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.

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

Lessons from prior election years

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

Chart 1: Outside of 2008, volatility in election years in line with the average
Source: CBOE, Macrobond

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

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

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

Market implications from US political platforms

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

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

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

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

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

Conclusions

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

Capital markets

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

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

Portfolio strategy

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

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

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

The Secular Environment The Cyclical Environment Valuation Portfolio Strategy and Structure Summary

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

Introduction

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

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

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

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

Chart 1: Growth has outperformed expectations

Source: Bloomberg

Chart 2: Core inflation has eased everywhere

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

The Secular Environment

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

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

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

Chart 3: Most jobs evolve out of innovation

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

 

Chart 4: Manufacturing capex is driving business investment

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

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

 

2. Business capital investment cycle

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

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

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

 

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

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

 

3. Era of fiscal dominance

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

The Cyclical Environment

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

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

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

Source: US Census Bureau

 

Canada: Recession to usher lower rates

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

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

Source: Bank of Canada Financial System Review, 2023

Chart 9: Mortgage debt servicing costs highest on record

Source: Statistics Canada, Macrobond

 

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

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

Chart 10: US inflation measures signaling path to Fed target

Source: BEA, Macrobond

 

Europe: Persistent fragility

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

Chart 11: European industrial production is stagnating
Real industrial production

Source: Statistisches Bundesamt, Istat, INSEE, Macrobond

 

China: Persistent structural challenges

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

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

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

Source: China General Administration of Customs, Macrobond

Valuation

VALUATIONS: Earnings growth crucial in 2024

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

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

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

 

VALUATIONS: Multiples to remain near current levels

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

Chart 14: Multiple expansion limited

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

 

VALUATIONS: Bonds remain fairly valued

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

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

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

Portfolio Strategy and Structure

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

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

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

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

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

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

Asset allocation

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

Chart 16: Sentiment has become extremely positive

Source: AAII, Macrobond

 

Stock and sector selection

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

Corporate credit

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

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

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

Duration and yield curve

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

Chart 18: 10Y yields have retraced very quickly

Source: Macrobond

 

Chart 19: Yield curve to move toward normalization

Source: Macrobond

Summary

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

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

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

Chart 1: Population surging in recent years

Source: Statistics Canada, Macrobond

 

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

Source: Statistics Canada, Macrobond

 

Data in the context of population growth

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

Chart 3: More people joining labour force than finding jobs

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

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

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

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

Capital Markets

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

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

Portfolio Strategy

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

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

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

Chart 1: Longer lags between policy shifts

Source: Federal Reserve, Minack Advisors, Macrobond

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

Chart 2: Normalization is a precursor to recessions

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

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

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

Chart 3: Interest costs are biting

Source: National Federation of Independent Business, Macrobond

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

Chart 4: Bond yield and earnings yield gap is closing

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

Capital Markets

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

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

Portfolio Strategy

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

As we approach the late cycle phase, the high level of interest rates is dominating both the macroeconomic and investing environment. We remain vigilant on the growing risks as the year closes out.

In bond markets, the late-cycle environment typically concludes because of central banks. Either short-term rates move higher, driven by central banks fighting inflation until the bitter end, or central banks recognize that rates have risen too steeply and too fast, so cuts get priced into short-term rates. To have long-term interest rates lead the charge higher, as has been the case very recently, is highly unusual. Indeed, market pricing for central bank rate moves over the coming year has barely budged. Yet, since the July Federal Open Market Committee (FOMC) meeting, US 10-year yields have marched relentlessly higher. In September alone, they surged 48 basis points (bps) to 4.6% while 30-year yields rose 50 bps to 4.7%. As of the first week of October, both are now at their highest level since 2007. Many factors are at play, but understanding the reasons behind the moves matters because it influences how much higher rates could still go.

• The most straightforward explanation for the persistent increase is that at the beginning of the year, many market participants anticipated, and were positioned for, a recession that we now know won’t materialize in 2023. With evidence that the economy can withstand the tightening to date, combined with ongoing high inflation and wage gains, the outcome is fewer expected rate cuts through 2025. Essentially, rates will remain higher for longer. The US Federal Reserve (Fed) has signaled this in its latest Summary of Economic Projections. Thus, the rise has been almost entirely in real interest rates, which reflects a more optimistic growth outlook as long-term inflation expectations have been flat.
• US Treasury supply is entering into a rough spot. Massive US deficits are expected to persist (see September Outlook). Debt maturities are skewed towards the short end of an inverted yield curve where yields exceed 5%. Interest payments are skyrocketing and new issuance is on the rise.
• US Treasury demand is also falling, notably through the Fed’s quantitative tightening program, that is allowing $60 billion of bonds each month to no longer be rolled over. This equates to some US$800 billion of bonds being returned to the market. But, more importantly, the enormous and growing twin international trade and fiscal deficits raise concerns over where the US will attract investors from to fund this deficit. While historically, holding the world’s lone reserve currency has alleviated this, a rising number of foreign trade transactions are shifting away from the USD, a byproduct of reversing globalization trends. This suggests that long-term rates must increase to effectively attract savings into the treasury supply.
• Looking ahead, there is now some reconsideration of the neutral rate of interest (where inflation at 2% is consistent with economic growth), and whether it might surpass the Fed’s current estimate of around 2.5%.

Notably, this is not restricted to the US; yields globally have also been on the upswing. Even in Japan, the 10-year rate, which had held near 0% since 2016, has climbed to 0.79%. Indeed, rates are up universally (see Chart 1), Canada included. However, many of these fundamental factors are less of a problem in Canada, which maintains a large and active pension and insurance sector in need of long-duration assets. Moreover, considering assets in social security programs like the Canada Pension Plan, overall debt levels on a net basis and associated interest costs appear much healthier. The “resilient economy” perspective is less applicable to Canada. While incomes enjoyed the benefits of a prior rise in short-term interest rates, resulting in a surge of inflows to money markets funds and GICs, this latest rally in long-term yields has not shown a similar benefit. Furthermore, a mortgage debt maturity wall looms large from 2025 on, and we believe consumers will cut back spending in anticipation of financial challenges.

Chart 1: Surge higher in global bond yields

Source: Macrobond

What next?

The argument that we are nearing the top of the rate-hiking cycle is predicated on either signs of a looming recession that eventually temper inflation or, alternatively, that the higher rates trigger some type of financial stress. Examples of such strains include the UK pensions issue last fall (refer to the November 2022 Outlook), or the challenges faced by US regional banks this past spring (see April’s Outlook). However, in the absence of clear signs pointing to an imminent recession or financial crisis, the supply and demand dynamics of Treasuries, as described above, have considerable momentum and no easy fixes. Moreover, with the approach of a US Presidential election year, proactive and meaningful fiscal restraint seems improbable. As such, the rise in interest rates is giving way to concern in asset markets. For now, equity markets are not pricing in an economic downturn, as earnings estimates for the next twelve months have held steady after easing through much of this year.

From our lens, equity markets remain vulnerable in the near term. Valuations have been edging lower. But if valuations are broken down into two components, the risk-free 10-year Treasury yield and the equity risk premium (ERP), the message is somewhat concerning. ERP gauges the excess return above the low-risk bond yields that compensates equity investors for assuming additional risk. Typically, ERPs have an inverse relationship with growth, rising when economic activity dips. Yet, thus far this year, amidst market anxieties about decelerating growth, ERPs have been defying all expectations and have fallen to reach their lowest level since 2002 (see Chart 2). This most recent move has been because interest rates are rising faster than price/earnings (P/E) multiples are contracting, implying that the advantage of holding equities today is marginal. In fact, equities are grappling with stiff competition from higher yields since dividend yields are not keeping up (see Chart 3).

Chart 2: Equity risk premium unusually low

Source: S&P Global, UST, Macrobond

Chart 3: Stiff competition

Source: S&P Global, UST, Macrobond

So, as we assess the current phase in the cycle, consumers are faced with headwinds from rising mortgage rates and energy prices, and investors are faced with higher funding rates due to governments’ mighty spending patterns. Meanwhile, equity markets are priced optimistically for a soft landing, and not really rewarding investors for taking risk. Given these prevailing trends, we remain cautious on our outlook for markets.

Capital markets

September proved challenging for markets, a trend becoming par for the course for this month. Both stocks and bonds have fared poorly in the past few Septembers and this year was no different. The US 30-year Treasury yield saw its biggest quarterly increase since the first quarter of 2009, while the Dow Jones Index gave up all of its gains year-to-date. The S&P 500 Index peaked for the year on July 31, and has since retreated by about 7%. Excluding the “magnificent eight” high flying tech stocks (see June’s Outlook), the performance of the S&P 492 closely mirrors the Dow Jones, remaining unchanged year-to-date. Although earnings estimates for the year have held steady, valuation multiples have declined, with the forward P/E ratio falling from 20x to 18x. Leadership has also predictably been shifting with bond proxy sectors such as utilities, telecommunication services and real estate underperforming, but also those with the richest valuations (information technology) struggled through September. In Canada, the S&P/TSX Composite Index fell 3.3% in September, marking its second monthly decrease this year. All sectors, excluding energy, were in the red led down by information technology, and interest rate sensitive areas such as utilities, REITs and telecommunication services. Energy posted a modest gain for the month, and was the best-performing sector, as the price of WTI crude oil rose 28.5% in Q3 to $90.79/bbl, its biggest quarterly rise since Q1 last year after Russia’s invasion of Ukraine.

With inflation still above central bank targets, and a seeming resurgence in Canada, monetary policymakers maintained a hiking bias. The Fed notably revised its growth forecasts upward and hinted at future rate hikes. Yield curves remain deeply inverted and credit spreads stopped tightening in the month, thanks in part to a surge in corporate bond issuance that counteracted the favourable technical factors supporting credit markets earlier in the year. The FTSE Universe Bond Index fell 2.6% in September, pushing the year-to-date return into negative territory in absolute terms and setting the trajectory for its third straight year of negative performance.

Portfolio strategy

The rise in rates is becoming an important feature for markets to contend with as we head into the final months of the year. The longer interest rates stay high, the greater the likelihood of a “hard landing” coming to pass. This continues to weigh on the outlook for risk assets. Consequently, we have recently increased our underweight to stocks within balanced portfolios, given our view of a challenging period ahead. We have also bought bonds through this backup in yields, and are now at benchmark weight. We continue to overweight cash. Within our Canadian fundamental equity portfolios, we are defensively positioned, with a preference for companies that demonstrate resilience during economic downturns. Our fixed-income portfolios have begun to add duration modestly after holding flat since the end of July. We remain underweight credit in anticipation of a difficult road in the near term. However, should inflation persists at high levels, we are adding some inflation protection. While there is no shortage of news to sift through to understand the factors driving performance across different markets, we believe overarching themes like sustained inflation and high interest rates will dominate. We are preparing for a bumpier ride heading into the final quarter of the year.