Duration calculation: Three-minute macro
Managing duration risk is important for all portfolios, so we modeled duration risk in equities. We also shed some light on what tech layoffs mean (or don’t mean) for the wider economy. Finally, we explain why the Bank of Canada’s aggressive monetary tightening relative to its peers may not be enough to prevent a recession.
Duration management—not just for fixed income anymore
With interest rates in restrictive territory and many global central banks nearing their terminal rates for the cycle, market narratives are increasingly being driven by monetary policy expectations, making duration management even more important. In the fixed-income space, metrics around duration are precise, but duration risk still exists in multi-asset and equity portfolios.
Consequently, we built a model that estimates implied equity duration. Our findings suggest that from a regional perspective, U.S. equities have the greatest duration, while U.K. and Latin American equities have the least. This regional dispersion is largely driven by the sectoral composition: Cyclical sectors like energy and financials are shorter duration assets. Conversely, information technology and consumer discretionary (within the S&P 500 Index) have a longer implied equity duration—a clear reason why U.S. equities, especially the NASDAQ, have much higher index-level implied duration relative to other regions.
Implied equity duration boils down to equity valuations. Our model relies heavily on the forward earnings yield—the higher the earnings yield expected in the short term (one to three years), the lower the equity duration. Indexes and sectors with higher valuations (and lower earnings yields) tend to exhibit higher equity duration, which makes intuitive sense: Higher discount rates present a greater shock to cash flows that are received far in the future. By extension, an expansion of equity valuations increases the sensitivity to interest rates.
While we believe we're nearing the end of the hiking cycle, we still expect policy rates to remain elevated relative to the previous four years and therefore are cautious on equities that have a greater sensitivity to duration risk. But we also acknowledge that in the shorter term, there could be periods of tactical outperformance of these longer duration equities given the dynamic nature of narratives regarding the path of monetary policy.
Equity duration varies across regions and sectors
Tech layoffs: not a labor market game changer … yet
Over the past couple of months, a growing number of tech layoffs have made headlines, leading to scary-looking charts like this one:
Big Tech making waves in employment
U.S. labor turnover by industry, January 2023
But this is a bit misleading: Layoffs so far are but a fraction of the amount of hiring many of these mega-cap tech companies undertook over the past two years. In terms of total headcount, the five companies with the most announced layoffs over the last two quarters in fact expanded their workforces by 73% from January 2020 to the present. In contrast, in that same timeframe, companies in the aggregate S&P 500 Index expanded their headcounts by a much more modest 4%.1
While it may be tempting to associate sizable Big Tech layoffs with a deterioration in the labor market, these companies are simply scaling back their workforces after a significant hiring binge. Furthermore, these five companies contribute just 1.6% of total U.S. full-time workers (private and public).1
We see the robust hiring trends and job openings in other industries (including education and health services, manufacturing, and leisure and hospitality) cushioning the impact of the tech layoffs–albeit, in the short term. Profits typically lead labor market moves by three to four quarters as margin pressures constrain labor costs on behalf of corporates, which generally lead to conservatism around hiring practices. Profit margins have begun to retreat from historic highs but there has yet to be a deterioration in overall employment. While we don’t see the overall unemployment rate deteriorating to the same levels seen in previous recessions (partly due to structural reasons, including demographics), we do expect the labor market to soften from current levels as monetary policy tightening is absorbed in the economy and margins continue to come under pressure. But for right now, Big Tech layoffs aren’t having a sizable impact on the broader employment backdrop.
Profit margins lead unemployment rates
U.S. unemployment rate vs. S&P 500 profit margins
Front-loading means the Bank of Canada pauses before other central banks
Since embarking on its tightening cycle in March 2022, the Bank of Canada (BoC) has hiked rates more aggressively than almost all other developed markets’ central banks. Following outsized rate hikes of 50, 75, and even 100 basis points at successive meetings last year, the Canadian overnight rate target has 4.50% in January 2023. That rate is higher than in every other advanced economy except the United States, where the U.S. Federal Reserve has brought its policy rate to 4.75% in February (and will likely keep going).
The BoC has on several occasions mentioned the concept of front-loading its tightening cycle in order to minimize the economic pain resulting from higher interest rates needed to bring down inflation. Indeed, the Bank for International Settlements showed in a 2022 research note that quicker and more aggressive rate hikes on average increase the odds of a soft landing of the economy. Now that the BoC has paused its tightening cycle at a 4.5% conditional terminal rate, despite the front-loading argument, we remain slightly pessimistic regarding the odds of a Canadian soft landing in 2023. There are several signs that the Canadian economy is slowing and could very well contract in the first half of 2023. The housing market as well as the construction industry have yet to fully integrate the impact of past rate hikes, with significant potential impact on Canadian households. A material adverse scenario could put additional pressure on the Canadian dollar through interest-rate differentials if the BoC is forced into early easing of its policy as a result of domestic weakness.
The Bank of Canada is "ahead" of the game
Global central bank policy rates (%)
1 Bloomberg and Manulife Investment Management calculations.
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