November 9, 2023

Financial letter, Fall 2023, 65^th edition

"More money is lost anticipating corrections rather than in the corrections themselves." (Peter Lynch)

2023 was characterized by banking sector turmoil, dashed hopes of an economic recovery triggered by China's reopening and slight improvements in core inflation in several countries. Economies' reactions have been mixed. Despite more aggressive rate hikes by the Federal Reserve, financial markets were optimistic that the US could achieve a soft landing. On the flip side, China's economy is bogged down and short-term solutions to the headwinds the country is facing are lacking. The eurozone started the year off on an optimistic note but is now facing an imminent contraction in real GDP.

Index		Level	3 months	6 months	1 year
S&P/TSX		19,541.27	-2.20%	-1.07%	9.62%
S&P 500 (USD)		4,288.05	-3.27%	5.18%	21.59%
MSCI Emerging Markets (USD)		952.78	-2.85%	-1.87%	12.06%
MSCI World (USD)		2,853.24	-3.36%	3.40%	22.60%
CAD/USD Exchange Rate		$0.74	$0.76	$0.74	0.75%
FTSE TMX Short-Term		739.38	-0.12%	-0.92%	1.56%
FTSE TMX Mid-Term		1,136.81	-3.74%	-5.60%	-1.63%
Oil (US$)		$90.79	$70.64	$75.67	11.77%
Gold (US$))		$1,848.63	$1,919.35	$1,969.28	11.33%

In today's complex world, the one constant factor influencing our assumptions is that high interest rates will continue to have a restrictive effect on the global economy. This is true for the United States, where the excess savings reserve underpinning consumer spending is now virtually exhausted. Combined with pressures like high real interest rates, a resumption of student loan payments, tighter credit conditions and a slowdown in hiring, a soft landing is still far from certain. Our baseline scenario for a mild recession is unchanged.

In Canada and Quebec, the economy is shifting quickly. The tightening cycle started more than 18 months ago, and its effects are starting to bite harder. Economic weakness is undeniable, especially given the acceleration in population growth, with real GDP per capita down 2% year-over-year in the second quarter. Meanwhile, the unemployment rate has been rising since May and as the tightness in the labour market eases, we anticipate that it will increase further.

Combined with the ongoing headwind of mortgage renewals, we anticipate that Canada will enter a mild recession at the turn of the year. That means interest rates are unlikely to stay high for much longer. By next March, we think the Bank of Canada will believe that the process of rebalancing supply and demand will have made enough progress to justify some easing of monetary policy. However, the 2% inflation target will likely not be reached until the end of 2024, which would keep the Bank of Canada, like most central banks, from injecting substantial monetary stimulus, as it did in previous downturns.

INTEREST RATES

Central bankers in Canada and the United States believe interest rates will need to stay higher for longer. That doesn't necessarily mean they'll be increasing rates again, but that they may wait longer before announcing any rate cuts. We still expect the Bank of Canada and the Fed to keep key rates the same for the rest of the year.

ASSET ALLOCATION

We've gradually shifted to a slightly more defensive position recently. Our stance remains that tighter monetary policy will lead to a global recession, and that prudent investors would benefit from maintaining a defensive portfolio position despite uncertainty about the timing of the recession. We haven't changed our opinion.

Whereas widespread low interest rates forced investors seeking absolute returns to take greater risks for more than a decade, the dramatic rise in interest rates has revived the bond market and added direct pressure on growth stocks. Between 2008 and 2022, the S&P500's earnings yield significantly exceeded government bond yields. The recent rise in bond yields has wiped out the equity risk premium, making equities expensive compared to the bond market.

The soft-landing runway (where inflation falls but growth holds up) is very narrow. In his press conference at the most recent FOMC meeting, Fed Chair Jay Powell said, "We may continue to see further labour market softening without the spike in unemployment we've seen in the past." But, he recognized, "this would go against history." The risks remain too high. We recommend that investors stay defensive, with a modest underweight to equities and an overweight to cash.

FIXED INCOME | UNDERWEIGHT

At the start of 2022, we said that low interest rates would not only undermine the performance of balanced portfolios, but also limit their ability to protect investors in the event of an equity market slump. With the entire interest rate structure at its highest level in a decade, the risk/reward ratio for bonds has improved significantly.

For a 10-year bond at 5%, a 0.5% rate hike would trigger a 2.5% return. In contrast, a decline in the 10-year yield to 3%—which would be perfectly possible in a recession scenario—would result in a 15.8% gain!

We're maintaining our recommendation for a slightly underweight position in government bonds given that this asset class represents the safest refuge in the event of a recession. We're remain underweight because we're prioritizing cash amid uncertainty about inflation. Moreover, given that short-term bonds are more attractive than long-term ones, the reward isn't enough to take on a long-term risk. Further increasing portfolio duration will be appropriate when clearer signs of a deterioration in the job market emerge. The average duration of our fixed-income portfolio is currently four years.

EQUITIES | UNDERWEIGHT

On average, stocks peak six months before the onset of a recession. If a recession starts in the second half of 2024 in the US—which is our baseline scenario—equity markets don't have much room to run.

Given the recent stock market gains and that most of our targets set at the start of the year have been achieved—especially since we don't think it's warranted to review our forward earnings and multiples at this time—passive exposure to equities could disappoint in the second half of the year. However, since performance has proven to be very concentrated and several high-quality companies underperformed, the coming months should be more conducive to active management.

In light of the economic outlook, our geographic allocation is as follows:

• United States: Overweight
• Canada: Underweight
• Europe: Neutral
• Emerging markets: Underweight

CONCLUSION

Our baseline scenario remains that our economies will enter a recession in the next 12 to 18 months. Faced with this pivot, deflationary forces will increase and pave the way for central banks to shift from a tightening to an easing stance. The current high interest rate environment considerably reduces the appeal of stocks relative to bonds, though an excessively cautious approach could also come at a non-negligible cost.

Regardless of the economic scenario, it's important to stick to your asset allocation and not change it to try to predict the market. Each investor's asset allocation was constructed based on their age, risk tolerance, investment horizon, financial and personal situation.

We hope that this information helps you better understand the markets. Please don't hesitate to contact us if you'd like to discuss our investment strategies in more detail. We'd like to reiterate our commitment to keep working hard to help you meet your long-term financial goals by seizing the best opportunities offered on the markets.