Macroeconomics Continues to Drive Sentiment - Portfolio Advisory Group

North American equity markets had a strong quarter as economies in the region proved durable, particularly in the U.S., despite higher interest rates. After experiencing several quarters of sluggish GDP growth in 2023, the eurozone, Japanese, and Canadian economies have shown some budding signs of improving momentum of late, while Chinese growth also appears to be stabilizing thanks to recent stimulus measures. Nevertheless, we expect the tailwinds that have underpinned U.S. economic outperformance to remain in place over the next few quarters.

U.S. job growth numbers for February and March supported tight labour market conditions. In addition, the first couple months of the quarter faced U.S. inflation data that came in stronger than the consensus expected, further pointing to a resilient economic backdrop in the United States. Federal Reserve Chair Jerome Powell maintained his stance that interest rates are at levels required to cool the economy, with policymakers holding rates steady in May while reiterating they need to be confident that inflation pressures are moving sustainability back to the 2% target before shifting to lower interest rates. With that said, Powell is confident that interest rates are already restrictive enough.

In Canada, a different story is playing out. The economy is softening, and that is becoming evident across a number of data points. On employment, February and March showed an uptick in unemployment, while April unemployment remained flat on a month-over-month basis. Regarding inflation, recent growth decelerated to 2.7% y/y, remaining below the upper end of the Bank of Canada’s (BoC) 1%–3% target range for the fourth consecutive month.

In our view, the softer economic data alongside lower inflation suggests a BoC rate cut is imminent (June and/or July). In contrast, a persistently stronger U.S. economy indicates to us a longer time horizon for a shift in monetary policy. This potential policy divergence should drive relative weakness in the Canadian dollar in the quarters ahead, in our opinion.

Against a complex macro environment, we recommend maintaining balanced defensive positioning with selective exposure to growth-oriented stocks. We continue to prefer high-quality dividend paying companies with a track record of execution, strong balance sheets, ample free cash flow generation, robust competitive moats, and secular growth tailwinds.

Global Investment Outlook – RBC Global Asset Management

Leading indicators of the global economy have been in a gradual upward trend since late 2022/early 2023 and have recently reached levels consistent with modest growth, suggesting the expansion is likely to continue.

In the U.S., consumer spending remains moderate, the labour market is healthy, and households have shown impressive resilience in the face of higher interest rates as many American homeowners are still benefitting from record-low long-term fixed-rate mortgages obtained during the pandemic. That said, there are some signs, at the margin, that the U.S. economy is slowing. The excess household savings accumulated during the pandemic have now been fully depleted, delinquency rates on credit cards and auto loans have been climbing, and wage growth has been

moderating.

While these trends represent headwinds, we don’t believe they are acute enough to push economies into recession over our 1-year forecast horizon and, as a result, we place greater odds of the economy achieving a soft landing, particularly if central banks begin to deliver monetary easing in the months and quarters ahead.

One of the key risks to our favorable economic outlook is that, should inflation pressures persist, high borrowing costs could be sustained and weigh further on economic activity. U.S. consumer-price inflation has been hovering just over 3% since June of last year and, although inflation has been a bit more stubborn than many had expected, a variety of signals suggest that disinflationary forces remain in place. Any moderation in U.S. economic growth should further help to cool inflation pressures. We recognize, however, that significant progress has already been made since U.S. CPI inflation peaked at 9.1% in 2022, and we expect inflation to ultimately achieve the 2% level targeted by most major central bankers, but the latter part of the journey toward lower inflation readings from here may be a slow one.

A recurring theme so far this year has been the trimming of rate cut expectations as better-than-expected economic data and firm inflation alleviated the need for imminent and aggressive rate cuts. The futures market is now pricing in only one U.S. rate cut in 2024 toward the end of this year, compared to an expectation of 6 rate cuts in 2024 when the year began. Other countries whose economies are more sensitive to interest rates than the U.S. may be inclined to cut rates earlier than the Fed. Market pricing suggests the likelihood of rate cuts by the European Central Bank (ECB) and Bank of Canada (BOC) as early as June or July.

Stocks extended their gains and many major equity indices reached new records during the quarter. The S&P 500 climbed above 5300 in May for the first time, lifting its year-to-date gains to just over 10%, and new highs were observed in Japanese, European and Canadian equity markets.

Although gains have been broad-based, outsized gains and market leadership has been increasingly concentrated in a small set of U.S. mega-cap technology stocks that have benefitted predominantly by themes surrounding artificial intelligence (AI). After the powerful rally since late 2023, S&P 500 valuations are around one standard deviation above the level our models deem appropriate given the current interest rate and inflation backdrop. On a global basis, though, equity markets are not unreasonably priced and non-U.S. markets offer relatively attractive return potential.

Considering the balance of risks and opportunities in the shorter- and longer-term horizons, we are maintaining our asset mix close to a neutral setting, with a slight tilt to fixed income. Our base case has the economy achieving a soft landing where inflation cools sufficiently to allow central banks to begin easing their currently restrictive monetary policies. Falling interest rates would be supportive for fixed income investments and we expect that bonds can deliver mid to high single digit returns over the year ahead. As a result, we had been adding to our fixed income allocation over the past couple of years as yields climbed. Importantly, higher yields mean that bonds offer improved ballast against a potential downturn in equities should the economy falter. We continue to expect stocks to outperform bonds over the longer term, but elevated valuations in U.S. large-cap stocks in particular and a resulting narrow risk premium versus bonds have us maintaining less equity exposure than we have had at earlier points in the cycle.