Friday Market Insights – Stock Market is concerned about higher rates and future inflation

Thomas Holloway: [00:00:03] I welcome everybody to our Friday Market Insights. Today is February 26th, nearly at the end of the month here in February. I’m joined today by Justin Hahn from our investment department. And my name is Thomas Holloway and portfolio manager at Genus. Let’s kick it off today. Justin, can you tell us a bit about what happened in the markets this week?

Justin Hahn: [00:00:22] Yeah, so the big highlight this week in the markets was the US 10 year bond yields hitting one point five percent, bringing it back to pre-covered trading ranges. This is a sign the market is starting to get a bit worried about the big spending coming out this year with about four trillion dollars planned on top of the spending that happened last year. On the equity fund, we saw more of the correction, larger corrections in the technology sector with more of the value and economic sensitive names outperforming this this week in terms of the commodity side, we saw commodities continue their gains, such as the economic sensitive ones, such as copper and oil.

Thomas Holloway: [00:01:00] Thanks, Justin. So some comments there about fixed income and equity and commodities will touch on all three, I think, in the next few questions. I want to start with the fixed income market. Looking at the Canadian 10 year, it looks like we rose from about one twenty one one point two percent to one point four percent. And if taking it back maybe to year end, it looks like the 10 years maybe almost doubled in yield. So what’s what’s going on there is that investors starting to think about inflation or is it more real yields?

Justin Hahn: [00:01:34] We think it’s a bit of both. Longer term inflation rates haven’t moved much this week, but they have been slowly trending upward since the start of the year. And late last year, we also saw real yields rise about 15 basis points in the US. But a lot of the moves this week in particular, we think it’s due to, as mentioned before, more of the market getting concerned about the big stimulus coming in with almost four extra trillion dollars being flowing into the economy.

Thomas Holloway: [00:02:03] Right, and, you know, I use the word inflation there, and if I think back to kind of classic finance literature that was developed over the last few decades, the word inflation and feels like a scary word for investors, is that still the right way to think about inflation?

Justin Hahn: [00:02:18] We think that inflation isn’t as big of a concern as it was 12 years ago. We’re finally seeing signs of a breakthrough. We’ve been in the trading range for about 12 years under two percent inflation, never really hitting the target. The Fed this year has also come out as a more accommodative, letting inflation rates hit above two percent. This higher inflation rate will also help draw down some of the interest burdens that’s going to come from the massive stimulus for all the governments this year.

Thomas Holloway: [00:02:48] Ok. And on the same subject, just maybe to extend that a bit, that went one comment that I’ve read about commodity price increases is that certainly there’s a sort of one time impact to inflation because we measure inflation year over year. So if the price of oil goes from 50 to 60, obviously that’s going to trickle down into the inflation measure for that year. But if we think about longer term inflation expectations, we’re talking about one or two or three percent per year like every year. So a one time change in any commodity price would never kind of trickle into long term expectations. OK, so maybe just to close the book on the fixed income market and bring it home to investors: year to date, if you owned the bond index, you would be down about four percent, actually, I think a little higher today. But I looked at it yesterday. So that’s kind of the a little bit of the sell off that everyone’s been waiting for. But I want to put it in context that you still earn a yield against that and now we’re at a higher yield. So I think our expectations are obviously minus four percent is disappointing for two months of a fixed income investment. But at the same time, we’re now at a higher yield. And so you get a chance to earn it back. And I just want to there’s some headlines which are maybe a bit more extreme than that. But let’s put it in context. If you own an equity, most of the equity portfolio, you’re up actually up about four percent and most clients would be somewhere around. What really matters for the sort of stability of markets is the rate of change of these things, so that’s why the fixed income markets in the spotlight, I think a bit, especially this week, just because of some more rapid rates of change on the on the yields. Anyway, let’s talk a little bit more about commodities, because that really is the other story of this year so far, and it’s not just the price of oil which might be in the headlines more in Canada, but it’s also, you know, everything from lumber to copper, pretty much just about everything, even agricultural commodities.

Thomas Holloway: [00:04:50] We talked about the impact that would have on inflation, but what about back in the equity portfolio? It must make a difference if copper prices are higher. You know, if you’re if you’re a business that actually uses copper or or produces it. So how how are we thinking about that in a back on the equity portfolio?

Justin Hahn: [00:05:05] Yes, on the equity portion, we are keeping that in mind, we’re favoring more of the material production companies and more economic sensitive names during these times than those input companies. This is also partly due to partly the reason why we saw the technology sector sell off. A lot of the parts they were using have gone up in price. As you mentioned, it’s not just oil. It’s a lot of the other materials have gone up in price. So it’s a little bit of lowering the expectations on that site. And going forward, we’re expecting this trend to continue with economic momentum picking up. A lot of these commodities are returning to or even higher than their trading ranges before the covid levels with oil shooting up and copper continuing to rise throughout the whole of last year and this year as well. So we’re keeping an eye on the portfolios, watching those prices not being too exposed and of the input usage companies that use a lot of these commodities right now.

Thomas Holloway: [00:06:03] vJust one point of clarification, by the way. The the one commodity sector which has been weaker is the gold equity sector. So that’s when Justin says economically sensitive commodities, he means like commodities that are actually useful for something like gold is useful for different reasons in portfolios, but not really tied to the economy. This conversation about commodity sensitivity in the equity portfolio does kind of make me think about for our fossil free clients. You know, there is certainly maybe a gap in the portfolio around energy producing companies in particular, but we do have some sort of tools in the toolbox to manage around that. So can you just maybe remind us a bit about that, how maybe investors in the fossil free don’t need to be too worried about missing out on the energy rally?

Justin Hahn: [00:06:50] Yeah, so ultimately, when oil does go up, it’s really hard to compete in the fossil for potfolios, but during the portfolio construction phase, we find highly correlated sectors to oil to fill the energy gaps. This is the financial sectors, particularly in Canada, as well as consumer discretionary or other materials are optimised. Software works to lower the tracking error. So we’re not too far off from the benchmark when these shocks do happen. As you mentioned, these one year shocks for a lot of these commodity prices, our move last year as well to more and more global portfolio from thirty five TXS to sixty five world into more of a twenty five TSX and seventy five percent MSCI World has also helped reduce some of the tracking error as the energy sector and the TXS is 12 percent on the S&P 500 It’s only about three percent, which is similar to what the world percentages as well.

Thomas Holloway: [00:07:47] You know, that’s a really great point. I mean, we know in Canada the energy sector is super important. I live in Calgary. I can tell you it’s a big part of our consciousness here. But, you know, it really helps to hear that global context. And, you know, like I said, in the US market, the energy sector is only two or three percent of the market. Makes sense if you decide not to own it. You’re not missing that much. Great, thanks for that summary and I just want to say to our viewers, thanks for tuning in, if you have any questions for future videos, please feel free to reach out to me or any portfolio manager and other that. Have a great weekend. And thanks again for tuning in.

Justin Hahn: [00:08:23] Thanks, everyone.