February 21, 2025
The year has got off to an interesting start. There are many moving pieces and a lack of clarity on impacts to the economy. The Trump administration’s trade policy is a known unknown, as is associated inflationary pressure in the United
States (US), and the market’s shifting response to Artificial Intelligence (AI). We believe the range of potential outcomes – with the overhanging threat of tariffs – is as wide as at any point since the 2022 interest rate shock.
Tariffs: Trump’s trump card
Trump recently imposed a 10% duty on all Chinese imports and called for 25% tariffs on steel and aluminum imports, over and above the delayed levies on goods from Canada and Mexico. He has also threatened reciprocal tariffs on all countries that impose
tariffs on US imports. While it is viewed as doubtful that 25% universal tariffs will come into effect, some insiders believe that a 10% universal tariff is the most likely outcome. Time will tell.
If tariffs end up being a simple negotiating tactic – and aren’t meaningfully imposed – there is good underlying momentum in the global economy, with leading indicators showing improvements in recent months. If, however, the 25% tariffs
are implemented, the risk of a recession in Canada is significant.
There is widespread consensus among economists that Trump’s policies, if pursued to their fullest extent, would be inflationary:
- Tax cuts are seen as inflationary, as they boost consumer spending, business investment, and overall economic activity.
- Deportations contribute to labour market tightness and could lead to inflation.
- Trade barriers would throw sand in the gears of complex and refined supply chains and likely have an inflationary impulse.
US inflation red flags
With respect to the latter point: if tariffs are implemented aggressively, this would add a one-time boost to price levels. With inflation already appearing to reaccelerate, this could further limit the extent to which the Federal Reserve (Fed) can cut
rates. Given the current state of elevated US inflation, the magnitude of tariffs may be scaled back, and this would be a net positive for Canada’s growth and inflation outlook.
For now, the Fed is on hold and the risk of rate hikes, while still low, is increasing. Accommodative monetary policy from the Fed was predicated on the view that wage growth was going to fall towards a level compatible with the Fed’s inflation
target. If wage growth accelerates materially, then history suggests the Fed will likely tighten policy.
Canada: a mixed bag
Tariffs and retaliation are expected to have a negative impact on the Canadian economy and may cause the Bank of Canada (BoC) to ease rates further this year. In the absence of trade risks, growth is stabilizing, inflation is around 2.0%, and the current
policy rate is within the neutral range. If trade uncertainty subsides, the BoC may take a more measured approach to rate cuts.
At the same time, economic divergence has widened. Canadian rates, bond yields and growth are lower than the US. While the Canadian dollar has moved higher, it remains volatile and under pressure relative to the USD. Concurrently, Canadian stocks are
outperforming the US and global benchmarks.
Market reaction to inflation and AI trends
Interest rates have a far greater impact on small caps than on large caps. Looking at the US equity market over the past six months, interest expense as a percentage of total debt for large caps (S&P 500) has remained roughly unchanged at 4.2%, while
small caps (Russell 2000) saw the same figure climb above 7%. Today, this number remains at the 7% level for small caps. These companies continue to look for a reprieve, which may not come as soon as anticipated, given the current macroeconomic backdrop.
At the same time this is priced into the market, and we believe small caps remain attractive on a longer-term basis.
We have also seen equity leadership shift from “Magnificent 7”, which dominated in 2024, to the rest of the world. Global stocks are up 4.2% year-to-date, while the Mag 7 is slightly negative. This is largely due to a decline in Al-related
stocks as markets assess the impact of new, cheaper technologies on the potential demand for chips and hyperscalers. There is also a question about the strength of the competitive moats for companies building AI models. Meanwhile, EAFE (namely, Europe,
Australasia, and the Far East) stocks have seen a strong, broad-based performance after a significant period of weakness relative to the US; with value stocks and lower quality names outperforming in this part of the world.
Where to from here?
Uncertainty is higher now than at the end of 2024. Ultimately, the blend of monetary, fiscal, trade, and regulatory policies will shape future growth and inflation trajectories. Even so, equity and bond markets have moved higher, and we remain optimistic
about the opportunities that exist, and our ability to weather these challenges.