Introduction

“While wars divide, the world unites in easing policy” was the overarching investment theme in our 2024 Forecast, which guided our asset class forecasts and positioning. Disinflation was achieved more rapidly across numerous countries and occurred more easily than expected. Global supply shocks eased, and tighter financial conditions reduced inflation pressures uniformly across the world. Geopolitics and domestic politics were enduring and critical themes. Countries engaged in wars on multiple fronts, as the interconnected trade’s unipolarity and peace dividend fractured. Many governments faced immense pressure, with around 40% of the global population heading to the polls, and the outcome a widespread rejection of the status quo due to inflation concerns which pressured cost of living for the populace.

The second half of the year was dominated by the US Presidential election. We had correctly believed that US monetary and fiscal policy stimulus would persist in a resilient growth environment. That combination of stimulus led to an upside surprise to growth in the US, allowing it to outpace other countries. We were caught off guard by how incongruent the upside surprise to growth would allow for persistent disinflation throughout the year. We were, however, right on with regard to our call on Canadian consumers’ inability to stretch given their already high debt loads. We believed any downturn would be mitigated by savings, cash balances and accumulated wealth.

Financial markets experienced a number of jittery periods, such as when the Sahm Rule was triggered raising recession alarms, and later the Bank of Japan’s rate hike led to a significant unwinding of the yen carry trade. The Federal Reserve’s (Fed’s) September rate cut provided some relief, but the prospect of a trade war with Mexico, Canada and China in November caused an end-of-year retracement.

Our forecast saw balanced risks after the rise in equity market valuations in 2023. As it turned out, we were correct on the continued room for earnings growth, but there was also room for multiples to continue to expand. Our expectations were conservative and globally, equity markets posted strong advances. The Nasdaq led the charge with a 30% gain after the 43% surge in 2023. We expected the S&P 500 to end the year at about 4975, and instead the index gained 24% to reach a high of over 6000 before a modest cooling to end the year. The S&P 500 posted a similar gain in 2023, marking the first back-to-back gains in excess of 20% since 1997-98. Despite the continued tech-heavy leadership, the optimism of investors broadened out to encompass more sectors and regions. Ten of the 11 GICS sectors posted advances with only the materials sector ending 1.8% lower. The MSCI ACWI gained 26% led by US stocks but was bolstered by gains across nearly all regions. Japan’s Nikkei finally eclipsed its 1989 high, posting its second straight annual gain of 16%. In Canada, the S&P/TSX Composite also benefited from investor enthusiasm with an 18% jump to hit a high of 25,691, bettering our expectation for 22,000 at year end.

Strong returns across geographies
Total returns in local currency rebased at 01/01/2024 = 100
Source: TMX, S&P Global, MSCI, Macrobond

Rate cuts from central banks took longer to begin than many anticipated, leaving sovereign bond markets struggling to advance. However, even when central banks cut rates, longer-term yields did not fall. In Canada, 10-year yields finished the year 15 bps higher, even though the Bank of Canada (BoC) was among the most the aggressive in the world with easing policy, reducing rates 175 bps in 6 months to bring the overnight rate back into its neutral range. The US actually saw 10-year Treasury yields increase 60 bps as the Fed cut the overnight Fed Funds Rate by 100 bps. US long-term interest rates moved higher for a fourth straight year, the first time since 1977-81. As the year came to a close, two main features were the normalization of yield curves – which are now positively sloped after over two years of inversion – and the deep negative gap in Canada-US yields. Bond returns benefited from a decent yield this year, as well as strong credit markets that took spreads to their tightest levels since before the 2008-09 Great Financial Crisis (GFC). We were on the mark expecting modest returns of 3-6% this year for the FTSE Canada Universe Bond Index, which ultimately returned 4.23%. Our strategies had a good year, as each of the quantitative factors, yield curve and rates call, as well as security selection contributed to performance.

A normalization finally
Source: Macrobond

The asset allocation strategy for balanced portfolios considered the high valuations of US equities and an overall conservative call for equity markets which led us to underweight global equities against Canadian equities to start the year, although this gradually moved towards a more neutral stance. Our call to overweight cash and underweight bonds was appropriate given the persistent inverted yield curve. It took some time for us to gain confidence in the easing trajectory as central banks defied expectations of accommodation until mid-year. Balanced portfolios exceeded their benchmarks largely due to security selection across each of the asset classes as asset mix positioning was broadly neutral.

In summary, the year will likely be remembered for the political circumstances and beneficial macro backdrop of easy policy in a resilient economy. Those conditions laid the foundation for the very strong returns from equities and positive returns from bonds, capped off by strong risk-on investor sentiment that saw gains broaden out over geographies and asset classes which all rewarded investors.

The secular environment

The era of secular stagnation is behind us and for several years now, our secular themes recognized the shift away from a broad disinflation environment to one where inflation is once again a key risk. This past year, electorates voted out incumbent governments, dissatisfied with inflation and immigration. Policymakers face a material challenge in answering those calls for action. Our first secular theme recognizes the potential that inflation is not only cyclical in nature, responding to an immediate imbalance between supply and demand, but could also return in force as a result of determined policy actions.

As we enter into 2025, we revisit our secular themes while assessing the cyclical influences in the foreground. As we have for the past five years, we believe there continue to be upside secular pressures to inflation, and now note the potential for a cyclical upside to inflation as well. These include the potential for tariffs (and retaliatory action), and the expected reduction in overall in migration. After three years, avoiding a recession has now become consensus. A lot of good news is priced into markets. We also note that it is often the normalization of yield curves that actually portends a recession, as short rates drop to stimulate the economy.

1. Inflation resurgence is an underappreciated risk to valuations

• The high inflation of the 2021-22 period has been tamed with remarkable success. Historically, whenever inflation hits 5%, it has typically taken more than a year, along with a recession, to bring it to heel. We now have inflation around central bank targets, without having experienced a material downturn. This is partly due to positive offsets from fiscal policy, the offsetting benefits of higher interest rates to savers, and the positive wealth effects to owners of real estate and stock portfolios. Indeed, across dozens of countries and cycles over the past century, a second wave of high inflation is the norm. Intuitively, this is because workers or businesses that operate on fixed contracts attempt to catch up with new higher priced contracts well after the first wave of inflation has passed. This disinflationary cycle is not over, and, in the US in particular, the main policies for the incoming administration will ultimately prove inflationary. The pressures could come from several potential sources: increased demand driven by lower taxes, continued infrastructure investments, lower supply resulting from the imposition of large tariffs on incoming goods or large-scale deportations of workers.
• The path of inflation has similarities to the mid 1960-80 period when a second inflation surge hit the US economy as the economy was recovering from the 1973 oil shock. Indeed, following any major global shock such as pandemic or war, the extended periods of rebuilding have led to volatile periods of inflation. Central banks recognize these risks. For the past five years, markets have been underestimating the Fed’s hawkishness, pricing in rate cuts early and recalling the recent zero interest rate periods. Notably, in the December 2024 Summary of Economic Projections, the long-term dots for the Fed Funds target rate actually went up for the first time in over a year.

Inflation path has similarities to history
Source: BLS, Macrobond

2. Interest rate volatility rises between push of fiscal dominance and pull of bond vigilantes 

• Governments have embraced fiscal spending as a powerful approach to managing crises and gaining favour with the electorate. Federal debt levels have surged in recent years at a faster pace than economic output, thereby sharply increasing the basic metric of a country’s fiscal health: debt-to-GDP. In the US, the debt-to-GDP ratio has soared from about 33% during the GFC in 2008-09 to about 100% today and the Congressional Budget Office (CBO) forecasts that will grow to 160% in 2050.

US debt projected to grow
Source: CBO, Macrobond

• While debt at 160% of GDP sounds unsustainable, there is no clear level at which investors balk. Indeed, Japan’s debt-to-GDP currently at 157% is not far off that level. Nonetheless, there have been plenty of examples in recent years of growing concerns amongst investors globally. The September 2022 UK budget under Liz Truss triggered bond market upheaval and the 2024 budget under Reeves was also declared overly inflationary. French spreads have also widened over other EU countries as debt levels have risen to 110% of GDP, and its debt was downgraded in mid-December. The bottom line is that bond issuance is likely to grow to meet the deficits, and investors will demand a rise in term premiums.
• This creates a vicious circle that will see debt service costs overtake all aspects of discretionary spending in the US federal budget (i.e. excluding the 2/3 of the budget that is Medicare and social security). In order to meet the cost of servicing all that debt, the Fed may face pressure to limit rate hikes and fund deficits through bond purchases, subjugating monetary policy to fiscal dominance. The ultimate outcome is higher interest rates but equally important, increased volatility in rates that will force a rethink on the valuation of risk assets.

3. Artificial intelligence (AI) and the capital investment cycle

• AI burst into the public consciousness in 2023 and expectations for its impact on the world were high. These expectations haven’t waned and according to Morgan Stanley, to capture the AI benefits, businesses are projected to invest $1.5T between 2024-27 as they look for ways to integrate AI into operations in the hope of productivity surges and improvements in margins. We are reminded that new technologies often take longer than expected to bear fruit; a study conducted by the Census Bureau last year found that only about 5% of American businesses said they are using AI. However, improvements can come with stepwise breakthroughs and investments will persist as firms search for AI-driven productivity enhancements.
• The focus on AI has already been a major feature of the resurgence of private sector business investment. Kick-started by fiscal stimulus to support private sector investment through infrastructure (Infrastructure Investment and Jobs Act), clean energy (Inflation Reduction Act) and domestic high-tech manufacturing (CHIPS and Science Act), an outcome of the AI arms race is the disruption that is underway in the industries required to support its development. Specifically, data centre construction, development and manufacturing of computer chips, cooling systems and servers as well as electricity production and distribution. AI has compounded the need for both augmenting and creating resilience in electricity generation on top of the already surging growth emanating from decarbonization initiatives and electric powered vehicles. The International Energy Agency estimates global investment in grid infrastructure was $400B in 2024, up 1/3 from 2020, and will rise to $600B annually by 2030.

Grid investment expected to surge
Source: IEA

The cyclical environment

World: The big adjustments to come

• Elections across countries covering half the population of the world last year broadly yielded changeovers in government. Incumbents were defeated and new policies are set to begin. Against this backdrop, positive and in some cases resilient growth, easing monetary policy, profligate fiscal policy and easing inflation pressures are creating the conditions of a ‘goldilocks’ scenario. Disinflation has come more quickly, across more countries, and has been achieved more easily than expected. Global supply shocks have eased and, combined with tighter financial conditions, have reduced inflation pressures across the world. While services inflation is broadly higher, goods prices have done a lot of the work. The International Monetary Fund (IMF) projects the world economy to grow at a 3.2% pace in 2025, just mildly slower than the long-term average.
• Looking ahead, two main challenges remain. First, as the world faced down the pandemic, rebounded from deep recessions and successfully tamed inflation, many Western economies now face the challenge of having to remedy the massive fiscal deficits brought on to deal with those challenges. The choices will be some combination of revenue growth, cutting spending or finding a way to produce non-inflationary growth. At the same time, governments are also under pressure to raise defense budgets, lower taxes or increase spending on aging populations. Large budget deficits, and the cost of servicing that debt, could restrain growth across the globe.
• Secondly, one of the most consequential shifts in global markets over the next year and next cycle will be assessing where neutral rates are, which may, in turn, lead to a broad repricing higher in long-term interest rates. For nearly 15 years, most investors and central banks have held neutral policy rates in the US at around 2.25-3.25%, but given increasing evidence of the resilience to higher rates, neutral may in fact be above 4%. With the rise in population, productivity and business investment in the US, the post-pandemic level of neutral could be markedly different than pre-pandemic.

Canada: Political winds of change – it’s our turn

• The Canadian economy has exceeded expectations, avoiding a recession in 2024. However, Canada faces a number of well understood issues, from the lack of political leadership and high debt levels, to trade uncertainty. Most recently, the high-profile resignation of Finance Minister Freeland last December followed by Prime Minister Trudeau in early January have taken centre stage. While the headlines in the first quarter will be filled with the leadership race of the Liberal party, the markets will rightly assume the main opposition, the Conservative Party led by Pierre Poilievre, will form the next government, given the massive 20-point plus lead in the polls.
• On some policies, a Poilievre government would simply continue with the status quo. An example is the recent proposal to limit immigration from 2025-27 and to reduce temporary residents to 5% of the population. Population growth gave a big assist to the Canadian economy in helping to avert a recession in the last two years. Looking forward, the capping of in migration will reduce labour supply, and businesses may adapt by taking advantage of the lower interest rates to increase spending on productivity-enhancing business investment.
• Trade uncertainty was already on the docket, as the sunset clause on the CUSMA free trade agreement was set for 2026. The new US Administration has already threatened new and expansive tariffs on its three major trading partners including Canada, looking to apply pressure on a number of unrelated fronts such as border crossings. It remains to be seen how much is bluster and negotiating, but we can be certain that levying tariffs would be detrimental to growth and raise US inflation.
• Finally, consumer balance sheets look markedly different depending on which side of the border you reside and these differences will result in further policy rate divergence between the BoC and Fed. The BoC has now lowered rates to a neutral range, but we believe it will push ahead with two more cuts in the first half of the year. Any external shocks will force the BoC to ease policy to an accommodative stance. Canada was early and aggressive in cutting rates. Already, the highest interest rate sensitive sectors, such as housing, have begun to see interest rekindled, with pent-up demand, tight housing supply and better affordability bringing buyers back into the market.

Policy is now at top end of neutral range
Source: BoC, Macrobond

US: An outperforming economy faces the test of new policy directions

• The US continues to lead the developed world in economic momentum. This exceptionalism is now well understood. The economy absorbed the 2021-22 rate hikes and kept on growing. It is now the only major economy where output is above pre-pandemic trend levels. The picture continues to remain bright with inflation returning to the 2% target and the unemployment rate stable around 4%.
• The next four years will be dominated by the incoming administration’s policies and reactions from the rest of the world. The incoming cabinet looks different than in the first Trump term, with fewer foreign policy hawks and more pro-US business members. Nonetheless, the policy agenda is relatively clear, if light on details. Two policies are aimed at boosting growth: extending earlier temporary tax cuts (in an environment of already large Federal deficits) and deregulating the energy, finance and technology industries. Two other important policies centre on “America First.” The first is to dismantle global trade by imposing tariffs and promoting foreign investment in domestic manufacturing to bring jobs to the US. The second is to deport illegal immigrants, reducing the supply of labour.
• Interestingly, while the tax cuts and tariffs garner the most attention, it may be deregulation and deportations that are ultimately more impactful. Many migrants have been working in labour-intensive industries that could face upward wage pressure. This will be passed through to consumers in necessities such as food and housing costs. The Peterson Institute’s research suggests that deportations will lower US GDP by between 0.5% to nearly 2% each year for the next four years. Indeed, with the US labour market tighter now than during the first year of the first Trump presidency (unemployment rate of 4.2% vs 4.7% in January 2017), reducing labour supply will cause upside pressure on wages. Meanwhile, deregulation and the associated substantial cuts to the public sector through the new Department of Government Efficiency, has generated some optimism over a streamlining of the entire government apparatus. US small business confidence has soared.
• As a result, the Fed has reduced its guidance for 2025 rate cuts. We believe this flatter path of rate reduction will not significantly hurt growth prospects as the current consumer spending strength is not arising out of credit expansion, but instead, strong household net worth growth. Indeed, we believe a key risk to growth is asset price volatility that could have the effect of dampening consumer spending.

US net worth in rising trend
Source: Fed, Macrobond

Europe: Not all bad news

• Political and fiscal challenges within Europe’s largest economies compound geopolitical frictions. The German government led by Olaf Scholz and Emmanuel Macron’s government in France both fell in 2024. Sovereign bond spreads in France have risen and the euro has declined over 5% against the USD, appearing to be on the way to USD-parity. Real GDP will be challenged to rise, given the structural headwinds from trade policy. That includes US tariffs, competition from China in many areas (including autos, where Europe has historically played a leadership role), as well as a weak Japanese yen.
• There is reason for optimism elsewhere in the eurozone. First, fiscal consolidation has been widely expected, with the most recent plan to return to neutral fiscal stance this year. However, given the problems in recent months, talk of fiscal restraint by reintroducing the EU fiscal framework that limits debt and deficits as a percent of GDP has now died down. Thus, concerns over a fiscal drag are easing. This is particularly true in Germany as even Bundesbank head Joachim Nagel said in early December that they need to loosen the “debt brake” that limits borrowing to 0.35 percent of GDP, in order to address structural threats. He has suggested measures such as boosting infrastructure and defense spending. This will support growth in the coming year.
• Separately, inflation is slowing, which will help real incomes as wages remain decent, and allow the European Central Bank to continue gradually providing stimulus. Finally, solid growth is being recorded in other European countries, notably Spain and Italy. In a turn of stability, Italy will be the only G7 country with no change in leadership these two years.

Euro area wages have not eased
Source: ECB, Macrobond

China: No preemptive fiscal plans, readying for negotiations on global trade

• Much in China has changed in the eight years since the beginning of the first Trump presidency. Notably, the real estate crash has resulted in a severe balance sheet recession that persists today. The government has taken a hands-off approach and not stepped in with fiscal stimulus or rescue packages. As a result, interest rates have dropped materially, hitting 1.6% and falling below Japanese yields. Elsewhere, however, economic data has surprised to the upside. Export growth remains strong, with manufacturing PMIs now back in expansionary territory at the end of 2024. Some of this is likely front-loading and inventory building with tariffs on the horizon. Nonetheless, it is worth noting that since 2017, Chinese exports to the US dropped from roughly one fifth of overall exports to just 15%, and trade partnerships have instead expanded in LatAm and ASEAN.
• Fiscal spending, whenever the government chooses to deploy it, should lead to improved growth prospects. For instance, a surprise People’s Bank of China policy package in September last year included CNY800B of liquidity support for the stock market. It produced a short-term reaction with the CSI surging 30% in a few days, but has since eased back. Into this year, the Chinese government is unlikely to engage in significant preemptive large fiscal support for consumers in the same way, instead reserving firepower for upcoming negotiations through the second Trump presidency.

Bond yields in China fall below Japan
Source: JBT, Macrobond

Valuation

VALUATIONS: Earnings growth will be vital in 2025 

• The growth of corporate profits in Canada was modestly positive in 2024, impacted by higher interest rates, lower energy prices, sluggish productivity and a weakening economy, all of which combined to exert pressure on earnings growth. Conversely, US corporate profits exhibited strong, high single-digit growth, driven by robust consumer activity, a stable labour market and a resilient non-manufacturing sector, underscoring US exceptionalism.
• For 2025, we anticipate continued growth in company earnings within the US, alongside an acceleration in Canada. Less restrictive monetary policy is expected to ease financial conditions, supporting GDP and earnings. We foresee earnings growth extending to more sectors, fostering a more stable environment in both the US and Canada. In Canada, the high consumer savings rate and lower interest rates should support spending. Furthermore, a federal election could stimulate economic activity under new leadership. However, the risk of tariffs persists, and the extent of their impact remains uncertain.
• Corporate profit margins in 2024 remained steady in Canada and expanded moderately in the US. In 2025, we anticipate margin growth in both countries due to gradually declining labour and other input costs, diminishing regulatory and interest expenses and broadening revenue growth across a wider range of sectors compared to 2024.
• In the US, we see a 12% rise in earnings per share (EPS) for the S&P 500 this year. With broader stability expected across sectors in the Canadian economy, we expect 8% earnings growth for the S&P/TSX Composite. Our 2025 EPS forecasts are $268 per share for the US – modestly ahead of consensus forecasts of $263 – and $1,540 per share for Canada – modestly behind consensus forecasts of $1,600.
• Global earnings growth for the MSCI ACWI is projected to be slightly lower compared to Canada and the US. The highest earnings growth globally is anticipated to come from the US and emerging markets. However, with muted growth in China and persistent challenges in Europe, these regions are expected to weigh on the overall rate of global earnings growth.

Earnings growth to rise further
Trailing earnings growth
Source: I/B/E/S, Bloomberg, Macrobond

VALUATIONS: Multiples to remain stable

• In 2024, valuation multiples saw steady expansion through the year, reaching exceptionally high levels in the US and multi-year highs in Canada. The combination of resilient economic activity and decelerating inflation supported the “soft landing” narrative, which was conducive to multiple expansion. Additionally, the US presidential election contributed to the positive market sentiment that drove this expansion.
• In 2025, price-to-earnings ratios (P/Es) in Canada and the US are likely to remain broadly unchanged at about 17.3x and 24.4x, respectively, on a trailing basis. Valuation multiples are currently higher than average, especially in the US. Although less restrictive monetary policy and positive economic activity support multiple expansion, these factors are largely accounted for in current levels, suggesting limited potential for further upside from here. Our year-end index estimates are 6,545 for the S&P 500 and 26,700 for the S&P/TSX Composite, driven by earnings growth. These forecasts are modestly lower than the market’s current projections and imply a low double-digit return in the US, and a high single-digit return in Canada from year-end 2024 levels.
• Global equity market valuations have expanded, though to a lesser extent. P/E multiples in regions outside of the US, such as EAFE and EM, have risen but remain below or near historical averages. Multiple expansion is expected to be limited in these regions in 2025, although accommodative monetary policy and stimulus measures in China suggest more capacity for expansion relative to North American markets. Mid-to-high single-digit returns are anticipated for global equities, with expectations that EM equities will outperform other global regions, although Europe may see a rebound in the second half of 2025.

Valuation multiples show little room for expansion
Source: I/B/E/S, Bloomberg, Macrobond

VALUATIONS: Bonds subject to macro volatility

• Bonds performed well in 2024 during the easing cycle. Looking forward, ongoing macro uncertainty is likely to keep policy rates fairly stable, as the Fed and the BoC adopt a more gradual approach to monetary easing. The Fed in particular, will need to proceed cautiously. Although interest rate cuts are still projected, monetary policymakers appear to be nearing the conclusion of their easing cycles, barring a further slowdown. During this transitional phase for policy, market narratives are expected to fluctuate, and bond yields are likely to trade with some volatility but within a contained range. Outside of this range, bond yields either stimulate the economy or become restrictive enough to cause a pullback. If rates remain in this current range, the “soft landing” narrative should prevail.
• In 2024, the yield on Canadian 10-year bonds increased by 0.11% to reach 3.24%. This modest rise conceals significant intra-year volatility, during which the 10-year yield hit a low of 2.89% and a high of 3.47%. We anticipate that yields will continue to trade within this broad range, provided that economic growth remains positive and inflation is well-managed. In our assessment, bond yields are likely to break higher in the event of a sustained resurgence in inflation or lower in the case of a pronounced recession – scenarios which we do not consider highly probable at this time. As a result, for 2025, we expect the 10-year Government of Canada bond yield to trade in the 2.9% to 3.5% range, with the yield at the start of the year near the middle of this range.
• We have a positive outlook for bonds in 2025, expecting yields to remain range-bound across the curve. Credit spreads have narrowed significantly, and credit markets are expensive compared to historical levels. The current macroeconomic environment supports credit fundamentals, and tight valuations may persist in this context, although there is limited scope for further tightening. We expect a return of 2% to 5% for the FTSE Canada Universe Bond Index in 2025, compared to the current running yield of 3.58%.

10Y Yield near middle of recent range
Source: Macrobond

Portfolio strategy and structure

Equity markets experienced another robust year in 2024, building upon the gains achieved in 2023. A lot of these gains were attributed to multiple expansion, with significant contributions from the Mag 7 stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla) for the second consecutive year. Notably, however, market breadth improved in 2024, with all but two sectors in Canada and all but one sector in the US posting positive returns for the year. It is noteworthy though, that in the US, the largest ten firms now account for 40% of the market capitalization of the S&P 500 index, the highest proportion since 1980. This represents a substantial increase in market concentration from less than 25% only five years ago.

Market sentiment indicators have surged in response to the outcome of the US election, combined with a resilient macroeconomic environment and monetary easing. Sentiment now reflects considerable optimism regarding the continued upward trajectory of stock markets. The momentum behind these movements has been strong, and the fundamental landscape supports ongoing equity market strength.

However, we recognize that stock markets are now at all-time highs, and the overwhelmingly bullish sentiment leaves little room for negative surprises, indicating an increasing probability of a near-term correction; we view the Fed as a potential catalyst for this correction. Considering the robust performance of the US economy, the diminishing disinflationary pressures in recent months and financial conditions suggesting that monetary policy is already accommodative, the Fed may choose to slow or halt its easing. Nevertheless, the Fed must navigate carefully; a sudden shift to a more hawkish stance could significantly dampen consumer and business sentiment, as well as asset valuations. Conversely, further accommodation may risk a resurgence in inflation. Either scenario would likely result in a surge in longer-term bond yields, adversely affecting the valuations of risk assets. Even so, given the ongoing strong economic backdrop, a short-term correction should offer a favourable buying opportunity, as we expect positive – though more volatile – equity market returns in 2025.

Regionally, we forecast positive equity returns in both developed and emerging markets, with emerging markets expected to perform similarly to the US. Economic activity in China remains subdued; however, government policy in the region is aimed at stabilizing economic growth and addressing the oversupplied property market. It remains to be seen whether these measures will be effective. A mitigating factor to the slower economic growth is more attractive valuations, offering greater potential for multiple expansion relative to developed market equities. Canadian equities are poised to benefit from a recovery in earnings growth following a subdued year, with some potential for multiple expansion.

Smaller capitalization stocks posted a positive return in 2024 but lagged their large capitalization counterparts. Small-cap stocks tend to outperform in an early-cycle environment, and usually lag in a late-cycle environment, driven by a flight to liquidity. We also recognize that small-cap stocks demonstrate higher volatility compared to large-cap stocks. As we enter 2025, we hold a cautious outlook for small-cap stocks, as we are in a more late-cycle environment and expect greater volatility. Investor expectations are high at the start of the year. With consensus opinion that we have avoided a recession, the consensus outlook calls for strong earnings growth, stable inflation and more accommodative monetary policy. Any developments that counter these predictions should lead to an increase in volatility.

Bond market valuations in Canada began 2025 neutral and range-bound, indicating neither overbought nor oversold conditions. However, with most of the monetary easing already implemented, there is limited potential for bond yields to decline meaningfully outside of a recession scenario. Consequently, bonds appear less attractive in 2025 compared to 2024.

Asset allocation

• Despite positive return expectations for both bonds and stocks, we begin the year with portfolio asset allocation at benchmark weights (a neutral position). We recently covered an underweight position in fixed income, removing an overweight position in cash. Bond yields backed up in December to a level at which we want to be neutral in our fixed income exposure. We remain mindful of expensive equity market valuations, and look for a more attractive opportunity to increase equities.

Stock and sector selection

• As the risk of recession has declined, we have added high-quality cyclical stocks that will benefit from a broadening of growth across the economy. We have also reduced lower-growth and interest rate-sensitive companies on the expectation we will see volatility of bond yields.
• We also added significant exposure to companies capable of delivering above-average earnings growth regardless of economic conditions. The portfolio is now more balanced between quality cyclicals and these resilient growth companies, offering potential upside should our view of stronger growth come to pass. We have also added exposure to utility and industrial companies. Each of these is expected to benefit from AI-related capital expenditures.

Corporate credit

• Corporate spreads tightened to multi-year lows (to the tightest levels in decades in the US). Resilient growth, decelerating inflation and reduced policy rates, along with strong corporate balance sheets and strong investor demand for attractive all-in yields, supported credit markets.
• Canadian corporate credit spreads are currently at their tightest level since early 2018. Typically, a recession triggers significant spread widening. However, given the lower probability of an imminent recession, credit markets should remain stable. In addition, current credit spreads suggest limited tolerance for negative surprises, with considerable potential for widening in the face of increased macroeconomic volatility. While we do not expect a substantial widening, further compression of spreads is unlikely, and the associated risks are asymmetrical.
• Fixed-income portfolios are currently modestly underweight corporate credit, and market weight provincial credit, relative to their benchmarks. In the near term, we expect outperformance from domestic banks, as lower interest rates start to stimulate loan growth and mortgage renewals are becoming more manageable with declining interest rates.

Credit valuations are expensive
Source: FTSE Global Debt Capital Markets Inc., Connor, Clark & Lunn Investment Management Ltd., ICE BofA Indices

Duration and yield curve

• We expect economic uncertainty to create opportunities as market participants adjust their narratives and reassess central bank expectations. Barring any external shocks, bond yields should stay within a volatile but contained range. We will manage duration opportunistically within this range. Entering 2025, bond yields are in the middle of the recent trading range, justifying a neutral exposure.
• Following over two years of inversion, the yield curve normalized in late 2024. In Canada, this normalization was primarily driven by a significant decline in short-term yields due to monetary easing from the BoC, while longer-term yields increased during the year. The portfolio maintained a steepening bias for much of 2024, although this positioning was adjusted as the yield curve normalized. With central banks now slowing the pace of interest rate reductions, we believe that the potential for further yield curve steepening is minimal, and consequently, we have eliminated this bias from the portfolio.

Summary

• Last year’s political headlines should come through in policy moves in 2025 with new governments taking shape. On the horizon, new immigration and trade policy have the potential to make significant changes to the supply of labour and goods, creating a possible second wave of inflation. Private sector business investment should continue at a strong pace, as companies work to adopt new technology. Public sector finances remain a key risk for bond markets. Large deficits at a time of full employment add to the risk of higher interest rates. These themes shape our 2025 market outlook. Central banks will be assessing the range of outcomes from these policies, US growth is likely to remain strong, supported by solid labour markets, while Canada’s economy is likely to avoid a recession, bringing low but positive growth after an aggressive easing cycle. Earnings for both countries should grow further, valuation multiples are expected to remain steady, and we expect positive equity returns. Our outlook is generally positive for bonds, though they are now fairly valued and credit spreads are at tight levels. We will continue to adjust portfolio positioning to capitalize on opportunities throughout the year.

Looking at the full accumulation of outcomes from this year of elections, it has become evident that incumbents around the world have generally been routed. For the first time since World War II, every governing party up for election in a developed country lost vote share and has either been voted out of office, or in some countries been forced to work with opposing parties in a coalition. Pundits have cited a variety of reasons for this phenomenon. One explanation reaches back in time, interpreting this year’s elections as a full repudiation of the economic inequality that has bubbled since globalization. The period after the Great Financial Crisis saw populace anger slowly crescendo into the post-pandemic higher inflation period that resulted from the surge in fiscal support. Politicians likely learned that inflation is damaging to election prospects and will be more attuned to any uptick and voter dissatisfaction.

This has all come into sharp relief with the decisive outcome of a Republican sweep in the US election in early November. In contrast to the first term, this administration should be more prepared and consequently more effective, which means more of the platform being implemented. It remains to be seen, however, which of the specific tax, tariff, immigration, housing and health policies proposed through the campaign will get enacted. This is because while numerous policies have been articulated, the President-elect likes to be seen as a deal maker and is transactional, looking to drive a good bargain for the US. The upshot, therefore, is far greater uncertainty in outcomes than what markets are currently anticipating.

This backdrop is different

Financial markets have so far been applying the same reaction function from Trump’s first tumultuous term to today, which is evident in the immediate post-election surge in stocks, the US dollar and bond yields. However, this does ignore some significantly different characteristics in today’s market environment compared to the President-elect’s first term.

For one, CPI inflation in 2016 averaged about 1.5% y/y in the US, recovering from near-zero in 2015. Today, inflation has “recovered” from 4% in 2023 to 2.6% in its latest October reading. The more stable core inflation measure, that strips out the volatile components, is still above 3% with recent 3-month annualized rates now creeping higher (3.6%). This suggests a lingering stickiness in inflation that has yet to be dealt with. Planned deportations would lead to a decline in the prime-age workforce and labour supply, which is ultimately inflationary. However, dissatisfaction with high inflation contributed to voter frustration. So while US policymakers appear committed to extending tax cuts and continuing with demand side stimulus, they may be constrained from doing so because upside inflation pressures could pose a problem for mid-term elections. But more directly, the President’s nominations for Cabinet and leadership positions (including National Security Advisor and Department of Justice) are being sourced from elected officials within the House of Representatives, narrowing the majority cushion and threatening the ability to pass tax legislation in 2025. Thus, actual stimulus may be more constrained than is currently being projected by markets.

Second and relatedly, interest rates in 2016 were extremely low, hitting a then-all time low of 1.1% in July 2016, after the Brexit vote. Today, US 10-year rates are trading in a broad range of 3.75% to 4.5%, levels that harken back prior to the Great Financial Crisis. Notably, rates at this level are also associated with heightened market volatility. Over the past three years, as equity markets have risen, we have experienced four bull market selloffs. Two were sparked by events — the US regional bank crisis in March 2023, and the Bank of Japan moving its policy rates up from 0.1% in August 2024, thereby revaluing the yen carry trade. However, the other events occurred when US 10Y yields hit 4.5%, in September 2023 and April 2024 (see Chart 1). During the 2023 sell offs, there was considerable intervention required via the expansion of the Fed’s balance sheet and the shifting of US federal debt financing away from bonds, towards short term paper. Ultimately, this latter move limited longer-term bond supply and helped to lower long-term interest rates. Perversely, however, this also meant that interest expenses on the federal debt have risen as a consequence of the inverted yield curve. These material federal debt and deficit levels may lead to spikes in longer term yields as markets assess the fiscal challenge, just as they have in France and the UK this year. The bigger issue is, however, that interest rates are now hovering right around the levels that equity markets see as challenging.

Finally, another change from 2016 is the leadership in the global world order as elections caused upheaval. As the US focuses internally, there is little counterbalancing stability. Voters across Europe are also rejecting the status quo which is in contrast with 2016, when German Chancellor Angela Merkel was 11 years into a 16-year long leadership role, an offset to the shake up from the US. It has gone by with little notice, but German Chancellor Olaf Scholz’s coalition government collapsed after less than two years in office, and is set for an election in February 2025. Similarly rickety government coalition structures persist in France, following French President Macron’s defeat in the European Parliamentary Elections and a snap domestic election resulting in a hung parliament. The forthcoming changes from the US mean that, in addition to domestic leadership challenges, each country will be dealing with upending trade relationships and seeking reliable allies.

Understanding the true trends for the coming years

Today, volatility in equity markets has dampened considerably, and sentiment indicators are tilting bullish and moving higher. Actual implemented policies are only going to be known over time, but there is a lot that could upset the bull market. The desire of the incoming President to upend the main executive departments including Defense, Justice and Health with his cabinet selections suggests the unpredictable will happen. The spectrum of potential policy outcomes is as wide as it has ever been. But there are different investment time periods, one of which is the near term, where the Fed and markets are focused on short term data and whether inflation will continue to subside. Then, there is a longer term over the coming year or two, where the new administration will implement trade, fiscal and macro policies. Ultimately we believe that we are embarking on an acceleration in the already evident shift from a low growth and low interest rate post-GFC world. But volatility in rates and equities will rise under uncertain policy setting and outcomes. All of this is mixed for investors. So, we will be watching for policies that do enhance productivity, such as investment, targeted tax cuts, and deregulation that perhaps unleash some business confidence and animal spirits. Until we get that clarity in policy, much is speculation, and we remain vigilant in appraising incoming signs for these turning points over the coming cycle.

Capital markets

While there were volatile market gyrations to start the month in both August and September, market performance was strong in the third quarter. This was somewhat reversed with weakness for bonds and equities in October. Despite the Fed’s surprise 50 bps rate cut, interest rates rose steadily after that outsized cut, with surprises on growth data coming in consistently to the upside. Perhaps most notably, third quarter GDP advanced at a rapid 2.8% pace and soft sentiment data such as the ISM Services report moved back to signalling expansion. This led market participants to pare back the likelihood of more rapidfire rate cuts, and the US 10-year yield pressed up towards 4.5%.

After a 5.5% rise in the third quarter, the S&P 500 declined 1% in October. November has seen markets recoup the October loss and more, rising around 3%, with banks, consumer discretionary, industrials and energy all performing well. Following some time to absorb the implications of cabinet picks, rate sensitive sectors and pharmaceuticals have lagged the broader move. With third quarter earnings season wrapping up, both earnings and sales growth have been outperforming expectations. Earnings growth in Q3 is over 8% higher than a year ago and three-quarters of companies have exceeded estimates. Canadian equities surged 10.5% in the third quarter. In the initial post-election period, the knee jerk expectation that tariff policy would be detrimental to all but US companies led to the TSX underperforming. This was short-lived and the TSX has since rebounded, with strength in financials and tech overcoming softer energy prices and economic malaise.

Canadian bonds posted five straight months of positive gains to September, leaving the FTSE Universe Bond Index up 4.7% in Q3 before giving back 1% in October. Canadian bond yields have been on the climb since the mid-September lows, and took another step higher in the aftermath of the election with the 10-year reaching 3.35%, its highest level since July. Since then, Canadian rate moves have lagged the US. The direction is unsurprising given proposed US policies have raised expectations of a resurgence of inflation. The path has been bumpy, but Chair Powell has clearly reinforced the market’s expectation of slower rate cuts, noting there is no need to be lowering rates given the economy’s current signals on growth and inflation.

Portfolio strategy

For the past year or longer, the debate over the macro backdrop has been whether central banks will have the ability to thread the needle and produce a soft landing in the US economy, after the high inflation and high interest rates that had not been present for two decades. Last quarter, the anxiety appeared to shift away from concerns over inflation towards growth as central banks all began easing policy. However, with the year’s elections cumulating in populist votes, the question appears to be less about soft landings and instead whether a resumption of high growth and high inflation may instead take hold. This will require looser monetary and fiscal policy to act as an offset to tightening trade and immigration policies. For the short term, the positive fundamental macro backdrop in the US, with solid growth, a balanced labour market and supportive financial conditions led us to cover the equity underweight at the beginning of October in balanced funds and maintain an underweight in fixed income and overweight in cash. Fixed income portfolios continue to hold positions that benefit from a steeper yield curve. Canadian fundamental equity portfolios are adjusting positioning to benefit from onshoring and continue to look for high-quality cyclical companies such as those in industrials, financials and materials sectors. We are assessing the combination of relatively high valuations and a potential reacceleration in growth and inflation as we look ahead to the next year – and the next four years – that will no doubt be filled with surprises.

Chart 1: Equity market turbulent when yields rise

Source: S&P Global, Macrobond

This summer has been anything but calm in financial markets, despite the distractions from the Olympics and constant political headlines. Global equities have declined, with the MSCI ACWI falling 8.3% from its July 16 peak before finding a bottom in early August. The biggest price moves were seen in Asia, led by the Nikkei that fell 25% over three weeks, but other markets including South Korea and Taiwan also declined significantly. The sell off was rapid and accelerated in the wake of the July 30 Federal Open Market Committee (FOMC) decision to keep interest rates unchanged.

Three key events piled on top of each other over this period, and drove a material risk-off move across global markets. First, data releases following the FOMC decision showed evidence of a significant slowing economy. The US ISM Index dropped to its lowest level of the year at 46.8, with the employment and production components, in particular, dropping to their lows for the year. US employment also disappointed on the headline gain of 114k, but notably the unemployment rate rose to 4.3%, more than half a percent above recent lows, which is historically a signal of a recession. Second, the world’s most dovish major central bank, the Bank of Japan (BoJ), surprised markets with an interest rate increase on July 31, from 0.1% to 0.25% and slowed the pace of its bond buying by half. This narrowed the anticipated spread on Japanese and US rates as the respective central banks policies diverge. This, in turn, caused the Japanese yen to appreciate relative to the US dollar from 162 to 145. The outcome was to reverse the attractive characteristics surrounding the Japanese yen carry-trade that profits from borrowing at low Japanese rates in a cheap currency and investing in higher yielding assets in other countries. Japanese companies, many of which are global conglomerates that will be hurt by a rising yen, also saw their share prices sell off. Third, US mega cap technology companies reported generally softer earnings, and investors questioned when the mass investment into AI related technology companies would finally pay off.

The messages beneath the surface

Even without the main triggers of the recent volatility, it has become evident that simply put, valuations have gotten rather expensive (see Chart 1). It is hard to see much upside to stocks overall, given they were priced for a pretty optimal scenario of decelerating inflation, steady growth and easing rates. Stocks were basically priced for a perfect outcome, with positioning consistently searching for upside and not protecting for downside. Indeed, beneath the surface, the rotation in stocks has been telling. US equities had been driven by a narrow group of stocks (Magnificent 7), that were increasingly being culled from 7 towards just 1 (Nvidia). This implied that on a capitalization-weighted basis, the gains were driven by fewer stocks, and reached a 40-year high relative to an index that weighted every stock equally (see Chart 2). However, during these past weeks, that trend began to reverse. The very expensive mega cap stocks were sold in favour of other industry groups. The broadening in leadership even saw small cap stocks outperform, at the same time as the utilities, consumer staples and real estate sectors, a highly unusual concurrence.

Chart 1: Valuations are high

Source: I/B/E/S

Chart 2: Narrow leadership was over-extendedSource: S&P Global, Macrobond

Moreover, equity market volatility spiked to an unusually high level during this period (see Chart 3). Intraday, the VIX Index jumped to its third highest level on record after the 2008 Lehman Brothers collapse and the onset of the Covid crisis in 2020. It’s especially unusual to see the surge in uncertainty, without a clear trigger event. It is also telling that gold prices actually sold off during the worst days in early August. All of this suggests that the market was experiencing a broad liquidation from extreme positioning, rather than a material risk-off event. Indeed, markets rebounded and settled down in the following few days.

Chart 3: Intraday volatility spiked to third highest level on record

Source: Chicago Board Options Exchange (CBOE), Macrobond

Where are we going from here?

Taking stock of the recent moves and sentiment, it appears that markets are looking somewhat vulnerable at the moment. Refocusing on fundamentals, it would seem that either growth needs to rebound or risk assets will look for soothing via central bank rate cuts. Worth noting however is that any emergency inter-meeting or outsized cut would likely be interpreted poorly, as a signal that something is terribly wrong. The former growth rebound scenario may still be possible – we have been through a see-saw period of financial conditions that led to rapid responses in the economy, and this recent period has seen conditions ease. But we are cautious about the prospects for a growth resurgence at this time. Spending is critical and it typically relies on people having and keeping their jobs. The trend in employment data suggest a deterioration in labour markets is underway. But more recently, we have noted that an increasingly important factor in confidence to spend relates to the wealth effect. Indeed, since the pandemic, new households, particularly those in the lower net worth groups, have started to become shareholders, taking their stimulus cheques and putting that into stock markets (see Chart 4). The values of both stocks and homes have gone up significantly, but both are now wobbling. As rate cuts begin, this should provide some support. However, where policy easing will have the biggest support is in countries with high levels of debt held at variable rates or with high turnover of debt. That is exactly the opposite of the US, where private sector debt has largely been termed out. For instance, much of the stimulus in the US arises from the refinancing activity of mortgages when interest rates drop. However, a significant portion of American households have 30-year mortgages with effective rates in the mid-3% range. With current rates in the US around 6.75%, mortgage rates have a long way to go to even start consumer stimulus (see Chart 5).

Chart 4: Change in equity markets mattering for a growing group of US households
Equity participation by wealth distribution in the USSource: Federal Reserve, Macrobond

Chart 5: Mortgage refinancing has flatlinedSource: MBA, Bankrate, Macrobond

Putting all of this together, markets are growing guarded, and becoming more attuned to a growth slowdown. Spending is becoming more cautious with less support in the US from anticipated rate cuts, all while the unemployment rate is climbing. Sentiment towards the AI boom is wavering and the last cheap place to borrow in the world has signaled the party is now over. Change is afoot in terms of market themes that have dominated in recent years, and volatility is likely to stay elevated.

Capital markets

Equity markets were broadly positive through the second quarter up until mid-July. The stability of US economic data and easing inflation supported the goldilocks outlook despite the myriad of surprising election outcomes globally, US election gyrations and escalating geopolitical tensions. Central banks began easing synchronously, with the Bank of Canada joined by the BoE, ECB and SNB. In the second quarter, the MSCI ACWI rose 4%, taking gains for the first half of the year to 15.5%. The Magnificent 7 drove the S&P 500 to all-time highs, posting a 5.4% gain in Q2 for a 19.6% first half performance, before the volatility set in through July. Second quarter earnings growth, with about 80% of companies having reported, continued at a strong pace, albeit moderating slightly from Q1. The TSX Composite lagged relative to broader equity markets, edging down 0.5% in Q2 for a more modest 6.1% gain in the first half. In mid-July, the market tone shifted and the TSX posted a 5.9% gain for the month, with a reversal in leadership notably favouring defensive sectors.

Though there has been much equity market volatility, currency and bond markets were, at least relatively, tamer. In Q2, the FTSE Canada Universe Bond Index rose 0.9%, and advanced a further 2.4% in July following the spate of weak data noted earlier. While day to day moves were generally orderly, short term interest rates in both Canada and the US dropped by nearly a full percent in the third quarter, as investors looked for safety in bonds. Credit spreads widened, alongside the risk off tone. While volatility has been evident in equities, it appears contained for now as demand for credit surfaced and issuance remained surprisingly strong through this rocky period as issuers looked to take advantage of lower rates and any positive tone. Important bond market moves included the widening in French spreads relative to other eurozone countries, given its large deficit and high government debt level drawing concerns following the outcome of the French legislative election. Commodities were broadly weaker, with declines in industrial metals, agriculture and energy.

Portfolio strategy

Confidence in a soft-landing has been high over the past year and equity markets priced in anticipation of that goldilocks scenario. This past month, a new environment has emerged. Anxiety among market participants has now shifted from inflation to growth. As a result, much of what was priced in before has been reverting, and markets are still adjusting to the changing dynamics of the yen carry trade and concern over when to expect a return from the massive investments in AI. While this anxiety persists, markets are pressuring central banks to provide stimulus, pushing short term interest rates lower. But in order to meet that demand, inflation trends need to continue declining, which is likely but not certain. Uncertainty and volatility are likely to persist over the second half of the year. As a result, we are shifting portfolio holdings towards more defensive stocks  and away from cyclical stocks that are more tied to the health of the economy. For example, we are adding to utilities and consumer staples companies. Fixed income portfolios continue to hold positions that benefit when the yield curve normalizes away from inversion, while holding a modest underweight in corporate credit. Balanced portfolios remain modestly underweight equities and overweight bonds and cash, and we lean towards increasing this defensive posture if an economic downturn proves more durable. On a positive note, periods of volatility often create good opportunities, and we are on alert for stretched valuations while remaining prudent and cognizant of the growing risks.