Equity markets continued to slide in September, driven by a sharp increase in bond yields. Although the TSX Composite declined 3.3% in its local currency, the Canadian dollar appreciated by approximately the same amount relative to the British Pound.
Bond yields have risen to sixteen-year highs but are still in-line with their long-term historical averages. The Canadian 10-year bond yield finished September at 4.03% which compares to an average yield of 3.87% over the past 30 years. We believe recent volatility is a function of markets adjusting to a more typical rate structure as we exit the extremely low interest rate environment of the past decade. We are not overly concerned by the current level of yields as equity markets have historically produced good returns in similar rate environments. Moreover, we believe that interest rate risk has largely been priced in and we see an attractive entry point for multiple sectors.
While we are comfortable with where interest rates are today, we acknowledge that further increases will continue to be a headwind for stocks. Aside from a resilient labour market, the latest batch of economic indicators have been weaker than expected. These developments match our base case of a soft landing for the Canadian economy, which should allow the Bank of Canada (BoC) to soften its hawkish stance. In fact, we believe the BoC may be done with rate hikes altogether, which is supported by the bond market pricing in just a 25% chance of a hike at its upcoming 25 October meeting.
Lower inflation is another key tenet of our stance on interest rates. In light of recent events in Israel and the expected fallout over the coming months, we expect commodity prices to trend higher through the end of the year. Fortunately, Canada possesses an abundance of natural resources and is less reliant on energy imports than the U.K. and Europe. In addition to being a top 5 global energy producer, Canada also has a clean and stable electric grid with hydroelectricity accounting for 60% of the country’s electricity supply. Moreover, Canada has the highest population growth among developed countries and can attract skilled workers to the labour pool through its points-based immigration system. These attributes have been a key differentiator for the Canadian economy, and help explain why year-over-year inflation in August was 4.0% compared to 6.7% in the U.K.
The Fund’s rate-sensitive sectors, including real estate, utilities and pipelines, have underperformed since the BoC started raising short-term borrowing rates in March 2022. Considering the growing body of evidence that suggests the pace of economic growth is moderating, we believe interest rates are peaking. Against this backdrop, we favour companies that possess defensive growth attributes – high free cash flow, low capital expenditures and strong balance sheets. Many businesses in MCT’s portfolio are currently screening as attractively priced and are well-positioned for a near-term rally. In recent days, 10-year bond yields in Canada and the U.S. have come down, thereby creating a more attractive backdrop for most companies in MCT’s portfolio.
