The sudden and massive rise in interest rates, though, will likely push economies into recession. Although valuations are no longer at extremes, we recognize that risk assets could still be vulnerable should corporate profits falter and/or macro risks intensify.
Pressure on economy grows, recession risk rises
The macroeconomic picture has improved in recent months and our growth forecasts have been upgraded, although we continue to expect a recession over our one year forecast horizon. Economic tailwinds exist from the strong labour market, buoyant consumer spending and, until very recently, a slight easing of financial conditions. China’s reopening and Europe’s resilience in the face of an energy shock have also benefitted the global economy, but investors may have become too optimistic regarding the outlook. In our view, the massive and sudden surge in interest rates over the past year is almost certain to cause economic pain. Weakness is already being seen in the housing market, rising goods inventories, diminished business confidence and scaled-back capital spending. Moreover, troubles have surfaced in a handful of U.S. regional banks. While policymakers have enacted measures to prevent widespread financial distress, the failure of Silicon Valley Bank exposes the vulnerabilities that exist for leveraged entities. We assign a 70% chance to a recession materializing and expect that it will occur in the second half of this year. That said, our GDP forecasts have been mostly upgraded for 2023, mainly due to the year’s better-than-expected start, plus the fact we have pushed our expected timing of recession to the second half of 2023 from the middle of the year. The anticipated recession’s depth, duration and the speed of the subsequent recovery are similar to our prior assumptions, and remain a bit more pessimistic than the consensus. For emerging markets, the expected trajectory of the economy is similar, but without an outright contraction in output.
Inflation is on a downward trajectory
The main drivers that were initially responsible for the inflation surge have all reversed. The massive commodity shock has calmed, supply-chain problems continue to improve markedly and excessive monetary and fiscal stimulus have been ratcheted down. Moreover, businesses’ pricing power may be fading and home prices have begun to fall. Given these conditions, we forecast inflation to fall faster than the market anticipates, although a variety of offsetting forces could hold it uncomfortably above the Fed’s 2.0% target. For one thing, the labour market is tight and inflation pressures have become widespread, affecting almost all goods and services. Service-based inflation is proving the last to turn, in part because it is at the very end of the chain of pricing decisions, and in part because people continue to embrace activities that were denied to them during pandemic lockdowns. Although we think our base-case inflation forecasts are reasonable, we acknowledge that there is an unusually wide range of possible outcomes. These range from inflation remaining too hot to, alternatively, inflation abruptly converting to temporary deflation.
Where do we go from Here?
U.S.-dollar weakness likely lies ahead
The tide is finally turning against the U.S. dollar. A reversal of the greenback’s gains has been overdue for some time, and we have warned for several quarters that the currency’s strength in 2022 had pushed it from already rich to levels of extreme overvaluation. As the dollar starts to retreat, and with a multitude of factors turning against it, we are growing increasingly confident that a multiyear period of U.S.-dollar weakness lies ahead. We expect most G10 and emerging-market currencies to benefit from this powerful cyclical shift.
Further significant central-bank tightening is becoming less warranted
Central banks continue to raise their policy rates in response to unacceptably high inflation. Some central banks, such as the Bank of Canada, believe they have reached the finish line after considerable effort, while the Fed, the European Central Bank and the Bank of England are signaling that modestly to moderately more tightening is to come. As inflation ebbs, though, central banks will eventually be in a position to take their foot off the brake. A neutral policy rate in North America is approximately 2.50%, around half the current policy setting. Interest rates are unlikely to return to prior lows, but it makes sense that a structurally low interest-rate environment gradually reasserts itself given elevated global debt levels, demographics, and a low speed limit for economic growth. More generally, the recent increase in interest rates highlights certain vulnerabilities. Countries with elevated public-debt levels such as Japan, Greece and Italy must now grapple with sharply higher debt-servicing costs. Japan merits close attention in particular because its debt burden is so much greater than its peers and because of the extraordinary actions the country took to depress borrowing costs.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 1.0% | 1.5% |
| Fixed income | 40% | 20-60% | 37.0% | 37.5% |
| total cash & fixed income | 45% | 30-60% | 38.0.% | 39.0% |
| canadian equities | 20% | 10-30% | 15.6% | 15.1% |
| U.s. equities | 20% | 10-30% | 25.8% | 25.3% |
| international equities | 15% | 5-25% | 20.6% | 20.6% |
| total equities | 55% | 40-70% | 62.0% | 61.0% |
Global Asset Mix:
Asset mix – trimming equities and moving allocation closer to neutral
Balancing the risks and rewards as well as weighing longterm versus nearby considerations, we remain cautiously positioned and moved our tactical positioning closer to neutral this quarter. Although we continue to expect equities to outperform bonds over the longer term, the rally in stocks from October 2022 to February 2023 diminished the risk-reward profile in equities in the near term, especially since corporate profits are vulnerable in an economic downturn. Our view has recently been modified yet again with the failure of Silicon Valley Bank and associated strain on the financial system in the United States. We were already expecting some weakness in the economic backdrop, but these recent events, we think, open the scope for further deterioration and, at the margin, reduce the odds of an optimistic outcome. As a result, early in the quarter we trimmed our equity allocation by 100 basis points, placing half the proceeds in bonds and the other half in cash. With yields at their highest level in a decade, sovereign bonds should act as ballast against any downturn in stocks within a balanced portfolio. Moreover, cash has become a more suitable holding at today’s higher interest rates, providing a cushion to the portfolio in the event that inflation surprises to the upside and triggers simultaneous declines in both stocks and bonds. Reflecting heightened uncertainty in the macroeconomic backdrop and an unusually wide range of potential outcomes, our asset mix is now the closest to neutral that it has been in several years. For a balanced global investor, we currently recommend an asset mix of 61 percent equities and 37.5 percent fixed income with the balance in cash.
Geographic allocations are as follows:
- Canada 15.1%
- United States 25.3%
- International 20.6%
Risk / Reward to our Strategy
Bond yields reset to long-term norms
After last year’s sudden adjustment in Fed policy ravaged bond markets, yields are now situated at levels that are closer to normal in the context of history. Back in December 2021, interest rates were at extreme lows with the yield on cash at 0.1%, U.S. 10-year Treasury yields of 1.5%, investment-grade credit yielding 2.4% (i.e. a spread of 90 basis point) and high-yield bonds at 4.9% (i.e. a spread of 340 basis points). But after the massive adjustments of 2022, these numbers at the end of February were 4.6% for cash, 3.9% for the U.S. 10-year bond, 5.8% for investment-grade credit (i.e. a 166-basis-point spread) and 8.7% for high-yield bonds (i.e. a 465-basis-point spread). Remarkably, even though fixed-income markets have suffered massive losses over the past year, the adjustment in markets represented a move away from extreme lows and back to something closer to the averages of the past three decades. At current levels, our bond models suggest valuation risk has greatly diminished and the prospect for future returns has improved considerably, especially if we are right in our view that inflation will continue to moderate.
Equity valuations are reasonable, risk sits with the corporate-profit outlook
Last year’s bear market in stocks addressed excessive valuations, boosting return potential according to our models. Our global composite equilibrium measure indicates that stocks are now 2% below fair value, down from a 32% overvaluation at the time of their late 2021 peak. Importantly, valuations range widely across markets, with the U.S. being the most expensive while others, especially emerging markets, are trading at compelling discounts to fair value. Given that stock market valuations have been reset and now appear consistent with the current and expected level of interest rates and inflation, we think the bigger risk to markets has to do with corporate profits. Earnings estimates have been gradually lowered over the past year amid slowing growth and rising costs, and the latest consensus of analysts’ projections anticipates no growth in 2023 profits versus 2022. However, we remain concerned that earnings estimates are not fully pricing in even a mild recession.
Shifts in market leadership worth noting
Beneath the surface, several themes and trends have emerged from October 2022 to February 2023 that we think could influence financial markets for many years. Some of the big shifts that we have observed are that the U.S. dollar has started to weaken; international equities have been outperforming U.S. stocks; cyclical sectors have been leading; small and mid-cap stocks have moved ahead of large caps; and value stocks have been winning against growth stocks. More evidence is required to convince us of a wholesale and durable shift in market leadership, but this bears watching. Some of these emerging trends have stalled amid the recent troubles within the U.S. regional banking sector, but we remain open to the possibility that the next bull market, whenever it takes hold, might not be led by the key themes that dominated for the better part of the past decade.
Conclusion:
As the expected U.S. economic downturn draws ever nearer, so too do the challenges it will present for equity investors.
With the U.S. Federal Reserve (Fed) pursuing one of its most aggressive rate hike cycles in history, U.S. credit conditions have become progressively more restrictive. We believe this “tight money” – which is intended to fight inflation – will eventually push the U.S. economy into recession. Canadian monetary conditions have followed a similar if not identical path and recessions in this country have typically aligned with U.S. economic downturns over the past century.
With just two exceptions, every U.S. recession for more than 100 years has been triggered by the arrival of tight monetary conditions. In our view, tight money has two components that are typically present simultaneously in the run-up to a recession.
The first is prohibitively high interest rates – high enough to induce those would-be borrowers who have a choice, to defer their borrowing plans. It just doesn’t make sense to buy that building (or piece of equipment, or business, or new car, or home, or holiday) if one has to commit to a loan at such a punishing rate. Rising interest rates eventually cause something to “break.” The dislocations in U.S. banking would suggest that the “prohibitive” threshold has been met.
The second tight money factor is an aggressive hiking of lending standards by banks, accompanied by a growing reluctance to lend even to those borrowers who meet the elevated standards.
Historic shift
Both of these factors have undergone a massive negative shift over the past 12 months. A year ago the fed funds rate was at just 0.25%, where it had been from the onset of the pandemic. Today it is at 5% – one of the steepest increases in history. Over roughly the same interval, the path followed by Canada’s bank rate has been only marginally less severe. Meanwhile, over the past year, the majority of U.S. banks transitioned from a stance of repeatedly lowering lending standards to one that has featured four successive quarters of raising loan qualification thresholds for almost every category of business and consumer loan.
The Fed’s January Senior Loan Officer Survey also revealed that a majority of banks are reporting reduced demand for commercial and industrial loans as well as for credit card and car loans, presumably in response to much higher interest rates. Despite the very large interest rate increases already in place, the Fed has not ruled out further hikes later this year.
It is widely thought that the turmoil in the U.S. banking sector will push banks to tighten lending standards even further. Fed Chairman Jerome Powell alluded to this likelihood at the March press conference.
We expect all of this will be enough to tip the U.S. into recession by sometime in the second half of the year. While several reliable leading indicators of U.S. recessions have already signaled a downturn is on the way, one noteworthy precursor of recession has still to be heard from. Over the last 75 years it’s always been the case that the fed funds rate has moved above the nominal GDP growth rate of the economy, usually shortly before or just as a recession is getting under way. (The nominal GDP growth rate includes the effect of price increases as distinct from the more commonly reported “real” growth rate, which does not.)
The nominal year-over-year growth rate of U.S. GDP peaked at a startling 17.4% in the first quarter of 2021 – aided mightily by comparison with the pandemic-induced deep decline in the same quarter a year earlier. Since then, the year-over-year growth rate has sagged to 7.4% as of the fourth quarter of 2022. By the third quarter of this year we expect it will be at or below 5%, putting the fed funds rate in the ascendant and strongly suggesting a recession would then soon be under way.
Canada’s nominal GDP growth as of the fourth quarter of 2022 was a full percentage point slower at 6.4% and likewise looks set to fall below our Bank Rate by mid-year.
While it appears likely Fed rate hikes may peak this summer, we do not see any rate cutting showing up before late in the year. All major central banks including the Fed and the Bank of Canada have alluded to the danger of cutting before inflation has been convincingly contained.
Changes in monetary policy in either direction are thought by many economists to produce effects in the economy six to 12 months later. Just as last year’s sharp sequence of rate hikes has only recently produced signs of economic slowdown, we believe that any start to rate cutting in late 2023 would be unlikely to turn the trajectory of the U.S. economy higher before the middle of 2024 at the earliest.
Invested but watchful
The stock market has been remarkably resilient in the face of U.S. and European banking missteps. It may be that the equity rally which began last October could have further to run. But at some point, the seeming inevitability of a recession arriving later this year could be expected to usher in another challenging period for equities, reflecting the declining expectations for earnings and eroding confidence in the future that typically comes with a period of economic retrenchment.
Equity markets usually turn higher before the associated recession ends. But in our view it would be too much to expect a new bull market to get started before that coming recession has even begun.
We believe leaning more heavily toward quality and sustainable dividends and away from specific individual company risks that may come home to roost in a recession continues to look like a good approach in a world where the precise timing of the economic cycle remains an open question.