But the lagged impact of aggressive monetary tightening, in our view, is still likely to eventually push the economy into recession and, in an environment of heightened macroeconomic uncertainty, substantial risk taking is unwarranted and PATIENCE IS CRITICAL.
Growth remains positive for now, but headwinds are likely to dominate
Most major economies have continued to expand so far this year and some of the key risks to growth have diminished. Inflation has moderated from an extreme, stress in the U.S. regional-banking system has eased, risk assets have rallied and North America’s housing market rebounded in the spring. But offsetting this long list of positives is the fact that the most critical headwinds have intensified. China’s economic rebound from late last year is fizzling as the world’s second-largest economy struggles despite attempts by policymakers to stimulate growth. Moreover, short-term interest rates have risen even further than previously anticipated in the developed world and are now at decidedly restrictive levels not experienced in over two decades. The full effect of tightening monetary conditions typically slows the economy with a significant lag, with the implication that the window for a recession may just now be starting to open. As a result, we continue to expect a recession in most of the developed world over the year ahead, though its contours should be mild in depth and short in duration. Our GDP growth forecasts have mostly been raised for 2023 and lowered for 2024, reflecting betterthan-expected economic data during the summer and the deferral of the start of the anticipated recession from the third quarter of 2023 to the fourth quarter. Our 2024 growth forecasts remain below the consensus.
Inflation trend remains favourable
U.S. consumer inflation peaked at 9% in mid-2022 and has since cooled toward 3% as the four main drivers of high inflation have all turned. The commodity-price surge following Russia’s invasion of Ukraine has reversed, supplychain problems have mostly been resolved, monetary policy has moved from extreme accommodation to a restrictive stance and fiscal policy has become far less stimulative. While inflation has declined relatively quickly during the past year, further material improvements toward the 2.0% target will prove more difficult in the near term as gasoline prices have rebounded in recent months and base effects will be less favourable. Nevertheless, we remain optimistic with regard to the medium-term inflation outlook and believe that inflation can fall faster than the consensus expectation, aided in part by weaker economic conditions, to just above 2.0% by next year.
Where do we go from Here?
Dollar detour: how short-term factors have interrupted the cyclical decline
The U.S.-dollar downtrend remains intact and we continue to expect significant U.S.-dollar weakness over the coming years. However, the long-term cyclical decline embedded in our outlook has run into a few shorter-term roadblocks, and so its progress has been slower than we had anticipated. While the dollar sits roughly 7% below its September 2022 peak, the currency is unchanged since the start of 2023. Higher U.S. interest rates and disappointing economic growth abroad have interrupted the dollar’s slide in 2023. Still, emerging-market currencies as a whole have fared impressively – a few even managing double-digit returns so far this year – and the euro, Canadian dollar and British pound have also outperformed the U.S. dollar. We remain optimistic on most emerging- and developed-market currencies over the next 12 months, as we expect the U.S. dollar to decline broadly.
Rate-hiking cycle is drawing to a close, and cuts are likely over the year ahead
Central banks are now near or already across the finish line in their monetary-tightening journeys. Emerging market central banks have been leading the way, raising rates before the developed world during this cycle, and some have now pivoted to delivering rate cuts. It is not unreasonable to think that central banks in the developed world may follow suit within the next year. Our model suggests the neutral U.S. fed funds rate is currently 3.4%, but if inflation continues to decline in line with our forecast, that neutral reading falls to around 2% in 12 months. As a result, and in combination with our recession forecast, it seems unlikely that the fed funds rate will remain at an elevated 5.5% for an extended period. This view is in line with pricing in the futures market, which flags the possibility of one more 25-basis-point hike by the end of this year, followed by the start of an interest-rate cutting cycle beginning in early 2024.
How We Are Positioned To Take Advantage Of This Outlook:
| Asset Class | BenchMark | Range | Last quarter | current recommendation |
| cash & Cash equivalents | 5% | 0-15% | 2.0% | 2.0% |
| Fixed income | 40% | 20-60% | 38.0% | 38.0% |
| total cash & fixed income | 45% | 30-60% | 40.0.% | 40.0% |
| canadian equities | 20% | 10-30% | 14.8% | 14.8% |
| U.s. equities | 20% | 10-30% | 24.8% | 24.8% |
| international equities | 15% | 5-25% | 20.4% | 20.4% |
| total equities | 55% | 40-70% | 60.0% | 60.0% |
Global Asset Mix:
Asset mix – maintaining neutral allocation
Assuming we are correct in our view that the economy is likely to enter recession over the next 12 months, interest rates, bond yields and stock prices could all be closing in on near-term peaks. While there are pathways to a positive outcome for the economy and markets if an economic soft landing is achieved, we think the reward for taking substantial risk in this environment is not as appealing as it would have been at earlier points in the cycle. Further supporting this view is the fact that the premium offered on stocks versus bonds is at its lowest level in nearly two decades. As a result, we have been gradually dialing down the equity overweight position in our asset mix over the past 18 months, balancing these near-term risks with the asset class’s long-term upside potential. We have used those proceeds to narrow our prior underweight in fixed income as rising yields boosted the appeal of sovereign bonds, whose current elevated yields should provide a better ballast against any downturn in equities. Last quarter, we completed the process of fully closing our tactical risk exposures. This quarter, we maintain that neutral stance relative to our benchmark weights. For a balanced global investor, we currently recommend an asset mix of 60% equities and 38% fixed income with the balance in cash. Actual fund or client portfolio positioning may differ depending on individual investment policies.
Geographic allocations are as follows:
Canada 14.8%
United States 24.8%
International 20.4%
Risk / Reward to our Strategy
Sovereign bonds offer attractive return potential, minimal valuation risk
Government-bond yields have climbed to their highest levels since just before the 2008/2009 global financial crisis and at this point represent attractive value. According to our models, much of the acute valuation risk that so worried us in 2020 and 2021 has dissipated with last year’s painful bond sell-off. With bond yields now at a much higher starting point, the economy likely to weaken and inflation pressures capable of moderating further over the coming year, we believe the risk of capital losses in sovereign bonds is minimal and forecast lower bond yields and thus higher bond prices ahead. As a result, sovereign fixed-income assets are the most appealing they have been in many years and we expect that government bonds will deliver returns in the mid to high single digits over the year ahead, with some regions even capable of low double-digit returns.
Equity-market gains have been dominated by U.S. mega-cap technology
Global stocks extended their gains in the past quarter, but their performance so far this year has been increasingly concentrated to just a handful of names. The “Magnificent 7” – the largest U.S. publicly listed companies – have benefited tremendously from emerging trends in artificial intelligence (AI), which have propelled valuations of these stocks to especially demanding levels. The group now makes up over a quarter of the S&P 500 Index’s market capitalization and has delivered outsized gains of 70% so far this year, contributing to almost three quarters of the S&P 500’s 17% gain over that period. Returns offered by the rest of the market, however, pale in comparison. The equal-weighted S&P 500, a better representation of how the average stock has performed, is up just 5.8%. As a result, the performance of the S&P 500 is masking the fact that underlying market breadth has been relatively poor – often an indication that the economy is struggling or set to weaken. Although global equity-market valuations are not unreasonable, earnings are vulnerable to a contraction in economic activity, which limits the potential upside in stocks. In this late-cycle environment, we are looking for low-to-mid-single-digit returns for stocks short-term, with relatively worse outcomes from U.S. equities due to their higher valuations and the influence of expensive mega-cap technology names that could falter if the economy entered a downturn.
Conclusion:
After a long haul moving higher from lows set back in the fall of last year, stock markets took a breather in August and September. That correction could have further to run through the often seasonally weak fall months, by which time we expect markets to reverse course, opening the way to a renewed move to higher ground.
The S&P 500 Index and Canada’s S&P/TSX Composite Index are the only broad-based, blue-chip indexes in the developed economies that have not yet moved above their late 2021 high-water marks. We expect them to do so before this advance has run its course.
A possible catalyst for any coming renewed up-leg might turn out to be investor conviction that the U.S. Federal Reserve (“Fed”) will begin cutting rates sooner than expected, giving the Bank of Canada and other central banks some room to do likewise.
Rate cutting would most likely be a response to the arrival of weaker-than-expected economic data, especially on the employment front. However, a rising stock market fueled by a deteriorating economic outlook is not a sustainable set of circumstances, in our view, especially when the market is already trading at a comparatively full valuation— currently 20x the 2023 consensus earnings per share estimate for the S&P 500 and 18x next year’s forecast.
Mega muted
It must be said that the performance of the TSX has been much more muted than that of the S&P 500 – it is trading at just 14.2x 2023 estimated earnings – almost entirely because it’s absent the seven mega-cap, tech-related stocks that have accounted for all of the S&P 500’s over-achievement.
While we think new highs for both indexes in the next few months are a distinct possibility, most of 2024 will likely be less upwardly dynamic than 2023 – particularly if a deeper economic slowdown or recession were to arrive over that interval, as we expect.
Expectations for a “soft landing” versus a “hard landing” for the U.S. economy have swung from favouring one over the other repeatedly this year. The jury is still out but we see mounting headwinds in the U.S. for both the consumer and for capital spending by businesses.
First among these is the continuing tightening of credit conditions. Along with Fed rate hikes, a majority of U.S. banks have been raising their lending standards for more than a year, and a significant fraction expect to further tighten standards.
Excess savings built up in the pandemic are gone or all but gone in the U.S. (although not in Canada). Credit card debt and delinquencies are rising sharply. Student loan repayments for almost 44 million Americans restarted in September. Mortgage refinancing and auto loans are much more expensive and harder to get.
Retail trade has shifted from full-price retailers to price discounters, suggesting that American consumers are feeling less confident about the state of their finances. Job openings, while still elevated, have been falling steeply for several quarters. Consumer confidence is not far above decade lows.
None of the above are insurmountable, in our opinion, but neither do they appear to have run their course. Dynamic new economic expansions usually begin when pent-up consumer demand and cheap credit combine to put unemployed workers and facilities back to work, kicking off a virtuous cycle of rising production engendering even greater demand. Today in the U.S. and Canada, there is very little pent-up demand and very few unemployed workers or idle factories, while credit is expensive and restrictive. Businesses are contending with slowing sales and rising costs.
Focus on quality
We believe there is enough fuel in the tank to push stocks up to new highs— where most averages were almost two years ago – and recommend remaining sufficiently committed to stocks to take advantage of that expected upswing. However, we believe investors should consider limiting individual stock selections to companies they would be content to own through a recession, which, in our view, is the most probable economic outcome in the coming quarters. For us, that means high-quality businesses with resilient balance sheets, sustainable dividends, and business models that are not intensely sensitive to the economic cycle.
Perhaps the most compelling reason for focusing on resilient, high-quality businesses is that all those economic headwinds cited above will in fact run their course and fully dissipate later next year. History strongly suggests that equity markets will anticipate the start of a new economic expansion several months before it gets underway. Portfolios that have held their value to a better-than-average degree will be best equipped to take advantage of the opportunities that are bound to present themselves at that positive turning point when it arrives.
Fixed income opportunity now
Of course, balanced portfolios also have a fixed income component (e.g., bonds). For most of the past 13 years our recommendation has been to maintain a below-normal exposure to fixed income because interest rates were not adequately compensating the investor for the risk that rates might rise from what were abnormally low levels.
Rates were as low as they were in large part because central banks led by the Fed pursued extraordinary policies designed to keep both short and longer-term interest rates well below where conventional markets forces would have taken them. Often during that long stretch when a bond matured in a portfolio the investor was faced with the prospect of having to reinvest the proceeds at a rate that was just a fraction of what they had been receiving.
A desire to fully replace that income propelled some investors into riskier, higher-yielding bonds and even more into dividend-paying stocks where absolute yields were usually higher than GIC and government bond yields, even more so when the favorable dividend tax treatment was factored in. Despite the pandemic, that shift from fixed income to dividend-paying equity worked out well from early 2019 through to early 2022. Taking on some extra risk delivered both more income and capital appreciation.
But now the extraordinary central bank policies that kept rates low have been replaced by aggressive rate hiking and an abandonment of massive bond buying (“Quantitative Easing”). Bond yields have moved dramatically higher. The 10-year Canada bond yield has skyrocketed from just 0.5% in the summer of 2020 to almost 4% today. U.S. yields have moved even higher. That means many maturing bonds today can be re-invested to fully replace or even exceed the income they had been generating.
What’s more, over 2020 and 2021 massive amounts of Canadian and U.S. government and high-grade corporate bonds were issued carrying very low coupons. Today, in the higher rate environment, those bonds are trading at big price discounts to the value they will eventually mature at. A buyer of one of those discounted bonds today will receive a comparatively small coupon income (taxed at regular income rates) and a large capital gain at maturity (taxed at a much lower rate).
In our view it is time to consider moving back to the full targeted exposure to fixed income in a balanced portfolio.