ECONOMIC & FIXED INCOME COMMENT- Navigating a new “Wall of Worry”

The global economy achieved a “soft landing” in 2024 with GDP forecast to expand 3.2%. The trend of global disinflation supported household spending, enabling central banks to ease monetary policy, helping to offset the uncertainties posed by geopolitical tensions. Major central banks will continue to ease monetary policies as inflation further abates. Specifically, 75% of all central banks should be reducing policy rates in 2025. As we enter the new year, global GDP is expected to slow to 3.1% and maintain this steady pace through 2026. During this time, the global economy will face new challenges as capital markets navigate a new "wall of worry," which includes Trump 2.0 and significant shifts in leadership among key economies like France, Germany, South Korea, and Canada.

The U.S. economy continues to lead among its peers, with projected GDP growth of 2.7% for 2024. Over the course of the year, the Federal Reserve (Fed) reduced interest rates by 100 basis points, bringing the Fed Funds rate down to 4.5%. As we move into 2025, the incoming administration will inherit a robust economic environment, with GDP forecast to grow by 2.3%. Notably, business balance sheets are strong, corporate profitability remains high, and consumer consumption is expected to stay resilient. Additionally, while the labor market is experiencing a slowdown, it has not faced any permanent job losses.

In 2025, the Fed is expected to slow the pace of monetary easing as progress on disinflation has stalled and potential shifts in fiscal, trade, and immigration policies may complicate the inflation outlook. The new fiscal environment could be beneficial, with tax cuts and deregulation potentially boosting economic activity and promoting above-average GDP growth. Conversely, changes in trade policies could extend high inflation levels and heighten market volatility as new tariffs are introduced. Furthermore, the administration's emphasis on enhancing government efficiency and reducing the deficit may result in stricter fiscal measures, which could impede economic growth.

Over the past two years, the Canadian economy has encountered difficulties, primarily due to elevated interest rates. As a result, GDP is forecast to expand 1.1% in 2024. For, 2025, growth is projected to pick up to 1.5%, largely driven by a rebound in consumer spending and a recovery in real estate investment. However, Canada’s growth outlook will largely depend on its ability to effectively manage relations with the incoming Trump administration.

The Bank of Canada (BoC) is navigating a complex landscape as it normalizes interest rates. In its last five meetings, the bank has implemented 175 basis points of rate relief, the highest among developed central banks. The most recent adjustment on December 11th, decreased the benchmark lending rate to 3.25%, reaching the upper boundary of its estimated neutral range (2.25% to 3.25%). This move was influenced by increasing signs of labor market weakness, with the unemployment rate climbing to 6.8% in November (see chart below). Moreover, the BoC is taking proactive steps to protect the Canadian economy from the potential effects of stricter immigration policies set to take effect in 2025 and possible U.S. tariffs on Canadian products. Moving forward, the BoC intends to use a data-driven approach for its future rate decisions. 

We believe the BoC is falling behind in its monetary policy easing cycle. Normally, the bank would start cutting rates long before the economy shows signs of excess supply; however, this time they have been slower to respond, a necessary step to combat persistent inflation. We believe risks of disinflation will persist until the excess supply is fully absorbed. To achieve this, monetary policy must shift toward a more accommodative stance. Currently market participants believe the BoC should lower the overnight rate to 2% by year-end.

Additionally, we expect the BoC to implement more substantial interest rate cuts than the Fed, primarily due to a noticeable lag in per capita GDP growth and a more pronounced softening in the labor market. Historically, Canada and the U.S. have only closely aligned their monetary policies during exceptional circumstances, such as the 2001 tech bubble, the Global Financial Crisis, and the post-COVID-19 recovery. Barring any unforeseen events, the BoC is likely to have the flexibility to navigate its own monetary policy. Specfcially, we believe that the interest rate differential between the BoC and the Fed could reach 200 basis points by 2025.

The varying economic conditions and monetary policies, alongside the possible threat of U.S. trade protectionism, are likely to exert downward pressure on the Canadian dollar. However, a weaker currency may not necessarily lead to a significant increase in inflation or narrow the gap in central bank policy rates, especially when economic growth paths are diverging. In its October 2015 report titled "Exchange Rate Pass-Through to Consumer Prices," the BoC noted that a 10% depreciation of the Canadian dollar could increase inflation by approximately 30 basis points (0.3%). This is mainly due to imports of consumer goods, excluding automobiles, accounting for less than 10% of total household spending.

We maintain a positive outlook for fixed income. As inflationary pressures ease and growth projections moderate, bond yields are likely to decline, leading to modest price appreciation.