The United States Capitol Building in Washington DC at Sunset.

In our 2024 Forecast, we noted that in this calendar year we would see countries with more than half the world’s population, representing nearly two-thirds of the world’s GDP and 80% of the world’s equity market value, undergo an election. None will be as consequential to the global economy and capital markets as the November showdown in the US where Presidents Biden and Trump are facing off. Current surveys reveal a very close race with Biden and Trump nearly even nationally, but Trump leading in key swing states. The Republicans look to win the Senate majority, while the Democrats look more likely to win the House majority. Then, there is the matter of a number of consequential legal events between now and November (both civil and criminal trials and a Supreme Court ruling on presidential immunity from prosecution among them) resulting in the outcomes from this election cycle being particularly volatile and difficult to predict.

Lessons from prior election years

When uncertainty over outcomes like the election loom in every headline and each election seemingly more consequential than the last, it is normal to expect volatility. Yet, there is no persistent increase in realized volatility as measured by either the VIX Index (equity volatility) or the MOVE Index (bond market volatility) during election years (see Chart 1). Moreover, equity markets typically do well in election years, as stimulus flows (see Chart 2), with no discernable difference in the average return in an election and non-election year.

Chart 1: Outside of 2008, volatility in election years in line with the average
This chart titled “Outside of 2008, volatility in election years in line with the average” shows the S&P 500 Volatility Index (VIX) levels during various U.S. election years from 1992 to 2020, as well as the average VIX index level from 1991 to 2023. Notably, the chart shows that volatility in election years has been broadly in line with the average, with the exception of 2008, where volatility spiked in response to the unfolding financial crisis. Source: CBOE, Macrobond


Chart 2: US equities do well into and out of elections
S&P 500 performance around all presidential elections since 1952, election day indexed at 100 at x=0
This chart titled Source: S&P Global, Macrobond

There is also a perception that with the Federal Reserve (Fed) independence from politics should come Fed inaction on policy rates. However, going back to 1972, there has only been one election year where policy rates ended at the same level at which they began (see Chart 3). This was during the elongated period of zero interest rate policies from 2009 to 2016. There is broad support for keeping the Fed’s objectives focused on maintaining inflation at 2% and maintaining the conditions for maximum sustainable employment. It’s worth noting that the Fed’s independence is being called into question as Chair Powell’s term ends in May 2026, and Trump has suggested he would like to exert some control over monetary policy decisions, going as far as suggesting he be consulted on changes. Needless to say, Congressional confirmation of a more pliable candidate would be unlikely. Furthermore, any attempt to directly politicize Fed policy would likely result in a counterproductive rise in longer-term interest rates (on the expectation of longer-term higher inflation). It is also worth considering other market implications.

Chart 3: The Fed doesn’t hesitate to make policy changes during election years
This chart, titled Source: Federal Reserve, Macrobond

Market implications from US political platforms

One of the key differences between the two candidates is their external worldview, with one dividing the world into friendly and unfriendly coalitions while the other places America first against all other nations. It’s not surprising that one of the major themes emerging from the US election is the expectation of material differences in how the global economy will function depending on the election outcome. One of the most impactful policy divergences could be related to tariffs. Trump has proposed a sharp 10% increase for all countries and 60% for imports from China. Even if other countries do not retaliate with tariffs of their own, this would greatly disrupt economic activity through uncertainty in trade relationships, reworking supply chains and precautionary inventory buildups – factors that can all contribute to higher inflation. Canada and Mexico could seek specific exemptions, but even CUSMA, the NAFTA replacement, is set for review in 2026, on a six-year cycle. Without any specific exclusion from tariffs, Canada, an open economy highly dependent on trade relative to the US, would experience a hit to its GDP. Additionally, any outcome would spotlight Canada’s productivity challenges and its struggle to compete or respond to shocks.

Furthermore, like Canada, the US has seen significant population growth due to large-scale immigration. Trump has proposed a mass deportation of illegal immigrants (on the order of 10 million). While perhaps an unrealistic outcome and logistically challenging, a decline of 3% in the population would impact both  spending and activity, as well as reduce the labour force, which is inflationary in itself.

Neither candidate has expressed any intention to curtail expansive and stimulative fiscal policies. The demographic situation already indicates that built-in costs for health care and social security are rising materially. Biden has proposed revenue measures including allowing Trump’s tax cuts to expire, raising the corporate tax rate by seven percentage points to 28% and increasing the tax on corporate buybacks from 1% to 4%. This would help curb uncontrolled deficit growth, but could reduce economic growth and inflation and potentially affect stock prices. Conversely, Trump is likely to extend the tax cuts introduced during his first administration.

Debt levels will also continue to rise. The Congressional Budget Office (CBO) predicts that debt as a proportion of GDP will grow from about 1x in 2025 to 1.15x over the next decade. Net interest expenses, already consuming 16 cents of every dollar of federal revenue, will increase alongside debt and surpass all other expenditures outside of social security and Medicare. The worsening of budget deficits from already high levels will likely lead bond investors to demand a fiscal risk premium (i.e., higher yields). Predicting the timing of a shift in sentiment is nearly impossible, but it can be triggered by events such as a budget (as was the case in the UK in September 2022) or an election. Higher long-term interest rates would negatively affect borrowing and the valuations of other asset classes.

Finally, regulatory issues will likely weigh on different sectors. Biden has proposed lowering prescription drug costs for seniors, addressing antitrust issues in the technology sector and limiting bank mergers. Trump has suggested reversing regulations that limit fossil fuel use and is likely to proceed with pipeline construction. Each policy would have varied impacts on companies in these sectors.

Conclusions

Each candidate’s policies would alternately restrict (through regulations, tariffs, immigration) and support growth (through infrastructure spending). Under either scenario, deficits are almost certain to continue widening (due to more spending, committed social security entitlements and lower taxes). Both candidates’ policies are also likely to contribute to higher inflation (due to tariffs, tax reductions and higher fiscal spending). It is unclear if Trump will be perceived as pro-business. The 2016 tax cuts and deregulation are already factored into expectations, while his newer policies might not be as favourable for businesses. Finally, the larger debt and increased Treasury issuance will only be slightly mitigated by the Fed’s recent announcement to slow quantitative tightening (QT), and we remain vigilant in monitoring sentiment around this. We continue to follow developments in the election and manage portfolios in accordance with our investment philosophy that fundamentals matter in the valuation of securities.

Capital markets

The market tone has been upbeat to start the year with stronger economic and inflation data. Despite these positive releases, central banks generally maintained a tendency to ease policy, and the Swiss National Bank became the first G10 central bank to cut interest rates this cycle. This led to expectations of a soft landing, propelling global equities significantly higher. The S&P 500 Index logged consecutive quarters with double-digit gains for the first time in over a decade, closing out the first quarter with a 10.6% rise. Elsewhere, even higher rates did not dampen spirits as the Bank of Japan responded to strengthening economic conditions and inflation by finally ending its negative interest rate policy, while reassuring markets that low rates would persist. Consequently, even though policy rates rose, the Japanese yen was the weakest-performing currency of the G10, hitting an intraday low of 160 versus the US dollar for the first time since 1990. The Nikkei, however, responded positively to the still-stimulative policy and posted its strongest quarterly performance since 2009, rising 21.4% and finally surpassing its previous high from 1989. Gains in equities globally were widespread and rose steadily week to week. Other asset classes joined the rally, with corporate credit spreads tightening materially, led by high-yield bonds, oil prices surging (WTI up 16.1%) and gold rising (up 8.1%). The US dollar strengthened against every G10 currency, and the dollar index rose 3.1% in the quarter.

The enthusiasm reversed in April, however, with most risk assets losing some ground. Market participants became concerned over the consistent upside surprises in US inflation that marked a clear trend in the wrong direction for the Fed. Bond markets pared back expectations for the Fed to cut rates from about six to seven times in 2024 early in the year to one to two at the end of April; interest rates across the term structure rose. The FTSE Canada Universe Bond Index fell 1.2% in Q1 and posted a further decline of 2% in April. The higher inflation prints pushed out the timing for the first rate cut to September and US 10-year treasury yields have risen about 90 basis points in total year-to-date. Equities pulled back, and the S&P 500 gave up 4.1% in April, after five straight monthly gains. The Magnificent 7 stocks participated in the decline, but outperformed the broader index, falling 2.3% in the month. Earnings season so far this quarter shows strong, high single-digit positive surprises for the S&P 500. Yet, there has been no corresponding positive price response to these earnings reports, as valuations have begun to be questioned with the higher interest rates. Companies with tighter operating margins were particularly vulnerable to price weakness, as investors searched for higher-quality companies.

Portfolio strategy

Investors are now increasingly concerned about a resurgence in US inflation. While the Fed has stated its next policy move is likely a rate cut, the challenge of tempering inflation grows the longer the economy runs hot. The US does stand apart from other countries, and the upcoming election will bring potential policy changes on regulation and fiscal policy that will influence debt levels and inflation.

In Canada, a clear picture has emerged, with households, businesses and government each feeling the weight of higher interest rates on high debt levels. Precautionary savings are rising, and commitments to larger projects and purchases are weakening. Thus, the Bank of Canada should begin its policy easing campaign in the coming months. With Canadian rates having followed US rates higher, we believe the level of rates today to be at a near-term peak.

Within balanced portfolios we have trimmed the underweight to equities, and after the rise in interest rates in April, brought the fixed-income underweight back to neutral. We maintain an underweight in equities as we anticipate pressure on valuations from the higher interest rates. We also maintain a small overweight in cash as yields remain attractive. Fixed-income portfolios have fairly neutral duration and sector positioning, the latter of which balances an overweight in provincial bonds against a small underweight in corporate bonds where spreads are tight (valuations are high). Fundamental equity portfolios have reduced defensive holdings and shifted in favour of companies that outperform in robust industrial cycles as global manufacturing data has improved. Commodity companies and industrial manufacturers are among the current overweights. We will continue to follow US election developments and together with changes in the path of economic activity, inflation and policy, will assess the full impact on our fundamental views.

The Fed’s preferred core price measure – the PCE price index excluding food and energy – rose by an average 0.36% per month, equivalent to 4.4% annualised, over January-March.

The FOMC median projection in March was for annual core inflation to fall to 2.6% in Q4 2024. This would require the monthly index rise to step down to an average 0.17% over the remainder of the year – see chart 1.

Chart 1

Chart 1 showing US PCE Price Index ex Food & Energy

The judgement here is that such a slowdown is achievable and could be exceeded, based on the following considerations.

First, such performance was bettered in H2 2023, when the monthly rise averaged 0.155%, or 1.9% annualised, i.e. the requirement is within the range of recent experience.

Secondly, the monetarist rule of thumb of a two-year lead from money to prices suggests a strong disinflationary impulse during H2 2024. From this perspective, any current “stickiness” may reflect the after-effects of a second pick-up in six-month broad money momentum in 2021, following the initial surge into mid-2020– see chart 2.

Chart 2

Chart 2 showing US PCE Price Index & Broad Money (% 6m annualised)

Momentum returned to a target-consistent 4-5% annualised in April 2022, subsequently turning negative and recovering only from March 2023, with the latest reading still sub-5%. Allowing for the usual lag, the suggestion is that six-month price momentum will move below 2% in H2 2024, remaining weak through next year.

A third potential favourable influence is a speeding-up of the transmission of recent slower growth of timely measures of market rents to the PCE housing component. Six-month momentum of the latter was still up at 5.6% annualised in March but weakness in the BLS new tenant rent index through 2023 is consistent with a return to the pre-pandemic (i.e. 2015-19) average of 3.4% or lower – chart 3. With a weight of 17.5%, such a decline would subtract 3 bp from the monthly core PCE change.

Chart 3

Chart 3 showing US PCE Price Index for Housing (% 6m annualised) & BLS Tenant Rent Indices (4q ma, % 6m annualised)

A modest upside inflation surprise in March has been portrayed as confirming that inflationary pressures remain sticky, warranting further delay in policy easing.

The stickiness charge is bizarre in the context of recent aggregate data. The six-month rate of change of core consumer prices, seasonally adjusted, has fallen from a peak of 8.4% annualised in July 2023 to 2.4% in March – see chart 1.

Chart 1

Chart 1 showing UK Consumer Prices & Broad Money (% 6m annualised)

Six-month momentum, admittedly, has moved sideways over the last four months. This mirrors a pause in the slowdown in six-month broad money growth in early 2022, with the relationship suggesting a resumption of the core downtrend from around May.

Claims of stickiness focus on measures of core services momentum. Such measures gave no forewarning of the inflation upswing and are unsurprisingly also lagging in the downswing.

“Monetarist” theory is that monetary conditions determine trends in nominal spending and aggregate inflation, with the goods / services split reflecting relative demand / supply considerations.

Global goods prices have been under downward pressure because of rising supply and falling input costs (until recently), resulting in a diversion of nominal demand and pricing power to services.

So a monetarist forecast is that a recovery in goods momentum is likely to be associated with faster services disinflation within a continuing aggregate inflation downswing.

A subsidiary argument to the sticky inflation view is that the MPC can afford to be cautious about policy easing because the economy is regaining momentum.

Monetary trends have yet to support a recovery scenario. Of particular concern is a continued contraction in corporate real money balances, which chimes with weakness in national accounts profits data and suggests pressure to cut investment and jobs – chart 2.

Chart 2

Chart 2 showing UK Business Investment (% yoy) & Real Gross Operating Surplus of Corporations / Real PNFC* M4 (% yoy) *Private Non-Financial Corporations

The latest labour market numbers hint at negative dynamics. LFS employment (three-month moving average) fell sharply in December / January and is now down 346,000 from a March 2023 peak. Private sector weakness has been partly obscured by solid growth of public sector employment – up by 140,000 or 2.5% in the year to December.

Ugly unemployment headlines have been avoided only because of a sharp fall in labour force participation. The unemployment rate of 16-64 year olds would have risen by 1.2 pp rather than 0.3 pp over the last year if realised employment had been accompanied by a stable inactivity rate – chart 3.

Chart 3

Chart 3 showing UK Unemployment & Inactivity % of Labour Force, 16-64 Years

Claims of labour market resilience rest partly on the HMRC payrolled employees series but this fell for a second month in March, although numbers are often revised significantly. (A previous post argued that this series has been distorted upwards by rising inclusion of self-employed workers in PAYE.)

A recent revival in housing market activity, meanwhile, could prove short-lived unless mortgage rates resume a downtrend soon. The latest Credit Conditions Survey signalled that banks plan to expand loan supply in Q2 but the balance (seasonally adjusted) expecting stronger demand fell back sharply – chart 4. Majorities continue to report and expect higher defaults, consistent with gathering labour market weakness – chart 5.

Chart 4

Chart 4 showing UK Mortgage Approvals for House Purchase (yoy change, 000s) & BoE CCS Future Demand for / Availability of Secured Credit to Households

Chart 5

Chart 5 showing UK Unemployment Rate (3m change) & Net % of Banks Reporting Increase in Default Rate on Secured Credit to Households

Two people hiking to the top of a mountain during a vibrant winter sunset. Mount Harvey, North Vancouver, BC, Canada.

 

At the heart of our organization is the commitment and desire to provide superior performance and service to our clients. Our primary objective is to meet our clients’ expectations while ensuring our people are highly motivated and enthusiastic. This requires that we keep the business narrowly defined on what we do best, and endeavour to remain at the cutting edge of research and development initiatives within financial markets.

Investing in our Future Leaders

Once a year, we take the opportunity to share an annual update with our clients on our business, outlining how we are directing our efforts within CC&L to ensure we are prepared to fulfill our commitment to meeting investment performance and service objectives for our clients.

The past few years have been a period of transformation and growth at CC&L. Our teams have expanded as we are building the next generation of leaders. We have met our investment objectives across most of our strategies, which is contributing to asset growth. Most notably, the expansion in our quantitative equity capabilities and the broadening of our equity offerings and client base have meaningfully transformed our business. This growth is making us consider how to position our business for the next decade.

Our people are the foundation of our company and intellectual capital is our most precious resource. We remain dedicated to investing in our people through career development planning and leadership programs, we strive to enhance skill sets, the depth of our teams, investment processes, and plan for succession.

In support of talent development, CC&L’s Women in Leadership (WiL) initiative began in 2021, led by a committee comprising most of the women in the organization, to identify and address issues contributing to gender imbalance in the leadership within our organization, our industry, and our society.

This imbalance, we believe (supported by academic studies, industry research and personal experience) results from societal influences, complacency and unconscious bias. Although the statistics on gender imbalance in senior positions are disheartening, we are optimistic about driving change through thoughtful and coordinated action. If we successfully tackle the key issues contributing to the leadership gender imbalance, we will substantially broaden the talent pool from which great leaders emerge, creating better business outcomes.

An important – and unexpected – outcome of our efforts is that the solutions identified for leadership gender imbalance are also solutions that apply to broader issues, that can benefit everyone. In 2023, we began implementing the WiL committee’s recommended solutions. For more details, please read our Women in Leadership whitepaper.

Another major initiative over the past year was a project to foster a culture of continuous, real-time feedback, driving innovation, professional growth and motivation. We see feedback as essential for both individual and collective success. Challenging the status quo, innovating and taking risks are crucial in our competitive industry. Reaching our full potential depends on receiving constructive feedback for improvement. This belief led us to invest in a firm-wide development program, facilitated by a third-party consultant, to cultivate and strengthen a culture of feedback and innovation. This process started with an offsite meeting to arrive at a shared vision for our feedback culture and continued with six workshops to build foundational knowledge and skills and integrate feedback practices. This 10-month project was a significant step in our continuous efforts to improve our culture, leadership skills and processes.

In 2024, we will look at enhancing practices for managing parental leaves and career coaching.

In closing, I want to express gratitude to our clients for your trust, confidence and continued partnership.

Sincerely,

Photo of Martin Gerber
Martin Gerber
President & Chief Investment Officer

Our People

Our teams continued to grow in 2023. CC&L welcomed 25 new hires, resulting in a net increase of 18 employees for the year, bringing CC&L’s personnel count to 135. Our business also benefits from the 410 people employed by CC&L Financial Group, supporting business management, operations, marketing and distribution.

Our firm’s stability and specializations remain primary drivers of our business. Key to our success is thorough succession planning and a disciplined approach to career development. Our disciplined annual review process allows us to identify achievements, trends and areas for improvement.

We are pleased to share that several employees were promoted to Principal effective January 1, 2024 in recognition of their important and growing contributions to our firm.

Photo of Chang Ding, Adriana Gelbert, Jeremy Gill, Chris Holley, Richard Hsia, Jason Li, Conrad Ng, Bradley Pick, Diana Prenovost, Dana Russell, Ian Tai, James Wasteneys, Albert Wong, and Yegor Zadniprovskyy.

CC&L’s Board of Directors is pleased to announce that, effective January 1, 2024, the following individuals were promoted to business owners of the firm, in recognition of their leadership and impact in their roles.

Photo of Kathryn Alexander, Lisa Conroy, Jack Ferris, Ted Huang, and Calum Mackenzie.

Fixed Income

Over the past two years, Brian Eby, Portfolio Manager-Macro Strategy, has been executing the final step of his succession plan, working closely with TJ Sutter in a mentorship role, transitioning macro analysis, forecasting and portfolio decisions. After 25 years at CC&L, Brian will be retiring effective June 30, 2024.

Photo of Brian Eby

CC&L is pleased to announce that TJ Sutter has been promoted to Co-Head of the fixed income team. TJ joined CC&L in February 2021, after 10 years with RBC Capital Markets where he was a Director and Regional Head of the Fixed Income, Currencies and Commodities Group. Previously at RBC, TJ had significant responsibility for implementing investment risk strategies as well as leading a team of nine traders and salespeople with oversight of relationships with some of the bank’s largest clients. In his time here at CC&L, TJ has developed a strong track record as macro strategist for the fixed income team. TJ will partner with David George in the Co-Head role for the next two years as David transitions towards his retirement.

The investment record of the fixed income team is a testament to the excellent work that David has done in shaping the team and building out the fixed income team resources during his tenure. He along with the other partners have developed a talented group that will continue to develop and see opportunities to expand their roles over the next two years. David’s support over this period will allow for a seamless transition of roles and responsibilities ensuring that we are able to continue to successfully meet client investment objectives.

Photo of David George  Photo of TJ Sutter

Ted Huang, a quantitative analyst who joined the fixed-income team in 2018 and became a Principal in 2021, was appointed business owner this year. Ted’s combination of strong quantitative skills and practical fixed-income experience has been invaluable in finding unique sources of added value in the bond market.

Fundamental Equity

Brian Milne moved into a role covering the energy sector, replacing Mark Bridges who retired from CC&L effective December 31, 2023. Brian has covered the energy sector for equities and credit for 13 years. He is a business owner and former Senior Credit Analyst covering energy credit for the Fixed Income team, where he collaborated with Mark on the energy sector.

Photo of Brian Milne

Michael McPhillips was appointed Fundamental Equity Research Director effective December 31, 2023, following Mark Bridges’ retirement. Michael is a business owner with more than 10 years of experience and has been a Fundamental Equity team member since 2013.

Photo of Michael McPhillips

The team is focused on developing the next generation of investment leaders and is pleased to announce the appointment of three individuals to business owner:

Lisa Conroy joined the Fundamental Equity Team in 2013 as an analyst covering a number of sectors in the Canadian equity market. Over time, her responsibilities have increasingly focused on supporting CC&L’s clients with insights on portfolio strategy and positioning. In recognition of her impact on the firm as a Product Specialist, Lisa became a Principal in 2022 and a business owner in 2024.

Kathryn Alexander joined the firm in 2017 as a Research Associate focusing on companies in the industrials and diversified financial sectors. She assumed increased responsibilities over time and was promoted to Principal in 2019, before deciding to take a break to start a family. We were excited to welcome her back in 2023 and she has quickly adapted. Her coverage now includes companies in the energy infrastructure, telecommunications and forest products sectors, and she’s also learning the skills to be a lead portfolio manager.

Jack Ferris joined the firm in 2022 as a Research Associate focusing on companies in the materials sector. He became a Principal in 2023. After quickly mastering that sector, his focus expanded to include companies in the consumer staples sector. In addition to researching companies, Jack is learning the skills to be a lead portfolio manager.

Quantitative Equity

Jennifer Drake completed her transition to Co-Head of the Quantitative Equity team effective January 1, 2024. Jenny has assumed primary responsibility for business and team strategy, working alongside Steven Huang, who continues to lead investment strategy.

Photo of Jennifer Drake  Photo of Steven Huang

The team continues to grow, adding people to all sub-teams in 2023, with approximately 10 new staff, bringing the team to 72 members. The plan is to continue investing in leadership resources across sub-teams at a similar pace this year.

Kyle Ingham, lead of the Q Investment Process Management sub-team, transitioned to a strategic role, Head of Investment Management Operations (IMO), effective January 1, 2024. The Q Investment Process Management sub-team is transitioning to a co-leadership model led by Cam MacDonald and Chris Holley.

Client Solutions

The team is adding to its leadership with an eye towards succession for Phillip Cotterill over the next couple of years. Calum Mackenzie joined the firm in July 2023, bringing significant experience from prior leadership roles and is increasingly contributing to the team’s strategic discussions. He became a Principal in 2023 and a business owner this year.

Diana Prenovost joined us in January 2023, working alongside Johanne Bouchard, a Senior Client Relationship Manager, who will be retiring on December 31, 2024, after 18 years at the firm. Diana was promoted to Principal this year and is CC&LIM’s first permanent employee located in our Montreal office.

Photo of Diana-Prenovost  Photo of Johanne Bouchard

Investment Management Operations

As Head of Investment Management Operations, Kyle Ingham is responsible for strategic leadership of investment management operations, reporting directly to the President and CIO. Kyle is a business owner who is providing succession for Lee Damji, and he also manages the Quantitative Equity Investment Process Management sub-team. Lee has been at CCL for 26 years, as Head of CC&LFG’s Information Systems team for 20 years and Managing Director, Operations for 2 years until 2019 when he transferred to CC&LIM to take on this new role. He continues to play an advisory role and provides mentoring for leadership development. His planned retirement date is December 31, 2024.

Photo of Kyle Ingham  Photo of Lee Damji

Responsible Investing

CC&L’s 2023 PRI evaluation scorecard reflects several improvements in our ESG activities. We are now ranked at or above median in all measurement categories.

The ESG Committee completed a review of our ESG practices in 2022 and prioritized several improvement areas. A project plan was developed, including enhancements to ESG training, reporting and engagement capabilities outside of Canada. Work in all of these areas began in 2023 and continues in 2024.

Business Update

Assets Under Management

CC&L’s assets under management (AUM) increased by CAD$10 billion in 2023 to CAD$64 billion as at December 31, 2023. We are pleased to report that our business continued to grow through new client mandates across all investment teams. In 2023, CC&L gained 21 new clients and five additional mandates from existing clients totalling CAD$2.6 billion. The majority of new mandates were for quantitative foreign equity from institutional investors outside of Canada.

By Mandate Type*. Fundamental Equity: 18%. Quantitative Equity: 50%. Fixed Income: 16%. Multi-Strategy: 16%. By Client Type*. Pension: $33,169. Foundations & Endowments: $2,468. Other Institutional: $9,060. Retail: $11,882. Private Client: $7,764. *Total AUM in CAD$ as at December 31, 2023.

Product Updates

We are launching a new Fixed Income Core Plus strategy in 2024 that will include CC&L’s core fixed-income strategy along with allocations to mortgages and emerging market debt managed by affiliated teams within CC&L Financial Group.

The distribution of CC&L’s Quantitative Equity strategies has been augmented with a Collective Investment Trust (CIT) platform in the US for ERISA-regulated pension plans. The Q Emerging Markets Equity CIT launched in January and the Q Global and Q International Equity CIT vehicles are also launching this year.

CC&L’s Ireland-based UCITS Fund platform is also expanding this year with the addition of Q Global Equity and Q Global Equity Small Cap funds.

Final Thoughts

We would like to thank our clients and business partners for their support and look forward to continuing to help you achieve your investment objectives.

Six-month core CPI momentum has returned to a target-consistent level in the Eurozone and UK, with January readings of 2.1% and 1.9% annualised respectively*. US momentum is significantly higher, at 3.6% – see chart 1. What explains this gap?

Chart 1

Chart 1 showing Core Consumer Prices (% 6m annualised)

One answer is that the US CPI is overstating core pressure. The six-month increase in the Fed’s preferred core PCE measure was 1.9% annualised in December. Assuming a monthly rise of 0.4% in January (the same as for core CPI), six-month momentum would firm to 2.4% – still little different from Eurozone / UK core CPI readings.

The stronger rise in the US CPI than the PCE index reflects a higher weighting of housing rents and a faster measured increase in “supercore” services prices.

Perhaps reality lies somewhere between the two gauges, i.e. the stickiness of US core CPI momentum is at least partly genuine. If so, the US / European divergence may be explicable by monetary trends in 2021-22.

Previous posts highlighted the close correspondence between the slowdowns in Eurozone and UK six-month CPI momentum and profiles of broad money growth two years earlier. Chart 2 updates the UK comparison to incorporate January CPI data.

Chart 2

Chart 2 showing UK Consumer Prices & Broad Money (% 6m annualised)

UK and Eurozone six-month broad money momentum peaked in summer 2020 and had returned to the pre-pandemic range by late 2021. This is consistent with the reversion of six-month headline and core CPI momentum to target-consistent levels around end-2023.

US broad money momentum followed a different path, with a more extreme surge in summer 2020, a return to earth in H2 2020 and a secondary rise in H1 2021, driven partly by disbursement of stimulus checks in December 2020 and March 2021 – chart 3.

Chart 3

Chart 3 showing US Consumer Prices & Broad Money (% 6m annualised)

The sharp fall in US six-month money growth during H2 2020 was echoed by a slowdown in CPI momentum into end-2022 – much earlier than occurred in the Eurozone and UK. More recent CPI stickiness may reflect the lagged effects of the secondary monetary acceleration into mid-2021.

What does this suggest for absolute and relative prospects? The judgement here is that broad money growth of 4-5% pa is consistent with 2% inflation over the medium term. US six-month money momentum crossed below both this range and UK / Eurozone momentum in May 2022, reaching an eventual low in February 2023, at a weaker level than (later) lows in the UK / Eurozone.

Assuming a two-year lead, this suggests that US six-month core CPI momentum will move down to 2% around mid-2024 on the way to a larger (though possibly shorter) undershoot than in the UK / Eurozone.

*Eurozone = ECB seasonally adjusted CPI excluding energy and food including alcohol and tobacco. UK = own measure additionally excluding education and incorporating estimated effects of VAT changes, seasonally adjusted.

A woman looking out over the ocean during a sunset as she leans on a railing. She is wearing winter clothing and there are mountains off in the distance behind her.

This year’s Forecast examines the secular themes shaping our outlook for financial markets, as well as the shorter-term cyclical factors influencing economic growth, inflation and monetary policy. We assess market valuations and, considering all of these factors, establish our portfolio strategy framework.

This year, updates to our Forecast will be featured in our quarterly Outlook publication.

Introduction

“A short cycle and a short recession” was the dominant investment theme in our 2023 Forecast. In hindsight, our outlook and forecasts were too conservative for 2023. We had broadly expected soft economic performance in Canada, China and Europe, which largely came to pass. However, we underestimated the US economy’s resilience, specifically the impact of fiscal transfers to support consumer balance sheets, the unleashing of excess savings, as well as corporate demand for labour which kept the jobs market humming. US economic growth will end 2023 accelerating to about 2.5%. In Canada, the surge in population added to demand and aggregate economic activity (overall GDP is expected to end up about 1.2%), but disappointed on a per capita basis (see December Outlook). We expected that central banks would need to engineer a slowdown to combat inflation, ascribing about a two-thirds probability of a recession at its peak. Indeed, an upside surprise to inflation, premised on the difficulty of rebalancing exceptionally tight labour markets, was our primary risk scenario. Historically, when inflation has reached 5%, it has typically taken more than a year and an economic downturn to resolve. Last year’s recession expectation was so universal that, in the past 55 years of economic surveys by The Economist, Q4 2022’s annual US GDP forecast ranked the fourth lowest. Contrary to expectations, we were humbled by both the economy’s resilience and the slowing pace of inflation without a more material slowdown. The economy withstood the tight financial conditions, reminding us in part of the long lags associated with monetary policy but also the role that outsized policy played in supporting the economy through the pandemic.

Both stocks and bonds finished the year with material gains, recovering from a dismal 2022. The S&P/TSX Composite Index had a volatile year but ended up 11.8%. Global equities performed even better, with the MSCI ACWI Index up 18.9% for the year, led by US stocks. The S&P 500 Index gained a hefty 24% to close at 4780, exceeding our forecast of a more moderate 8% gain. We missed the mark on the massively positive investor sentiment that overwhelmingly favoured the “Magnificent Seven” (Mag 7) mega-cap stocks of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla, as AI moved into the mainstream, driving P/E ratios past last year’s overvalued levels. Notably, only three sectors surpassed their prior year’s valuations: information technology, telecom services and consumer discretionary. The expected outperformance of defensive stocks and corporate bonds did not materialize. The S&P/TSX, with its heavy weighting in higher dividend payers within financials, telecom and REITs broadly struggled amid higher longer-term interest rates.

Bond markets also saw large moves, but essentially did a big round trip during the year as 10-year yields in the US and Canada closed very near their opening levels. November and December were among the best months for global bonds since 2008 as tame inflation readings enabled central banks to begin to discuss the potential rate cuts. Our forecast was too conservative, calling for a return of around 2% to 5%, while the FTSE Canada Universe Bond Index ultimately closed the year up an even stronger 6.7%. Financial markets saw large moves throughout the year, responding to rapid shifts in narratives and investor sentiment and our positioning was impacted by the viewpoints. The outcome was strongly positive absolute returns for investors, and despite the miss in forecasts, many of our strategies’ overall security selection performing well.

Even as last year’s forecasts for growth turned out to be overly conservative and inflation overly worrisome, we now consider these factors for 2024. Over the next pages, we assess underlying secular themes while recognizing the cyclical influences in the foreground. We still see long-term inflation pressures, but we now note a possible resurgence in productivity that could provide some balance. In the near term, just as we began 2023 with conviction in our outlook for a recession, we begin 2024 with a strong degree of confidence that policymakers can engineer a soft-landing scenario. While many are prepared to adjust portfolios in response to a long-expected recession, (e.g., the growth side of being wrong on soft landings) it is less clear how investors will be prepared to respond if inflation is misjudged.

Chart 1: Growth has outperformed expectations

Source: Bloomberg

 

Chart 2: Core inflation has eased everywhere

Source: Statistics Canada, Statistics Sweden (SCB), Swiss Federal Statistical Office (Bundesamt fuer Statistik), U.K. Office for National Statistics (ONS), U.S. Bureau of Labor Statistics (BLS), Eurostat, Australian Bureau of Statistics, Macrobond

The Secular Environment

We believe the era of secular stagnation is behind us. During this period, geopolitical risks were low, and companies benefited from lower-cost alternatives through globalization and employed increasingly complex supply chains. Our secular themes indicate a shift away from an environment characterized by widespread disinflation to one where sustained inflation, more than a temporary cyclical response, challenges policymakers. However, we start our secular themes with a new development that has the potential to offset the broad inflationary pressures arising from our other secular themes.

1. Artificial Intelligence – and productivity – will reshape our world

  • 2023 may come to be remembered as the year that AI entered the mainstream, particularly through generative tools based on large-language models, like DALL-E, Character AI, Bard and ChatGPT. Their widespread applicability, ease of use, and human-like interactions will facilitate adoption.
  • If last year, companies were testing and brainstorming uses of AI, over the coming years companies will look to integrate it into their operations. As a result, many existing jobs will transform or even become obsolete. Research suggests AI could perform or assist with a quarter to half of current jobs. As with past technological advancements, AI is also likely to create new jobs that do not exist today.
  • The ability to generate growth without inflation depends on productivity. This matters greatly, as labour markets in developed countries contract with demographic shifts. The gains from AI are expected to be swifter than those of previous technologies like PCs, the internet, mobile devices and cloud computing, which took years to reflect in official data. The effects from AI are likely to be more rapid this time – adoption will be smoothed by the human-like interface, wide applicability and attention being paid across a wide swath of industries.
  • AI was a dominant market theme in 2023. Tech companies, supplying hardware, models and infrastructure and aggressively integrating AI into their operations, have been the primary beneficiaries. We will consider companies across a spectrum of adoption. Those most directly impacted will be companies involved in AI themselves, training the models and adapting them for business applications. The impact will be more pronounced in the US due to its thriving tech industry, government support and encouragement, as well as cash flow to invest. Farther down the spectrum will be businesses that enable the AI industry to thrive, through hardware manufacturing or supplying the infrastructure such as energy generation and data centers. Finally, there will be companies who will be early and willing adopters, who will benefit from margin improvement and rising revenue.

Chart 3: Most jobs evolve out of innovation

Source: The Labor Market Impacts of Technological Change: From Unbridled Enthusiasm to Qualified Optimism to Vast Uncertainty David Autor NBER Working Paper No. 30074

 

Chart 4: Manufacturing capex is driving business investment

Note: The ‘other’ category includes health care, educational, amusement & recreation, lodging, and religious.

Source: US Census Bureau, Macrobond, CC&L Investment Management

 

2. Business capital investment cycle

  • Business investment was a bright spot in 2023, growing approximately 4% in the US, even amid rising interest rates. Investment in structures particularly soared, increasing by 30.3% in Q1 and as of the latest reading is up by a decade-high rate of 13.7% y/y as businesses took advantage of a range of government subsidies from the government. Fiscal stimulus moved away from consumer-targeted measures (e.g., employer tax credits, cheques, student loan deferrals, rent caps) to private sector infrastructure investment (under the Infrastructure Investment and Jobs Act (IIJA), clean energy (via the Inflation Reduction Act) and domestic high-tech manufacturing (as part of the CHIPS and Science Act).
  • Public infrastructure has suffered from underinvestment, and governments have begun the renewal, with US government investment up 10% y/y to Q3 2023. The November 2021 IIJA doubled the amount of spending in a normal five-year spending plan, but these construction projects take time to implement. The spending, initiated in 2023, is expected to continue in 2024.
  • Looking ahead, several factors are poised to boost capex globally. First, the urgency of transitioning to a low-carbon world is escalating. Europe will reduce its energy reliance on external sources and all countries will add to renewable (hydrogen, solar, wind) and nuclear energy sources. Commodities linked to the energy transition are likely to perform well. Second, international trade and supply chains are being realigned globally. Emerging markets (EMs) are increasingly trading bilaterally in their own currencies instead of in US dollars. The West is moving towards onshoring manufacturing, reducing dependence on Eastern sources. This deglobalization will ultimately be inflationary. Finally, the business interest in AI is enormous. Data from surveys, earnings calls, internet search terms and job postings citing AI-related skills all suggest a material planned capex likely to drive spending on machinery, equipment and intellectual property.

Chart 5: Recent fiscal bills are expected to increase deficit in coming years

Note: CHIPS and Science Act; Infrastructure Investment & Jobs Act; Inflation Reduction Act.
Positive value is deficit reducing, negative value is deficit increasing.
Source: Source: Congressional Budget Office, Macrobond, CC&L Investment Management

 

Chart 6: How high can policy rates go when there is debt to be paid?

Line graph showing high US government net interest costs and government debt as percentages of GDP, which are both expected to climb higher over the next 10 years, challenging the feasibility of higher policy rates amid growing debt.

Note: Shaded area is CBO 10-year forecast.
Source: Congressional Budget Office, Macrobond, CC&L Investment Management

 

3. Era of fiscal dominance

  • Governments have embraced fiscal spending as a powerful crisis management tool. While that has improved economic resilience, this comes at the price of subjugating monetary policy to achieve fiscal needs, a concept known as fiscal dominance (refer to our September Outlook for more details). A notable example was the September 2022 UK budget, which triggered bond market upheaval. In response, the Bank of England initiated unlimited gilt purchases to stabilize markets and a return of inflation.
  • In the US, a series of COVID-19 relief bills, financed through new borrowing without offsetting revenues, pushed the US national debt to an unprecedented $34 trillion, up from $31.4 trillion at the start of 2023. Last year’s deficit roughly doubled compared to 2022, with government spending remaining above 2019 levels, reduced tax receipts and importantly, increased interest costs for debt servicing. The $2.5 trillion annual increase in federal debt represents growth above GDP and has come at the most unnecessary time – when the economy is at period of full employment. This unsustainable development poses a risk of either higher inflation or fiscal austerity. In August, Fitch downgraded US debt from AAA to AA+, at a time when deficits are expanding due to spending, US Treasury issuance is being compounded by the Fed’s quantitative tightening (QT) and interest costs as a percentage of tax revenue are in excess of 14%, while the cost of servicing debt is rising for the first time in nearly four decades. In an effort to avoid liquidity issues, the Treasury is shifting issuance to higher-cost T-bills (over 5%), even though locking in rates for longer periods would be more cost effective.
  • The likely outcome is higher neutral interest rates and increased economic and inflation volatility. Bond issuance will rise, and markets will likely raise term premiums accordingly. This is the end of the 40-year bond bull market, and the era of easy monetary policy.

The Cyclical Environment

World: Wars and elections divide, but world unites in easing policy

  • The global economy defied expectations of a recession in 2023. However, the world is awash in debt, a consequence of prolonged financial repression. Policymakers aimed to moderate growth from a state of excess demand, indicating we are in the late stages of a policy-led business cycle. Without forceful policy easing to stimulative conditions, 2024 is likely to continue experiencing slowing growth. With the long lags in policy, we have yet to see the full impact of higher interest rates. Disinflation has come more rapidly across numerous countries, and has been achieved more easily than expected. Global supply shocks have eased, and combined with tighter financial conditions, have reduced inflation pressures homogeneously across the world. While services inflation remains elevated, the reduction in goods prices has done a lot of the work. In all, monetary policymakers are signaling a close to their tightening phase and are now considering when to begin bringing rates back to neutral levels.
  • Geopolitics and domestic politics will be enduring and critical themes this year. Countries are engaging in wars on multiple fronts, as the unipolarity and the peace dividend from interconnected trade has fractured. Trade is increasingly focused on politically aligned or friendly countries and closer to home. This year, for example, Mexico and Canada eclipsed China as the largest source of US imports. Additionally, China’s trade with ASEAN and Latin America has soared. Notably, this year marks a record in democratic elections, with half the world’s population, representing nearly two-thirds of global GDP and 80% of the world’s equity market valuations, participating in elections. This includes nations like India, Mexico, Taiwan, the UK and the US.
  • The IMF projects global growth will slow to 2.9%, below the 20-year historical average of 3.8%. EMs are expected to drive much of the growth, notably India (6%) and China (4.7%). Despite a resilient US economy, advanced economies are likely to slow further, with deleveraging taking place in heavily indebted countries.

Chart 7: Reshoring – US imports from Canada and Mexico surpassing China

Source: US Census Bureau

 

Canada: Recession to usher lower rates

  • Like their counterparts in the US, Canadian consumers, who form the largest part of the economy, are likely to cut back over the next year. Canadians carry a high debt load relative to disposable income. Yet, the impact of high interest rates is taking time – 47% of mortgages have been reset to higher rates, with the balance expected to follow in the next two years. Debt servicing costs, however, are already back at their highest levels since 1990. Higher interest rates and some meeting of pent-up demand last year (e.g., new vehicle sales grew by 11.8% y/y in 2023), imply real household credit growth and consumer spending will contract. The severity of a consumer downturn might be softened by accumulated savings and wealth, but will also significantly depend on the resilience of labour markets. Despite high population growth enhancing labour supply (discussed in our December Outlook), balanced labour markets could begin to show strain if job creation does not keep pace with new immigrants.
  • Housing markets are a wildcard. Under normal interest rate hiking cycles, the most interest rate sensitive sector would soften. However, world-leading population growth and limited housing supply should support residential demand overall (as detailed in our July Outlook). The Bank of Canada (BoC) easing should come sooner than in the US, but this could be delayed if reduced mortgage rates reignite excessive housing demand. Both our consumer and economy appear much less resilient than the US. Nevertheless, business capex, reinforced by our secular themes, should help boost productivity. Fiscal policy offers potential upside risks as the minority Liberal government could call an election within the next two years. Although a global recession may marginally reduce demand for Canadian exports, the robustness of the US economy could provide a compensatory effect.
  • Headline inflation has shown significant improvement, falling from 5.9% y/y in January 2023 to 3.1% y/y by year’s end. Inflation in Canada appears more persistent than in other countries, partly owing to consistently high shelter costs (which grew by 5.9% y/y in November 2023), with both rents and mortgage interest costs continuing to pressure inflation to the upside. These factors will ultimately contribute to slowing demand and disinflation in goods and non-shelter services. However, for now, core inflation metrics remain at the high end of the BoC’s target range (core CPI 3.4% y/y), though they are showing signs of progress (2.8% on a 3-month annualized basis). This trend will be closely watched for any change in momentum.

Chart 8: 100% of of mortgages will have payments increase in the next 3 years

Source: Bank of Canada Financial System Review, 2023

 

Chart 9: Mortgage debt servicing costs highest on record

Source: Statistics Canada, Macrobond

 

US: Lower interest rate sensitivity, dampening prospects of a slowdown

  • Of all the major world economies, the US is experiencing the slowest impact from policy tightening, resulting in relatively strong growth compared to other developed countries. US consumer debt is at a more manageable level than it has been in years, and households with long-term fixed rate mortgage debt have not felt the higher rates. Business borrowing has been termed out. Labour markets are more balanced, with a reduction in unfilled job openings and a persistently low unemployment rate. Low-skilled workers are seeing real income gains, while high-income consumers benefit from the wealth effect. While delayed, the prior increase in policy rates will weigh on growth this year, as evidenced by increased credit card usage and rising delinquency rates.
  • Business spending and fiscal policy will likely be buoyed by the spending out of the trifecta of the IRA, Infrastructure and CHIPS bills. However, the federal deficit, now at 6.6% of GDP, remains a serious risk. Fully two-thirds of federal spending is now non-discretionary and growing due to demographic trends. Discretionary spending is unlikely to contract, particularly with the upcoming US presidential election. Historically, recessions during election years (1960, 1980, 2008, 2020) have resulted in the incumbent party losing power. Therefore, preventing a recession will be important in this high-stakes election to focus attention on the issues at hand. Despite stimulative fiscal policies and full employment, the Fed has signaled its intent to cut rates to a more neutral stance. This “pivot” – cutting rates before a significant rise in unemployment – supports a soft landing, aiming to achieve the 2% inflation target without a growth slowdown. Nonetheless, we assign a lower probability to this “goldilocks” outcome than the markets, which appeared highly convinced of this scenario at the end of last year.
  • A notable inflation headline closing out last year was the six-month annualized core PCE deflator falling to around 2% in November, effectively signaling a clear path to the Fed’s target. However, if monetary and fiscal policies inject stimulus next year, in what is a fairly stable growth environment, there is a risk of an unexpected increase in growth, which may not align with continued disinflation. We believe a key underappreciated market risk is the potential for an inflation resurgence, with the Fed’s current dovish stance increasing the probability of a misstep similar to that made by Arthur Burns in the 1970s.

Chart 10: US inflation measures signaling path to Fed target

Source: BEA, Macrobond

 

Europe: Persistent fragility

  • Europe’s growth continues to be challenged, with the Eurozone GDP ranging between 0% and 1% for 2023 and not improving much in 2024. Against the backdrop of a decelerating global economy, Europe confronted negative supply shocks last year, stemming from increased global competition in manufacturing and continued adjustments to energy insecurity. This year, Europe also faces a negative demand shock as consumers and businesses adjust to higher interest rates.
  • Fiscal policy remains constrained from providing a large stimulus, although EU finance ministers did successfully put through reforms to the fiscal union at the end of 2023. These reforms will adhere to the principle of limiting budget deficits but introduce two key changes: firstly, allowing a margin of deviation depending on individual country circumstances, and secondly, aiming for a return to a deficit target of 3% of GDP over a longer period. Beyond being more realistic and achievable goals, these provide some flexibility for countries to support growth on the margin.
  • Wages are a concern for all central banks. In Germany, with an unemployment rate (UR) of only 3%, labour costs (compensation per hour) are rising approximately 6% y/y, double the UR rate. Inflation has eased significantly, ending the year at 2.9% y/y, and risks are becoming more evenly distributed. Nonetheless, a slowing economy and productivity growth are expected to help control inflation in the medium term. The European Central Bank (ECB) closed out last year with a tough stance on inflation. In the coming year, the ECB’s ability to raise rates might be limited by a Fed intent on cutting rates, as any ECB hikes could lead to unwanted appreciation of the euro in an already tough international competitive environment. Rate cuts by the ECB later in the year, facilitated by a deceleration in inflation towards target, should help support a mild recovery.

Chart 11: European industrial production is stagnating
Real industrial production

Line graph charting the rising trend in industrial production in Germany, Italy and France in the 1990s. Growth in industrial production in Italy and France stalled in 2010, and has mor recently moved below trend in Germany.

Source: Statistisches Bundesamt, Istat, INSEE, Macrobond

 

China: Persistent structural challenges

  • China’s rebound in 2023 was disappointing, largely due to weak consumer spending from a deflating property sector. To counter the slower growth and deflationary threat, policy has been easing incrementally through interest rate reductions, curbing of home buying regulations and an unusual increase in the fiscal deficit. These measures have been incremental however, as the government is wary of moral hazard and reflating the property bubble. Residential construction has slowed materially. With the maturing economy, growth is still likely to ease from last year’s rate of 5.3%.
  • International trade remains a bright spot, with China diversifying trade away from the US towards EMs. China has also moved up the value chain in manufacturing, becoming the world’s largest exporter of light vehicles, and a major producer of heavy machinery poised to benefit from investment in green energy and infrastructure development. Downside risks remain, notably with worsening demographics, as India has now eclipsed China as the world’s most populous nation, as well as high unemployment rates among university-educated young workers. The ongoing property market correction has no short term fix, after significant overbuilding and the decline in confidence.
  • In contrast to much of the world, China faces deflationary pressures, with a Consumer Price Index (CPI) reading of -0.5% y/y in November and producer prices falling 3% y/y. Thus, the risks are tilted towards stronger fiscal and monetary stimulus. The US-China relationship has moved to a more strategic dimension that will likely see less trade and foreign direct investment.

Chart 12: China’s trade with EM has surged compared to DM

Value of China’s exports plus imports for major trading partners on a 12-month rolling basis and indexed. EM is Brazil, Russia, India, and South Africa

Source: China General Administration of Customs, Macrobond

Valuation

VALUATIONS: Earnings growth crucial in 2024

  • Canadian corporate profits peaked in early 2023, and deteriorated through the year, contracting by approximately 5% as economic momentum waned and input costs continued to rise. In contrast, US corporate profits remained stable. A solid US consumer supported by excess pandemic savings and a healthy labour market helped provide resilient economic growth.
  • For 2024, we expect modest company earnings growth. Revenue headwinds remain, from slowing US nominal GDP and a likely contraction in Canada’s nominal GDP, though we expect any slowdown or recession to be relatively mild. Secular tailwinds should offset cyclical weaknesses, and operational efficiencies should, in turn, drive earnings growth. That said, we expect lackluster earnings growth in the near term, with a probable pickup in the second half of 2024.
  • Profit margins contracted through 2023 but leveled off in the second half of the year, in line with our expectations. In 2024, we expect profit margins in the US and Canada to expand modestly. Companies are finding operational efficiencies, including improved inventory and supply chain management, to offset labour and other input costs. We also anticipate that input costs will be more muted in 2024 as labour markets become more balanced and wage pressures ease.
  • In the US, we see a 7% rise in earnings per share (EPS) for the S&P 500 in 2024. Canada is already experiencing a more pronounced economic slowdown, and we expect 4% earnings growth for the S&P/TSX. Our 2024 EPS forecasts are $235 per share for the US and $1,475 per share for Canada, lower than consensus forecasts of US$245 and C$1,518, respectively.
  • Earnings growth for MSCI ACWI is expected to land somewhere between Canada and the US. Globally, the highest earnings growth should arise from the US (outlined above) and EM, particularly India, driven by increased capital spending and exports. This growth should more than offset weaknesses in China, which continues to face secular headwinds.

Chart 13: Earnings growth to pick up in 2024
Trailing earnings growth

Line graph comparing year-over-year change of trailing earnings growth of the S&P 500 Index and S&P/TSX Composite Index between 2013 and 2024.

Source: I/B/E/S, TD Securities, Macrobond

 

VALUATIONS: Multiples to remain near current levels

  • Valuation multiples expanded in 2023, particularly towards year-end, driven by easing inflation and economic activity, alongside the Fed’s dovish pivot that lowered bond yields. This sparked optimism for a soft economic landing, supporting valuation multiples. In 2024, price-to-earnings ratios (P/Es) in Canada and the US are likely to remain broadly unchanged at about 14x and 21x, respectively, on a trailing basis. Risks look fairly balanced. Our year-end index estimates are 4975 for the S&P 500 and 22,000 for the S&P/TSX, driven by earnings growth rather than multiple expansion. These forecasts are lower than the market’s current projections and imply mid-to-high single-digit returns in the US and Canada from year-end levels, with the S&P/TSX modestly outperforming given its lag in the recent rally.
  • Global equity market valuations have also expanded. P/E multiples in regions outside of the US, such as EAFE and EM, have increased but remain below historical averages. We expect multiple expansion to be modest in 2024 for global equity markets. Regardless, we expect positive returns for global equities, and we anticipate that EM equities will outperform relative to other global regions, likely in the latter half of the year.

Chart 14: Multiple expansion limited

Line graph illustrating trailing P/E multiples of the S&P 500 and S&P/TSX Composite indices between 2000 and 2023.

Source: I/B/E/S, TD Securities, Macrobond

 

VALUATIONS: Bonds remain fairly valued

  • The outlook for bonds is more balanced. Real yields are positive compared to contained inflation expectations and central banks are likely to lower nominal yields to maintain more neutral real rates. Interest rate cuts in the first half of the year should support near-term bond returns, although these cuts are already reflected in current yields. Monetary policymakers appear to have completed their interest rate hiking cycles. As a result, the risk of pronounced negative bond returns from further interest rate increases is minimal relative to 2022 and the first three quarters of 2023. Additionally, bond investors will benefit from higher starting yields.
  • The Canadian 10-year bond yield declined 0.21% in 2023 to 3.12% thanks to a year-end bond rally. We continue to believe that structural forces are likely to keep bond yields elevated relative to the post-Global Financial Crisis period. However, with our expectation of a mild recession in Canada in 2024, we believe there is room for bond yields to decline, particularly in the short-term maturities, with less opportunity for mid- and long-term yields to fall. Longer-term yields are already reflecting recession-like valuations. Additionally, technical factors in Canada, including strong demand from pension plans and an undersupply of 30-year bonds, continue to weigh on longer-term yields. However, some of these factors may dissipate as pension plans approach their target allocations and long-term bond yields become less attractive. This could result in some upward pressure on longer-term yields in 2024. For the year, we expect the 10-year Government of Canada bond yield to trade in the 2.75% to 4% range, with 2024’s starting yield already at the lower end of this range.
  • The FTSE Canada Universe Bond Index rose 6.7% in 2023, narrowly avoiding a never-before-seen third consecutive year of negative returns, thanks to a strong fourth-quarter rebound. We have a positive outlook for bonds in 2024, expecting modest upward pressure on long-end yields to be offset by downward pressure on short-term yields. Credit spreads may widen in the case of a more pronounced slowdown, but given our expectations for a mild recession in Canada, spreads are likely to narrow after the initial widening. We expect a return of 3% to 6% for the FTSE Canada Universe Bond Index in 2024, compared to the current running yield of 3.94%.

Chart 15: After solid gains last year, looking for positive returns again in 2024

Source: TSX, FTSE Global Debt Capital Markets Inc, S&P Global, MSCI

Portfolio Strategy and Structure

The rally across asset classes at the end of 2023 brought solid returns for investors after a dismal 2022. While much of the S&P 500’s performance throughout 2023 was attributed to the Mag 7 stocks, the broadening of the rally across all GICS sectors marked a material change in sentiment. By the end of 2023, investor sentiment, a contrarian indicator at extreme levels, moved from pessimistic to neutral, and has now reached its most bullish print since April 2021. This improvement coincided with rises in equity and bond markets. However, this now tilts risk towards the downside, particularly if the soft landing fails to materialize. Equity markets are currently “priced for perfection.” This requires validation of the aggressive rate cuts that are already priced into bond markets, continuing above-trend growth and easing inflation, a combination that seems improbable.

The Fed’s turn towards a more accommodative policy stance does bolster the soft-landing narrative for now, even if it may later be regarded as a policy mistake. Regardless, there could be some downside in equity markets if the economy slows more than expected, or if inflation deceleration stalls. Valuations, particularly in the US, have become increasingly expensive, although lower interest rates help to justify these levels. Canadian valuations are less expensive, reflecting the market’s different composition and concerns of a weaker outlook. As such, we expect equity gains to be primarily driven by earnings growth rather than multiple expansion.

Revenue growth may be challenged if nominal GDP slows materially or contracts. Additionally, given the strong performance in December and the current bullish sentiment, there could be short-term downside risk to equity market returns. Regardless, we believe that equity markets will generate positive returns overall for the year.

Regionally, we anticipate positive equity returns in both developed and emerging markets, with EMs and Canada likely to post the strongest performance overall, notwithstanding potential near-term weakness. EMs should benefit from a weaker US dollar when the Fed begins to lower interest rates. This would support economic activity in the region, as a strong US dollar negatively impacts trade volumes and a number of financial metrics, including the availability of credit and capital inflows. Canadian equities stand to benefit from an earnings recovery following a mild recession, with less risk of multiple contraction relative to the US given more attractive starting valuations.

Smaller capitalization stocks, being more sensitive to economic cycles and often exhibiting more volatile earnings than large-cap stocks, warrant a cautious view entering 2024 given the ongoing risk of a downturn, particularly in Canada. Despite the Fed’s pivot, we believe the risks associated with small-cap stocks – lower profitability prospects and increased volatility – still outweigh potential rewards. We are not forecasting broad-based multiple expansion in small caps, but remain open to increasing our exposure should signs of a broader global growth resurgence emerge.

Bond market valuations in Canada remain generally favourable, although the substantial decline in yields to close 2023 suggests overbought conditions. Regardless, with yields at attractive levels and central banks set to begin lowering interest rates in 2024, bonds present a compelling risk/reward profile.

Asset allocation

  • Despite positive return expectations for both bonds and stocks, we begin the year with a defensive position. The asset mix in balanced portfolios currently favours cash due to its enhanced yield, partly a result of inverted yield curves. Both equities and bonds are underweight relative to benchmark target levels, with a smaller underweight in bonds than equities. Within equities, we have a preference for Canadian stocks over global equities.
  • With equity and bond markets reflecting sizeable interest rate cuts, we should expect some reversal of the year-end 2023 rally in the near term. A market reassessment of the soft-landing narrative could trigger a selloff in equity markets that would present an attractive opportunity to rotate back into equities, and in particular, Canada, small cap, and EM.

Chart 16: Sentiment has become extremely positive

Line graph showing a measure of equity market sentiment between 2020 and 2023, with a spike at the end of 2023 suggesting positive sentiment.

Source: AAII, Macrobond

 

Stock and sector selection

  • While overall equity markets look expensive, certain segments have already priced in a downturn, and we are adding some early cyclical companies with favourable valuations.
  • We also prefer companies capable of generating earnings growth in a weaker revenue environment. These are companies likely to benefit from topline growth due to secular trends, overcoming some of the cyclical headwinds. This includes companies that gain from decarbonization, supply chain reshoring, capital spending and construction, and those integrating or exposed to AI.
  • Companies with stable and durable free cashflow are also favoured. These companies can drive earnings growth through share buybacks and accretive M&A activities (where an acquiring company’s earnings increase following a deal).

Corporate credit

  • Much like equity markets, corporate credit performed well to close 2023. Yields have risen in recent years and despite tightening spreads in 2023, the all-in yield remains attractive for investors. There is strong demand in both investment-grade and high-yield credit, as they offer compelling returns compared to the ultra-low equity risk premiums that show earnings yield relative to 10-year Treasury yields hovering near its lowest level in decades.
  • Corporate credit spreads, at about 155 basis points (bps) above sovereign bonds after a tightening into year-end, are around their 15-year average. These spreads are unusually tight for a period of expected weakness associated with an economic and earnings slowdown in Canada. These are far from the levels experienced in the last three recessions where spreads typically exceed 200 bps. With the year-end rally’s impact on valuations, further spread compression seems relatively limited for now.
  • Credit spreads are currently in the middle of the historical ranges. We see a good degree of benefit in holding corporate bonds in areas with favourable yield carry while adjusting overall credit exposure accordingly considering the limited potential for further meaningful spread narrowing.
  • Fixed-income portfolios are currently underweight in corporate credit and market weight provincial credit, relative to their benchmarks. In the near term, we expect outperformance within some of the more defensive sectors.

Chart 17: Spreads already tight leaving limited opportunity for further compression

Note: Average spread of corporate bonds in the FTSE Universe Bond Index.
Source: FTSE Global Debt Capital Markets Inc., Connor, Clark & Lunn Investment Management Ltd.

Duration and yield curve

  • The fourth quarter of last year saw a drop in bond yields in the US and Canada that reversed the prior quarter’s rise. As we enter 2024, there is familiarity to the expectation for a slowdown and thus outperformance from bonds. Nonetheless, the starting point looks unfavourable following the year-end decline in yields. Adopting a long-duration strategy now hinges on a more pronounced recession given markets are pricing in five interest rate cuts in Canada starting in spring. This is an aggressive call, even with our dour view on Canada’s growth backdrop. Additionally, the market appears completely sanguine on the prospect for any reacceleration of inflation or even a growth rebound – each should increase longer-dated yields. Thus, we begin the year positioned with duration shorter than that of the benchmark.
  • Our higher conviction lies in the dynamics of the yield curve. Short-term yields were pushed higher than most prognosticators thought last year, and active pension buying along with recession fears together pulled down long-term yields. This led the yield curve to reach its most inverted level since the early 1990s (about -125 bps between Canadian 2-year and 10-year yields) that stayed there for most of the year, in contrast to the rest of the world where yield curves became less inverted. In a recession, normalization led by short-term yields is likely, while the long end could see upside pressure from potential inflation or technical factors, such as global bond supply increases and continued QT, particularly in the US. Even in a recession scenario, we believe long-term rates in Canada have limited room to rally due to market pricing and technical factors that have weighed on long-end yields. Thus, we see yield curve normalization through various scenarios in 2024.
  • Real return bonds also offer an attractive risk-reward profile, as the market is heavily discounting the risk of inflation reacceleration.

Chart 18: 10Y yields have retraced very quickly

Source: Macrobond

 

Chart 19: Yield curve to move toward normalization

Source: Macrobond

Summary

  • We believe political headlines and uncertainty will dominate much of the conversation this year, muting the impact of a modest cyclical slowdown. Recent years have seen the end of secular stagnation as governments have rediscovered the power of fiscal policy, a major contributor to inflation. We anticipate continued public and private investments to strengthen supply chains, combat cybersecurity threats, fortify energy sources and business operations against climate change, and attract and retain workers through the demographic changes. Moreover, the emergence and disruption of AI has added the potential for further investment to leverage productivity gains. These themes shape our 2024 market outlook. We foresee central banks refocusing from primarily fighting inflation to a more balanced approach, considering the damage of prior rate hikes. All of this will present both challenges in the near term for corporate margins and earnings, and later opportunities as valuations become attractive. Our outlook is generally positive and we will adjust portfolio positioning to capitalize on opportunities amid the expected volatility.

The money and cycles forecasting approach suggested that global inflation would fall rapidly during 2023 but at the expense of significant economic weakness. The inflation forecast played out but activity proved more resilient than expected. What are the implications for the coming year?

One school of thought is that economic resilience will limit further inflation progress, resulting in central banks disappointing end-2023 market expectations for rate cuts, with negative implications for growth prospects for late 2024 / 2025.

A second scenario, favoured here, is that the economic impact of monetary tightening has been delayed rather than avoided, and a further inflation fall during H1 2024 will be accompanied by significant activity and labour market weakness, with corresponding underperformance of cyclical assets.

The dominant market view, by contrast, is that further inflation progress will allow central banks to ease pre-emptively and sufficiently to avoid material near-term weakness and lay the foundation for economic acceleration into 2025.

On the analysis here, the second scenario might warrant a two-thirds probability weighting versus one-sixth for the first and third. This assessment reflects several considerations.

First, on inflation, developments continue to play out in line with the simplistic “monetarist” proposition of a two-year lead from money to prices. G7 annual broad money growth formed a double top between June 2020 and February 2021 – mid-point October 2020 – and declined rapidly thereafter. Annual CPI inflation peaked in October 2022, falling by 60% by November 2023 – chart 1.

Chart 1

Chart 1 showing G7 Consumer Prices & Broad Money (% yoy)

Broad money growth returned to its pre-pandemic average in mid-2022 and continued to decline into early 2023. The suggestion is that inflation rates will return to targets by H2 2024 with a subsequent undershoot and no sustained revival before mid-2025.

Secondly, economic resilience in 2023 partly reflected post-pandemic demand / supply catch-up effects. On the demand side, an analytical mistake here was to downplay the supportive potential of an overhang of “excess” money balances following the 2020-21 monetary explosion. Globally, this excess stock has probably now been eliminated – chart 2.

Chart 2

Chart 2 showing Ratio of G7 + E7 Narrow Money to Nominal GDP June 1995 = 100

The moderate economic impact of monetary tightening to date, moreover, is consistent with historical experience. Major lows in G7 annual real narrow money momentum led lows in industrial output momentum by an average 12 months historically – chart 3. With a trough in the former reached as recently as August 2023, economic fall-out may not be fully apparent until H2 2024.

Chart 3

Chart 3 showing G7 Industrial Output & Real Narrow Money (% yoy)

The suggestion that economic downside is incomplete is supported by a revised assessment of cyclical influences. The previous hypothesis here was that the global stockbuilding cycle would bottom out in late 2023 and recover during 2024. Recent stockbuilding data, however, appear to signal that the cycle has extended, with a recovery pushed back until H2 2024.

The assumption of a late 2023 trough was based on a previous low in Q2 2020 and the average historical cycle length of 3 1/3 years. This seemed on track at mid-2023: G7 stockbuilding had crossed below its long-run average in Q1, consistent with a trough-compatible level being reached in H2 – chart 4. The downswing, however, was interrupted in Q2 / Q3, with a further decline likely to be necessary to complete the cycle and form the basis for a recovery.

Chart 4

Chart 4 showing G7 Stockbuilding as % of GDP (level)

A resumed drag from stockbuilding may be accompanied by a further slowdown or outright weakness in business investment, reflecting recent stagnation in real profits – chart 5. Capex is closely correlated with hiring decisions, so this also argues for a faster loosening of labour market conditions.

Chart 5

Chart 5 showing G7 Business Investment (% yoy) & Real Gross Domestic Operating Profits (% yoy)

Real narrow money momentum remains weaker in Europe than the US, suggesting continued economic underperformance and a more urgent need for policy relaxation – chart 6. Six-month rates of change are off the lows but need to rise significantly to warrant H2 recovery hopes. Globally, the US / European revivals have been partly offset by a further slowdown in China, suggesting still-weakening economic prospects.

Chart 6

Chart 6 showing Real Narrow Money (% 6m)

The frenetic rally of the final two months resulted in global equities delivering a strong return during 2023 despite the two “excess” money indicators tracked here* remaining negative throughout the year. The indicators, however, started flashing red around end-2021, since when the MSCI World index has slightly underperformed US dollar cash.

Historically (i.e. since 1970), equities outperformed cash on average only when both indicators were positive, a condition unlikely to be met until mid-2024 at the earliest.

The late 2023 rally was led by cyclical sectors as investors embraced a “soft landing” scenario. Non-tech cyclical sectors ended the year more than one standard deviation expensive relative to history versus defensive ex. energy sectors on a price / book basis – chart 7. Current prices appear to discount an early / strong PMI recovery, which the earlier discussion suggests is unlikely.

Chart 7

Chart 7 showing MSCI World Cyclical ex Tech* Relative to Defensive ex Energy Price / Book & Global Manufacturing PMI New Orders *Tech = IT & Communication Services

Quality stocks outperformed during 2023, reversing a relative loss in 2022 and consistent with the historical tendency when “excess” money readings were negative. Earlier underperformance partly reflected an inverse correlation with Treasury yields, a relationship now suggesting further catch-up potential.

Contributing factors to the dramatic underperformance of Chinese stocks during 2023 include excessively optimistic post-reopening economic expectations at end-2022 and unexpectedly restrictive monetary / fiscal policies. MSCI China is at a record** valuation discount to the rest of EM – chart 8 – while monetary / economic weakness suggests an early policy pivot.

Chart 8

Chart 8 showing MSCI China Price / Book & Forward P / E Relative to MSCI EM ex China

A key issue for 2024 is the extent to which central bank policy easing will revive money growth. While inflation is expected to trend lower into early 2025, the cycles framework suggests another upswing later this decade – the 54-year Kondratyev price / inflation cycle last peaked in 1974. Aggressive Fed easing 54 years ago – in 1970 – pushed annual broad money growth into double-digits the following year, creating the conditions for the final Kondratyev ascent. Signs that a similar scenario is playing out would warrant adding to inflation hedges.

*The differential between G7 plus E7 six-month real narrow money and industrial output momentum and the deviation of 12-month real narrow money momentum from a long-term moving average.

**Since June 2000. MSCI China included only B-shares through May 2000, when red chips and H-shares were added.

The MPC’s November inflation projections are ancient history. Price pressures have plunged in line with a simplistic monetarist forecast suggesting a return to target in Q2 2024 and an undershoot in H2.

The simplistic forecast is based on the Friedmanite rule that inflation directionally follows money growth with an average lag of two years. This is converted to a numerical profile by assuming a one-for-one relationship of deviations in inflation and money growth from 2% and 4.5% respectively.

Friedman emphasised the variability of the money growth / inflation lag but a two-year assumption has proved accurate in timing the inflation peak and subsequent decline – see chart 1.

Chart 1

Chart 1 showing UK Consumer Prices & Broad Money (% 6m annualised)

post in July suggested that the six-month rate of increase in the CPI, seasonally adjusted, would fall to 2% annualised or lower around end-2023, reflecting a decline in six-month broad money growth to below 4.5% annualised in Q4 2021. The fall is ahead of schedule, with the six-month CPI increase at 1.6% in November.

The simplistic forecast suggests that six-month inflation will fluctuate around the current level through mid-2024 before dropping further in H2 – chart 1. The implication is that the annual rate will return to target in Q2 and undershoot during H2.

By contrast, the modal forecast for annual inflation in Q4 2024 in the November Monetary Policy Report was 3.1%, with the mean forecast (incorporating an upside risk assessment) at 3.4%.

Broad money momentum remains negative, suggesting that an inflation revival is unlikely before mid-2025.

Bottom-up considerations support the view that annual inflation will return to target by next spring, assuming no adverse shocks:

  • Annual inflation of food, alcohol and tobacco of 9.4% in November could fall to 3% by Q2. Annual producer output price inflation of food, beverages and tobacco is already down to 2.1%, while input prices of home-produced food are falling year-on-year.
  • The energy price cap will rise by 5% in January but Cornwall Insight currently projects a 14% cut in April.
  • Annual core goods inflation of 3.3% in November could fall to 1%. Core producer output prices are flatlining, while base effects are favourable through May.
  • Slowing food prices will feed through to catering services, with the historical sensitivity suggesting a fall in annual inflation from 7.8% in November to 4.5%. This would cut services inflation by 0.75 pp, based on the 23% weight of catering in the services basket.
  • The above two assumptions coupled with a 1 pp slowdown in the rest of the services basket would imply a 1.75 pp fall in annual core inflation by Q2 (5.1% in November). This would be sufficient to generate a 2% headline rate given the assumed food slowdown and a large year-on-year decline household energy bills.

Winter sunset overlooking the city of Vancouver. Cypress Mountain Provincial Park, North Vancouver, British Columbia, Canada.

A year ago in our December 2022 Outlook, we made a case for investing in Canada. Acknowledging that, like many other countries, Canadians accumulated debt to become homeowners in the low interest rate decade prior to the pandemic, there were many positives to admire about the country’s long-term prospects. We believed that Canadian asset markets were well positioned to benefit from these positives. One of the standout reasons was the reshaping of Canada’s demographic pyramid with a large influx of new immigrants.

Over the past year, tightening monetary policy has produced its intended effect, and real GDP in Canada will likely grow by a modest 1.2% in 2023 according to the Bank of Canada (BoC). Economic activity is indeed softening through lower consumer spending and business investment, with both taking a hit from higher interest rates. By contrast, Canada’s population is expected to expand by nearly 3% in 2023, the strongest immigration rate in decades (see Chart 1). In total, the population will expand by more than 1 million people – net births contributing about 5%, immigration 40% and the balance non-permanent residents. Taking these together, GDP per capita has not only failed to return to its long-term trend in the post-pandemic expansion but is falling outright and opening up a material gap to our potential (see Chart 2). It is worth exploring the issue of population growth’s outsized impact on Canada, and particularly in the different ways it has been skewing data.

Chart 1: Population surging in recent years

Chart 1 shows Canadian population growth, grouped by immigrants and temporary residents, from 1980 to 2022. There has been a noticeable increase in population growth since 2016, with a particularly large spike in 2022 that is driven by temporary residents.

Source: Statistics Canada, Macrobond

Chart 2: While GDP is holding in, per capita activity is falling

Chart 2: While GDP is holding in, per capita activity is falling Chart 2 shows Canadian GDP per capita plotted against its trendline, starting in 1980. GDP per capita had been growing in line with the trend from 2010 to 2020, dipping during the pandemic. While GDP per capita rebounded following the pandemic, it has remained below trend, and more recently, has moved lower.

Source: Statistics Canada, Macrobond

 

Data in the context of population growth

There are many reasons for the high inflation over the past few years, with services prices under particular pressure recently through rising wages. The job vacancy rates across the country more than doubled to 6% in the last year compared to the pre-pandemic period, and the influx of new workers has been a welcome source of labour supply. Today, the labour market continues to produce remarkably steady job gains, some 20 months after the start of a record fast rate hike cycle. In November, 25k net new jobs were created, a respectable gain that is above the long-term historical average and continuing a trend that saw average monthly gains of 39.1k year to date. On the flip side, Canada’s population growth casts the job gains in a different and less favourable light as the economy needs to generate a net new 56k jobs each month, in line with the labour force growth, just to prevent a rise in the unemployment rate (see Chart 3). While the data suggest still tight labour markets under normal conditions, the recent surge in population implies at best a balanced labour market today. Indeed, jobs are being filled now and job vacancy rates are now down 2 percentage points from the highs in 2022 to just 3.6% last month, the top end of the pre-pandemic range.

Chart 3: More people joining labour force than finding jobs

Chart 3: More people joining labour force than finding jobs Chart 3 shows the year-over-year change in Canadian employment, plotted against the change in the Canadian labour force. Over the history of the chart, that begins in 2014, the growth in Canadian employment has been in line with or exceeded the growth in the labour force, with the exception of the post-pandemic rebound period. As of 2023, the growth in the labour force has exceeded the growth in employment.

Note: Y-axis excludes volatile period during the pandemic.
Source: Statistics Canada, Macrobond

Across housing markets, Canada is well understood to have an affordability problem as home prices compared to incomes top global ranking tables, while home equity comprises an unusually large component of household net worth in the country. Many have attributed this issue to low housing supply. However, construction activity has actually surged in recent years with housing starts averaging some 267k over the last 3 years, 40% above the long-term average (already an achievement given the shortage of skilled trades in the sector). Even so, the new supply has not grown enough to meet the new demand and done little to alleviate the affordability issue. This is particularly true as new residents are only adding to the peak Millennial age cohort that is arriving at the prime household formation age of 32. This imbalance has left cities dealing piecemeal with trying to create supply where possible and forming more robust housing policies. As a result, this sector that is traditionally the most highly sensitive to interest rates may see very little impact through the expected slowdown.

As noted above, only about half of the newcomers are actually immigrants that stay. Understanding this difference may be important given non-permanent residents, comprised of students or those on temporary work visas, may create some further volatility in the data. This is because this group may actually exhibit pro-cyclical characteristics with the economy. For instance, should the labour market soften, workers of all types will be shed, leading many on temporary work visas to search for work elsewhere or return home. Additionally, student visas may slow as overdue government oversight will see a cracking down on sketchier educational institutions and fraud. To put it simply, a strong economy will bring new entrants, but a recession may be exacerbated If some of these new, less permanent residents choose to leave.

As mentioned above and discussed last year, there are many reasons we remain positive on the outlook for Canada. One that is very much not top of mind, but that we believe will become increasingly important, will be that the population growth will dramatically alter the demand for services beyond shelter. Governments may be forced into a renewal of spending on services, buildings and infrastructure, including hospitals, schools, roads and airports, all of which will compound other business investment over the coming years. Indeed, one of our longstanding secular themes has been the significant capex that we anticipate will evolve out of the adoption of artificial intelligence integration, green energy transformation and global supply chain reconstruction. All of this could go far in providing support to reverse what has been a dismal period of productivity.

Capital Markets

More recently, financial markets have been in a cheery mood. November was a banner month for public market assets across the board. After three straight months of negative returns in Canadian equities, the S&P/TSX Composite Index rallied 7.5% in November. That monthly gain was exceeded only five times in the post-Global Financial Crisis era. Every one of the 11 sector groups was in the black this month, led by a massive 27.4% gain in information technology. That strong gain was seen across both large and small cap stocks, with the former outperforming the latter, and cyclical sectors of the market outperforming more defensive sectors. While the November equity market gains were broad based, market breadth has been quite uneven through the year. In the US, there has rarely been a year where the strong returns were generated by so few individual stocks. The S&P 500 Index, weighted by market capitalization, has surged 20.8% year-to-date, thanks primarily to the narrow leadership of mega cap tech stocks; meanwhile the equal weighted S&P 500 Index is up by a much smaller 8.1%. Commodity prices were mixed. Notably oil prices eased back, as WTI fell 5.1% m/m to US$75/bbl and dropped further into early December. Meanwhile, precious metals prices surged to a 6-month high, rising 2.6% in the month. Gold hit an all-time high towards the end of the month, as the US dollar finally lost momentum. Following a surge off the July lows, the dollar broadly depreciated in November.

The shift in sentiment was spurred early in the month by the FOMC meeting and gained momentum with softer US CPI data in combination with Q3 GDP that was revised up to an astonishing 5.2% q/q annualized pace, more than 1.5 years after rate hikes began. This led the market narrative to shift firmly into a soft landing camp. As a result, interest rates began to reflect the likelihood that central bank rate hikes have peaked and that a slowdown is on the way. In Canada, 2-year and 10-year bond yields dropped by about 0.5% while credit spreads tightened materially despite a pickup in issuance. Combined, this led the FTSE Canada Universe Bond Index up 4.29% in November and the Long Bond Index up an astounding 8.54%. The latter marked the highest monthly return for the index since 1982. Similarly, the US Aggregate Bond Index returned 4.53%, its best monthly return since May 1985. The positive returns across both fixed income and equity markets drove traditional 60/40 balanced to post the best monthly returns since November 2020, when markets absorbed the positive COVID vaccine news. Through all that good news, one message to note is that we believe markets remain in a state of higher uncertainty and volatility.

Portfolio Strategy

Indeed, the market narrative remains in constant, rapid flux. Risk assets were displeased with higher interest rates through the summer and fall, and bond markets pushed yields higher than warranted. Once a peak in short term rates appeared at hand, interest rates have tumbled just as forcefully, shepherding in a year-end all-asset rally across public market assets. The risks from here appear to be skewed to the downside, and thus our balanced portfolios continue to underweight equities and hold cash as we anticipate earnings to come under some pressure with the slowdown in the economy. Canadian fundamental equity portfolios are selectively investing in companies with favourable valuations while maintaining a high-quality bias. Fixed income portfolios are increasingly positioning for a move toward normalization in the yield curve while remaining cautious on credit.

Much of the market direction now depends on the ability for policymakers and the economy to hit the soft landing narrative that the markets have now priced in. This in turn hinges on labour markets striking a balance from here. This is true both for the need to limit wage gains and the follow on to services prices in the CPI, and the ability for people to hold on to jobs and sustain spending. To properly assess the economic status quo of Canada, it must be acknowledged that population growth has had an outsized influence. The changing demographic profile of the country will alter short term demand dynamics for labour as well as housing. Data will appear more favourable in absolute terms, but in many ways it will be less optimistic considering the positive population shock. The influx has been beneficial from a labour supply perspective and importantly for future infrastructure development. We are optimistic about the longer run outlook for the economy, but we are expecting to see a rockier cyclical period over the next few quarters. We will explore this further in our year-ahead Forecast to be published in January. From everyone at CC&L, we thank you for your support and wish you a festive holiday season and a prosperous New Year.

Autumn trees in Downtown Vancouver, Canada.

Markets have long anticipated an economic downturn, and looking beyond it to a potential decline in interest rates as central banks step in to support the economy. A key indicator has been the deeply inverted yield curve over the past year and a half. In the last couple of months, the US Federal Reserve, Bank of Canada and other major central banks seem to have reached the peak of their rate-hiking cycles. We are now in a late stage of the business cycle where central banks have stopped raising rates, but are not yet easing policy. Over the last 40 years, this transitional period has lengthened because central banks generally have not overtightened, which would necessitate an immediate and sharp U-turn to an easing cycle. Before 1985, the median period from the last rate hike to the first rate cut was about two months, but this extended to eight months after 1985 (see Chart 1). Thus, in the past few decades’ business cycles, there have been times when markets, absorbing new data, anticipated a soft landing. However, initial signs of slowing can also forewarn of a more severe downturn.

Chart 1: Longer lags between policy shifts

Chart 1: Longer lags between policy shifts. Chart 1 shows the Federal Reserve's policy target rate over the period from 1971 to 2023, along with the number of months between the last tightening to the first easing, over the period. The data reveals that prior to 1990, there was a short span between the last interest rate hike and the first interest rate cut. Since 1990, the period between the last interest rate increase and the first cut has increased.

Source: Federal Reserve, Minack Advisors, Macrobond

If a yield curve inversion signals economic slowdown, its normalization often coincides with that slowdown. As the yield curve transitions from inverted to flat, and then back to normal (where long term bond yields are above short term yields), unemployment tends to rise, economic activity falls and inflation decreases. Notably, the two-year to 10-year US Treasury yield curve moved from a -93 basis points (bps) inversion in July to just -20 bps at the end of October (see Chart 2).

Chart 2: Normalization is a precursor to recessions

Chart 2: Normalization is a precursor to recessions Chart 2 shows the US yield curve, measured by the 10-year bond yield less the 2-year bond yield, plotted against US recessions. Historically, the yield curve moves toward normalization just prior to recession. The yield curve has moved in a similar fashion in the most recent period.

Note: Shaded area represents US recessions.
Source: US Department of Treasury, Macrobond

Equities weaken in a downturn but fare better in a soft landing. However, even if, in today’s cycle, we end up in a soft landing scenario, the strength of equities is uncertain due to considerable optimism already priced into the market. Forward earnings, especially in the US, appear overly optimistic. For instance, 2024 earnings are forecasted to rise by 12.5% above this year, but if a recession materializes, earnings are likely to decline outright. This is evident as third quarter earnings report marginally weaker revenues, despite a strong 4.9% quarter-on-quarter annualized real GDP growth. Additionally, current equity valuations remain high by any metric. Thus, the asymmetry of outcomes stands out — in a hard landing, equities could face material declines, while even with a soft landing, upside may be limited.

Within the S&P 500 Index, the “Magnificent Seven” large-cap tech stocks have driven all year-to-date gains, now comprising nearly half of the Russell 1000 Growth Index, up from 12% a decade ago. This late-cycle phase has also seen small-cap stocks underperforming, in line with the latest NFIB survey of small and medium-sized businesses remaining low. Higher wages and operating costs are weighing on profit margins, with interest paid on loans reaching 10% in October (see Chart 3), the highest since the early 2000s. The full impact of higher rates on companies is still unfolding, but is becoming increasingly evident.

Chart 3: Interest costs are biting

Chart 3: Interest costs are biting. The chart illustrates a trend in the escalating interest costs faced by borrowers, as indicated by the NFIB Survey on the actual interest rates paid on short-term loans. Covering the period from 1989 to 2023, the series has surged from an all-time low in 2020, to currently the highest level since 2006.

Source: National Federation of Independent Business, Macrobond

In contrast, bond returns have been weak for an unprecedented third straight year driven by a sharp increase in yields, which are now back at long-run averages. In October, US 10-year yields crossed above 5%, with real yields at 2.1%, the most attractive levels in over 15 years and comparing favourably relative to earnings yields on equities (see Chart 4). The FTSE Universe Bond Index in Canada and the Bloomberg US Aggregate Bond Index yielded 5.1% and 6.5%, respectively, at the end of October, a significant increase from around 1% a few years ago. While investors can assess for themselves whether interest rates will go up or down from here, it is certainly true that bond yields are more attractive today than before, with greater potential for capital gains, especially if a downturn occurs. Recent data, notably in the US labour market, is demonstrating the excess demand conditions are moving back towards balance with the gap between labour demand and supply halving since its peak. A modest rise in continuing jobless claims suggests that, on the margin, jobs are becoming harder to find. Given these factors, we are increasingly cautious on risk assets, including small-cap stocks, and more positive about bonds as the year concludes.

Chart 4: Bond yield and earnings yield gap is closing

Chart 4: Bond yield and earnings yield gap is closing. Chart 4 shows the US 10-year Treasury bond yield against the S&P 500 earnings yield, from 1995 onward. Since 2002, the earnings yield of the S&P 500 has comfortably surpassed the yield on the 10-year Treasury bond. With the recent spike in bond yields, these two series are now closely in line.

Source: US Department of Finance, I/B/E/S, Macrobond

Capital Markets

October was another tough month for markets, with both equities and fixed income showing weakness. The horrific attack by Hamas on Israel early in the month raised concerns about a wider conflict in the Middle East, and elevated geopolitical risks. However, the direct market impact of this so far appears to be muted, with efforts made to limit a broader escalation in the region. The effect on oil, and safe-haven assets such as gold was generally subdued, with initial short-lived rallies followed by a decline in prices, ending the month only modestly higher.

In Canada, two-year interest rates fell 16 bps and rose by 5 bps at the 10-year term, leading to a 0.37% gain in the FTSE Canada Universe Bond Index. In the US, 10-year Treasury yields surged 33 bps over the month, marking the sixth consecutive month of increase, and closed October at 4.93%. This surge in yields was a response to strong economic indicators, such as the third-quarter GDP report. The rising yields contributed to equity markets ending lower for the third straight month, a trend not seen since March 2020. The S&P 500 fell 2.1%, while the S&P/TSX Composite Index dropped 3.2%.

Portfolio Strategy

The market is still adjusting to the new reality of higher interest rates (and responding very favourably when yields fall). The path for risk assets depends heavily on the unfolding economic scenario. The US is holding in, aided by strong fiscal policy thrust. However, the longer interest rates stay elevated, the greater the risk of a hard landing. Against that backdrop, equity markets seem to be anticipating a very optimistic outcome. Thus, our asset mix for balanced funds remains overweight cash while equities are underweight. At the same time, current bond yields are becoming more attractive, prompting us to assess the opportunity to increase our bond allocation. Our fundamental portfolios continue to focus on stable, defensive companies as we anticipate an increase in equity market volatility. Fixed-income portfolios are looking to add to positions that will benefit from the yield curve moving toward normalization, and remain underweight credit, anticipating wider spreads.
As we approach the late cycle phase, the high level of interest rates is dominating both the macroeconomic and investing environment. We remain vigilant on the growing risks as the year closes out.