What Happens When Central Banks Pivot?

December 6, 2022 | By: Dillon Culhane, Richard Fisher, Wyeth Wright, Lazar Naiker, Wai Tong and Jean-Sebastien Nadeau

What Happens When Central Banks Pivot?

AGF analysts explain how a slowing of interest rate hikes (or outright stop to them) could impact key segments of the equity and credit markets in 2023.

 


 

Equities

Will Energy run out of gas?

Dillon Culhane

The Energy sector has outperformed broader equity markets over the past two years, driven by post-COVID demand recovery, years of supply underinvestment, industry capital discipline, attractive equity valuations and a refocus on energy security in the wake of Russia’s invasion of Ukraine. As inflation and interest rates have risen, Energy has been the only sector showing positive earnings revisions and rising free cash flow, driving increased shareholder returns and decreased balance sheet leverage – and thus it has felt little impact from the rising cost of debt. Of course, rising energy prices are a huge driver of inflation and subsequent interest rate hikes, which are designed to slow the economy down, theoretically reducing energy demand. However, past recessions have shown minimal lasting (or material) impact on oil-and-gas demand.

Once we get a clear line of sight to a pause on interest rate hikes, the Energy sector will likely underperform growth sectors and other laggards in the market. But that doesn’t necessarily mean it will trade down. On the day of the lower U.S. inflation print for October, the S&P 500 traded up 5.5%, with Technology (+8.3%) and Real Estate (+7.7%) the top-performing sectors, while Energy was still up by 2.2%, per Bloomberg. A pause in rate hikes should signal that inflation has bottomed and economic growth will eventually resume, which is positive for energy demand. There are also many structural forces supporting the sector, including Europe’s pivot away from Russian energy, OPEC’s willingness to manage supply and an eventual China reopening. So while Energy is unlikely to continue outperforming the broader market once central banks turn direction on rates, it's quite feasible that oil-and-gas prices remain in a band around current levels over the coming years, driving very strong profits for energy companies.

S&P 500 Sector Performance

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Source: Bloomberg LP as of November 25, 2022

How will Financials handle a slowing economy?

Richard Fisher and Wyeth Wright

For banks, we expect the benefit stemming from increasing interest rates to moderate as we progress through 2023. Nearer term, banks should report solid net interest income growth, driven by higher margins associated with lagging deposit cost inflation, moderating loan growth and reasonably well-behaved credit quality. Financial institutions with the strongest deposit franchises should outperform, as they typically have more diverse revenue streams and the largest securities portfolios on their balance sheets (which generally reprice faster than loans). Earnings moderation follows from a shift in deposit mix towards higher-cost term funding like GICs and a heightened level of competition for deposits and loans as the economy slows under the weight of higher rates. And with that slowing economy, banks will build reserves for performing loans to address possible losses in the future.

For Financials that are sensitive to the consumer, a slowdown in rate hikes would have positive effects on stock multiples in the short term. However, a recession or “harder landing” leading to higher unemployment and a worsening economy would weigh on the entire sector, even in a more liquid financial environment, and we would expect to see delinquencies and charge-offs rise, putting downward pressure on earnings. Bank stock performance would be negatively affected by increasing credit impairments, accompanied by the group valuation re-rating lower. For insurance companies, those that are exposed to personal and commercial lines should outperform their life-insurance counterparts due to the former’s lower equity market exposure and defensive characteristics – assuming, of course, that inflation does not increase the cost of claims more than expected. Insurers with shorter-duration books should also see a benefit to earnings as their investments roll into higher rates.

Can Industrials weather the storm?

Lazar Naiker and Wai Tong

Despite the macro uncertainty driven by the U.S. Federal Reserve’s rate path and the potential impact on the economy, Industrials are exposed to secular growth drivers that should result in resilient demand in the medium to long term. The energy transition, encompassing renewable energy, grid resilience, electrification and decarbonization, as well as infrastructure upgrades and water security, will be key areas supporting growth.

Supply chains remain tight, and many markets are constrained by supply rather than demand. This has resulted in elevated inventory levels. Ordinarily, this would be a concern heading into a potential recession; however, given the experience of supply chain disruptions through the pandemic, a structural shift higher in inventories is likely due to a move towards “just-in-case” rather than “just-in-time” inventory levels. The question is whether demand will slow sufficiently to overwhelm supply constraints in the market and result in inventory levels becoming an overhang.

The most recent quarterly results from cyclical Industrials have shown no signs of demand slowdown. Most industrial manufacturers are still showing below-historical inventory-to-sales ratios while carrying record backlogs. These backlogs, combined with the demand for inventory replenishment, may maintain more than sufficient demand to carry these cyclical industrial companies through a mild downturn until end-market demand recovers. Logistics cost and raw material costs having peaked and now rolling over should benefit manufacturers’ margins and offset the lack of pricing power in a slowing demand environment.

Overall, we believe these longer-term secular drivers will be supportive of Industrials in the next cycle, relative to the market. The extremity of any near-term downturn will determine any downside risks. Slowing growth or a mild recession are unlikely to have a material negative impact, given the structural underpinnings to demand and supply constraints.

 


 

Fixed Income

Will quality be more important than yield?

Jean-Sebastien Nadeau

An end to central banks’ tightening cycles could be positive for the fixed income market, but we believe investors should remain cautious. The two main roles of fixed income are to generate income and to preserve capital, acting as an anchor in a diversified portfolio comprising both stocks and bonds. Despite a potential end of the tightening cycle, we believe high-quality corporate bonds will outperform lower-quality bonds in the first half of 2023. Central banks are usually behind the curve and pivot when it is already too late; in other words, they usually cut rates once the economy is already in recession. Recessions are usually accompanied by underperformance in lower-quality bonds. 

We therefore remain constructive on high-quality corporate bonds due to their attractive valuations and their current high potential for income generation, and we believe they can achieve returns of mid- to high-single digits in 2023. U.S. investment-grade bonds now offer higher yields than high-yield bonds did 12 months ago due to historic interest rate hikes by the Federal Reserve in 2022. On the other hand, once the tightening cycle truly ends, we believe lower-quality corporate bonds could start to outperform high-quality bonds. In general, this market backdrop bodes well for the corporate fixed income market in 2023, as higher income should offset any potential weakness in prices. A central bank pivot does not necessarily mean the end of volatility for the market, but given current valuations, the bond market offers plenty of high-return/low-risk opportunities going into 2023.

U.S. Investment Grade (IG) Versus U.S. High Yield (HY)

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Source: HSBC using Bloomberg data

Dillon Culhane
Dillon Culhane, CFA®, CPA, CA
Equity Analyst
AGF Investments Inc.
Richard Fisher
Richard Fisher, M.A. (Econ.)
Equity Analyst
AGF Investments Inc.
Jean-Sébastien Nadeau
Jean-Sébastien Nadeau, MBA, CFA®
Senior Credit Analyst
AGF Investments Inc.
Lazar Naiker
Lazar Naiker
Equity Analyst
AGF Investments Inc.
Wai Tong
Wai Tong, MBA, P.Eng., CFA®
Equity Analyst
AGF Investments Inc.
Wyeth Wright
Wyeth Wright
Equity Analyst
AGF Investments Inc.
Equity Analyst

Dillon Culhane is an Equity Analyst focusing on the Energy sector, particularly oil and gas companies, as well as developed markets Real Estate.

Most recently, Dillon was an Equity Research Associate Analyst covering the Energy sector at RBC Capital Markets. Prior to that, he was a Senior Associate at Deloitte & Touche LLP.

Dillon earned a B.Comm. from Queen's University and is a Chartered Professional Accountant as well as a CFA® charterholder.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Equity Analyst

Richard Fisher is responsible for fundamental research of Financials (Global banks) and the Transport and Transportation Infrastructure sub-sectors. He works closely with AGF’s portfolio managers, providing qualitative and quantitative analysis and recommendations. His support of the team includes company visits and the documentation of research results.

Prior to joining the Equity Analyst team, Richard held several positions within the retail sales division of AGF. Most recently he was Regional Vice-President, having steadily assumed more responsibility since joining AGF in 1996.

Richard earned a B.A. (Honours) from York University and an M.A. in Economics from the University of Waterloo.

Senior Credit Analyst

Jean-Sébastien Nadeau is a member of the AGF Fixed Income team and is responsible for providing fundamental and credit research support. He also supports the team’s Portfolio Managers in managing AGF’s various Fixed Income mandates. He has a strong background in developing quantitative models for both corporates and sovereigns with specific expertise in the Technology, Media and Telecommunication as well as the Consumer Cyclical sector.

Prior to joining AGF, Jean-Sébastien was a lead analyst at the Bank of Canada, with a focus on banks in North America, Europe and Asia as well as Government-related entities (GREs).

He holds a BBA (major in Finance) and MBA (Finance) from Université Laval, has an FRM designation and is a CFA® charterholder.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Equity Analyst

Lazar Naiker is an Equity Analyst focused on the Industrials sector.

He is a seasoned investment professional with prior experience in the resources sector and equity portfolio management. Prior to joining AGF, Lazar held roles in banking and asset management, gaining experience in sell-side equity research, fund management and account management.

He attended the University of the Witwatersrand, Johannesburg, earning a Bachelor of Science (Hons) and a Bachelor of Commerce.

Equity Analyst

Wai Tong is responsible for investment research focused on the Industrials sectors. Since joining AGF in 2006, Wai has been working closely with the equity portfolio management team, contributing both top-down and bottom-up equity analysis. His contribution to the generation of ideas for the portfolios includes financial modeling and meetings with the management of companies considered for the portfolios.

Wai's career in global capital markets includes three years in equity research with BMO Nesbitt Burns, where he focused on telecom equipment and industrial equipment market segments. Prior to that, Wai spent two years in investment banking with the media and telecom group of Bank of America Securities. Prior to joining the investment industry, Wai worked as an engineer for IBM Corp. and Nortel Networks.

Wai earned a B.Sc. in Electrical Engineering from Queen's University and an MBA from the Richard Ivey School of Business, University of Western Ontario. He is a CFA® charterholder and a licensed professional engineer.

CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.

Equity Analyst

Wyeth Wright is an equity analyst, focusing on the Financials and Emerging Markets Real Estate sectors. He previously covered the Telecommunications, Utilities and Global Real Estate sectors.

Wyeth previously worked within the Portfolio Specialist Group at AGF, where he was responsible for monitoring key market developments and providing timely updates to AGF’s Sales team.

He earned a B.A. in Economics from Queen’s University (with honours) and is working towards his CFA® designation.

The views expressed in this document are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.

The commentaries contained herein are provided as a general source of information based on information available as of December 6, 2022 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.

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