The trouble with overconfidence and securities priced to perfection is that something always happens to upend the narrative. Underdogs often accomplish more for less; it’s a question of when, not if. Necessity has always been the mother of invention because constraints drive ingenuity.
Anna Edwards, Guy Johnson, Kriti Gupta and Mark Cudmore break down today’s key themes for analysts and investors on “Bloomberg: The Opening Trade.” Here is a direct video link.
Canada’s loonie (CAD) traded at .6939 U.S. this morning, the lowest since January 2003.
Part of the weakness comes from the Canadian overnight rate at 3.25%, which is expected to be cut to 3% on January 29, 133 basis points (bps) below the current U.S. effective funds rate at 4.33%.
Foreign capital flows where it’s treated best. The 2-year Canadian Treasury yield, at 2.932%, trades a wide 135 basis points below the U.S. 2-year yield, at 4.282%—making for the relatively least attractive nominal Canadian yield spreads in over a decade (2-year Canada vs. U.S. yield spread charted below since April 2015).
That said, inflation rates have fallen faster in Canada (1.8% yoy in December vs. 3% in America), so on an after-inflation basis, Canadian 2-year real yields are a tighter 1.13% compared with 1.28% in the U.S.
The prospect of increased trade tariffs between the two major trading partners is a wild card for inflation and rates. Canada’s economy comes into the negotiations weaker and more vulnerable than America.
Historically, the commodity-centric Canadian dollar bottoms against the greenback near the end of recessionary bear markets after the U.S. Fed and Bank of Canada have been working to ease credit for several quarters. So far, this time, central banks have had less influence in lowering market interest rates than in past cycles.
The loonie bottomed in the spring of 2009, as the stock market completed a -50%, 3-year drubbing, and oil prices hovered near $30 a barrel. It also bottomed in the summer of 2002, as the stock market halved over two years and oil prices hovered around $25 a barrel.
Remarkably, the loonie is weaker today than the risk-off pandemic lows of March 2020, when the stock market plunged 37% in three weeks and oil prices went negative. Yet, so far, the stock market remains near all-time highs, and West Texas Crude is around $75.
Retesting the January 2002 all-time USD/CAD high of $1.60 is possible if unfavourable financial/economic developments cause the Bank of Canada to ease more aggressively than currently priced in. That would also suggest downside for still-high equity prices and more upside for Canadian Treasury prices.
President Trump comes back to office amid one of the most over-valued stock markets of all time, even more inflated than at President Hoover’s inauguration months before the Black Tuesday crash of 1929. See WSJ: Make America Cheap Again. The CAPE is just one of a long list of historically prescient indicators ringing alarm bells.
Of all the measures of irrational equity market pricing, the cyclically adjusted price to earnings ratio (CAPE) developed by Yale economist Robert Shiller, since it looks back a decade and adjusts for inflation. On that basis, American stocks are 83% more expensive than when Bill Clinton first took the oath of office, 145% more than when Barack Obama first did and a whopping four times Ronald Reagan’s starting point. They even are a third pricier than at the start of Trump’s own first term.
Nothing matters more to long-term equity returns over the next decade than the level of fundamental valuation at the starting point. Today, bullish high hopes meet elevated multiples that suggest negative annual returns over the next 7 years or more.
Asset manager GMO recently forecast that the return of U.S. large capitalization stocks will be negative 5.2% annually over the next seven years after inflation. It would be like putting money into a CD today and having the bank pocket almost a third of it when it matures in 2032.
With U.S. stock markets the most widely held globally, their prospects magnify downside risk for consumer and investor sentiment worldwide. For those who manage not to go down with this ship, however, the opportunity embedded on the other side of present euphoria has also rarely been greater.
…when indexes like the S&P 500 become cheaper, which they surely will, investors should look past gloomy headlines and see the glass as half full since it will mean a better rate of return.
If a rough patch for U.S. markets is what it takes for that imbalance to right itself then it would be small solace to retirees, much less to President Trump. Those still in their saving years, though, might find that it is the pause that refreshes their nest eggs.
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