Commentary
At the end of the first quarter, the Canadian economy found itself in a situation similar to many other advanced economies—albeit with a few uniquely Canadian wrinkles.
Stocks rise on hopes that central banks will make the cut
At the end of the first quarter, the Canadian economy found itself in a situation similar to many other advanced economies—albeit with a few uniquely Canadian wrinkles, such as immigration dynamics and household debt levels. Although there were ongoing signs of softness in new housing and business investment, overall economic activity and sentiment held up better than consensus expectations, while inflation continued to trend down.
Inflation data could be considered the most encouraging of the lot, given that, as of February, it had descended to a level just outside the upper end of the Bank of Canada’s (BoC’s) target range of 1% to 3%. Measured over shorter time frames, the news is even more encouraging. For example, on an annualized basis, three-month moving averages of CPI-median and CPI-trim were both below 2.5%. It’s important to note that Canada has been outperforming other countries in terms of getting domestic inflation under control.
However, like most advanced-economy central banks, the BoC has not yet taken enough comfort in the inflation data—or become concerned enough about the economic outlook—to begin cutting interest rates. In Canada and elsewhere, rate markets spent the first quarter toning down end-of-year rate-cutting expectations that SEI believed were far too dovish. The BoC took a wait-and-see approach at its March meeting, with members of the Governing Council agreeing that “they need to see further and sustained easing in underlying inflation,” with close attention paid to indicators such as supply-and-demand balance in the economy, corporate pricing behaviour, inflation expectations, and wage growth relative to productivity.
Encouragingly, supply-demand imbalances appear to be improving—although we worry that a rebound in energy prices could cause renewed pressure on headline inflation measures in the quarters ahead. According to the BoC’s first quarter 2024 Business Outlook Survey, fewer firms were planning to meaningfully hike prices in the next 12 months. However, the last two indicators—inflation expectations and wage growth relative to productivity—could prove challenging for those hoping to see a BoC easing cycle get underway soon. The most recent BoC Survey of Consumer Expectations found that near-term inflation expectations remained stubbornly high, while five-year expectations—which had fallen to 2.6% in the prior survey— ticked up by half a percentage point, bringing them above 3%.
Meanwhile, wage growth in 2023 was well above pre-COVID levels in Canada as well as several other advanced economies, and in Canada’s case, this has occurred against a backdrop of declining productivity in recent years. While we should note that productivity can be difficult to measure with precision in services-heavy economies, to the extent it provides a reasonable approximation of underlying trends, it’s something the BoC has to remain concerned about.
A turnaround in productivity growth would certainly help the inflation outlook and give the BoC more room to cut interest rates. But while Canada’s southerly neighbour has been enjoying upside productivity surprises of late, the catalysts for a similar dynamic at home are not yet clear. Business investment has been lackluster, and according to the latest Business Outlook Survey, “Businesses are moderating their investment plans in response to high borrowing costs, persistently weak demand, and easing capacity pressures. In this environment, fewer firms feel the need to expand. Instead, more businesses are focusing their investment on maintaining existing capacity.” That’s hardly a recipe for a productivity revolution. Perhaps generative artificial intelligence and large language models will provide some support as they become adopted more widely. Meanwhile, proponents of immigration argue that population growth can foster innovation and thus greater productivity; however, these are likely to be second- and third-order effects that take time to unfold, possibly across multiple generations.
Given immigration’s ongoing importance to the Canadian economy and some recently announced changes, a further word on the matter is in order. The net economic effects of the federal government’s strong immigration push in recent years are widely believed to be positive, as immigrants have likely provided some measure of labour market relief, added to consumer activity and contributed to pent-up housing demand. The housing aspect may be a double-edged sword however, as shelter price inflation has been the largest contributor to official price measures in recent quarters. This may have been a motivating factor behind Immigration Minister Marc Miller’s March announcement that the government would seek to lower temporary residents to 5% of the population from over 6%. While this decision certainly won’t undo the government’s ambitious immigration targets of roughly half a million permanent residents each year through 2025, it may have some interesting marginal effects on consumer activity, the labour market, and housing in the years ahead.
Given this outlook, it makes sense to us that the BoC’s Governing Council has adopted a more patient approach than markets expected at the start of 2024. Better—but still weak—data, a potential spring thaw in home sales, and “less bad” business and consumer sentiment could mean that the economy continues to avoid recession in 2024. With inflation still above target, markets now expect a more reasonable 0.75% decrease in the BoC’s target rate over the rest of this year. In this environment (as in most!), investors should stick to their long-term strategy, seeking to take advantage of diversification benefits and employing active management where appropriate.
U.S. interest-rate expectations have converged thus far in 2024, as stubborn inflation data and a mixed employment picture have led investors to back away from predictions of aggressive interest-rate reductions from the Fed. As of the end of the first quarter, roughly three rate cuts were priced in, most likely starting in June, putting market expectations only slightly ahead of our own. Nonetheless, risks to this view are, in our opinion, clearly on the side of fewer rate cuts.
We would not be surprised to see mild weakness in the jobs data seize the attention of policy-makers and serve as a catalyst for the first rate cut in early summer, even if inflation remains above target. We believe inflation will remain stickier than expected on a slower decline in service inflation and a continued rebound in goods inflation.
U.S. equity investors are starting the quarter from what can only be described as “elevated levels” in the market. The S&P 500 Index currently trades at a forward price-to-earnings (P/E) ratio of 21. That is well above the historical average of roughly 16 and a good distance away from the rest of the world at just under 14. While it is true that equity market performance has broadened thus far in 2024—Japanese stocks are enjoying a strong rally and, in the U.S., the Magnificent Seven” mega-cap technology stocks are ending their run in favour of the “Fab Four” or maybe the “Terrific Trio”—quite a bit of good news is already priced into the U.S. market. Starting from here, the bar has been set fairly high for earnings to outperform expectations and drive prices higher. We acknowledge that P/E multiples can still expand from these heights, especially if they’re helped along by a pivot to easier monetary policy via interest-rate cuts from the Fed.
The 10-year U.S. Treasury yield is down from the 16-year high of 5% reached in October 2023, but well above where it started the year. We see additional room for bond yields to move higher, not only on the aforementioned sticky inflation data, but also on the substantial budget funding pressures and the lack of term premium priced into the yield curve. We would not be surprised to see the 10-year Treasury yield retest the 5% level even with the prospect of rate cuts on the horizon.
Global equity markets garnered positive returns over the first quarter of 2024, due to optimism that major central banks will begin to cut interest rates sometime this year. Investors had a positive reaction to the Federal Reserve’s (Fed) monetary policy announcement and so-called dot plot of economic projections, released in March, which indicated that the central bank remained on track to pivot to interest-rate cuts as soon as June of this year. Generally positive corporate earnings reports also bolstered the markets. This offset previous concerns that stickier-than-expected inflation data would prompt the Fed and other central banks to delay a pivot to interest-rate cuts. Developed markets outperformed their emerging-market counterparts during the quarter. North America led the major developed markets for the quarter due to notable strength in the U.S. All three major U.S. equity market indexes reached new highs late in the quarter, with the broad-market S&P 500 Index recording its strongest start to a calendar year since 2019. The Pacific ex. Japan region was the primary developed-market laggard, as Hong Kong and New Zealand recorded negative returns for the quarter. Europe was the top-performing region within emerging markets for the quarter, led by strength in Greece and Poland. Conversely, Latin America was the most notable underperformer due to relative weakness in Brazil and Chile.
Global fixed-income assets, as measured by the Bloomberg Global Aggregate Bond Index, declined 2.1% in the first quarter. High-yield bonds registered modest gains for the quarter and led the U.S. fixed-income market, while U.S. Treasury securities, corporate bonds, and mortgage-backed securities recorded losses. Treasury yields rose across the curve—with the exception of 1- and 2-month Treasury bills—over the quarter. Yields on 2-, 3-, 5- and 10-year Treasury notes increased 0.36%, 0.39%, 0.37% and 0.32%, respectively. The spread between 10- and 2-year notes widened from –0.35% to –0.39% over the quarter, and the yield curve remained inverted. Yields for Canadian bonds generally moved higher across the yield curve.
Global commodity prices, as measured by the Bloomberg Commodity Total Return Index, rose 2.2% for the first quarter. The West Texas Intermediate (WTI) and Brent crude oil prices rallied during the period as ongoing geopolitical tensions in the Middle East spurred investors’ worries about a disruption in oil exports. WTI and Brent crude oil prices ended the quarter with gains of 16.0% and 13.0%, respectively. The New York Mercantile Exchange (NYMEX) natural gas price plunged 24.7% over the quarter amid slowing demand due to above-average winter temperatures in the U.S. The 8.8% decline in the gold spot price was attributable to stronger-than-expected U.S. economic data and the rise in U.S. Treasury yields during the quarter. (The gold price typically moves inversely to bond yields.) Wheat prices were down 10.6% for the period amid relatively weaker demand for exports from the U.S.
As widely anticipated, the Federal Open Market Committee (FOMC) maintained the federal-funds rate in a range of 5.25% to 5.50% following its meeting on March 19-20. In a statement announcing the continuation of the pause in its rate-hiking cycle, the FOMC noted, “Inflation has eased over the past year but remains elevated. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”
During a news conference following the FOMC’s meeting, Fed Chair Jerome Powell noted that continued strong labour market data would not preclude rate cuts. Powell said “Strong hiring in and of itself would not be a reason to hold off on rate cuts.” He also acknowledged that the January and February consumer-price index (CPI) data and core personal-consumption expenditure (PCE) inflation for January came in a bit hotter than expected. Powell said, “We don’t really know if this is a bump on the road or something more. We’ll have to find out.”
On the geopolitical front, the Russia-Ukraine and Israel-Hamas military conflicts continued. Russia’s invasion of Ukraine marked its second anniversary on February 24, with little hope for a resolution in the near term. Republican Party leaders in the U.S. House of Representatives rejected a bipartisan bill approved in the Senate that would have provided $95 billion in military aid for Ukraine, Israel, and Taiwan. In mid-March, the administration of President Joe Biden announced a plan to send $300 million more in ammunition and other weapons to Ukraine while the U.S. Congress debated a new aid package.
The U.S.- and U.K.-led coalition (with support from Australia, Bahrain, Canada, Denmark, and the Netherlands) continued to engage in a military conflict with the Houthi movement, an Iran-backed militant group that seized Sanaa, Yemen’s capital, in 2014. In late February, the coalition struck 18 Houthi targets in Yemen, including underground weapons storage facilities, missile storage facilities, air defense systems, radars, and a helicopter. In a news release, the U.S. Central Command noted that the military strikes sought to “degrade Houthi capability and disrupt their continued reckless and unlawful attacks on international commercial and U.S. and U.K. vessels in the Red Sea, Bab AI-Mandeb Strait, and the Gulf of Aden.” The Houthis have attacked U.S. military bases in Iraq and Syria, as well as numerous commercial ships in the Red Sea. This has forced international shipping companies to reroute their vessels around the Cape of Good Hope in South Africa, putting upward pressure on freight costs. In late March, the Houthis reached agreements with China and Russia to allow safe passage for their ships through the Red Sea and Gulf of Aden.
Elsewhere, in late March, the Francis Scott Key Bridge over the Patapsco River in Baltimore, Maryland, collapsed after a Singapore-registered cargo ship struck its support columns. The accident resulted in the deaths of six construction workers who had been repairing potholes on the bridge. Consequently, Baltimore Harbor, which is a major global shipping channel, was closed, leading to a back-up for cargo ships that were unable to pass through the river into the Chesapeake Bay and, ultimately, the Atlantic Ocean. There initially were concerns that the disaster could disrupt the global supply chain and have a negative impact on the local economy, as many dockworkers are employed in the cargo shipping industry and an estimated 30,000 vehicles crossed the bridge each day.
Unless otherwise noted, data sourced to Bloomberg.
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