Volatility rules

Inflation, rising bond yields, trade friction, Mideast tensions stress markets

Volatility remained the dominant theme as markets moved into the fall. Renewed inflation concerns and ongoing tensions in the Middle East weighed on sentiment for another month, with no sign of easing. What set September apart from recent months was the strain that began to show in the bond market.

Global government bond yields rose sharply on inflation and deficit concerns, and several U.S. Treasury yields across the curve reached multi-year highs. The 30-year Treasury yield hit its highest level since 2002, while the benchmark 10-year briefly touched 5.25%, a level last seen in 2007 on the eve of the Global Financial Crisis. The speed of the move was as notable as its size. Moves this fast have usually come alongside some form of economic stress, which has left investors on edge and markets repricing risk.

The significance of the Fed’s rate hike

Particularly noteworthy was the Federal Reserve’s September meeting, where it raised the federal funds rate by 25 basis points to a target range of 3.75%-4.00%. It was the Fed’s first increase in more than three years. The decision was unanimous, and the Fed said inflation had been elevated for too long and that the hike was needed to put it back on a path to the 2% target.

Fed Chair Kevin Warsh noted that underlying inflation trends have not meaningfully improved. The Fed now expects inflation to end 2026 at 3.7%, and most officials expect at least one more increase before year-end. The Fed also raised its 2026 growth forecast to 2.3%. Higher rates may help cool price pressures by slowing U.S. spending, but they could also slow economic activity more broadly; for example, softer U.S. demand could reduce spending on Canadian exports and add pressure to an already fragile trade relationship.

That fragility was on full display in September, as the Canada-U.S. trade dispute escalated. After negotiations broke down in late August, the U.S. imposed 50% tariffs on about $28 billion of Canadian goods. On September 8, Canada responded with retaliatory tariffs of 15% to 50% on a similar value of U.S. goods. The U.S. then banned nearly US$1 billion (C$1.4 billion) of Canadian imports effective September 29. Although the ban is small relative to total bilateral trade, the broader dispute is already taking a toll, and with the Canadian economy already under strain, higher trade barriers could weigh further on exports, business investment and employment in the months ahead.

In response, Ottawa is stepping up efforts to diversify its trade relationships beyond the U.S. During Prime Minister Carney’s visit to the European Union, Canada was offered associate membership. It’s not yet clear what the designation would involve, though it would likely mean closer trade and security ties. Any move would need to be voted on in Parliament, but it’s something worth keeping an eye on.

Investment implications

Moving to equity markets, higher rates weighed on returns, though not evenly. The AI theme lifted many growth stocks in September, helping offset weaker results in July and early August. Fundamentals continue to hold up, with most S&P 500 companies beating consensus earnings estimates on higher revenues and expanding margins. However, many smaller, more rate-sensitive companies were hit hard during the month and the Russell 2000 declined more than 5% (USD).

One other item of note: The U.S. midterm elections are only a week away, and markets are awaiting the outcome against a highly partisan backdrop. Historically, divided government has tended to be good for equity markets. However, given how divided the parties are, both within and between them, the next 12 months could see continued volatility, with market returns and sentiment swinging on headlines.

As usual, there are reasons for both optimism and caution about where the economy and markets are headed. In our view, uncertainty is often what creates opportunities for investors. Waiting for the outcome is the hard part.

Greg Taylor, CFA, is the Chief Investment Officer and a Portfolio Manager at PenderFund Capital Management. He manages the Pender Alternative Multi-Strategy Growth Fund. 

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