5 • 4 • 3: What can we expect from markets?

Hello, everyone. Today is September 10. We're going to take stock of how the markets and the economy have evolved over the last few months and what that likely means for what's to come. So if we begin by looking at how the equity market has behaved year to date. We remember that in Q1, we had a very substantial upsurge in equity markets, followed by in Q2 a somewhat more hesitant price action. And in Q3, so far, it has been much more volatile, although equity markets remain largely positive year to date. But what's new here is that bonds have actually been doing some catch up against the rest of the market, now actually even above what cash has returned year today. So as you can see, the race is tightening across asset classes.

And the key factor behind that is actually what we've been talking about for some time, a further slowdown in the labour market, featuring an increase in the unemployment rates, which to be clear remains far from being dramatic, just barely above 4%. But what's more worrisome is that historically, whenever the unemployment rate begins to rise, it usually keeps on rising, especially when we reach a certain threshold, which we did, and reaching above the Sahm rule, which is a recession indicator that's never been mistaken since the 1950s.

Now, I want to be clear: the U.S. economy is still too strong to be deemed in a recession. But what's equally clear is that the warning signal has been heard at the Fed. And indeed, we've seen markets review their rates expectation accordingly much lower and indeed, in all likelihood will see a first rate cut by the U.S. Federal Reserve this month. Now, if we know that now that the Fed's about to begin cutting rates, the follow up questions is where is it going to stop? And right now, markets expect the Fed to stop somewhere in the neutral range, which is totally reasonable against the current backdrop. But bear in mind that if we were to base our expectations simply on the average response from the Fed following a similar rise in the unemployment rate, we would instead be talking about a policy rate that could be close to 2%. That is essentially where it was just before the pandemic. And I want to be clear again, we're not there yet. That's not the base case here. But we should expect rate expectations to move quite a bit over the coming in the coming few months.

If we do the exact same or similar actually exercise with how the equity markets have fared around previous rises in the unemployment rate, what we see is that on average, stocks were already on the downtrend, a downtrend that typically continues for a few more months only to see stocks bounce back and finish the year positive, as you can see here. And obviously that's not the exact path that current markets are following. Stocks are actually on an uptrend this time around. And it's not all that surprising either that we're not following that pattern to the letter, knowing that there's a wide range of historical path behind that average featuring, for instance, both an increase and a drop of nearly 40% at some time. So I guess both optimists and pessimists can conclude what they want here. But in their mind, this all boils down to a backdrop in the near term that's probably more fragile for stocks, without necessarily meaning that this story will end up with losses over a one-year horizon. Hence why it will be important for investors to stay the course in the face of inevitable ups and downs that are ahead of us.

To conclude, so as I said earlier, the overall picture is a rather positive one for markets and especially so for bonds with the last quarter that, you know, recoup some of their losses or actually lost ground against the rest of the market. Even now beating cash in the face of an increase in unemployment rate, which has confirmed that the Fed is about to cut its policy rate as we have seen elsewhere in the world, including here in Canada. And for investors, it likely means a volatile year end. But the good news here is that with inflation now taking the backseat – note that I didn't talk about inflation, I believe that's a first –, we can better rely on bonds to play their diversification role should the economic backdrop deteriorate further.

That's it for today. Thank you for listening and we will talk again in December.