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Markets May Be Pricing In Ideal Scenarios

February 5, 2024 11 min 46 sec
Michael Sager
CIBC Asset Management
String of cubes with arrows showing disruption in the path
iStock / Cagkansayin
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Welcome to Advisor To Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Michael Sager, managing director and head of multi-asset and currency management at CIBC Asset Management.

So for much of 2023, we were emphasizing the heightened risk of recession across the global economy. As we look at the outlook today, it’s important to note that several key economies did indeed experience really weak data consistent with recession.

Canada is one of those. In the second half of the year, consumer spending GDP data, were consistent with recession. Europe, China, Japan, all were consistent with a recession at the back end of 2023.

The exception was the U.S. where growth remained much more resilient. Q3 GDP data, for example, that were released in January, came out north of 3% annualized. That’s very strong. So a very dichotomous experience in 2023 with the U.S. resilient, other parts in recession, and of course financial markets took their lead from U.S. resilience as well as the pivot by the Fed and other central banks towards a prospectively easier policy.

So for 2024, those trends are likely to remain. The U.S. has started with continued resilience, based for instance, on strong household real income growth, which supports consumers expenditure. Whereas data in Canada, for instance, are likely to remain weak. Inflation has come down a lot faster than expected across the global economy. That includes in Canada as well as the U.S. There is still work to be done in Canada, and that reflects the stickiness of wage inflation that is running at a rate that is well above pace, that is consistent with the Bank of Canada achieving its policy target.

We do expect wage inflation to moderate, reflecting a loosening in the labour market, a weakness in economic activity. But the Bank of Canada is set to walk something of a tight rope as it waits for data to print that demonstrates that further weakening in wage inflation. Until that happens, there’s a tug of war between weaker consumer price inflation, weak economic activity, but still too strong wage inflation.

The situation’s a little bit different and more benign in the U.S., where if you look at the Federal Reserve’s key inflation metric, the core PCE Index, it returned to the Fed’s target in the second half of 2023. So the challenge for the Fed is to cut at a pace that doesn’t provoke growth too much, doesn’t re-strengthen growth too much, but also doesn’t leave the U.S. economy with too high a real interest rate. So it looks at the moment like a very benign outcome, a Goldilocks-type outcome for the U.S. with Canada and Europe looking for a bit more work to be done bringing down inflation still.

Markets are pricing almost perfection for the Federal Reserve and the Bank of Canada in terms of the outlook for their interest rate policy in 2024. For both of them, the markets are pricing about 140 basis points of cuts. That implicitly assumes that growth in the U.S. remains resilient and inflation remains benign. And in Canada it assumes that the wage inflation data I mentioned quickly return to a level that is more consistent with the Bank of Canada’s inflation target. We think that’s asking a lot.

Soft landings, Goldilocks landings are the types that are being assumed by the market are very rare in history. So that suggests to us that key central banks will definitely be cutting policy rates. They will be beginning an easing cycle in 2024, but perhaps will not be cutting quite as much as the market implies. The outlook for equity markets and bonds, I would characterize our view as cautious optimism.

In the U.S. for instance, we have relatively resilient growth, which will be positive for equity markets. And global central banks, as I mentioned, have either begun or will be beginning soon a policy easing cycle, cutting interest rates. Both of those facets are positive for the outlook for equity markets.

On the flip side of the coin, we don’t think that key central banks will be cutting quite as much as the markets suggest. So that’s a little bit of a headwind. And particularly in the U.S., valuations remain high. Margins remain high, so there’s not much room for error. So it’s a cautious outlook on equities, but it’s also selectively cautious. We’re focused on country markets, indexes, where fundamentals are strong, where valuations are not prohibitive, where dividends are a important contributor to returns. Fixed income opportunities have also become much more attractive than a few years ago.

Bond yields have risen quite markedly, and that’s a good starting point to understand the long-term expected return to bonds. Whatever your starting yield today is, history tells us that that’s a reasonable guide to the average annualized return that you’ll experience over the next 10 years. So that’s a good starting point.

There are a couple of headwinds though that we just need to navigate, particularly the fact that we think the market is pricing in a little bit too much rate cutting for key central banks. That suggests that bond yields could back up a little bit more than they have over the past couple of weeks. They could rise a little bit higher, which means that in the context of a good long-term outlook, there are potentially better entry points. But certainly we view bonds as a key part of many investors’ strategic portfolios, and certainly much more attractive than they’ve been for a while, and certainly much more attractive than we think cash or money markets will be over the next several years. So again, cautiously, selectively optimistic on both bonds and equities.

In terms of the Canadian dollar’s outlook for 2024 against the U.S. dollar, we are a little bit negative. The Canadian dollar starts from a point of being cheap. It screens as undervalued relative to our long-term valuation metrics. However, it could get a little bit cheaper yet before it reverts back to fair value. And the reason why it might get a little bit cheaper again, focuses on the economic outlook in Canada in the near term versus the U.S. The U.S. economy looks quite resilient. The Canadian economy looks quite soggy, particularly in the consumer sector. This is definitely a headwind. Canada is a cyclical currency.

We also have a push-pull story in the Canadian housing market, which means that, again, the Bank of Canada is going to be walking a tightrope. The affordability of Canadian housing is as low as it’s been for several decades. Housing in Canada is very expensive. If the Bank of Canada cuts too much too quickly, that affordability will deteriorate because house prices will bounce. And so that’s an important break on the Bank of Canada that the Fed doesn’t have.

So again, the Bank of Canada is walking an economic and inflation tightrope that makes it difficult to be positive on the Canadian dollar. So cheap for now, probably a little bit cheaper versus the U.S. dollar in 2024 before longer term strength and reversion back to fair value.