May 29, 2024

Financial letter, Spring 2024, 67^th edition

Moment of truth in the fight against inflation

While Canada's inflation rate is back within the Bank of Canada's target range, victory against inflation looks less certain south of the border. The next data releases will be critical. If US inflation returns to target, the Federal Reserve (Fed) can start easing the pressure. But if inflation persists at an uncomfortable level, the Fed will be forced to maintain the pressure for longer, which could lead to more significant economic consequences.

Encouraged by a resilient economy and the Fed's dovish tone, more investors are betting on a "no landing" scenario. In fact, a consensus seems to be growing around this outlook. Reinforcing this view is the fact that central bankers in the United States still anticipate rate cuts this year, despite upward revisions to real GDP outlooks by the consensus view and the Fed. We'll have to watch and see!

Despite the tense geopolitical environment, which has led to increased price volatility for stocks and commodities (notably oil), the global economy is showing signs of improvement. China posted solid quarterly real GDP growth at the beginning of 2024. In Europe, PMIs (including for services) are also looking better after several quarters of stagnation, though we have yet to see signs of very substantial improvement.

Index		Level	3 months	6 months	1 year
S&P/TSX		22,167.03	6.62%	15.27%	14.03%
S&P 500 (USD)		5,254.35	10.55%	23.47%	29.86%
MSCI Emerging Markets (USD)		1,043.20	2.13%	10.22%	8.21%
MSCI World (USD)		3,437.76	8.98%	21.55%	25.69%
CAD/USD Exchange Rate		$0.74	$0.76	$0.74	-0.18%
FTSE TMX Short-Term		772.26	0.33%	4.45%	3.48%
FTSE TMX Mid-Term		1,216.91	-1.12%	7.05%	1.05%
Oil (US$)		$83.17	$71.65	$90.79	9.91%
Gold (US$))		$2,229.87	$2,062.98	$1,848.63	13.23%

Asset allocation

Investing during an economic slowdown requires patience. We're maintaining a slightly cautious position in the short term in order to seize opportunities as they arise.

We recommend a neutral position for all our asset classes (cash, equities and bonds).

Equities | Neutral

The challenge of valuations

The aggregate valuation of the MSCI World Index was in the 95th percentile of its historical distribution as of March 31, the highest valuation since 2021. It's also well above its 10-year average (74th percentile).

Across the various regions, it's getting harder to find bargains. Valuations for Europe and Canada, in the 69th and 70th percentiles respectively as of March 31, have risen by several ranks since the end of 2023.

The US stock market continued to stand out, with an aggregate valuation ranked in the top decile of its historical distribution.

Despite a more favourable macroeconomic outlook, corporate earnings estimates for the next 2 years remained relatively unchanged. This creates a downside risk for the stock markets, as market performance has outpaced the optimism of analysts. If upward revisions to earnings growth forecasts fail to materialize, analysts' optimism is unlikely to follow.

With the recent resilience of the US economy, the majority of economists and investors now believe that a recession will be avoided. This is in striking contrast to the "comfortable" consensus view. Twelve months ago, the opposite was true. The indicators were quite reassuring, but the consensus view was pessimistic. The financial press even called it the most anticipated recession in history!

Sector decisions are being influenced by several factors, including a slowing US economy, a Canadian economy that continues to perform below its potential, the imminent start of a rate cut cycle and uneven inflationary outlooks across different economic zones.

We recommend focusing efforts on sectors and stocks that offer significantly higher earnings growth than the market and perform well in a context of moderate economic growth, high interest rates and persistent inflation. We favour the industrial and technology sectors, which are generally less sensitive to a slowdown in consumer spending than other sectors.

We expect interest rates to drop in the second half of 2024. In the meantime, high dividend yields (Boralex, Northland Power, Rogers) are recommended.

Fixed income | Neutral

With inflation expected to continue trending down and economies slowing (or in some cases, even tipping into recession), it's still worth considering adding bonds, the refuge of choice in the event of a recession. Our average duration is 4.25 years, which allows us to obtain an attractive return while controlling short-term volatility in the event of inflation surprises.

In early 2022, our long-term return expectations for a balanced 50/50 portfolio were diminished by very low interest rates, minimal bond market protection and equity valuations above historical averages. Since then, the fight against inflation and rising rates have helped restore the bond market's current yield, and perhaps more importantly, re-establish bond protection capacity.

Interest rates

Canada's economic data continues to exceed expectations. Real GDP growth has improved and inflation was lower than expected in early 2024. The labour market is also showing signs of a slowdown. If this trend continues until the next Bank of Canada rate announcement, it will only reinforce our expectation that rate cuts will start in June. The Bank of Canada should then gradually ease its monetary policy, as mortgage renewals at higher rates will continue to restrict household budgets and weigh on consumer spending. Our analysis has shown that, if implemented as planned, the recent federal government decision to reduce non-permanent resident admissions will put additional pressure on real GDP growth and inflation in the medium term.

With inflation still running too high in the United States, many investors now anticipate a more moderate rate cut scenario. We've scaled back our forecast to 2 cuts in 2024. The first should come around fall, provided that inflation eases and US economic growth cools a little. Strong productivity gains in the United States should also help bring down inflation. Lower inflation on our side of the border suggests the Bank of Canada may already have some leeway to start lowering interest rates. Canada and the US can take divergent monetary policy paths to a certain extent, but not without impacting the Canadian dollar. The loonie has already depreciated in the past few weeks, as have several other currencies. It will likely remain low for another few months and could even temporarily reach CAN$1.40/US$.

Conclusion

To wrap up, we're currently seeing very divergent economic scenarios. While the early adoption of an overly cautious position significantly detracted from performance over the past 12 months, a degree of caution now seems to be the key. If the economy holds up, the stock markets may be a bit more lenient (although limited by valuations that are already above average). Conversely, if the economy slows further, corporate revenues and earnings could disappoint. Fortunately, the fight against inflation in recent years has restored not only the bond market's current yield but also bonds' capacity to provide protection in the event of economic and/or market disruption.

In short, a cautious stance seems appropriate, though favourable conditions could keep pushing stock markets to new heights. And given the challenges investors face, it's important to keep a couple of things in mind:

1. Understand the margin of error. Beware of analysts with unshakable convictions. When making forecasts, the key is anticipating that they may not materialize.
2. Resist the appeal of pessimism. Being a pessimist can make you sound smart, says Morgan Housel in The Psychology of Money. Pessimistic messaging is more powerful and catches more attention. Pessimists seem to be preparing for the worst while being prudent and acting as good stewards. But on average, optimists usually make more money over the long term. The idea isn't to be one or the other, but to have a plan, put it into practice and stick with it!

In uncertain times, the advice of an expert can be extremely valuable.

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 on the markets.