broad perspective. Bond prices appear to have bottomed in October 2023, after which they have been slowly rising, but with wobbles along the way, such as the pullback into April 2024 and the second pullback just now in October 2024.

Fig. 1: TLT ETF price since 2005 (illustrative of US 20+ year treasury bond prices) –Yahoo Finance

We do see the gradual cooling of the economy in the US and also in Canada.  There are concerns among some people, however, about the possibility of inflation heating up again, and forcing the central bankers to return to higher interest rates to keep things under control.  I don’t think that will be the direction things will take.  I think interest rates will be decreasing (and bond prices rising) from where they are.

One of the sources of inflation worries is the long list of promises being made by both US presidential candidates.  In reality, post-election those strong positions will tend to get watered down, in part because usually the Presidency, Senate, and House of Representatives do not fall to the control of one party through a clean sweep.  As a result, we get divided government and gridlock in Washington and the changes promised during the election are moderated drastically.  The middle-of-the-road ideas have more chance of getting through.

Also, many homeowners could not afford the current mortgage rates if they were to renew or buy a home.  Even though most Americans have mortgages with rates locked-in for the full timeframe until their mortgage gets amortized right down to zero (i.e. 20-30 year rate lock-ins),  as the years pass, people are gradually pushed into the mortgage market due to loss of jobs, divorce, relocation, coming-of-age, and other factors.  The result is that, over time, more and more people bump up against this mortgage cost pressure from higher interest rates and they either cannot buy or renewal rates force them to rein in their spending in other areas just to cope.  Ultimately, the consequence is a cooling of the economy and a need for interest rates to go lower (and bond prices to go higher) than where they are now.

After the past year’s movement in the US 10-year interest rates, those rates still remain at least a couple percent higher than the rates people are currently locked into.  We can see that rates still have room to fall more to come into line with realistic affordability.

Nonetheless, we do keep the opposing thesis in our minds to at least be aware of where things could go if something else panned out.  The opposing thesis largely circles around nationalism/deglobalization.  To the extent that Americans believe their economic woes come from foreigners, they are susceptible to raising barriers to trade with foreigners.  This could raise the cost of many goods that would have to be made in the USA, causing inflation.  If such a scenario unfolds it will be wise to protect against rising inflation, which would likely push US interest rates and the US Dollar higher.  We keep this possibility in the back of our minds for close monitoring.

Currencies

As is typically the case, when US interest rates fall, the US Dollar weakens and when US interest rates rise the Dollar strengthens.  This is generally the case to the extent that large moves do not happen to the other currency to which we are comparing the US Dollar.  Since investors usually compare it to a basket of currencies called DXY (which is a mix of Euro, Yen, Pound, Can Dollar, etc.) then the individual moves of those other currencies are watered down in the index and it basically conveys the US Dollar behaviour.

During the most recent quarter, the Canadian Dollar dipped from 0.7342 US at the beginning of the quarter down to 0.7204 in August, bounced back up to 0.7443 in September, and then receded to about 0.7244 in October, just after the quarter ended.  There is a chance the Canadian Dollar could go lower.  The signs of the economy fading are more evident in Canada than in the US and so the Bank of Canada may drop interest rates at a slightly faster pace in the coming months than the US Federal Reserve does.  If this happens the CAD could be toying with the 70 cents US mark.  Similarly, any geopolitical shock (e.g. Middle East escalation worse than it already is) could temporarily bump the “safe haven” US Dollar higher as I feel the rise of the USD to the current level does not reflect much of a safe haven trade so far.

Fig. 2: US Dollar Index (green) and USD vs CAD (blue) – 2 years – Yahoo Finance

The implication is that now is likely a better time to convert from USD to CAD rather than the reverse (sorry, Snowbirds) an although the CAD could dip even lower, I don’t see it going very much lower from here, the main caveat being that if Donald Trump wins the presidency and initiates tough NAFTA renegotiations, the CAD could get spooked temporarily. By the way, I just can’t get my tongue around calling NAFTA 2 the USMCA or CUSMA or whatever so for now, for me its still NAFTA 2.

 

Stock Markets

Just like bonds, the US stock market started out the quarter fairly stable before receding into August and then recovering into the end of the quarter, putting it at its frothiest since late 2021 and vulnerable to a pullback.  At this point I would say we have lots of “dry powder” (money ready to deploy) should a pullback happen.  We have moved capital from stocks to bonds and from cyclical stocks into utilities and less cyclical businesses.

With the strong recent markets, we have reduced/exited certain holdings which seemed to face dark clouds in the short term ahead.  Methanex was one of them.  We no longer own any shares.  I still do believe Methanex has strong prospects in the long term.  The growing interest of methanol as a fuel, particularly for ocean shipping is promising and when stacked up against other fuels that can have a green source such as green hydrogen, green LNG, or biodiesel, methanol seems to be one of the best candidates from the perspective of cost of carbon-neutrality production and ease of storage (liquid at room temperature and pressure).  Nonetheless the stock does have some near-term headwinds if a broad economic headwind creates challenges for the plastics end-markets that use methanol as a source.  We wouldn’t hesitate to hold Methanex again in the right circumstances as it likely controls the market for a fuel of a green future.

Fig. 3: Equities: US-purple, Can-blue, Jpn-red, UK-yellow, Germany-green – 2 yrs – Yahoo Finance

When reviewing markets around the world, we can see from the chart that over the past two years Canada (blue line) lost ground to most other markets back in 2023 and hasn’t really regained that yet.  Canada is jointed by the laggard UK stock market in yellow.  I believe this will shift.  While the US markets rose on the backs of high tech (especially artificial intelligence stocks) and Japan started to emerge from decades of struggles, those factors are abating.  I expect to see Canada close the gap on the US market however not the way you think.  With its numerous high-priced high-tech stocks, the US index is more likely to come down to meet Canada’s rather than Canada’s index leap to meet the US index.  Of course, even in our US positions at the moment we are not highly exposed to those tech stocks and therefore not exposed to their potential retrenchment.

Respectfully submitted,

Paul Fettes, CFA, CFP, Chief Executive Officer, Brintab Corp.