The U.S. and Canadian economies outperformed expectations throughout 2023, weathering above-target inflation rates and aggressive tightening of monetary policies. As inflation rates trended lower, the Bank of Canada (BoC) and the U.S. Federal Reserve pivoted toward the possibility of cutting interest rates in 2024. Stock and bond markets responded with significant rallies into the end of the year, with major stock indexes extending gains into the first quarter of this year.
However, the markets’ movements and economic picture must appear somewhat perilous to central bankers. The threat of inflation has not retreated to the point where they can be confident it will not return. Yet, there are some initial signs that past rate hikes are slowing economic growth. Finding the policy balance to keep inflation at bay without tipping the economy into recession is increasingly like walking a tightrope.
In the U.S., a tight labour market and the growth in the price of services have kept most measures of core inflation above the Fed’s target range of 1%–3%. A modest loosening of labour market conditions may provide some cover for the Fed to reduce the policy rate this year. The worry remains that the U.S. economy is not particularly interest-rate sensitive, and a loosening of financial conditions may restoke inflation higher, which in turn may force rates higher again and increase the odds of a recession down the road.
In Canada the effects of higher interest rates are becoming more pronounced. The consumer price index only recently dipped just under 3%, and although Canadian core inflation is moderately higher, it has been trending down. The most recent consumer data are flashing signs of weakness as households now contend with higher debt-service costs plus the cumulative effects of more than two years of rising prices on food and many core services. With mortgage rates sitting near 15-year highs, homeowners carrying mortgages have been facing higher payments as their floating rate adjusts or as they refinance. With many more fixed-rate mortgages set to refinance over the next 18 months, the pressure for the BoC to cut rates may intensify this spring if gross domestic product growth doesn’t pick up from the current 1% annualized rate.
For now, the Canadian and U.S. bond markets have priced in approximately 85 basis points of rate cuts to December 2024, which is slightly more than the most recent median estimate of expected Fed funds rate reductions by the survey of Fed governors. Except for the Bank of Japan, other major central banks are also looking to cut rates this year. For the most part, the soft-landing scenario is what markets and policymakers are expecting this year.
Likelihood of soft landing calls for balanced approach
Against this policy backdrop, current valuations of stock and bond markets present a challenge. On the one hand, real yields in bonds are still somewhat attractive if inflation continues to ebb. But on the other hand, with a soft landing already priced in to yields today, and with the narrowing of corporate bond spreads in recent months, bond markets are likely to generate returns close to their yields with a lot less volatility compared with the past two years.
Stock markets, fuelled by the Fed’s pivot toward the possibility of rate cuts and a few high-growth technology companies, have seen their valuations push higher, with some U.S. indexes hitting all-time highs in Q1. Earnings multiples, particularly for major U.S. stock market indexes, look slightly rich, which could leave markets vulnerable should earnings growth weaken or the economy slow more than expected. If inflation ticks higher than expected, the bond market might reduce or remove expectations for Fed rate cuts. This would likely be a catalyst for a stock market pullback.
What to expect in the coming months
The most likely outcome is a soft-landing scenario, in which the stock market responds to the expected rate cuts distributing performance across more sectors and capitalization weights. With more diversity driving markets, modest positive returns are possible through the rest of this year. Rebalancing earnings multiples away from the Magnificent Seven stocks and toward the other 493 names in the S&P 500 index is a theme inside the market that may be starting to emerge.
With the first quarter of 2024 under our belt, here are three key considerations for advisors looking ahead at client portfolios:
- A neutral portfolio asset mix is where investors should feel the most balanced.
- With a cautiously optimistic economic outlook, including a soft landing and modest rate cuts, earnings growth can meet market expectations.
- Seeking opportunity through diversity of exposures is a smart move when the risk/reward between stocks and bonds becomes more balanced.
Steve Locke is chief investment officer, fixed income and multi-asset strategies, with Mackenzie Investments.