January 09, 2024
As we move into the new year, we consider how the economy and markets have performed and how the investment landscape is changing. As the title suggests, looking forward, we see a downshift in many areas of the economy including economic growth, rates and inflation. Looking back on how 2023 transpired, it seems we couldn’t have asked for a better outcome. Global stocks rose over 20% and Canadian bonds were up over 6%. The global economy avoided one of the most forecasted recessions in history despite the fast pace of rate increases from central banks. The global economy remained resilient largely because inflation fell while consumers kept spending despite higher interest rates. Yet, concerns remain for the investment landscape. Here we highlight some of the conversations we are having across our firm with both our views and questions that will get answered with time.
The strong consumption we saw in 2023 is losing steam this year. Higher than expected spending in 2023 came from excess savings during the pandemic and now seems to be nearly all spent. Data from the US Federal Reserve (Fed) suggests excess savings peaked
at $2.1 trillion in August 2021 and at the end of October was at $285 billion. In 2023 alone, it’s estimated that over $1 trillion in excess savings was spent. This has been a large tailwind for the consumer; however, this support is fading
as savings balances across the globe are dwindling. We are also seeing consumer credit quality deteriorate and more unpaid credit cards and auto loans. In Canada, consumers are being hit hard as mortgages renew at much higher rates, leaving
less disposable income for spending. This is all leading to a material slowdown in global economic growth.
While our investment process doesn’t rely on the outright prediction of a recession for success, our portfolio managers tend to believe that a recession in the developed world is the most likely
outcome this year. In the US the call is not clear, while in Canada and Europe the likelihood is higher. The question now becomes the severity of the contraction. Consensus amongst economists is that if we get a recession it will be mild, with the downside
mitigated by the absence of any significant imbalances and a consumer that is healthier coming into this period than prior recessions. The big question remains if we will see a significant uptick in unemployment in a recession or if companies will continue
to hold workers if they forecast just a temporary slowdown.
The combination of high interest rates and the downshift in consumption and growth should lead to inflation easing further from here. The components of inflation which have been slowest to fall are in housing, while we still see elevated prices in many
services including travel. Overall inflation remains too high for comfort. However, when looking at core prices over the last six months, it shows inflation getting closer to target. The forecast from the Fed is that it will take until 2026 for inflation
to fall to the target of 2%. The big question for inflation is also related to employment. Will we need a meaningful increase in unemployment to further cool inflation? Or will the current level of rates plus lower spending be enough to get inflation
to target? History suggests unemployment will need to rise for inflation to reach 2%.
Central banks have been winning the fight against inflation while not causing a recession, yet. To achieve the so-called “soft landing,” where inflation falls to target and a recession is avoided, they will need to begin cutting rates in 2024. In the US, the Fed is calling for three rate cuts this year, bringing their benchmark rate down to 4.75% by year-end. The market is pricing in a larger rate cut, estimating a 3.6% rate at the end of 2024. In Canada, the market is pricing in a similar decline in rates. If we get a recession this year, these rate declines are likely. However, if growth downshifts but remains positive, it will be difficult to cut rates as this could mean the central bank's goals for inflation are not going to be met. The big question for rates is why are they being cut? Is it because we are in a recession or moving towards the soft-landing scenario? Equity markets have been pricing in the latter and will be disappointed if growth contracts.
It may sound like déjà vu, but the investment landscape leads us to start another year with cautious positioning. At the same time we are optimistic in many areas. We are most cautious in clients' equity allocation. Strong equity returns
in 2023 on the back of higher valuations lead us to feel stocks are priced for perfection, i.e. stocks at current levels are factoring in growth that remains positive, inflation falling, rates coming down and companies that continue to grow their
earnings. While this outcome is possible, it’s not our base case. In our base case, we see a downshift in growth and rates take a bigger bite out of consumption and company earnings fall. If this comes to pass, we will expect to see a temporary
decline in stock prices.
In 2023 most of the performance for global equity came from increasing valuations. Despite economic headwinds, parts of the market look more expensive than others. In the US, valuations are elevated relative to history. Much of this is fueled by the “Magnificent
7” stocks which have led performance this year on the hopes for artificial intelligence (AI). The rest of the market has lower valuations but is still high relative to where we are in the cycle. While we like many of the companies benefiting
from AI, we are also cautious about extrapolating 2023 returns into the future. As such we have allocations to other areas of the market which have been more beaten up. This includes global small caps as well as emerging markets where valuations are
attractive and return prospects are strong on a longer-term basis.
In fixed income we see the opportunity for good returns. It’s been many years since we have seen yields at these levels. In addition, yields may come down this year as central banks lower rates and economic growth slows. This provides a boost
to bond returns. Yet over a longer time horizon, we think that yields will remain above where we were in the last two cycles. This has implications for how we strategically allocate client portfolios. In particular, we think over time we will
allocate more of a portfolio to corporate credit.
Within the allocation to credit in our portfolios we have been making enhancements and adding to our investment platform. Within high yield bonds we have broadened our investment management team's mandate to better generate return and manage risk.
We have also added mortgages to our investment platform. Here we see strong yields as there has been less competition from banks, which gives us more bargaining power. Later this year we are also adding emerging markets bonds. This is an evolution
in our fixed income offering as we look to expand our opportunity set to this large market. The benefits are higher yields, improved diversification as well as our better ability to add value through active management.
We will continue to steward client capital through shifting environments: both strong markets that we have seen recently to more challenging ones that inevitably lie ahead. We always seek to balance short-term tactical views against long-term assessments
of risks and rewards. It is also part of our DNA to evolve our investment capabilities as opportunities arise. These approaches have served clients well and we expect will continue to do so in 2024 and beyond.