Delivery times improving (even if it doesn’t feel like it)
Anecdotally, it still may seem like it’s taking time to get the goods you need (or want), but we’re actually witnessing a remarkable decline in supplier delivery times recently, and July has been an extension of this trend. Delivery times in the United States, euro area, and Canada all peaked in 4Q21 and we are of the view that these will continue to decline. While July’s CPI results eased—giving investors and consumers alike a needed reprieve—any continued decline in delivery times should contribute to easing price pressures as U.S. CPI has typically followed the trend of delivery times by a few months.
These releases also support one of our key macro anchors: We’re transitioning from COVID-19-driven inflation to conflict-driven inflation. By 2023, we expect inflation to materially decelerate due to base effects, excess inventories in non-auto retail goods, and the alleviation of supply chain disruptions.
Importantly, while delivery times in the United States, euro area, and Canada have been following the same path, China’s data is bucking the trend. In fact, aside from a brief increase at the onset of the pandemic in 2020 and again in early 2022, delivery times in China were never elevated for a sustained period. This is supportive of our concerns about Chinese growth given the rising economic costs of ongoing COVID-zero policies where economic support remains underwhelming relative to the challenges that China faces.
A stingy Bank of Canada might sting Canadian banks
With a 100 basis point (bps) hike in July, the Bank of Canada continued to aggressively tighten monetary policy, putting pressure on both the Canadian consumer and Canadian banks. Canadian yield curves flattened off the back of this hawkish surprise, with the 2-year/10-year spread inverting for the first time since the first quarter of 2022; the 3-month/5-year spread also fell, heading closer to inversion.
This is on our radar since Canadian financials typically struggle to perform as the spread between 3-month and 5-year bonds moves closer to inversion. This relationship makes intuitive sense: Curve inversions typically occur because of a deteriorating macro backdrop, and since banks are cyclical in nature, their stock prices respond accordingly. This cyclicality is also intuitive, given the sector’s relationship with the consumer: Higher interest-rate levels are likely to exacerbate the strain of already-high household leverage. In particular, mortgage costs for Canadians (which are typically tied to 5-year yields) will continue to climb at a time when households are already being squeezed for cash by painful inflationary pressures; as a result, bank balance sheets may come under pressure as consumers struggle to keep up with increasing mortgage payments. The quantitative tightening program will also create headwinds for Canadian banks as record levels of liquidity are removed from the system, creating a drag on liquidity coverage ratios.
While our strategic asset allocation favors an overweight posture in Canadian equity, we see the current tightening cycle as a potential headwind to Canadian financials, putting broader pressure on the TSX in the short term, given the sector’s prominence.
The stubborn European equity risk premium
With a recession in Europe being our base case, we believe that the regional equity risk premium isn’t sufficiently compensating investors. High-yield securities have started to reflect the challenged outlook in Europe, and there has typically been a close relationship between the equity risk premium and high-yield spreads, but the former doesn’t seem to be getting the message that the latter is delivering.
Macro headwinds in Europe continue to build: growth forecasts are falling, while inflation forecasts are ratcheting higher. In fact, our estimates suggest that the consensus for European GDP is still too high in 2022 and 2023, possibly because of benign assumptions around Russia’s invasion of Ukraine. While Germany’s energy crisis is already putting pressure on households as they grapple with increasing energy costs, energy rationing would force consumer and corporate activity to slow—that is, German factories could conceivably be faced with limited output.
While high-yield markets have recently started to price in these risks, the equity risk premium has not caught up (as it has historically during other pre-recessionary periods), making us think that European equity markets aren’t compensating investors enough, considering the gloomy outlook. As it stands, the current premium is a function of a lofty earnings yield that is being propped by forward earnings that have actually risen year to date. We foresee this trend reversing, leading to lower European forward earnings in 2H22 and an even less attractive equity premium (all else being equal). Furthermore, at about 105bps, the spread between the European high-yield credit spread index and the equity risk premium hasn’t been this wide since 2008.
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