Dear Clients,
In our previous installment, we emphasized our baseline call of a soft landing for the US economy, wherein the Federal Funds Rate is sufficiently high enough to bring down inflation without triggering a recession. Our views on this remain constant into 2024, as more data has now come in to support this concept. At the November FOMC meeting, it was noted that wage inflation was now consistent with a 2% inflation world, the Federal Reserve’s target, and ensuing economic reports would indicate that the resilient labour market has unlikely been fueled by wage increases, but instead productivity gains. In a secular sense, some of these productivity gains will come from the disinflationary impact of generative artificial intelligence, which will increasingly be viewed as a substitute for the outsourcing of human capital. Productivity, as we will reiterate to clients, is a long-term contributor to the disinflationary and secular impacts stemming from innovation and more optimal production possibilities. As a result, current financial conditions would lead us to conclude that we have already reached the peak terminal US Federal Funds Rate; while most market participants have priced in a series of interest rate cuts in 2024, our belief is that the number and magnitude being priced in may be premature, based on the Federal Reserve’s priority to bring inflation sustainably down to 2%.
Clients will recall that at the beginning of this year, the fixed income markets were pricing in a protracted recession in risk assets, contrary to the base case of a soft landing targeted by the US Federal Reserve. Later in the year, as the 10-year treasury yield climbed on stronger economic data and productivity gains, the yield curve started to dis-invert, resulting in the 10-year US treasury bond returning almost 0% in total return YTD. This was one of the reasons that explained our muted enthusiasm for the fixed income universe and bond-like proxies in the equity universe at the start of the year. Now, with the yield curve returning to its normal shape (i.e. steepening), much of the fixed income market’s bearish positioning has dissipated.
Having said this, economic forecasters are still “fighting the Fed” in a more subtle way – while the Federal Reserve’s Summary of Economic Projections is for positive GDP growth and cooling inflation over time, half of economists’ private forecasts are for a recession. These recession forecasts assume a sharp decline in consumer expenditures and private investment, which as explained in our prior investment journal, is unlikely due to the degree of economic cushioning present in this cycle.
As we close out the year, we would also like to summarize our third quarter earnings which continue to demonstrate that secularly growing, wide moat companies are outperforming in a narrow market leadership that rewards predictable growth characteristics. Our focus on selecting the growth and innovation leaders of tomorrow continues to produce results. We have been capitalizing on our views of a steeper yield curve in 2024, selecting resilient earners with under-recognized cash flow and dividend yielding characteristics. The financials would be a case in point. With credit quality showing modest signs of normalization, and an overall sector that has been dislocated by investor sentiment, we believe that the companies’ valuations do not reflect the strength of their underlying asset values. If loan growth resumes its current trend in a slow growth, moderating inflationary environment, and the yield curve continues to steepen, we believe our investment thesis will be borne out sometime in 2024.
To conclude, the market’s resilience is underpinned by earnings results, which continue to show that sustainable growth characteristics with predictable return of capital attributes are rewarded. These sources of return can come from a myriad of areas: growth and innovation, de-globalization, regionalization of supply chains, and generative artificial intelligence to name a few. This is why we will re-emphasize to clients that we select secularly growing companies with sustainable and long-lived profitability profiles that are also good investment holdings over the long run; in other words, good companies that are also good stocks. Our selection strategy is underpinned by long-term earnings compounders leading thematic change and transition, as well as resilient earners with a sufficiently wide margin of safety. That productivity enhancements will likely have a disinflationary impact on the economy lends credence to our soft-landing thesis, and augurs for a broadening of market participation in 2024.
We hope clients have a wonderfully “dovish” holiday season.
Warmest regards,
Grace Wang, CIM, PFP | Senior Portfolio Manager
Samuel Jang, CFA | Investment Associate | samuel.jang@rbc.com
Leslie Mah | Associate Advisor | leslie.mah@rbc.com | 604-257-7059
Katherine Jialing Yang | Associate | jialing.yang@rbc.com | 604-718-3035
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