Employment Data, Interest Rates And Correlations

Monthly employment and unemployment data were released on both sides of the North American border this morning. It may be market moving in the very short-term, but these monthly data that financial market participants get so focused on are fraught with revisions and as you can see in the chart above, rather erratic from month to month (white line). So we focus on the longer term trends (pink line) and try to avoid the short-term noise.

However, it is data that the central bankers in both Canada and the US will monitor and leave all of us who try to make sense of the current economic and investing environment scrambling to anticipate their next moves on interest rates.

It seems that the consensus of opinion will have the Bank of Canada raising rates at their next meeting by a 1/4%, despite the fact that inflation remains well below their target (and this is their mandate, so they need to be pretty darn certain that future inflation will be trending higher). There is little wage growth to support the potential for a sustained increase in inflation (at this moment) and Household debt servicing is going to cost more, so the consumer is going to get hit on both sides of that equation. Is the Canadian economy going to be able to take that and the current housing market slowdown in stride? I am not that confident and the BOC's forecasting track record has not been bang on. 

On the US side, a bit of a similar story, no wage growth and inflation well below target, but a central bank that wants to continue to push interest rates higher (likely another 1/4% in September). As we also continue to point out regularly, the economic cycle has grown long in the tooth and the natural tendency for it to slow will be pushed along as the yield curve flattens (higher short-term rates and no inflation to drive longer term rates).

When unemployment levels (now at 4.4%) cross the 3 year moving average (now at 5.1%) as it has historically, a recession will follow. Unemployment in June stayed put at 4.4%, so that gap closed a little further.

In Canada, bond prices are tumbling and so have stock prices (see Paul's blog) so these correlations are not helping balanced portfolios that have an over-exposure to Canadian equities. Often a portfolio will have a "home country bias" where investors tend to put too much emphasis on owning companies domiciled in their own country (because of familiarity). The All Country World Equity Index (ACWI, which we use to benchmark our global equity performance) has only about 3% Canadian companies. Any more than that and you are overweight and over-exposed. Best to have a look. It is why we have a tactical model that allows us to be more flexible on our exposure to Canadian stocks.

In the US (which is over 50% of the ACWI) stocks have been rising, but the bulk of it is attributed to 5 companies in the Tech sector. NASDAQ volatility is rising, so even here there is something amiss. It wouldn't surprise us to see the correlations between the US stock and bond markets re-adjust (again).

Risk is high. We remain cautious.

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