July 19, 2023

Financial letter, Summer 2023, 64^rd edition

First half of 2023 significantly exceeds expectations

Canada's economy continues to beat economists' forecasts. Real GDP growth in Q1 2023, up 3.1% (annualized) and far exceeding the 2.3% growth anticipated by the Bank of Canada, is just the most recent example. However, we believe the momentum won't last. While real GDP growth in Q2 will likely amount to at least 1.5%, most of this growth will have occurred in the early stages of this period. We expect growth to continue to slow in the second half of the year and into the beginning of 2024.

Index		Level	3 months	6 months	1 year
S&P/TSX		20,155.29	1.15%	5.75%	10.57%
S&P 500 (USD)		4,450.38	8.74%	16.88%	19.56%
MSCI Emerging Markets (USD)		989.48	0.97%	5.02%	2.12%
MSCI World (USD)		2,966.72	6.99%	15.44%	19.17%
CAD/USD Exchange Rate		$0.76	$0.74	$0.74	-2.78%
FTSE TMX Short-Term		740.30	-0.80%	1.00%	1.37%
FTSE TMX Mid-Term		1,181.02	-1.93%	1.85%	3.06%
Oil (US$)		$70.64	$75.67	$80.26	-33.21%
Gold (US$))		$1,919.35	$1,969.28	$1,824.02	6.20%

US growth remains strong for now. This strength was one of the main factors behind the stock market rally. But the enthusiasm around higher-than-expected growth proved to be short-lived. The forecasts now call for modest real GDP gains in Q2 and Q3. However, the 500 basis point increase in key rates by the Fed since March 2022 (with another rate hike expected in July) with the impacts on mortgage rates, tightening credit conditions and a slowing global economy will eventually have negative consequences for economic activity. Real GDP is expected to decline in late 2023 and early 2024.

The eurozone has already suffered 2 consecutive quarterly drops in real GDP, and the impact of key rate hikes should lead to other declines in the coming quarters. The UK has managed to stave off a recession so far, but its economic environment is also due for a more severe deterioration. Japan is also feeling the impact of higher prices. In China, however, inflation is non-existent and a weak economic rebound is the main concern.

Asset allocation

We have gradually shifted to a slightly more defensive position over the recent period. Our stance had been that the tightening of monetary policy would 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.

History shows us that an increase of just 50 basis points in US unemployment has always preceded a recession. The recent rise in new applications for jobless claims points in the same direction.

Meanwhile, inflation has persisted. We've been saying for a long time that it would be relatively easy to bring inflation down from 6% to 4%, but reaching the 2% figure would require the ultimate tool: entering a recession. That remains the case today. Inflation is influenced by many variables. Many of these variables have been analyzed, such as shifts in the cost of housing, used vehicles and financial products. But the broadest measure of core inflation—the Trimmed Mean PCE inflation rate—does not point to any significant downward movement toward 2%, according to Peter Berezin, Chief Global Strategist at BCA Research. Furthermore, the latest PCE inflation data reveals that its trajectory is higher than what's needed to align with the FOMC's forecast, namely a core PCE inflation rate of 3.6% at the end of 2023 and 2.6% at the end of 2024.

While the European stock markets have performed better than expected since the beginning of the year, returns on US stock markets have been 2% higher. This is largely thanks to technology and AI stocks, while most other US sectors have lagged behind their global peers. We are still of the opinion that the United States will outperform other regions during a recession.

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

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

Interest rates

Interest rates rose over the past month as central banks shifted back to a tighter policy stance. Faced with economic activity that refuses to slow down and persistent inflationary pressure, the Bank of Canada ended its rate hike pause while the US Federal Reserve eyed an even higher terminal rate. Against this backdrop, interest rates rose even higher across all sovereign yield curves.

Yields on 10-year US Treasuries rose to a peak of 3.82% from 3.35% in May while the market began to rule out rate cuts by the Fed this year in its forecasts. In Canada, 10-year rates climbed from a low of 2.62% in March to as high as 3.45% in June. Returns could rise even higher if the Fed and the Bank of Canada signal new rate hikes. We are shifting from a slightly underweight position in bonds to a neutral position given that this asset class represents the safest refuge in the event of a recession.

It will be prudent to further increase portfolio duration when clearer signs of a deterioration in the job market emerge. For now, the average duration of our portfolio is 4.25 years compared to 5.25 years for our benchmark index.

Forex

If the global economy deteriorates sharply, foreign exchange risk will be tilted more to a rapid appreciation of the US dollar, especially against the currencies of countries considered more economically and financially fragile. The recent appreciation of the Canadian dollar is mainly attributable to narrowing interest rate spreads with the United States.

Conclusion

In our view, investors face a range of predominantly downside scenarios. 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.

While we'd like to believe a soft landing is possible, this prospect looks very unlikely. The risks are too great to suggest massively purchasing risky assets. It's important not to succumb to the fear of missing out (FOMO). Going forward, we recommend an overweight position in government bonds, a neutral cash position and a moderately underweight equity stance.

Barring a significant change in an investor's personal situation, it's better to stick with their existing investment strategy and take full advantage of portfolio rebalancing. A properly diversified portfolio is designed to help investors achieve their goals over 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.