Market reaction to UK April CPI numbers focused on the overshoot of headline and core inflation relative to forecasts, ignoring a continued slowdown in headline price momentum. 

The six-month rate of increase of headline prices, seasonally adjusted here, fell to 6.6% annualised in April, the slowest since September 2021 and down from a peak 12.6% – see chart 1. 

Chart 1

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

Six-month headline momentum is tracking a simplistic “monetarist” forecast that assumes a two-year lag from money to prices and the same “beta” of inflation to money growth as on the way up. 

This forecast suggests a further decline in six-month momentum to about 5% annualised in July on the way to much lower levels in late 2023. 

The projection of a fall to 5% or so in July is supported by a bottom-up analysis incorporating the announced 17% cut in the energy price cap that month. 

Markets were spooked by annual core inflation reaching a new high of 6.8% in April but it is normal for core to lag headline at turning points. 

The April result, moreover, is consistent with a mean historical lag of 26 months between peaks in annual broad money growth and core inflation: money growth continued to rise into February 2021 – chart 2. 

Chart 2

Chart 2 showing UK Core Consumer / Retail Prices & Broad Money (% yoy)

The suggestion that core inflation is at or close to a peak is supported by PPI data: core PPI output inflation usually leads and has slowed significantly from a May 2022 peak – chart 3. 

Chart 3

Chart 3 showing UK Core Consumer & Producer Prices (% yoy)

PPI data also indicate that CPI food inflation is peaking and could fall rapidly over the remainder of the year – chart 4. 

Chart 4

Chart 4 showing UK Food Prices (% yoy)

It might be expected that G7 central bankers, in attempting to judge inflation prospects and the appropriate policy stance, would be paying close attention to indicators that signalled the recent inflationary upsurge.

Such indicators include:

  • Broad money growth, which led the inflation increase by about two years.
  • The global manufacturing PMI delivery speed index, a gauge of excess supply / demand in goods markets, which led by about a year.
  • Broad commodity price indices, such as the S&P GSCI, which displayed a sharp pick-up in momentum six to 12 months before the inflation upsurge.

Indicators that provided little or no warning of inflationary danger include measures of core price momentum, wage growth, labour market tightness and inflation expectations, i.e. indicators previously cited to argue that an inflation rise would be “transitory” and now being used to justify continued policy tightening.

Chart 1 shows G7 CPI inflation together with the three informative indicators listed above, with appropriate lags applied.

Chart 1

Chart 1 showing G7 Consumer Prices (% yoy) & Three Leading Indicators (Broad Money, PMI Delivery Speed & Commodity Prices)

The three indicators have fallen far below pre-pandemic levels, suggesting that CPI inflation rates will return to targets – or undershoot them – in 2024.

Core inflation and wage growth moved up more or less in tandem with headline inflation during the upswing. Hawkish central bankers need to explain why they expect an asymmetry on the way down.

A possible “monetarist” argument for inflation proving sticky is that the stock of money remains excessive relative to the price level. The judgement here is that any overhang is small and – with monetary aggregates stagnant / contracting – will soon be eliminated.

The G7 real broad money stock is 3% above its 2010-19 trend, down from a peak 16% deviation in May 2021 – chart 2.

Chart 2

Chart 2 showing G7 Real Broad Money (January 1964 = 100)

While agreeing on the destination, the indicators are giving different messages about the speed of decline of inflation.

The PMI delivery speed indicator and commodity prices are more relevant for goods prices, with recent readings consistent with the expectation here of goods deflation later in 2023.

Broad money trends, by contrast, suggest a temporary slowdown in the rate of decline of CPI inflation during H2, reflecting a stabilisation of money growth during H2 2001. This resulted from a reacceleration of US broad money following disbursement of a third round of stimulus payments.

A possible reconciliation is that the bulk of a fall in services inflation will be delayed until 2024. Such a scenario would suggest a slower reversal of policy rates and an extension of real money weakness, with negative economic implications.

Summer in Coal Harbor in downtown Vancouver, Canada.

Cautionary signs from abroad.

The Bank of Canada (BoC) began tightening policy in March 2022, ahead of most major central banks and has recently been among the first to pause. However, there have been some surprising developments in other countries over the last month, and it is worth examining whether they have any implications for Canada.

For instance, the Bank of England began raising rates even before the BoC. Like Canada, the UK is sensitive to interest rate increases, particularly as mortgage interest rates are typically fixed for two to five years. Despite Brexit reducing mobility overall, the UK saw a net migration inflow over the past year, leading to a 0.65% population gain. Although slightly higher than pre-pandemic levels, this growth is far from the 2.7% population increase seen in Canada. Furthermore, the UK economy has slowed but is facing the highest inflation rate in Europe and one of the highest inflation rates among developed markets, with the CPI annual rate stalling at over 10% year over year (y/y) in eight of the last nine months (see Chart 1). Core inflation is at 6.2%, not far from its 30-year highs of last summer. The implication that inflation is difficult to wrestle is potentially concerning, yet UK inflation has remained high in no small part due to extended supply pressures emanating from Brexit and more rigid trade rules.

Chart 1: UK inflation highest among developed peers

Source: Statistics Canada, Australian Bureau of Statistics, UK Office for National Statistics, Statistics New Zealand, Macrobond

In early April, the Reserve Bank of New Zealand (RBNZ) surprised the market by increasing the Official Cash Rate by 50 basis points (bps) to 5.25% due to concerns over higher near-term inflation readings. Supportive fiscal policy combined with rebuilding after recent storms may add fuel to upside pressures. The RBNZ has matched the Federal Reserve (Fed) for the largest cumulative rate hikes and may still increase rates further.

In Australia, the central bank paused in April, but quarterly inflation reports for both headline and its core metric of trimmed CPI, while modestly lower than expected, still exceeded the central bank’s targets at 7% y/y and 6.3% y/y, respectively. In early May, the Reserve Bank of Australia surprised the markets with a 25-bps rate hike, taking the target cash rate to 3.85%, citing high services prices as a concern. It noted that inflation may take “a couple of years” to return to the top of its target range. 

Are higher rates a material risk?

Canada is, like many other countries, currently adjusting to past rate hikes. On the surface, the country has appeared resilient in the face of short-term adjustable rate mortgages, high sensitivity to interest rate increases because of large debt, and its broad exposure to the cyclically-sensitive commodities sector. In spite of these factors, there have been no banking stresses, fewer mass layoffs and no sharp rise in mortgage delinquencies. But as with countries elsewhere, at least for the near term, we should not underestimate the potential for a surprise on the side of further policy tightening. Indeed, the April BoC Summary of Deliberations showed that the discussion leaned towards whether rates needed to rise again. There are reasonable arguments for this.

While it may be too early to call it a trend, the Canadian spring housing market appears to be picking up steam. New listings to start the spring season were the lowest for any March over the past 20 years, and demand from natural household formation and new immigrants has been strong. This has coincided with a peak in mortgage rates as the BoC stopped hiking rates. Five-year mortgage rates have fallen from last October’s peak of 5.88%, with the latest 75 bps of BoC rate hikes having little effect. As a result, house prices in major cities have risen for the last two months.

Fiscal policy is adding stimulus, with provincial governments adding about $6 billion in new support measures and tax reductions and the federal government more than doubling that to $13 billion. These support measures are delaying a material slowdown and working against tighter monetary policy. Perhaps the most important lesson we take from other countries is that overall inflation is still at risk of remaining above target, particularly with Canadian economy-wide average hourly wages running at over 5% (see Chart 2).

Chart 2: Strong Canadian wage growth risks above target inflation

Source: Statistics Canada, Macrobond

While we view the most likely scenario to be no further rate hikes, the longer inflation is above the explicit target, the more extrapolative expectations become, making it harder to bring inflation under control. So even if the BoC does not surprise with more rate hikes, there is a risk that monetary policy will be held tighter and rates higher for longer. This is not being priced into markets. The implications for asset prices are material; the longer rates are held high, the more stresses build and the harder it is to push problems down the road.

Capital markets

After three of the largest four US bank failures in history, it is surprising that April was one of the calmest months in markets. Volatility indices for both bond and equity markets eased, evidenced by the daily and monthly change in prices. Two areas stood out: US regional bank stocks continued to fall, led by First Republic. Secondly, the quiet world of US T-bills reflected anxieties surrounding the US debt ceiling limit. Investors kept purchases below one month to avoid debt ceiling default risk, pushing yields down and the spread to 3-month T-bills to historic wide levels.

Bond yield changes were subdued in Canada over the month, while corporate credit spreads tightened, leading the FTSE Canada Universe Bond Index to rise 0.98%. A decent corporate earnings season contributed to the sanguine market sentiment and equity markets recovered from the March upheaval. The MSCI ACWI Index gained 1.4%, led by developed markets. The S&P 500 Index rose 1.6%, although breadth was narrowly concentrated in the technology sector, which was buoyed by lower interest rates that helped boost valuations. In Canada, the S&P/TSX Composite Index outperformed, rising 2.9%. Commodities were generally weak in April, except for oil prices, where the OPEC+ group cut output at the start of the month, leading WTI to hit a peak of US$83/bbl. This was short lived and prices eased back to close the month nearly unchanged.

Portfolio strategy

Similar to other economies, Canada’s late cycle environment presents risks that are not one-sided, and central banks are unlikely to intervene aggressively in a slowdown. While recent economic releases suggest momentum is slowing, consumers are gradually using up their excess savings and businesses are exercising restraint in spending, which is a process that takes time. Meanwhile, inflation remains stubbornly high and we do not anticipate significant interest rate cuts in the near future. Our outlook indicates that a recession is the most probable scenario for the latter half of 2023.

In our fundamental equity portfolios, we continue to look for companies with strong fundamentals that can navigate slower aggregate economic growth. Our portfolio positioning emphasizes defensive strategies, with earnings stability a crucial theme at both the sector and security level. However, we are also exploring opportunities to invest in oversold cyclical companies that will likely perform during an economic recovery. Our fixed-income portfolios follow a similar theme, focusing on corporate bonds while we remain patient in our macro positioning given the possibility of tighter lending during a recession later this year. Our balanced portfolios maintain an underweight position in equities in favour of cash. We continue to assess both domestic and global data and seek out opportunities in both calm and volatile markets.

The Chinese economy has bounced back since reopening but the pick-up has arguably been underwhelming. GDP grew at a 9.1% annualised rate in Q1, according to official data, but this partly represents payback for a weak Q4. Growth averaged an unexceptional (by Chinese standards) 5.7% over the two quarters. 

Inflationary pressures remain weak despite the activity rebound. Nominal GDP expansion was only marginally higher than real in Q4 / Q1 combined: the GDP deflator rose by just 0.4% annualised – see chart 1**. 

Chart 1

Chart 1 showing China Nominal & Real GDP (% 2q annualised)

Muted nominal GDP growth has contributed to lacklustre profits, with the IBES China earnings revisions ratio diverging negatively from recent stronger official PMIs, questioning the sustainability of the latter – chart 2. 

Chart 2

Chart 2 showing China NBS Manufacturing PMI New Orders & IBES China Earnings Revisions Ratio

Monthly activity numbers for March were mixed and don’t suggest a pick-up in momentum at quarter-end. Retail sales were a bright spot but strength in industrial output, fixed asset investment and home sales has faded after an initial reopening bounce – chart 3. 

Chart 3

Chart 3 showing China Activity Indicators January 2019 = 100, Own Seasonal Adjustment

Moderate nominal GDP expansion is consistent with recent narrow money trends: six-month growth of true M1 (which corrects the official M1 measure to include household demand deposits) remains range-bound and slightly below its 2010s average – chart 4**. 

Chart 4

Chart 4 showing China Nominal GDP & Narrow / Broad Money (% 6m)

Broad money growth, as the chart shows, is significantly stronger. However, examination of the “credit counterparts” indicates that a rise since late 2021 has been driven mainly by banks switching to deposit funding and reducing other liabilities – domestic credit expansion has been stable. 

The judgement here is to place greater weight on narrow money trends, which currently suggest a moderate recovery that probably requires additional policy support to offset external headwinds. 

*Official unadjusted nominal GDP seasonally adjusted here; GDP deflator derived from comparison with official seasonally adjusted real GDP.

**March true M1 estimated pending release of demand deposits data.

The “monetarist” forecast is that G7 inflation rates will fall dramatically into 2024, mirroring a collapse in nominal money growth in 2021-22.

G7 annual broad money growth returned to its pre-pandemic (2015-19) average of 4.5% in mid-2022. Based on the rule of thumb of a two-year lead, this suggests that annual inflation rates will be around pre-pandemic levels in mid-2024. More recent broad money stagnation signals a likely undershoot.

Pessimists argue that inflation will prove sticky because of high wage growth. Wages are a coincident element of the inflationary process. Low (but rising) wage growth didn’t prevent the 2021-22 inflation surge and high (but moderating) growth isn’t an obstacle to a substantial fall now.

The 2021-22 inflation surge was initially driven by excess demand for goods, due to a combination of covid-related supply disruption, associated precautionary overbuilding of inventories, a spending switch away from services and – most importantly – excessive monetary / fiscal stimulus.

Excess goods demand was reflected in a plunge in the global manufacturing PMI supplier delivery speed index to a record low. This plunge predated the inflation surge by about a year versus a two-year lead from money – see chart 1.

Chart 1

Chart 1 showing G7 Consumer Prices (% yoy), G7 Broad Money (% yoy, lagged 2y) & Global Manufacturing PMI Supplier Delivery Speed (lagged 1y, inverted)

The reverse process is now well-advanced, with supply normalising, firms running down excess inventories, the services spending share rebounding and monetary policies far into overrestrictive territory. The PMI delivery speed index is at its highest level since the depths of the 2008-09 recession, signalling substantial excess goods supply.

Global goods prices are heading into deflation. Chinese reopening has added to excess supply and Asian exporters are already lowering prices in the US – chart 2. Chinese producer prices are falling and the renminbi is competitive, with JP Morgan’s PPI-based real effective rate at its lowest level since 2011. Other Asian currencies are similarly weak.

Chart 2

Chart 2 showing US Import Prices of Goods by Country / Region (% yoy)

The global manufacturing PMI output price index lags and correlates negatively with the delivery speed index. It has plunged from 64 to 53 and is likely to cross below 50 soon. The current prices received balance in the US Philadelphia Fed manufacturing survey turned negative (equivalent to sub-50 in PMI terms) in April, the weakest reading since the 2020 recession.

Global goods deflation will squeeze profits and wage growth in that sector, with knock-on effects on services demand, pay pressures and pricing.

Central bankers are once again asleep at the wheel, pursuing procyclical polices that amplify economic volatility and impose unnecessary costs.

Illuminated Abstract office building seen in downtown Vancouver, BC, Canada.

Averting crisis, but anxious about credit.

The US Federal Reserve (Fed) and Bank of Canada (BoC) have raised their overnight rates at the fastest pace since the 1980s. As we passed the one-year mark since the start of this rate hiking cycle, the economy and financial system appeared stable and even resilient, and markets bore the scars as higher rates led to declines in valuation multiples throughout 2022. While there have been some signs of strain, such as UK pensions, the Bank of England’s (BOE) rapid response curtailed negative outcomes. Additionally, the collapse of cryptocurrency exchange, FTX, was less related to interest rates than fraud. However, this past month’s failure of three banks: Silicon Valley Bank (SVB) and Signature Bank in the US, followed by Switzerland’s Credit Suisse being forced into a merger with its long-time domestic rival, UBS, marked somewhat of a turning point.

In comparison to prior crises, today we are at a better starting point. Issues with US regional banks are not the same as during the Great Financial Crisis (GFC), when banks held assets that were complex, massive, interlinked and then severely impaired. The legacy of those problems was a shift to tough regulatory requirements for large global banks. They now have deeper capital bases that can better withstand inevitable recession-induced asset write-downs. However, recent instability is reminiscent of more classic problems, such as outflows of deposits from banks when the rates paid do not rise in line with policy rates, combined with an inverted yield curve that impacts bank margins.

Over the weeks surrounding the stresses on the US regional banks, data releases showed depositors moved more than US$400 billion out of bank deposits (see Chart 1), with two-thirds of the outflows coming from small and mid-sized banks. Most of those flows went into financial assets that now yield higher returns than bank accounts (see Chart 2), notably money market funds. This outflow of deposits is forcing banks to sell assets and recognize losses in bond holdings due to the rise in interest rates. The Fed has taken steps to prevent the situation from worsening. Banks are now borrowing at the Fed’s discount window or using the newly established Bank Term Funding Program that was created to provide banks with a liquidity backstop. Although the rate of borrowing at the discount window remains elevated, the exodus of bank deposits slowed by the end of March and the problems have become less acute. This turmoil will require banks to bolster deposits. One way to do that is to raise interest paid on deposits, which may result in a higher cost of funding and pressure on profitability.

Chart 1: Deposits have been leaving banks at a rapid clip

Source: Federal Reserve, Macrobond

Chart 2: Deposit rates not keeping up with policy rates

Source: Federal Deposit Insurance Corporation, Federal Reserve, Macrobond

Following the banking instability, central banks seemed to face a choice between price stability (raising rates to combat stubbornly high inflation) or financial stability (injecting stimulus to save a precarious financial system). Separating out tools to deal with these two problems, they have continued to raise rates even in the face of the bank failures. What has made this whole situation a turning point, however, is that this turmoil has brought markets into a position where they are now working with the Fed rather than against it. The Fed has persistently stated that inflation remains high and financial conditions will need to tighten, and markets rallied and credit spreads stayed tight allowing for the economy to remain supported rather than constricted. Now, markets appear to be heeding the warning signs. Credit markets have seen decreased issuance and wider credit spreads.

It is worth noting that a key link in the transmission of central bank actions and the economy is through bank lending. The Fed’s Senior Loan Officer Survey shows that banks have been tightening lending standards for months now (see Chart 3). Given concerns about liquidity, outflows of deposits into money market funds, costlier sourcing of funds, net interest margin pressures and weakening demand, banks are likely to pull back further on lending activity in coming quarters. This will directly dampen prospects for business investment and consumer spending to varying degrees. One sector that may be particularly impacted is commercial real estate lending. While shifting demand for office space is one factor, it is notable that smaller US regional banks with assets under US$250 billion hold about three-quarters of total commercial real estate loans. While this segment represents approximately one quarter of overall loan books, the combined supply and demand pressures imply a vulnerable sector. Overall, the message is clear: lending will be scarcer economy-wide, and an economic slowdown to recessionary levels is now looking increasingly likely.

Chart 3: Lending standards tightened to levels typically preceding recessions

Lending standards tightened to levels typically preceding recessions Chart 3 displays a pattern of US lending standards becoming more strict starting in mid-2022. The chart highlights this trend by demonstrating recently tightened lending requirements in three important categories from the Federal Reserve Senior Loan Officer Survey: commercial real estate, consumer credit cards, and household auto loans.
Source: Federal Reserve, Macrobond

Capital Markets

Both riskier equities and safe-haven bonds have performed well over the past six months, benefiting from a sharp repricing of short-term interest rate expectations. However, this does not necessarily signal that all is well as there has been considerable volatility in the interim. Persistently high inflation led Fed Chair Powell to assert in March’s semi-annual congressional testimony that the Fed may increase the pace of rate hikes, resulting in expectations of a 50 basis-points (bps) move that pushed yields to a high of over 5% and the endpoint of rate hikes to 5.69%. After the recent bank events unfolded, expectations flipped. Two-year Treasury yields posted their single-largest, one-day drop since 1982 with Canadian yields closely following suit. For March overall, two-year yields declined by 48 bps and 10-year yields by 43 bps. This helped the FTSE Universe Bond Index rise 2.16%.

The flight to safety that was triggered by the US bank run similarly helped gold prices surge by 7.8% and silver prices by 15.2% in March. Meanwhile, energy prices declined, especially oil prices, which fell by 7% for the quarter. Natural gas prices experienced a sharp retreat, especially in Europe despite strong economic activity data and the reopening of China’s economy. The softening in energy prices was short-lived as oil rebounded within the first days of April due to OPEC’s surprising announcement of a material cut in supply.

Risk assets posted strong performance in March, with the MSCI ACWI Index up 2.5% and the S&P 500 Index closing up 3.7% in local currency terms despite regional bank stocks plunging 35.6%. Notably, even though the epicenter of the bank failure was in California’s Silicon Valley, the tech-heavy Nasdaq Index was up 9.5% in March as tech stock valuations benefited from the fall in rates. On the other hand, the S&P/TSX Composite Index was nearly flat, declining 0.2% during the month. The large weight of banks and energy in the Index was a drag on overall gains.

Portfolio Strategy

In light of the continuing effects of aggressive tightening by central banks over the past year and the recent turmoil in the US’s and Switzerland’s banking sectors, we anticipate even tighter lending standards than already posted in the second half of 2022. An economic downturn seems now more a question of “when” rather than “if”. Even as we approach the period of recession, the equity risk premium (ERP), which is the additional return demanded above lower-risk bond yields, has remained surprisingly unchanged despite recent events. While the ERP is holding in at recent average levels in Canada, it remains low in the US. As the ERP rises in response to slowing economic activity, valuation multiples will be pressured lower, compounding lower earnings. As a result, we maintain an overall underweight position in global equity markets in our balanced portfolios. We also have a modest underweight position in fixed income and are overweight in cash. In our fundamental equity portfolios, we continue to favour companies that offer stability with resilient earnings and dividend profiles.

The recent volatility in fixed-income markets has reflected a high level of uncertainty, with narratives that oscillate between expectations of further central bank rate hikes, or rate cuts mid-year. Our fixed-income portfolio decisions have been guided by valuation forecasts in line with our unwavering outlook for a mild recession, and our belief that central banks are nearing the end of their tightening cycles, although we do not foresee interest rate cuts in the near term. We remain underweight credit and have a modestly short duration position.

We anticipate that contracting lending standards will support central bankers’ goals of slowing the economy. We will closely monitor and assess the conditions around the economic slowdown to gauge what the recovery may look like and position portfolios accordingly.

Current monetary stagnation implies that policy-makers’ worries about a sustained inflation overshoot are as misplaced as their deflation panic in 2020 when money growth was surging.

UK annual broad money growth peaked in February 2021. It should be no surprise that annual inflation was still riding high in February 2023, based on the “monetarist” understanding of a roughly two year lead. 

Annual money growth, however, collapsed after February 2021. Non-financial M4 rose by 2.4% in the year to January and by only 0.9% annualised in the latest three months. 

A consensus concern is that a coming inflation decline will fail to return it to target – one informed commentator expects stickiness at about 4%. No explanation is offered of how such a scenario is compatible with barely growing broad money. Is velocity expected to pick up, against its long-term downtrend? Or is 4% inflation projected to coexist with economic contraction of 3% pa – the implication if money growth runs at 1% pa and velocity is stable? 

The collapse in annual money growth closely resembles a decline over 1990-93, following which annual core RPI inflation fell below 2% in H2 1994, consistent with a core CPI rate (unavailable then) of about 1% – see chart 1. 

Chart 1

Chart 1 showing UK Core Consumer / Retail Prices & Broad Money (% yoy)

The push-back to a similar scenario now is that the unemployment rate is much lower than at the start of the 1990-92 recession. Average earnings growth, however, was significantly higher then – the annual increase in total pay was above 10% (three-month moving average) when the recession started versus below 6% now. Private pay momentum is already slowing despite limited labour market cooling to date – chart 2. 

Chart 2

Chart 2 showing UK Average Weekly Regular Earnings (% 6m annualised)

The 1991-1994 inflation plunge, moreover, occurred despite upward pressure on import prices from a 12% drop in the effective exchange rate between 1990 and 1993 (calendar year averages). There is no such currency headwind to an inflation decline now. 

Annual core CPI inflation rose in February but three-month momentum remains well down from its May 2022 peak – chart 3. Commodity prices signal a coming slowdown in food inflation – chart 4 – while energy prices will soon be falling year-on-year. The February inflation result is irrelevant for assessing 2024-25 prospects and the MPC should ignore it. 

Chart 3

Chart 3 showing UK Core Consumer Prices ex Policy Effects* *Ex Energy, Food, Alcohol, Tobacco & Education Adjusted for VAT Changes

Chart 4

Chart 4 showing UK Producer Input Prices of Imported Foods & FAO Food Price Index (% yoy)

Lessons of history must sometimes be learned, unlearned and relearned.

The recent market cycle can be characterized by numerous unusual aspects. Many of these relate to being in a highly inflationary environment for the first time in more than 40 years, a climate that predates the majority of today’s market participants. For instance, the pace of rate hikes in the past 12 months by both the US Federal Reserve and the Bank of Canada has been among the fastest since 1980, but by some metrics has done little to quell inflationary forces. The most recent strength of activity data in January cast doubt on the likelihood of a recession scenario; however, we remain confident that the tightening in policy will bring the current high levels of inflation to heel with a modest recession. In addition to the direct impact on the economy, we are also seeing unintended strains in areas such as UK pension and US regional banks, the latter of which took excessive unhedged risks with safe assets like US Treasuries! We believe the process to get to the recession will be non-linear and repeat history lessons that investors must unlearn before relearning the signals and correlations under high inflation.

Inflation is acting as a moderator 

Counterintuitively, some features of inflation seem to be acting as a cushion to growth and auger for the delayed onset of a recession. As an example, those receiving inflation-indexed incomes, such as retirement planholders, just saw their monthly payouts increase and could have temporarily boosted their spending in nominal terms. Moreover, inflation rates are, very unusually, coming down before a recession has set in. Inflation typically lags, falling only after corporate profits are squeezed, workers are laid off and a recession starts. This year is different, with the clearing of supply chains helping headline inflation fall from high single-digit peaks to the most recent three-month trends of just over 3%. Thus, even before the full effects of policy are felt, an easing of inflation could provide some support to real labour income in this late-cycle period.

For companies, it is worth noting that earnings-per-share contractions during the 1970s and 1980s recessions were milder than those in the 1990s and beyond. The worst post-war recessions averaged declines of approximately 16% whereas since the 1990s, a period of substantial economic and inflationary moderation, earnings plunged 30% to 35% on average (see chart 1). Undoubtedly, these more recent precipitous drops resulted from the multiple financial crises compared to the more standard policy-induced recessions from previous decades. Nevertheless, inflation provides some cover for firms to raise prices and guard some of the profit margins and earnings that come under pressure during downturns. Inflation also reduces the future value of corporate and personal debt, and higher rates may encourage the paying down of some debt with excess savings, helping overall balance sheets.

Chart 1: Earnings contractions during recessions

This chart shows the annual change in S&P 500 earnings per share dating back to 1950, with US recessions shaded. The decline in earnings per share during the 1970s and 1980s recessions were more moderate compared to more recent recessions
Source: S&P/Robert Shiller, I/B/E/S, Macrobond
Note: Shaded areas represent US recessions.

So, are we going to avoid a recession?

In our view, a recession is within our forecast horizon and we believe that the market is currently seeing a reversion to norms that is sending important but confusing signals. Predictive data on recessions tends to draw from goods-producing sectors. Business cycles that are driven by tightening monetary policy are led into recession by borrowing-driven sectors, such as homes, automobiles and major appliances. Unsurprisingly, about half of the world’s purchasing managers’ indices are in contractionary territory, as are developed markets’ housing resales, and auto and retail goods sales.

A classic predictive data point is The Conference Board Leading Economic Index (LEI, see chart 2). Since 1960, the LEI has never given a false recession signal, after declining year-to-year for three consecutive months. As of January, it has declined for seven months. This seems at odds with the current bout of strong activity data. Of the 10 components that make up the LEI, four relate to goods sectors: manufacturing hours worked, manufacturing new orders, non-defense capital goods orders and building permits. The rest are financial or consumer expectations. Yet in the last couple of years, personal consumer spending in the US has swung first toward goods and now services, with a focus on hotel and travel, personal care, health care, air travel and recreation, public transportation and restaurant dining over the last six months. Similarly, in that blockbuster January employment gain of 517,000 new jobs, all services sectors posted monthly gains, led by leisure and hospitality that accounted for 128,000 (25%) of those jobs. Notably, goods-producing sectors have declined in importance as the economy has matured, with their proportion of gross domestic product down about five percentage points in both the US and Canada over the last decade (see chart 3). Some signals, while not wrong, may instead be skewed by the unusual normalization of spending and delay the arrival of the business cycle ending recession. Nonetheless, for us, this remains a key indicator to be attentive to.

Chart 2: Never seen annual decline in LEI without recession

This chart shows the year-over-year change in the Conference Board Leading economic indicator, starting in 1960, with US recessions shaded. The indicator has declined on an annual basis during prior recessions. More recently, the LEI has turned negative.
Source: Conference Board
Note: Shaded areas represent US recessions.

Chart 3: Goods-producing sector on the decline

This chart shows the proportion of goods-producing industries as a percent of GDP for both Canada and the US, starting in 2006. Both of the series have steadily declined within this time frame.
Source: Statistics Canada, BEA, Macrobond

Two more comments are worth noting. First, the last few market cycles have created an expectation that central banks will act and that information is absorbed and reacted to instantly. Impatience stands at odds with the long lags associated with monetary policy actions, especially during periods when it seems like we are collectively working to limit the damage. Some companies appear to be holding on to workers, fearful of being unable to hire again. Chartered banks in Canada are now extending variable-rate mortgage terms to over 35 years to help keep payments unchanged in the short term. Secondly, the path to a recession can closely resemble a soft landing. It is common for investors to operate on the hope of escaping a recession through the late-cycle period. This becomes especially true when data signals are skewed by extraordinary pandemic policy or an unfamiliar inflation environment. Synthesizing the available information, we continue to believe that policy will be effective eventually and thus remain cautious in our approach.

Capital Markets

What January gave, February at least partly took away. Positive market sentiment about the potential end to rate hikes turned to fear that exceptionally strong economic momentum is a sign that the rate hikes to date have been insufficient. While inflation over the last three months has eased, sustained strength in wages combined with anemic productivity demonstrate the continuing fight. Concerns remain even in Canada, where 5.9% headline inflation year-over-year currently represents one of the lowest rates among developed countries.

As a result, 10-year yields pressed higher in February, up 41 basis points (bps) in Canada and 43 bps in the US, more than reversing January’s decline. Corporate and provincial credit spreads help up well, leaving the FTSE Canada Universe Bond Index down approximately 2%, although year-to-date returns are up 1%. Equity market volatility contributed to the month’s 2.4% decline in the S&P/TSX Composite Index. Year to date, the Index is still up 4.8%. February’s caution was evident through more defensive leadership as consumer staples, utilities and real estate outperformed while materials, technology and energy underperformed. Notably, milder weather eased the energy complex, softening commodity prices across the board. Despite European inflation pushing higher, at 8.6% year-over-year in January, and U.K. inflation still stubbornly above 10%, the MSCI EAFE Index outperformed, led by Europe-based stocks. The MSCI EM Index fell 4.6%, giving up some of its late-2022 advances. The S&P 500 Index fell 2.4% but remains up 3.7% year to date. The potential shift in central bank sentiment to renewed hawkishness helped stabilize the U.S. dollar. After declining for four consecutive months, the US Dollar Index was up 2.7% in February.

As we headed into March, multiple crypto and tech related financial institutions (First Republic, Silvergate, Silicon Valley Bank (SVB) and Signature Bank) reported distress related in part to the withdrawal of liquidity and the rapid rise in interest rates as central banks tightened policy aggressively. Of these, the US$319 billion in assets at SVB is particularly notable as it represents the second largest bank failure in US history. The confluence of reduced demand for loans, elevated withdrawals, and challenging capital raising circumstances forced the bank to sell what were formerly risk-free assets, ie. US Treasuries. Ultimately, SVB ran into liquidity problems and was shut down by regulators. The Federal Deposit Insurance Corporation (FDIC), Treasury Department and Federal Reserve have acted swiftly to ensure depositors would have access to all their funds signalling their support to the beleaguered regional bank industry in the US. Equities globally were hit, though the declines were felt most significantly in regional bank stocks in the US; the S&P 500 is down over 5% since its early March peak. Bond markets, meanwhile, have now significantly repriced expectations for Fed rate hikes for the fourth time in about four weeks. In the aftermath of the first few days of the crisis, two-year Treasury yields plunged 75 bps, and it is no longer clear the Fed will put through any more rate hikes.

Portfolio Strategy

In terms of asset mix, balanced portfolios continue to hold an underweight in equities against cash. The equity market surge earlier this year was supported by optimism about a soft economic landing. Equity gains were led by multiple expansion as corporate earnings softened as expected. Following January’s rally in risk assets, we added to the equity underweight, reducing global equities exposure in favour of bonds. Some of the positive influences of inflation discussed above serve to highlight that the path can include skewed signals and red herrings. With policy only beginning to tighten a year ago, we may have yet to feel its full effects and are only now seeing consequences of the sharp drop in Treasury prices on various parts of financial markets. We reduced the underweight in fixed income based on improved valuations and the interest-rate backup that now provides a decent yield. Bond portfolios continue to be traded tactically, extending duration through the backup in yields, particularly in Canada. Equity portfolios maintain their focus on stability and resilient earnings, particularly through the current turmoil. Recognizing the positive impact globally of the reopening of China’s economy, exposure to companies in the commodities and industrial sectors has been increased. We continue to see opportunities through the volatility and the market’s relearning all of the various challenges of inflation.

Vancouver's Granville Island bridge at night with skyscrapers and marina with boats.

We recently published our 2023 Financial Markets Forecast, which presents a comprehensive review of our investment thinking for the year to come. Therefore, as in years past, we devote the February edition of Outlook to providing an annual update on organizational developments at Connor, Clark & Lunn Investment Management (CC&L).

President’s Message

Martin Gerber.

Over the past three years, the global economy and capital markets have endured a series of significant macro shocks—COVID, recession and war. These forces have resulted in volatile markets.  While most market participants and pundits tend to focus on the near-term cyclical consequences emanating from these macro forces, it is worth noting that we are also witnessing a much longer term, secular shift in the geopolitical, economic and market landscape. This is important because it has the potential to impact markets for years to come and may require adjustments to portfolio strategy.

During COVID, governments and central banks introduced synchronized, unprecedented stimulus via both fiscal and monetary policy.  At the same time there has been a seismic shift in the global geopolitical climate with the U.S. no longer being the single dominant global superpower. As an outcome of this, we are witnessing increased tensions in many regions and the largest armed conflict in Europe since World War II. This is reshaping political alliances globally, with an increased focus on national security. Additionally, inequality and dissatisfaction with the current economic model is increasingly giving rise to populist governments.  This is resulting in policies that are more inward focused. They include a trend toward onshoring and regionalization – deglobalization.  This is also resulting in reduced immigration in most of the developed world.  Finally, we are undergoing a significant period of investment in infrastructure as countries strive to transition toward clean energy solutions.

All of these macro events have contributed to higher inflation. Central banks have responded to the threat of unhinged inflation with the most aggressive rate hiking cycle in a generation. While there are some signs that inflation is moderating, the changes to the secular landscape will remain in place.  Going forward, we believe we will continue to experience upward inflationary pressures and higher interest rates, a dramatic shift from the last 40 years. Throughout the last several cycles, investors benefited from an extended period of ultra-accommodative monetary policies as central banks prescribed lower and lower interest rates to mitigate the risk of deflation and to sustain growth. This environment provided incentives for risk taking as the cost to borrow was cheap. It resulted in the steady expansion of valuations for risk assets.

Over the next few years, inflationary pressures and higher rates could result in headwinds for markets as adjustments are made to asset valuation levels. As we look forward to the next cycle, we are anticipating more volatility and policy actions that will result in shorter cycles accompanied by lower asset valuations. In this environment it will be important to be nimble. We see attractive opportunities for active management and expect manager added value to become an increasingly important contributor to achieving client investment objectives.

While we have faced a broad range of investment environments in the four decades since our company’s inception in 1982, at the very heart of our organization is a commitment and desire to provide superior performance and service to our clients. Our ability to deliver on these commitments starts and ends with the quality of our people and the strength of our relationships. This requires that we keep the business narrowly defined and intently focused on what we do best while endeavoring to remain at the cutting edge of research and development initiatives within the financial markets. Importantly, our business structure provides stability and keeps us focused on maintaining a long-term horizon. Despite the challenging operating conditions over the past year with negative returns across markets and high levels of employee cost inflation, we continued to invest in our teams and expanded the resources we are employing in the business.

To this end, we have been focused on several initiatives at CC&L:

  • As always, we are investing in our people and through career development planning and leadership programs, we strive to enhance skill sets, the depth of our teams, investment processes, and plan for succession.
  • We continue to focus on fostering a team-oriented culture of collaboration with a particular emphasis on continuing to improve diversity and inclusion. There are numerous projects underway to ensure our objectives are met. The Women in Leadership (WiL) initiative has been a key priority at CC&L over the past two years and a significant number of recommendations were brought forward to our Board in 2022. We began implementing these ideas in 2022 and have plans that will continue through 2023, 2024 and 2025.
  • We have expanded our Corporate Social Responsibility (CSR) activities supporting the health and wellness of both the people who work at CC&L and continuing to create a positive impact in the communities where we do business. We implemented a number of new policies aimed at supporting our employees and their families’ well-being, and the CC&L Foundation awarded a broad range of scholarships and financial support during the year.

Thank you for your partnership and as always, I welcome your feedback and invite you to contact me directly at any time.

Martin Gerber
[email protected]

Team Updates

We are pleased to report our teams continued to expand in 2022. CC&L welcomed 20 new hires, resulting in a net increase of 13 employees for the full year, bringing CC&L’s personnel count to 117. Our business is further supported by over 350 people employed by the CC&L Financial Group, responsible for business management, operations, marketing, and distribution.

The stability and focus of each of our teams continues to be a primary driver of our business. One of the key tenets to ensuring continued success has been thoughtful and comprehensive succession planning across the organization and a disciplined approach to career development.

A number of employees were promoted to principals of the firm in recognition of their important and growing contributions to our business bringing the total number of principals to 27.

Principal Appointments in 2022 and 2023

Fixed Income Fundamental Equity Quantitative Equity Client Solutions
Joe Dhillon Jack Ferris Piper Hoekstra Lisa Conroy
Kyle Holt Haley Mayers Derek Moore Monica Demidow
Kevin Malcolm Joe Tibble Isaac Ho Mandy Powell
TJ Sutter   Nolan Heim  


Below we highlight a number of personnel developments within our organization.

Fixed Income

Left to right: Brian Milne, Brian Eby, TJ Sutter.
  • We are pleased to announce Brian Milne, Senior Credit Analyst, was appointed a business owner at CC&L in 2022. Brian joined CC&L in 2018 and became a principal in 2020. He brings 15 years of capital market experience. Brian is responsible for credit research and has been a member of the CC&L’s ESG Committee since 2019.
  • Succession planning is an important process at CC&L and we are in the process of implementing a longer-term succession plan within the Macro Strategy group. TJ Sutter joined CC&L in 2021 working alongside Brian Eby. Over the past year, TJ has taken increasing responsibility for portfolio decision-making. He was appointed a principal at CC&L in 2022 and a business owner in 2023. Brian Eby continues to be an active member of the team contributing to investment strategy and mentorship within the team.
  • There was one new addition to the team in 2022. Catherine Clarke joined as an analyst on our Portfolio Analysis and Design team.

Fundamental Equity

Top (left to right): Mark Bridges, Haley Mayers, Chang Ding, Simon Mo.
Bottom (left to right): Joe Tibble, Ryan Elliott, Jack Ferris.
  • In March 2022, Steven Vertes, Portfolio Manager, retired after 20 years with the organization. We are pleased to report that his responsibilities were seamlessly reallocated to other members of the team.
  • We are pleased to announce Ryan Elliott, Senior Research Associate, was appointed a business owner at CC&L in 2022. Ryan joined CC&L in 2012 and has been a principal since 2013. Ryan has responsibility for coverage of the technology and health care sectors.
  • Mark Bridges, Portfolio Manager, is responsible for covering the energy sector research and his responsibility on the team expanded with the newly created role of Research Director in 2022. He is responsible for working closely with all sector specialists to ensure the optimal level of structure, rigour and consistency in the team’s research process. The research team expanded with the addition Chang Ding, a research analyst in 2022. We are also pleased to welcome Haley Mayers, as a Senior Research Associate in January 2023. Haley has over a decade of experience as an equity research analyst within the asset management industry.
  • Simon Mo took on the newly created role of Senior Portfolio Management Analyst in 2022. Simon is responsible for portfolio management operations, administration and modeling. Simon has been an important contributor to the CC&L quantitative equity team’s success in his 16 years with the team, and we are excited to have Simon apply his skills and experience to the fundamental equity team.

Quantitative Equity

Top (left to right): Glen Roberts, Richard Au, Steven Li.
Bottom (left to right): Daniel Cook, Brian Bardsley.

We are continuing to make investments in the expansion of our capabilities, including the net addition of seven new team members in 2022, bringing our team count to 65 dedicated investment professionals.

All of the new hires joined either our Investment Process Management (IPM) or Investment Management Systems (IMS) groups, which bridges research and portfolio management, creates all of the investment technology infrastructure, collects and processes all of the roughly 45 million data points that flow into our models every day, and oversees all of our operational processes.

We place high value on continuous career development, including the movement of people across different functional roles within the team. Gaining exposure to different investment functions provides career path options and enables employees to bring broader investment context to their roles. In 2022, two individuals transitioned from the IPM and IMS groups to trading and portfolio management. Overall, on net, the proportionate breakdown of functional roles within our team has remained relatively stable over the years.

With team expansion also comes the need for more specialized leadership. We are pleased to announce five individuals—spanning various groups within the team were promoted to business owners in 2023, in recognition of the development of their investment leadership over their time with CC&L:

Portfolio Management: Brian Bardsley joined CC&L in 2007 and has been a principal since 2013. His primary responsibilities include the implementation of new strategies, mandates and model changes.

Research: Glen Roberts joined CC&L in 2007 and became a principal in 2015. Steven Li joined CC&L in 2015 and became a principal in 2020. Both Steven and Glen are senior members of the research team. In addition to conducting their own quantitative research, they also have leadership roles in managing research projects and the research process.

Investment Management Systems: In January 2020, 19 members of the Connor, Clark & Lunn Financial Group portfolio management and research systems team became direct employees of CC&L. Dan Cook and Richard Au have led the members of the team since and became principals of the firm in 2020. They continue to operate in a co-lead model, with Dan providing technical leadership and Richard focusing on people leadership.

Client Solutions

  • Our Client Solutions team has grown with the arrival of Diana Prenovost in January 2023. She works out of the Montreal office and will be responsible for client relationship management.

Responsible Investing

In 2022, the ESG Committee undertook a review of industry practices in all aspects of responsible investing including integration, active ownership and communication. The outcome of this project validated our approach to ESG and has led to the prioritization of several areas for improvement in 2023. These generally relate to the improvement of the communication and tracking of our RI activities. We also committed to formalize our climate strategy in 2023 with a key focus on advocating for greater transparency in company disclosures regarding emissions and transition plans.

Business Operations

In the fourth quarter of 2022, we formally implemented our return-to-office policy. This new hybrid policy provides all employees with flexibility and has everyone working together in the office a minimum of three days a week (Tuesday to Thursday).

Business Update

Assets Under Management

CC&L’s assets under management (AUM) declined by approximately $5 billion in 2022 to $54 billion. The decline in AUM was driven by the negative returns experienced in both equity and fixed income mandates as a result of declines in market levels. We are pleased to report that our business continued to grow through new client mandates across all of our investment teams. In 2022, CC&L gained 17 new clients and nine additional mandates from existing clients totalling $2.5 billion. The majority of the new mandates were quantitative foreign equity mandates from institutional investors outside of Canada, which now represent approximately 20% of our total AUM.

By Mandate Type.
Fundamental Equity: 21%.
Quantitative Equity: 44%.
Fixed Income: 17%.
Multi-Strategy: 18%.
By Client Type.
Pension: $27.5 billion.
Sub-Advised: $17.7 billion.
Foundations, Endowments & Other Institutional: $8.9 billion.
Total AUM in CAD$ as at December 31, 2022 = $54 billion.

Final Thoughts

We would like to thank our clients and business partners for their partnership and support. We look forward to continuing to work with you and provide support in achieving your investment objectives in the coming years.

This year’s Forecast looks at the secular themes that underpin our outlook, and then considers the shorter-term cyclical factors influencing the outlook for the economy, inflation, and monetary policy. We examine market valuations and taking into account all these factors, we set the framework for our portfolio strategy. Throughout the next year, updates to our Forecast will be highlighted in our monthly newsletter – Outlook.

The COVID-19 pandemic is largely in the rearview mirror. The last major country to accept “living with the virus,” China, is now dropping its longstanding zero COVID policy. The Russia-Ukraine war displaced health as the primary concern over the year. War-induced increases in in food and energy prices added to supply/demand imbalances that were already driving inflation higher globally.

For financial markets, high inflation triggered a forceful response from central banks that pushed interest rates up and led to asset class revaluations. 2022 will be remembered as the first year that both US stocks and bonds declined more than 10% in the same year. The year also saw an end or reversal to many longstanding trends in markets:

  • Multi-decade long secular stagnation characterized by low growth and benign inflation came to an end
  • Flexible average inflation targeting, introduced in August 2020, ended before it could even get going
  • The confident extrapolation of cheap borrowing costs far into the future is behind us
  • Negative yielding bonds vanished after hitting a peak globally of US$18 trillion in mid-2020
  • Liquidity excesses achieved through quantitative easing are now in full reversal globally
  • The extended bull market propelled by growth stocks and high valuations ended
  • The negative correlation between stocks and bonds broke down

What are we to make of this as we look forward to the coming years? The answer depends on the path of inflation from here. Fifty years of history tells us that when a country has dealt with inflation rates of 8% or more, the shock takes more than two years to settle to a moderate rate (below 3%). The expectation of a return to target inflation in the next 12 months is therefore optimistic.

Typically, a recession and higher unemployment are needed to rein in demand. With central banks resolutely focused on inflation, a recession is likely. But beyond this next downturn, we remain apprehensive about the long-term prospects of returning to the 2% inflation targeted by central banks. For four years, our secular themes have projected that we will not return to a secular stagnation world and that higher inflation will take root. If anything, the events of the last few years have accelerated these secular trends. We will discuss these trends and assess the shorter-term cyclical themes including the inflation outlook and the monetary policy response, highlighting risks to our view. Finally, we will outline our thinking on market valuations after a tumultuous 2022 and discuss broad portfolio strategy.

CHART 1: 2022 WAS AN OUTLIER FOR STOCKS AND BOND RETURNS. This scatter chart shows annual total returns of the S&P 500 index against the total return of US government bonds over the last 150 years. The year 2022 stands out as a year in which both the S&P 500 and US bonds had significantly negative returns.

The Secular Environment

The Great Moderation was the period experienced since the mid-1980s. It was characterized by increased stability in economic data, low inflation, and modest economic growth. During this period, geopolitical risks were low, companies benefited from lower-cost alternatives through globalization and employed increasingly complex supply chains. COVID highlighted the fragility of the existing system in times of stress. Some of the secular forces that we first identified four years ago were inflationary in nature – reversal of globalization, aging demographics, actions to reverse climate change and the growing importance of fiscal policy. These have been strongly reinforced by the events over the past three years. Our secular themes each lead to a shift away from a broad disinflation environment to one where inflation – not a temporary cyclical response to the supply-demand imbalance but sustained upside pressure – complicates the work of policymakers.

1. Security matters in geopolitical climate

  • After several years of instability from trade wars, health challenges, politics, war, staffing problems and broken supply chains, the security of business relationships will now take priority as global relationships realign. Globalization reached an apex in the 1990s with free trade agreements (WTO, NAFTA, Maastricht Treaty), but is now in reversal with little prospect of being stabilized. An extended period of relative global calm allowed businesses to move toward increasingly efficient supply chains focused on lowest costs globally. Both consumers and governments are now demanding more nationalist policies related to goods production and companies are now putting value on increased resiliency in a more uncertain geopolitical world and will pay higher costs to achieve that.
  • The China – US realignment is the most critical of these relationships by virtue of their size as the world’s two largest economies. In 2000, China’s joining the WTO was a driver of global disinflation for 20 years. China supplied the US with cheap manufactured goods and labour, flattening the global Phillips Curve. In recent years, even prior to the Trump administration’s trade wars, global trade was already slowing, as the ratio of US to Chinese wages fell from 34x to just 5x in those 20 years, leading to dwindling mutual gains. Thus, even though US goods imports surged 38% since COVID, the result of the boom in purchased goods, the proportion of those goods imported from China has fallen. The China-US relationship has now morphed into competition – for technology, financial services, commodities and geopolitical dominance. Just as globalization helped provide access to a global workforce, aid disinflation in goods prices, reduce inventory investment and business cycle volatility, the reversal of globalization implies the opposite of these effects.
  • Russia has supplied western Europe with natural gas, oil, and coal supporting Europe’s manufacturing industry. However, most alternatives to Russian energy are costlier and the current economic sanctions placed on Russia are unlikely to disappear immediately, even if the war was to end. The war has also catalyzed countries into restarting defense spending. Trade and finance are being shaped by tactics in geopolitics as well, with countries freezing FX reserves of other central banks, restricting access to payment systems, asset expropriation, self-sanctioning by many companies, and restricting commodity exports. Taken altogether, a focus on security, resilience, and relationships leads to higher costs.
CHART 2: SHARE OF IMPORTS FROM CHINA HAS DECLINED. This line chart shows the proportion of US goods imported from China between 1999 and 2022. The proportion of goods imported from China increased substantially from about 8% in 1999 until peaking at about 22% in 2017. Since then, this series has been in a downward trend, notwithstanding a short-lived boost during COVID.

2. Beneficial but costly capital investment cycle 

  • The direct outcome of the security concerns is that a demand-driven capital expenditure cycle may be upon us. Part of the demand will be securing reliable and nearby supply chains, the importance of which the pandemic starkly demonstrated first through vaccines and medical supplies, and later general goods and services. This should pull manufacturing away from the lowest-cost mentality. With investments in machinery, technology, and innovation, the hope is this will pay dividends through a productivity surge.
  • A second driver is the rethinking of energy sources. Europe must replace Russia with another source for energy, but all countries are looking for ways to pivot away from carbon-based fuels to address climate change. Renewable energy is more costly and generally less reliable overall (it is not always sunny or windy when needed), while nuclear power requires large investments. However, the International Energy Agency (IEA) notes the current energy crisis could act as “an accelerant” to clean energy transition in its 2022 report. Global energy investment is expected to reach US$2.4 trillion this year, an increase of 8%, of which three-quarters is directed to clean energy. Among the many commitments globally, the US delivered a US$370 billion climate and energy security package through the Inflation Reduction Act in August 2022 to make public money available for research and investments in renewable energy. The European Commissions’ REPowerEU plan is investing €210 billion into renewables and fuel switching. More broadly, public sector infrastructure investment will also grow, with the path already underway in the US following the US$1.2 trillion Infrastructure Investment and Jobs Act passed in late 2021.
CHART 3: CLEAN ENERGY INVESTMENT TO RISE MEANINGFULLY. This bar chart shows clean energy investment of advanced economies, China, and emerging and developing economies between 2015 and 2021, and projections for 2030. Clean energy investment has been generally stable between 2015 and 2021, but is expect to rise significantly in 2023 for all regions shown.

3. World labour supply will diminish

  • The world’s population hit 8 billion on November 15, 2022 according to the UN. The world’s population took 70 years to grow from 2.5 billion to 8 billion, and in the next 70 years, is still projected to grow but at a much slower pace, reaching about 10 billion. This matters because growth in the share of the working-age population, defined as 18 to 65 years old, contributes to economic expansion. However, in most advanced economy countries this is no longer going to occur. Indeed, the dependency ratio, the share of the population over 65 years of age relative to the working-age population, is projected to rise starkly, from 10% in 2022 to 16% in 2050.
  • Population projections are well understood, but even within the labour force, trends are indicating a slower pace of participation. In the US, the proportion of working age Americans in the labour force declined sharply from 67.3% in 2000 to 62.1% at the end of 2022. About half the decline was due to the retirement of the baby boomer generation and this should continue to be an important force until 2030. Canada’s participation rate of 65% remains near its longer-term average, even with the same baby boomer influence. The country has made aggressive changes to its international immigration policy to shore up the demographic profile of the country, which does augur well over the medium term. We have seen consequences of demographics on the workforce through the pandemic. Workers retired early or dropped out of the workforce to either take care of their own health or a loved one. As the size of the global labour force shrinks, this naturally raises the bargaining power of labour for the first time in decades. These trends should bias wages higher.
CHART 4: DEPENDENCY RATIOS TO WORSEN IN DEVELOPED REGIONS. This bar chart demonstrates the old age dependency ratio (defined as the population over the age of 65 relative to the population aged 15-64) for 2021 and projections for the old age dependency ratio in 2050, for the OECD, Canada, the U.S., and the European Union. In each region, the ratio worsens significantly in 2050. The 2050 projections represent the UN’s medium population scenario.

4. Importance of fiscal policy will grow, but needs to be managed carefully

  • Prior to the pandemic, monetary policy was constrained by the zero-interest rate bound and central banks were already purchasing bonds at a large scale. At the time, monetary policy was reaching the limits of efficacy and the job of managing business cycles, we believed, would be handed off to fiscal policy. The pandemic turbocharged that, with massive government intervention in the form of social support programs that led to ballooning deficits. Monetary policy played a critical but secondary role, buying the bonds being issued to fund government spending. Yet even when faced with high inflation into 2022, governments were enacting wide-ranging spending programs, sending cheques to help families cope with high inflation, forgiving student loans, creating national dental care programs, and providing direct support for renters. Thus, while in the big picture, fiscal deficits improved markedly from the worst projections coming out of the pandemic, government deficits continue to be larger than pre-pandemic levels underscoring their impact in this very late-cycle environment.
  • It is always easier to enact stimulative fiscal policy with virtually no end to the demands on government. But to finance this properly and organically, it helps to have the combination of strong economic growth and low interest rates which we benefited from in the 2020-21 period. Indeed, if debt levels are shocked suddenly higher – as they were during the pandemic – high inflation also reduces the real value of outstanding debt. As we barrel towards a period of below trend economic activity and slowing but not low inflation, it’s worth recalling two notable events of 2022 that raise warning flags on unfettered fiscal spending. First, the release of the UK budget showing significant spending plans caused a historic surge in gilt yields that nearly caused a collapse in the UK pension funds. This reminds us that in an era of quantitative easing, governments can run large deficits if the central bank is a major purchaser of those government bonds. As liquidity is withdrawn from the system, governments must check those impulses and place constraints around borrowing. Second, the Bank of Japan doubled the allowable trading range of 10-year Japanese Government bond yields to 0.5 percentage points on either side of the 0% target, widening the effective cap on yields. Being the last major central bank to budge on higher interest rates, this was perhaps the death knell for zero-interest policy and a sign of structurally higher yields globally. Taken together, fiscal policy will remain a potent force, however unchecked spending coupled with higher servicing costs of debt are unlikely to be tolerated by market participants.

The Cyclical Environment

World: Short cycle, short recession

  • The head of the IMF believes that one third of the global economy will be in recession in 2023. The US, EU and China are all slowing at the same time. World economic growth is expected to decelerate from 3.2% in 2022 to 2.7% in 2023. If that comes to pass, the current cycle will register as one of the shortest on record, marking a return to a sort of boom-to-bust cycle that was more common during the 1980s and 1990s. Aggressive monetary tightening to combat inflation is expected to induce the third worst year for global growth this century, behind the pandemic in 2020 and the aftermath of the Global Financial Crisis (GFC) in 2008.
  • However, just as the 2020 recession was, unusually, driven by extraordinary measures to close down an economy otherwise humming along, the 2023 recession will, unusually, be characterized by still-large caches of savings and vibrant labour markets. Indeed, savings, wages, employment, overall asset prices (housing and equity prices as compared to the 2019 levels) and commodity prices all augur for a mild recession. The typical markers of a serious downturn – corporate and household bankruptcies, unintended inventories, saturated demand – are not present.
  • The recession of 2023 could also be the first since 1980 that is absent some major financial shock, and turn out to be a true policy-induced, plain vanilla recession (though this remains to be seen). Encouragingly, no major government has actively refuted central bankers’ efforts to reduce inflation because inflation is highly unpopular. It is not hard to see why – inflation destroys nominal wage gains and asset valuations, hurting the full spectrum of households. Thus, we are willing to accept short- term pain to get inflation back to target.
CHART 5: 2022 GLOBAL GROWTH TO EASE IN 2023. This bar chart shows the expected growth rates in GDP between 2021 and 2023 for the world, advanced economies, and emerging market and developing economies. The years 2022 and 2023 represent IMF estimates. The chart year over year change in GDP growth in each of the world, advanced economies, and emerging market and developing economies, is expected to slow over the years shown.

Canada: Recession, then a Dawn

  • Having been one of the first central banks to recognize the need to reduce policy stimulus, the Bank of Canada ended asset purchases in late 2021, started reducing its balance sheet in 2022 and raised rates earlier than its peers. Under the weight of higher interest rates, highly indebted households will slow spending to manage higher debt service costs. Consumer spending is expected to contract, but strong labour markets, nominal incomes lifted by higher wages, and high savings will moderate what otherwise might have been a precipitous decline. Personal saving rates were 5.7% of personal disposable income in the third quarter of 2022, well above the 2015-19 average of 2.3% and continue to add to the excess savings cache built up during the pandemic. Federal and provincial governments alike have been sending income support, particularly to lower-income Canadians, extending pandemic relief to inflation relief.
  • Housing markets will continue to deteriorate with posted five-year mortgage rates having surged from 3.2% in late 2021 to 5.9% in 2022. House prices have already declined but are holding in near 2019 levels and could see some support from high immigration levels that should help keep demand for homes strong amid dwindling supply. While the global recession reduces demand for Canada’s exports, strong commodity prices will support national income, through higher terms of trade. Business capex will stall, but in line with our secular outlook, look brighter in the next cycle.
  • Canada’s economy outperformed expectations in 2022, leading to a positive handoff to 2023. But under the hood, domestic demand is contracting due to both consumption and investment declines. The full force of higher mortgage and consumer borrowing rates is likely non-linear and households could retrench more dramatically. The risks to the outlook are to the downside. Beyond that, a number of factors, notably Canada’s export breakdown, trading partnerships and most notably perhaps demographics, all suggest Canada could well shine in the next cycle (see December Outlook).
CHART 6: CANADA PRIME AGE POPULATION HAS SURGED. This line chart shows the annual change in prime age population in Canada, defined as those aged 25-54, between 1972 and 2022. The chart indicates a gradual decrease in the number of working age Canadians from the late-1980s to the mid-2010s, followed by a sharp increase up to 2022.

US: An irrepressible consumer

  • The US represents one of the more important unknowns in the global economy, because it is still somewhat unclear how far the US Federal Reserve (Fed) must tighten before inflation can be controlled. Growth does not have much room to slow from a moribund pace of about 0.2% in 2022 and strictly by the numbers will be posting back-to-back weak years of growth. Much of last year’s slowdown was due to weak international trade, while domestic demand was decently strong. Consumer spending is helped by having reduced debt and lowered servicing costs relative to pre-GFC levels, even with the recent rise in interest rates, while having grown excess savings. While spending on services has held up, rate sensitive parts of consumer spending did contract. The volume of home resales has dropped one-third from its highs, due in part to the structure of the mortgage market where low interest rates have been locked-in for the long-term, and any move results in having a new mortgage taken out at current rates of over 7%.
  • A key question is whether the magnitude of the slowdown in the US will be enough to bring inflation back under control. Given inflation today is largely driven by the price of services, excluding shelter costs, and critically, given how important wages factor into this, this cycle depends greatly on how much labour markets will need to weaken to bring wages in line with inflation targets. Historical experience suggests this requires at least a 1 percentage point increase in the unemployment rate which has always implied a recession. While absolute job growth and hours worked have so far held stable, the gap between job openings and available workers has been historically large, reaching nearly 6 million, about 4x the level from before the pandemic; quit rates remain elevated as the market for workers is competitive. Given the unusual strength in labour demand this cycle, the Fed appears to still have considerable work to do and will prioritize labour market data to determine when it will be able to pause its hiking cycle. The risks to the downside will grow with the current strength of the labour market.
CHART 7: METRICS SHOW TIGHT US LABOUR MARKET. This line graph shows two series, the US quits rate and the ratio of job openings to the number of unemployed, from 2000 until 2022. These series have been trending higher since 2009 and peaked in 2021, but still remain quite high. This indicates a tight US labour market.

Europe: Stagflation while retooling energy supply

  • The Euro area will be the one region likely to experience stagflation. Growth will slow from a better-than-expected 2022, which was buoyed by fiscal support and a buildup of gas storage. Governments offered some cushion to the high energy prices through a combination of tax cuts, energy subsidies and income support measures before finally moving to direct price caps. There will still be some fiscal supports going forward, but it will be constrained, with public deficits in France, Italy and Spain already in excess of 4% of GDP. Leading indicators and consumer and business confidence show the eurozone economy is contracting. Further down the road, any recovery will likely be a weak one. The decline in energy supply has slowed industrial production and high energy prices have squeezed real household income. Labour markets, however, are a positive, holding generally tight; the unemployment rate is at a record low of 6.6%.
  • Inflation was already higher in the eurozone than nearly all developed market economies around the world. Headline inflation peaked at 11%, and the largest countries within the eurozone continued to post double-digit inflation rates into the fourth quarter of last year. In contrast to the breadth of CPI that is being experienced in other countries, the surge in food and energy prices were the main drivers of the headline CPI, accounting for almost 70% of the increase. Both moderated towards the very end of 2022, but could still see upside surprises due to supply shocks, while a weak euro implies higher imported prices. Even with a meaningful economic slowdown, headline and core inflation are likely to remain in the upper single-digits, well above the ECB’s comfort zone. Inflation expectations risk becoming unanchored, causing broad upside wage pressures. The outlook remains fragile in the region.
CHART 8: EUROZONE UNEMPLOYMENT IS AT RECORD LOW. This line graph shows the rise and fall of unemployment in the Eurozone between 1998 and 2022. The chart indicates a peak of over 12% in 2013, and a record low of just over 6% in 2022.

China: Challenges will take time to address fully

  • For the first time in 40 years, China may post growth in 2022 that lags the world, as activity is hampered by the outcome of a tumultuous two years. In 2021, the government instituted decisive structural policy changes in China’s tech sector, for-profit education and excess debt in shadow banking. This was followed by an extended COVID-lockdown and real estate correction. By mid-November 2022, China ended its zero-COVID policy, and is transitioning to an endemic state. As with other reopenings, this will likely be a difficult process worsened by limited hospital capacity, and lower vaccination rates of its elderly population. Nonetheless activity in China should rebound in 2023, but likely not until at least the second quarter as the reopening will lead first to a rise in hospitalizations and cautious mobility before full normalization. While consumers did not get the same fiscal support as in other countries, limiting “revenge shopping and travel,” they have been raising precautionary savings which should allow for a rebound in retail sales.
  • The second challenge for China is the liquidity crunch facing private property developers that has been exacerbated by a sharp drop in new home sales, typically used to finance future projects. Sentiment among homebuyers is low. Deleveraging in the property sector will be a multi-year process, which will eventually reduce longer-term financial instability but requires a painful adjustment.
  • Longer term, the new strategic relationship between the US and China, including limiting trade and semiconductor controls, will reshape exports (lower) and domestic business investment (higher). The weakest growth in 40 years is the near-term economic cost to the longer-term global repositioning. Policy may ease, but moderately and in a targeted way. China will no longer provide the countercyclical expansion for the world economy.
CHART 9: HOUSEHOLD SAVINGS IN CHINA SUGGEST PENT UP DEMAND. This line chart compares Chinese household new deposits against new loans, both on a 12-month rolling basis from 2010 to 2022. Since the year 2020, household new deposits have spiked while new loans have declined, creating a significant gap between the two series.


  • After 40 years of decelerating inflation, including fears of outright deflation in recent years, 2021 showed that inflation can be generated with enough fiscal stimulus and money supply growth. In 2022, we learned inflation can be longer lasting once expectations become unanchored – as some consumer and business surveys demonstrated. As we enter 2023, inflation has peaked broadly around the world and will continue to decline in coming months.
  • In our forecast horizon, headline CPI inflation in the US and Canada falls to below 4%. Much of the easy work will be done by goods prices (already falling 0.4% m/m in the latest US release), after the inflationary effects of clogged supply chains reverse. Shelter costs, while lagging the actual market movements in house prices and rent, will flow through to CPI over the course of about a year and as a result will also help ease headline inflation. However, Fed Chair Jerome Powell has highlighted that the most critical category in the inflation outlook will be core services prices excluding housing costs. This accounts for more than half of the core PCE price index. Critically, this category is driven by wages, which constitutes the largest cost in delivering these services. Wages are still elevated, and show little sign of easing.
  • Overall core prices will be slow to ease, particularly in the US where the trimmed mean and median core gauges of CPI have only eased back to between 6% and 7.5% in the last three months. In contrast, Canada’s trimmed mean and median core inflation are now growing between 2.9% and 3.2% on a three-month annualized basis, a testament to the sensitivity of the economy to high interest rates. Euro area inflation has been among the highest in the world, 10.1% y/y in November, where in addition to the positive demand shock the rest of the world has seen, it copes with a negative supply shock as well.
  • Normalization after high inflation usually takes years, not months. Consumer balance sheets and labour markets are generally healthy. All in all, inflation risks are skewed to the upside and the inflation fight will take some time yet. We see both the Bank of Canada (BoC) and the Fed continuing to hike until their target policy rates reach 4.5% and 5% respectively, and will then keep them at these levels for much of the rest of the year.
CHART 10: US CORE SERVICES PRICES STILL STRONG. This chart shows the US core services consumer price index that excludes the owners’ equivalent rent and rent of primary residence components, from 2013 to 2022, on a year over year basis. The series has been generally stable between 1.5% and 2%, dipped down to 0.5% in 2021 and has since surged to around 4.5%.

Risks to our Outlook

1. Inflation is sticky / labour markets stay strong

  • Persistent inflation is a material risk to our outlook. As noted above, Chair Powell has called focus to core services prices excluding shelter costs, implying the path of wage growth remains critical. The San Francisco Fed estimates the natural rate of unemployment could be about 6%, considerably above the 3.5% registered today. Combined with other metrics like quit rates, unemployment insurance claims and the ratio of job openings to available workers, it is clear current labour markets are extraordinarily tight. This presents a notable challenge to central banks that may have to persist longer than they would otherwise want in a tightening stance. This, in turn, requires a sharper global economic slowdown with more countries pulled into a deeper recession.
  • The persistence of war and geopolitical tensions could catalyze a rebound in commodity prices. China could also see a more rapid than expected reopening, leading to a powerful rebound in consumer activity. Globally, inflation expectations could remain elevated, posing an upside risk to actual inflation.

2. Disinflationary pressures faster to emerge without recession

  • High interest rates impact countries differently depending not only on absolute debt levels, but also the structure, term and distribution of debt. The range of mortgage types, for example, extends from largely variable rates in Australia, the UK and Spain to majority 30-year fixed rates in the US. While Canadian mortgages are typically a fixed five-year term, the period of record low rates more recently that prompted rapid appreciation in housing markets saw an unusually high proportion of new mortgages (just over half) use a variable rate. No doubt, Canada stands out in terms of debt relative to incomes and overall debt servicing costs, but the worst of the impacts from higher rates has been buffered by prior prudent mortgage lending rules and an overall cautious consumer sector. Nonetheless, risks to the consumer from high interest rates are particularly elevated, especially if unemployment jumps. While we believe the risk of a housing crisis resulting in forced liquidations is low, this scenario would result in a deeper downturn in Canada and a faster pace of disinflation.
  • We highlighted in last year’s Forecast that inventory overbuilding is a risk coming out of businesses that faced limited supply, engaged in fierce competition for scarce resources (including labour) and are in the process of building cushions within their businesses. There was some evidence of this inventory rebuilding towards the tail end of last year, with supply chains easing materially and measures of inventory levels rising in both Canada and the US. Together, these prompted discounting into the holiday season. Looking forward, consumer spending is likely to dwindle in response to higher interest rates, which in turn places continued downward pressure on retail prices.
  • While a boom in capital expenditures would be short-term inflationary via the competition for resources, in the longer-term this is a potential force for disinflation. Technological innovation could be a positive outcome of the capex cycle and could help mitigate future inflationary pressures that come from labour shortages or supply bottlenecks. Associated productivity gains will help improve potential output allowing economies to grow faster without generating inflation. This is a medium-term risk.
CHART 11: WAGE GROWTH SHOWS LITTLE SIGN OF EASING YET. This chart shows the Atlanta Fed measure of wage growth from 1997 to 2022. This series declined from about 5% in the late 1990s to a low of 1.7% in 2010. Since 2010, the series has been rising slowly, and then surged more recently, from 3.5% in 2021 to 6.3% at the end of 2022.


VALUATIONS: Negative earnings growth in 2023  

  • Corporate profits continued to grow in 2022, but the pace of growth decelerated throughout the year alongside slowing economic momentum and a rising probability of recession. Resilient labour markets and consumers with improved balance sheets kept demand strong even as businesses raised prices to offset higher costs.
  • Looking ahead to 2023, corporate earnings growth is expected to deteriorate further and actually contract, consistent with a recession and therefore worsening top-line sales. However, given we do not expect a deep, extended recession, the contraction in earnings is likely to be fairly moderate, with an improvement in the latter part of the year as inflation pressures ultimately ease. The net result will be negative profit growth for 2023.
  • Profit margins peaked in early 2022 and we expect margin contraction in 2023 particularly in the first half of the year. Margins will be negatively impacted by negative operating leverage. As inflation decelerates and demand slows, companies cannot lower costs as quickly as they are forced to lower prices. While this will continue to weigh on margins, there will be some offsets as labour markets loosen, and supply chains slowly improve.
  • In the US, we expect annual earnings per share (EPS) to post -6% contraction for the S&P 500 in 2023. Canada is less exposed to volatility in technology earnings. However, demand for oil is likely to wane with deteriorating economic activity and given the significance of oil prices on the S&P/TSX Composite (TSX), we expect a contraction in EPS of -6%. Our forecasts for the US, at $205 per share for 2023, and for Canada, at $1,400 per share in 2023, are slightly behind the consensus forecasts of US$230 and CA$1,595, respectively.
CHART 12: EARNINGS GROWTH TO CONTRACT. This chart shows trailing earnings growth year over year for both the S&P 500 and the S&P/TSX Composite from 2013 to the end of 2022. Earnings growth for both indices dipped negative in 2020, and rebounded sharply in 2021. Since 2021, earnings growth has decelerated but remained positive.

VALUATIONS: Multiples to face pressure

  • Valuation multiples contracted significantly in 2022 driven by tightening financial conditions (rising interest rates), high inflation, slowing economic growth, and geopolitical shocks. We believe the equity risk premium remains too low given the economic uncertainty. As a result, price-to-earnings ratios (P/Es) are likely to face pressure in 2023, particularly in the US, where the P/E remains higher than its historical average. However, the main drivers weighing on multiples in 2022 should begin to reverse in the latter part of 2023 (inflation decelerates and monetary policymakers dial down aggressive rhetoric), which should provide some stability for P/Es. Canada has experienced a more significant multiple contraction in 2022 relative to the US, and we expect more pronounced normalization later in the year, leading multiples to expand, though end the year below the long term average. Outside of Canada, our expectation is that P/Es will be unchanged to slightly lower at year-end, although the path will not be a straight line.
  • Our year-end index estimate for the S&P 500 is 4150, which is based on improved earnings expectations in 2024 following a difficult 2023, and a relatively unchanged forward P/E multiple compared to the current level. For the TSX, we expect a higher P/E multiple from 2022 year-end levels, resulting in a year-end index level of approximately 21,850. Our price targets imply a positive return in the US and in Canada from year-end levels, with Canada outperforming.
  • Global equity market valuations have contracted. Europe, Australasia and Far East (EAFE) and emerging markets P/E multiples are now below historical averages. The energy supply issue in Europe fueling ever higher inflation has prompted the European Central Bank to proceed with interest rate increases and restrictive policy. Emerging markets have been weighed down by China’s stringent zero-COVID policy. A reopening could provide a boost to its economy. Additionally, Chinese policymakers have announced targeted stimulus measures. With a backdrop of a peaking US dollar and the positive impact of China reopening, we have a positive outlook for emerging markets in the second half of 2023.
CHART 13: MULTIPLES LIKELY TO FACE PRESSURE. This chart shows trailing price to earnings multiples for both the S&P 500 and the S&P/TSX Composite indices from 2000 to 2022. Price to earnings multiples have contracted for both indices in 2022 from the high levels reached in 2021.

VALUATIONS: Bonds are more fairly valued

  • Since the GFC, ultra-accommodative monetary policy suppressed yields, causing bonds to be expensive for more than a decade. This ended in 2022. Excessive monetary and fiscal stimulus in response to the COVID-19 pandemic in 2020 combined to fuel the highest inflation rates in decades. This eventually drove monetary policymakers to tighten policy aggressively (in both pace and magnitude) through 2022, causing a significant shift higher in bond yields. The move was so dramatic that by the start of 2023, the total amount of outstanding negative-yielding debt— which peaked at US$18.4 trillion in 2020— had been eliminated. Relative to the low yields that characterized the post-GFC backdrop, bonds now offer a positive real return (as inflation recedes) on a safe investment that competes with riskier assets. In short, bonds are no longer expensive relative to the last 10 years. Upwards momentum in bond yields is likely to persist until policymakers determine their terminal rates. However, the mild recession we expect in 2023 should provide offsetting downward pressure on bond yields, particularly at the shorter end of the curve.
  • The Canadian 10-year bond yield rose 1.85% in 2022 to close the year at 3.33%. While we believe secular forces are likely to keep bond yields structurally higher relative to recent history, an economic downturn and deceleration in inflation in 2023 suggests some downward pressure from current levels over the next 12 months. Higher interest rate structures overall may trigger inflows as investors seek safe and attractive income streams. There are technical factors to consider as well that run counter to lower rates. Central banks have now transitioned to quantitative tightening (QT), a contractionary policy that reduces the assets on a central bank’s balance sheet (in this case by allowing bonds to mature, rather than actively selling them). QT has removed a large buyer of bonds from the market, thereby reducing demand for bonds. This will continue into 2023.
  • The FTSE Canada Universe Bond Index declined 11.69% in 2022, posting the worst annual loss since 1980, and the first time the Index has ever delivered negative returns for two consecutive years. Following a very difficult year, we have an improved outlook for bonds in 2023. Our expectation for some downward pressure in government bond yields, offset by a widening in corporate spreads as a recession triggers a default cycle, suggests slightly lower yields for 2023. We expect the FTSE Canada Universe Bond Index will return +2 to +5% in 2023.
CHART 14: FOLLOWING THE SPIKE IN YIELDS, BONDS APPEAR ATTRACTIVE. This chart shows the Canadian 10-year government bond yield from 2010 to 2022. The yield is been in a downward channel from 3.5% in 2010 to a low of 0.44% in 2020. Since the low in 2020, the yield has spiked to 3.3% at the end of 2022.

Portfolio Strategy and Structure

Many of the drivers that led to negative returns across stocks and bonds in 2022, including high inflation, tight financial conditions, and slowing economic activity, remain in place at the start of 2023. The macro backdrop calls for further economic slowing, alongside additional rate hikes and continued withdrawal of liquidity. However, with inflation showing signs of peaking, and the Fed and BoC in the later stages of their rate hiking cycles, we do not expect a repeat of the dismal returns from last year. Equity and bond markets alike were rattled in 2022 in response to the historic interest rate shock from aggressive monetary policy. While central banks may raise interest rates further, the magnitude and urgency will not be nearly as extreme.

However, one market driver that is expected to worsen through the year is economic activity, as we expect a recession to take hold mid-2023. In a mild recession scenario (our base case), we would expect a downturn to be shorter than recent contractions, as healthy consumer balance sheets and strong job markets provide a cushion. However, we expect equity markets to face downward pressure, largely in the first half of the year as most central banks will maintain their restrictive policies despite a slowing economy. This should be followed by a recovery later in the year as the conditions for a stabilization in the economy take hold.

We assess that equity market valuations broadly will remain under modest downward pressure as interest rates and inflation remain elevated and that the conditions for an equity market bottom have not yet been met. Equity markets are not reflecting the decline in earnings that is typically associated with a recession. However, the latter part of the year should favour equities, as pronounced economic weakness and the resulting lower inflation should lead to some anticipation of central bank rate cuts and importantly the early stages of an economic recovery. Regionally, we expect developed and emerging markets to perform similarly heading into this recession, as China’s relatively rapid reopening presents some upside risk. We would expect emerging markets to outperform during the recovery, with China’s reopening adding positive momentum, as well as a US dollar that may ease somewhat as the Fed slows rate hikes.

Small capitalization stocks tend to have higher earnings risk going into a recession and are more cyclical in nature relative to large cap stocks, although entering the year, they reflect more attractive valuations. Large cap stocks generally have more stable earnings profiles relative to small caps, however they are also fairly concentrated in the technology sector in the US, where the impact from high interest rates is being felt the most, and valuations are likely to derate further. As a result, small caps appear more attractive, as their valuations already reflect a higher probability of an economic recession relative to large caps.

Canadian equities should continue to benefit from the TSX’s composition, with a relatively high weighting to energy and materials stocks that perform well in inflationary environments (although to a lesser extent compared to 2022) as well as less exposure to the tech sector, compared to the US. Additionally, Canada began its rate hiking cycle earlier than its developed economy peers, and now looks to be positioned to move away from interest rate increases sooner. Although not enough to overcome a global recession, we expect these factors to lead to outperformance for the TSX relative to the S&P 500. Outside of Canada and the US, developed market equities will also be challenged in the near term as we head into recession in a number of advanced economies.

Bond market valuations appear considerably more favourable today relative to the beginning of 2022 following the spike in interest rates. Although the path to these levels of interest rates was difficult, fixed income markets now yield a return not seen since the 2000s. Further upward pressure on bond yields should be limited and yields are likely to ease in a recession. Asset mix within balanced portfolios will continue to underweight equities relative to benchmark targets and to a lesser extent this is the case for bonds as well. This will persist until the economic backdrop deteriorates and markets more fully reflect that reality.

Asset Class Returns

  • Our base case is for the 10-year Government of Canada bond yield to ease moderately over the year, although we expect a range between 2.6% to 3.5%. Secular factors and conservative central bank reactions (not wanting to ease too quickly for fear of resurgent inflation) are catalysts for higher bond yields. However, we expect the cyclical factors to dominate in a slowing growth environment, causing government yields to ease, and credit spreads to widen, from current levels. As such, we expect total returns for the FTSE Canada Universe Bond Index to range between +2% and +5%, compared to the running yield of 4.25%.
  • Despite the worsening economic outlook, we expect positive equity market returns for 2023, although our outlook is not optimistic in the near-term. Top line corporate revenues should decline and margins are likely to contract further. We forecast a return of 8% for the S&P 500 and a higher return of 13% for the TSX relative to year-end 2022 levels. EM equities, particularly in China, have some positive tailwinds and small cap stocks have priced in a higher probability of a recession and appear attractive from a relative value perspective.
  • The asset mix in balanced portfolios currently favours cash, helped by its more attractive yield than we have seen for some time. Both equities and bonds are underweight relative to benchmark target levels (although the underweight in bonds has been reduced and is smaller than equities). Within equities, we have a preference for Canadian equities relative to global equities.
CHART 15: HEADWINDS REMAIN FOR EQUITY MARKETS. This chart shows total return series for the S&P/TSX Composite index, the S&P 500 index, the FTSE Universe Bond Index, and the MSCI Emerging Markets index, from the end of 2021 to the end of 2022 (and rebased at 0% at the end of 2021). This chart shows that each of the indices declined in 2022, and performance over the period from best to worst is as follows: S&P/TSX Composite index, FTSE Universe Bond Index , S&P 500 index, MSCI Emerging Markets index.

Stock and Sector Selection

  • We have a cautious outlook for equity markets in the near-term, in light of our view of slowing economic growth over the coming months. The lagged response to central bank tightening, declining leading indicators combined with lower inflation all point to a worsening in top line sales. Company surveys show declining new orders and rising inventory levels. Expectations for corporate earnings are growing more pessimistic.
  • Market valuations, while not overly stretched due to the contraction experienced last year, still appear to have more room to decline. This is particularly true in the US, where current P/E ratios remain above their historical averages, but also in Canada in the near-term. Combined with a contraction in earnings, the outlook for risk assets across developed markets over the first half of the year remains negative and the risk-reward on equities is skewed to the downside.
  • As a result, within equity portfolios we favour companies that can deliver resilient earnings growth in a moderating inflation and low-growth environment. These companies are characterized by strong balance sheets, higher liquidity and stable earnings and margins, and are typically more defensive. As the period of adjustment persists, we are increasingly looking to add companies that are more cyclical in nature, where valuations have become favourable and in particular those companies who will benefit from a strong global capex cycle and the global recovery later in the year.
CHART 16: HISTORICAL US EQUITY MARKET AND EPS DECLINES. This chart shows index declines in the S&P 500 relative to earnings declines, from 1996 to the end of 2022. Recession periods are shaded, and the chart shows that index and earnings declines are quite significant through a recession. The more recent index decline has been substantial at about 20%, but is less than the declines of prior recessions. The earnings decline at the end of 2022, at -3.7%, is significantly less than the earnings declines in prior recessions.

Corporate Credit

  • It has been a difficult year for corporate credit mostly due to the large move in interest rates, though spreads have also widened. Credit spreads represent a pickup of about 180 basis points above sovereign bonds. While this is above the long-term average spread, it is still some distance below the highs experienced during the 2015 recession and tighter than experienced in a typical recession. Credit spreads overall have outperformed other risk assets, and could continue to see some further widening as corporate earnings deteriorate.
  • The environment of higher policy rates, a global recession and importantly the withdrawal of liquidity is expected to weigh on corporate credit. QT policies will extend through much of the year, with many central banks in the process of reducing the size of their balance sheets. The BoC’s purchases did not directly support corporate and provincial credit in a material way (although its signal of standing ready to support the market was beneficial to spreads). Nonetheless, the buying of Canada bonds pushed investors up the risk curve in order to achieve even a modicum of yield. It is notable, though, that all-in yields in investment-grade bonds represent an appealing return, with valuations looking favourable. Nonetheless, an outlook for any material spread narrowing is not currently within our forecast horizon.
  • As a result, fixed income portfolios are positioned to start the year underweight both corporate and provincial credit relative to their benchmarks. In the near-term we look for opportunities for bonds to outperform within some of the more defensive sectors. However, given the overall risk-reward prospect of a further widening of spreads offsetting additional yield, we will calibrate portfolios to take advantage of spread tightening later this year once markets more fully adjust to the recession environment.
CHART 17: CORPORATE SPREADS HAVE ROOM TO WIDEN. This chart shows Canadian investment grade corporate spreads over a period from 2004-2022, starting at 70 basis points in 2004, spiking to 400 basis points in 2009, and ranging between 120 to 260 basis from 2010 to 2022. Corporate spreads have widened in 2022, from 142 basis points to end the year at 185 basis points, but are not yet near some of the wider levels.

Duration and Yield Curve

  • Globally, nominal bond yields have risen aggressively, as central banks ended their ultra-accommodative policies. Looking ahead, markets have priced in further rate hikes for the Fed and BoC, with an eventual pause by Q2 of this year. By that time, it is expected that despite the lags in policy, economic growth and inflationary pressures will have slowed materially. Markets will then expect central banks to be biased towards easing policy to manage the pending slowdown. Bond yields typically peak around this time (shortly before rate hikes come to an end). However, we anticipate the path to rate cuts will be bumpier than markets currently expect, keeping volatility in rates markets high for the year.
  • As a result of higher central bank policy rates pushing up short-term yields combined with the expectation of a recession pulling down long-term yields, the yield curve has inverted to its most negative point since the early 1990s (about -100 bps between Canadian two-year and 10-year yields). As the environment moves into recession, the yield curve will begin steepening again, and persist in that direction. However, the timing of recession may be later than market participants currently expect, given fourth quarter GDP in both US and Canada have been tracking much stronger than anticipated. Thus, we will look to add duration and enter into steepening yield curve positions but will be patient to assess the evolving situation.
CHART 18: AN EXTRAORDINARY INVERSION IN YIELD CURVE. This chart shows the Canadian yield curve, represented by the 10-year less the 2-year bond yield, from 2010 to 2022. During this period, the yield curve has fluctuated, but trended downward. In 2020, the line rose significantly, representing a sharp steepening in the yield curve. From 2021, the line declined, representing a flattening in the yield curve, and then in 2022, the line became deeply negative, representing an inversion of the yield curve.


Through the past year, financial markets have undergone a rapid series of changes in response to the surge in interest rates. Public market asset classes have adjusted to higher interest rates and the year saw a shift in many longstanding market trends. This is not over. The coming year is likely to see developed market economies fall into a synchronized recession. While we optimistically look at the unique aspects of this downturn to allow a mild recession, much depends on the path of inflation and there are clearly risks on both sides. Further out, secular themes support upside risks to inflation overall, and central banks will have a tougher job ahead, particularly as they fight to regain credibility. The combined slowdown in growth and inflation will present a challenge for company margins, pressuring earnings. This will be the main driver of markets over the coming year. Valuations have become more attractive but are likely to face downward pressure. While the outlook remains very tenuous, we continue to see positive prospects ahead, particularly in the ability for high quality companies with stable earnings to shine. We will adjust our thinking and our portfolio positioning through the year to capitalize on opportunities.