May 9, 2023

Financial letter, Spring 2023, 63^rd edition

A recession is on the way, but...

The rapid rise in interest rates could have a more delayed effect on economic activity, particularly in the United States. While the impact of the interest rate hikes was felt quickly in Canada, households and businesses south of the border were able to take advantage of low rates to freeze their long-term financing costs and repair their balance sheets. Furthermore, the rate increases we've seen so far still haven't reached their maximum impact on the economy, as this generally takes 6 to 8 quarters. As a result, the announced rate hikes will continue to have a slowing effect on the North American economy over several more quarters.

Index		Level	3 months	6 months	1 year
S&P/TSX		20 636.54	0.17%	8.01%	2.75%
S&P 500 (USD)		4 169.48	2.71%	8.61%	2.64%
MSCI Emerging Markets (USD)		977.05	-4.68%	16.52%	-6.15%
MSCI World (USD)		2 835.93	2.54%	12.58%	3.75%
CAD/USD Exchange Rate		0.74$	0.75$	0.73$	-5.09%
Bond yield Canada 2-year		749.58	0.90%	3.02%	2.08%
Bond yield Canada 10-year		1 213.05	1.28%	5.39%	3.81%
Oil (US$)		76.78$	78.87$	86.53$	-26.66%
Gold (US$))		1 990.00$	1 928.36$	1 633.56$	4.91%

 

Although the central banks raised interest rates at the fastest pace seen since 1980, the data points to surprising resilience in the economy. While the labour market remains tight, inflation has started to ease, albeit at a much slower pace than we'd like to see. The resilience of the economy alone could prevent inflation from declining further and force central banks to keep key interest rates higher for longer.

By the looks of most economic indicators, the global economy is holding up quite well. Trade growth remained slow early this year, but China's reopening seems to be paying off now. China's real GDP growth came in at an annualized 9.1% in the first quarter after the government scrapped most lockdown measures. Meanwhile, European PMIs improved further, especially on the services side, suggesting the economy continued to grow in the first quarter of 2023. However, interest rate hikes are expected to bite later this year. While overall inflation is easing just about everywhere, benchmark indexes—which exclude food and energy—are proving more resistant.

Asset allocation

With a slight recession as the baseline scenario, 2023 will likely remain a tough year for risk assets, and we are favouring an approach centred on quality and defensive securities. At the same time, we're paying close attention to valuations. There's certainly a price to pay for quality and defensive stocks, but it can't be just any price. At the same time, companies from defensive and quality sectors could be well poised to navigate the turbulence on the way.

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

• United States: overweight
• Canada: overweight
• Europe: neutral
• Emerging markets: underweight

After a first quarter that far surpassed reasonable expectations, we're maintaining a healthy dose of caution regarding the recommended allocation. While high stock valuations call for an underweight equity weighting, relatively high interest rates and the nearing of the end of the monetary tightening cycle suggest bringing bonds back to at least neutral. By continuing to underweight alternative investments, the balance should swing in favour of cash, which would nonetheless generate quite satisfactory returns. Now that's something new!

Geographic allocation

United States: Overweight

In the United States, consumer spending slowed in February and March, but January's strong gain should mean solid growth that contributes positively to first quarter real GDP. The economy is also being supported by the labour market, with employers adding just over a million jobs in the first 3 months of the year.

The recent failures of Silicon Valley Bank and Signature Bank, along with the forced merger of Credit Suisse and UBS, generated concerns about the banking system and led lawmakers, central banks and governments to take rapid measures. While these events bear a few similarities to the big 2008–2009 financial crisis, there are also important differences to keep in mind. For example, the recent upheaval is not related to a deterioration in the quality of assets held by banks. Furthermore, liquidity doesn't appear to be drying up on the market. In our assessment, the recent events can be mainly attributed to the direct and indirect consequences of the current monetary tightening cycle. They represent an additional challenge for central banks, which have been trying to restore price stability. A modest recession remains our baseline scenario, while Fed Chairman Jerome Powell's preferred metric is also pointing to an imminent recession.

Canada: Overweight

Canada's economy continues to show unexpected resilience despite high borrowing costs, persistent inflation and volatile financial markets. Despite economic difficulties, consumer spending had a good start to the year thanks to a robust labour market, solid wage gains and strong demographic growth. These factors also helped temporarily stabilize Canada's housing market. However, we still believe that interest rates will continue to weigh on economic activity in Canada. Interest rates combined with a sluggish US economy should result in a considerable growth slowdown in 2023 leading to a recession in the second half of the year. The economic contraction will put upward pressure on unemployment in 2024 while also cutting into wage growth. This decline, combined with a rapid easing of inflation, should lead the Bank of Canada to cut its key interest rate before the end of the year and bring it near its neutral rate by the end of 2024.

While Canada's economy is clearly slowing down and could enter a recession, the TSX could fare better. The share of consumer discretionary in the Canadian index is much lower when compared to the US market. Canada's banking sector will likely see lower credit demand and growing provisions for bad debts. Nonetheless, the sector remains well capitalized and trading is already occurring at a 25% discount relative to historical ratios. Therefore, a modest recession is already priced in.

Fixed income

Earlier this year, the resilience of the economy and persistent inflation led us to believe that there was a potential for additional rate hikes, and that there could be more of them than the market seemed to anticipate. However, tightening financial conditions (following the failure of Silicon Valley Bank) have become an unexpected ally for the monetary authorities, and they may no longer need to step up the pressure through more rate hikes. This means that peak interest rates in the current cycle may already be behind us. In addition, interest rates across the entire curve have reached the highest quartile of the past 10 years, conversely indicating strong appeal. In other words, bond market yields have rarely been higher in the past 10 years, and rarely has the market been so attractive.

Judging by the rising yields over the past 12 months, we anticipated that the protection potential of bonds had been at least partly restored. The month of March proved to be a good example of this. The Canadian bond index has posted a 3.22% gain since the beginning of the year.

Conclusion

Exactly one year ago, we called for a humble approach in light of recent years' returns and level-headed management of expectations in terms of future performance. Initially, most markets held up relatively well despite the shock from the pandemic. But then the extremely low absolute level of interest rates and equity valuation multiples above pre-pandemic averages limited the returns that could reasonably be expected. Despite concerns, the current situation is much more promising. According to a recent study by J.P. Morgan Asset Management, expected returns for the coming years are at their highest level in a decade. And despite the short-term uncertainty, there seems to be much more potential than there was in early 2022 for investors with sufficiently long investment horizons.

Faced with an uncertain environment, active management has the potential to deliver strong results. While there's room for convictions in investment decision-making, they need to stay within clear guidelines. In chemistry, it's not the substance that makes the poison, but the dose, and the same is true in investing!

While we might opt for a slightly cautious stance in the short term, it shouldn't be excessive. Pessimists might sound smart in the short term, but the optimists are the ones making more money in the long term!

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.

 

Louis Vazzoler
Portfolio Manager