“When you’re born, you’re born with 30,000 days. That’s it. The best strategic planning I can give to you is to think about that.” – Sir Ray Avery
Note that the contents of this memo are all my thoughts, and not the views of RBC Dominion Securities. As well, no part of this content was AI-assisted or created.
Friends & Partners,
“It’s different this time, until it’s not.”
I’m not sure if I can attribute that quote to any particular person, but it certainly causes some caution. Things were different this time in 2000 and 2007, then it wasn’t. How will things turn out this time? The million dollar question.
We need to identify what the latest market expectations are for the future of the economy, not personal views of the future economic environment. This is an important distinction, because there is a wide array of opinions on Bay & Wall Street regarding the economy ranging from “no landing” scenarios to calls that we are already in a recession. The market usually errs on the side of economic optimism, even late in the cycle when risks to growth are on the rise like we are seeing today. Sadly the Central Banks have a .000 batting average in achieving soft landings in the past amid comparable economic dynamics to today’s. The most notable examples are 2000 and 2007; two instances when soft landings were also widely anticipated.
In 43 years, there has been one soft landing, which came while globalization was taking hold and the federal budget moved into surplus – not exactly the environment we’re in today. On top of that, we must assume inflation has been defeated. Historically, a recession was needed to slay that beast.
That said, so far, the U.S. and Canadian economies are relatively resilient, are still growing, and there are few signs that a material economic slowdown is near. Financial conditions have massively eased, which is positive for markets and the economy (i.e. money is flowing). The impact of the easing in financial conditions is estimated to be similar to a 25-50 bp Fed Funds rate cut in interest rates. This has been a solid tailwind for the economy and stocks so far.
Current consensus forecasts are calling for Central Bank cuts to begin in 2024 (mid year) – the market got ahead of itself in this call last year. Remember, there were many calls for cuts to be happening in early 2023! Generally, the stock market has performed well in the 6-month period before and after first cuts – assuming the economy doesn’t fall into recession.
Inflation continues to ebb which is good, but it’s important to remember that a decline in inflation is only virtuous for markets if growth remains resilient. Put plainly, a drop in inflation doesn’t matter if economic growth starts to dramatically slow. So, we’re back to economic growth remaining the important driver, and if economic data points towards a more intense slowing than what’s currently expected, it won’t matter what inflation does or what the Fed says – markets will feel some pain. The question for the next while is will there be an economic ‘growth scare’? Potentially. More on that below.
The gap between what the Fed says it plans to do (cut rates just once next year) and what the market expects it to do (cut rates 3-4 times next year) is extremely wide. Expectations for those future rate cuts have pushed stocks higher recently, but any datapoints that refute the idea of rate cuts in the first half of 2024 will erode this pillar of the rally and increase the chances of a pullback.
That’s just stocks – the outlook for bonds is much more attractive than it has been in decades.
Don’t be mistaken – I am not a raging bear. Just cautious still. There are many reasons to be optimistic. There is significant pent up demand for goods as corporate America has had a recession mindset since early 2022, resulting in cautionary spending and behaviour. US GDP was negative 2 consecutive quarter in first half of 2022 – was this the recession sniffed out by the inverted yield curve? Investors have a ton of cash on the sidelines to buy stocks. Inflation should continue to track sub-3% and has consistently been undershooting consensus. Financial conditions are easing. Mortgage rates are finally dropping. Europe and China should emerge from stagnation, and valuations aren’t crazy (ex some of the big tech names). Equity earnings yield versus bond yields are tight (i.e. what stocks ‘pay’ in earnings vs what bonds ‘pay’ in interest), suggesting that stocks are expensive versus bonds – BUT, this was the case throughout much of the 1990’s, and this relationship has historically also resulted in strong 1-year returns. Finally, the S&P500 historically rises ~8% in Presidential election years.
As always, there are lots of puts and takes, and reasons for optimism as well as caution. So we have to position accordingly – that is my job, and I love it.
Some Other Interesting Things to Highlight + Events
November was financial literacy month. I am excited to once again help Junior Achievement again and visit Admiral school in Collingwood to discuss topics around this subject. This is getting more relevant as finances are becoming more stretched for many. As the cost-of-living crisis continues to squeeze household budgets, a lot of people are facing significant stress when it comes to their finances. Below is a snapshot of Canadians’ financial well-being in 2023, based on a Financial Consumer Agency of Canada survey:
Source: Summary of FCAC 2023 survey findings
I was honoured and proud to be able to support Easter Seals Ontario in their Collingwood event, which raised over $100k. Being able to play alongside and against greats like Wendel Clark and Theo Peckham was a blast too.
Economic Data Remains Our ‘North Star’ – Will There Be a Growth Scare?*
Economic data will remain our “North Star” in determining if we are going to have a soft or hard landing, and so far, that data continues to point towards a soft landing. But corporate commentary matters a lot too, as those insights can (and often do) prove to be leading indicators of economic data.
Here’s the takeaway: Growth isn’t collapsing (or even meaningfully slowing) but there are clear hints of a softening in the Q3 earnings results and we saw some of those “hints” backed up by the underwhelming economic data in November (ISM Manufacturing PMI, job adds, ISM Services PMI). That’s not enough to increase hard landing worries but it is enough to increase concern that a growth scare is lurking somewhere in the coming months.
Earnings season wasn’t bad enough to cause caution yet and the resilient U.S. economy must be respected as expectations for a growth slowdown or recession have, so far, been incorrect. But I continue to believe in the power of simple economic truths.
First, the longer inflation stays elevated (and remember prices are still rising year over year, just at a slower pace) the greater the chances it negatively impacts consumer spending. Though things are looking better on the inflation front:
Inflation being defeated historically requires a recession to quell it:
Second, high interest rates cause economic slowdowns.
These two economic truths can be delayed, sometimes for years longer than experts think, but I have yet to see them proven wrong. And with nearly three full years of high inflation now in the economy and a year-and-a-half of higher rates impacting the economy, it could be a matter of time before we experience a growth scare.
Source: Bloomberg
In addition, markets and the economy are gradually adjusting to higher costs of capital (in the form of higher interest rates) and less abundant capital. This process usually takes a long time to work its way through the system and causes noise in the markets along the way.
The positive is that even if this leads to a recession that may be a ‘harder landing’ that consensus believes, we are making progress towards a better starting place for the next cycle.
When Central Banks Start to Cut, That Can Only Mean Good Things, Right?*
It is usually ~8 months from last Central Bank hike to first cut, which would put us into March 2024 for the first cut. However, the Fed will likely be more cautious if inflation remains an issue, and we know that the economy could continue to remain resilient. The market is expecting June 2024 cut at this point.
Source: Apollo
We remain a bit stuck between a hot US economy leading to rates being higher for longer and a weakening economy leading to cuts…
The market is hoping cooler inflation will clear the path for a Fed pivot but by the time the cuts come, it is normally too late – recession has taken hold.
Source: SocGen
On average, the S&P 500 has fallen 23.5% over a period of 195 days from the first rate cut to the market low.
Source: SocGen
The key is whether there is a recession or not. In prior Fed pivots where the economy avoided a hard landing, the S&P 500 rallied 22% on average between when the central bank first paused hikes and 6 months after the Fed started cutting. This chart shows how the market has traded around Fed Pauses (and into rate cuts). It brings us back to the recession question in terms of the market outlook:
Investment & Portfolio Implications*
I have written extensively about the outlook of bonds versus stocks, which is supported by the preceding data points as well – bonds tend to perform just as well in terms of returns when compared to equities following the last Fed rate hike, with much less volatility. This is the holy grail of investing. After the past seven tightening cycles, bonds delivered 89% of the return of stocks with only 26% of the volatility with more consistency in their range of outcomes. This leads to a higher Sharpe Ratio (which measures the return relative to risk taken, the higher the better). This can be augmented through the addition of various alternative assets into the portfolio as well, which have proven their mettle through the noisy markets of 2022 and 2023.
