Despite a growing accumulation of headwinds, equity markets continued to advance in the third quarter, posting modest but positive returns, particularly in North America. The results were less favourable for the Canadian fixed income universe, however, which declined as long-term bond yields reached new highs for the year. Meanwhile, gold and energy prices rose, reflecting an environment in which inflationary and geopolitical risks remain firmly entrenched.
From an economic perspective, a key theme was the persistence of tensions in the Middle East and the pressure they continue to exert on energy prices, particularly refined products such as gasoline and diesel. Although the global economy has remained resilient so far, the duration of the shock is becoming increasingly important. In the absence of a lasting easing of tensions, elevated energy costs risk keeping inflation above target and eventually triggering second-round effects across the consumer basket. Fragmentary information about the evolution of the conflict is adding another layer of uncertainty to an outlook that is already difficult to assess.
For the Federal Reserve and its new Chair, Kevin Warsh, this environment gradually made inaction untenable. The resilience of the labour market, combined with persistent inflation, ultimately prompted the central bank to raise its policy rate for the first time in three years, contributing to the rise in bond yields. Despite this monetary tightening, the earnings outlook remains solid, supported by a resilient economy and continued robust investment in technology.
Against this backdrop, our base-case scenario continues to anticipate economic growth close to potential, despite volatile commodity prices and uncomfortably high inflation. A more favourable outcome also remains possible if the tensions driving energy prices ease on a lasting basis, allowing inflationary pressures to subside more rapidly. However, the balance of risks remains tilted toward a temporary overheating scenario, in which persistent price pressures would force the Fed to tighten monetary conditions more aggressively. Such a development could ultimately weigh on economic growth and earnings, as well as on artificial intelligence-related investment. One thing is certain: from an investor’s perspective, the room for manoeuvre narrowed over the past quarter, which was marked by a simultaneous increase in interest rates and energy prices.
Against this backdrop, we reduced our overall risk exposure in September by taking profits on a portion of our equity overweight. The proceeds were reallocated to bonds, where yields to maturity are near their highest levels in two decades. Within equities, we ended a profitable, year-long overweight to Emerging Markets and increased our allocation to Canadian stocks. Canada’s greater exposure to commodities provides an attractive source of diversification in the current environment, while market dynamics also remain favourable.