Good morning,
Global equities have continued to perform well as of late. But more noteworthy has been the breadth of the rally, with a variety of sectors, and not just technology, enjoying significant gains. As a result, markets outside the U.S. have also performed better, with Canada, for example, recently outperforming the U.S. We view this broadening as a healthy sign as it suggests growing confidence in the investment outlook and portfolio performance that may be less reliant on a narrow part of the market. Below, we turn our attention to the anticipation of interest rate cuts in North America, despite the diverging paths of the Canadian and U.S. economies.
Canada has thus far avoided a recession. Its most recent real gross domestic product (GDP) figure was around 1% in the last quarter of 2023. But this modest growth masks some underlying economic weakness. Canadian real GDP per-capita, which accounts for the country’s strong population growth, has been in decline for over a year now. Weak consumer spending, business investment, and lower job growth have slowed the economy, partially offset by strong exports. Recent U.S. economic data has painted a different story, generally exceeding projections. In February, U.S. real GDP grew at an annual rate of 3.2%, with the per capita rate showing similar strength. At the same time, the U.S. labour market has remained relatively tight, which continues to support consumer spending. Though manufacturing sector activity had been on a downtrend from pandemic era peaks, it has picked up in recent months.
Therefore, we see the final push towards the 2% inflation target proving to be the most difficult. As we wrote a few months back, with base-effects no longer helping pull inflation lower, the real test for the Fed lies ahead. Clearly, the move from the 9% YoY headline toward the 3 handle was the easy part, with the last push towards 2% proving the most difficult in the absence of some form of economic pain. Despite inflation receding from its mid-2022 peak, growing evidence continues to support the higher-for-longer narrative as the Services price component continues to prove stickier than originally expected. In fact, more than half of the CPI basket saw prices rise in February. Looking beneath the surface, the Fed’s preferred “Supercore” (core services excluding Shelter) improved on a month over month basis, decelerating to 0.5% compared to the 0.8% jump in January. Though moving in the right direction, “Supercore” remains elevated at 4.3% YoY and likely 2X higher than the Fed would prefer at this stage.
The economic divergence in Canada relative to the U.S. has also been on display in recent inflation readings. Canada’s consumer price index (CPI) report for February, released over the past week, revealed lower than expected inflation for the second month in a row. There was a broad easing in price pressures, with the exception being shelter related costs including rents, mortgage interest, and the expenses tied to owning a home. In contrast, the U.S. has witnessed a modest reacceleration in inflation over the last two months, slightly exceeding expectations. These results are likely to frustrate many of those who were hoping for imminent financial reprieve in the form of monetary policy easing. Despite CPI data moving in the right direction in the eyes of the Fed, at this stage we don’t see a compelling case for yelling “mission accomplished” just yet. Bond market expectations – that were not long ago positioned for 7 cuts in 2024 starting as early as March – appear to be readjusting to this new reality.
Despite these differences, both the Bank of Canada and the U.S. Federal Reserve have telegraphed the potential for rate cuts in 2024. Policymakers at the Bank of Canada recently indicated that cuts could be appropriate this year if the economy evolves in-line with current forecasts. The case for lower interest rates in Canada has become more convincing as recent economic data point towards moderating inflation. On the other hand, the argument for rate cuts seems less compelling in the U.S., given the economic strength that has been maintained amid higher rates. Nevertheless, Federal Reserve Chairman Jerome Powell reiterated this past week that the Fed believes it may be appropriate to cut interest rates at some point this year. In response to questions on the recent reacceleration in inflation, Powell noted that inflation continues to trend lower despite the recent “bumps in the road”. Markets are currently expecting three cuts this year in both Canada and the U.S., with the first one occurring as early as June.
The key takeaway is that rate cuts are a real possibility in both Canada and the U.S., even if the rationale and extent of these policy moves might be debated based on the current state of the two economies. Historically speaking, an environment characterized by declining interest rates tends to be supportive for investment returns. The strong equity market performance in recent months may reflect some of this optimism, though we would not be surprised to see markets continue to push higher, at least until some future developments prompt a reassessment of the outlook for inflation, growth, and interest rates.
Please continue to call us as our entire team is available to answer any questions that you may have. We can also be made available to speak with any friends or family members who made need reassurance during these times.
Enjoy what is hopefully our last blast of winter here in YYC.
Devin