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Further Tightening, Depleted Savings Could Undo Resilient Economy

July 18, 2023 10 min 00 sec
Luc de la Durantaye
CIBC Asset Management
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Luc de la Durantaye, chief investment officer, CIBC Asset Management.

This is very unusual and surprising. The economy, and particularly the North American economy, has been much more resilient than consensus.

So many economists and the consensus was that we would be at this point in time, in a recession, and that most people are still waiting for that recession to occur. The resilience is pretty impressive, considering how fast the interest rates have been rising. We think the economic resilience, particularly in the U.S., has been caused by a few factors.

One is, and there’s recent Federal Reserve research that has just been published that explains that a little bit, excess savings for consumers were historically elevated following the pandemic with government support, and clearly, a lack of spending during the pandemic, because people couldn’t really spend as much. That excess saving has been supporting consumption so far. This research points to the fact that these excess savings are almost depleted by now.

In the second half of the year, we could see something that is a bit different or a bit more weakness from consumption. That’s one element that we’re going to continue to watch. This is one element that would point to that resilience. We may be finally fading that resilience in the second half of this year.

The commercial bank is very interesting as well. The commercial bank lending rates, like on mortgages, on line of credit, did not follow fully the rise in market interest rates for a while.

That helped cushion the impact on rising interest rates. We hear that in some of the news, where Canadian banks, for example, had been extending mortgages, or renewal of mortgages. They haven’t touched the rates, but they’ve extended the maturity, et cetera. This effect has helped cushion the impact on the economy. This is also diminishing as we enter the second half of the year. We see that these lending rates from banks are starting to catch up to market rates.

A bit more technical issue was, if you recall, the quantitative tightening, particularly in the U.S., and this is more to the US.. than Canada, but that quantitative tightening has been disrupted by the events surrounding the fiscal cliff. Something to do with the Treasury General Account, the TGA, as we call it in our lingo. That has helped keep interest rates lower than probably they should have been. We’ve already seen that starting to move. We’ve seen rates starting to move again since the fiscal cliff has been resolved until January, 2025.

Those are the elements, I think, that have helped the US economy, the North American economies hold up better than most people expected.

The final thing that I think is going to change the outlook for the second half is we are already seeing a second round, a second wave of central bank tightening. The Bank of Canada, the Federal Reserve has signaled that as well. A number of European central bank as well have signaled that they would continue to raise rates.

To bring that in terms of what the outlook looks like is we still expect that we should see growth deceleration in the second half of this year, helping central banks move towards their inflation targets of 2%. Central banks, and this is still going to be tricky because central banks continued to have a very difficult balancing act between meeting their inflation goals, and regaining credibility on that front, because that’s very important, while not tightening too much to create a more pronounced economic slowdown, giving the high level of debt in the developed economies.

We could be more interest rate-sensitive going forward. Already, some economies in Europe are showing some signs of recession, like Germany is in a technical recession, having two consecutive quarters of negative growth. China is gradually putting some effort to support its economy, but they have limited flexibility.

They don’t have as much leeway to stimulate their economy because of the real estate debt problems that they have, and they don’t want to continue to support poor investment. We see both risks in the second half, but also opportunities in financial markets coming in the next six to 12 months.

Well, we would advise to keep portfolio optionality, and by that, we mean one way to do that is to maintain a low duration bond portfolio. That way, you can benefit from the recent rise in interest rates. Don’t forget, you’re getting paid much better today than you were a year or two ago. In real terms, given the decline in inflation that we’ve seen already, but also the decline in inflation that is going to continue, you’re also getting a better real return, that is your nominal return minus your inflation, than a year, year and a half ago.

That’s one thing on the fixed income side is to keep interest rates… Like in a short duration, take advantage of the rising interest rates, and you have optionality in your portfolio. Also, on the equity side, after a stronger than expected equity rally, I think most people think in the face of central banks that continue to raise interest rates, I think the further upside in the equity will be more difficult in the shorter term, as central banks will seem to be really focused on fighting the stubborn inflation.

Therefore, having some low duration bond portfolio might be giving you some optionality to take advantage of an equity market that might be a bit more going sideways, and providing some better entry points opportunity-wise.

You can also position your equity portfolio in a more defensive posture. Think about if we’re going to have a continued slowdown, the cyclical sector might have difficulty to perform, and then you want to be exposed to some of the defensive sectors that provides good dividends that are going to get you that cash flow again. That’s providing more stability in your portfolio as well.

On the thematic side of things, there’s been a lot of optimism around the theme of AI. In the long term, it looks like we’re sold to the idea. It looks to be an important revolution to be invested in. Our investment solutions are exposed to this AI theme. We have to think that in the more immediate term, it’s not likely to boost productivity tomorrow. It’s not completely immune from the risk of a soft batch in the economy. As I mentioned, central banks continue to, they’re resolved to deal with inflation in the coming months.

That might provide some better entry points in the second half of the year. Being patient to get greater exposure to the AI theme is probably being able to be exposed to that over the coming six to 12 months. As opposed to jumping in right away, as the central banks are accelerating their tightening.

It’s interesting, there’s been a sea change in the bond market. The bond market is not pricing, remember the bond market was pricing in cuts in interest rates for the second half of this year. That’s been completely taken out. The bond market has been aligning itself with the Federal Reserve, which is saying, “We’re going to keep rates higher for longer.” That’s a good thing, and I think that provides some better entry points in the bond market.

We should also be careful from an equity perspective, because with a slowdown that is likely to come, corporate earnings might have a bit more difficulty to grow. If you have a slowdown and if you have inflation that continues to come down, that’s an environment that’s going to be a bit more difficult for corporate earnings. We’ve got to think also that the last two quarters, earnings have not been great. They’ve been better than expected, but still in terms of growth, earnings growth has not been great.

That’s creating opportunities going forward in this next six months, I’d say. Being patient, I think, is going to be rewarded.