ECONOMIC & FIXED INCOME COMMENT - "Year of the Pivot"
The global economy continues to confront the challenges of persistent inflation and tepid growth. While global growth is forecast to be stronger than expected in 2023- estimated to expand 2.9%, it is slowing as the impact of tighter financial conditions, weak trade growth and lower business and consumer confidence is felt. Against this backdrop, the International Monetary Fund (IMF) expects the world economy to grow 2.7% in 2024; well below the historical (2000-19) average of 3.8%. Moreover, there will be a growing divergence in GDP progress among economies in the near term, with growth in the emerging-market economies holding up better than in the advanced economies (i.e., the United States, the Euro area, Japan, the United Kingdom, and Canada), and growth in Europe being relatively subdued compared to North America.
The Canadian economic backdrop continues to soften with a string of weak economic data in the second half of the year. Q3 GDP contracted more than expected by 1.1% (annualized), driven by slowing business investment, B.C wildfires and flat consumer spending while Q4 is expected to be flat or slightly negative. Nonetheless, the Canadian economy is forecast to expand 1.1% in 2023 supported by strong population growth and the ensuing robust consumer demand. Moving into 2024, the Canadian economy should avoid a recession however, growth will remain elusive. Canadian GDP is forecast to expand 0.5% in 2024, reflecting slowing domestic demand due to higher borrowing costs and weakening exports leaving a very narrow margin for error thus elevating recession risks. However, the Canadian economy should recover to 1.9% in 2025 as global conditions improve and strengthen exports.
The resilience of the U.S. economy took many by surprise in 2023. U.S GDP is forecast to expand 2.4% in 2023 supported by a robust labour market, a surplus of consumer savings from the 2021 COVID stimulus package and unexpected liquidity injections from the Federal Reserve Board (Fed) to bail out regional banks. Moving into 2024, many of the tailwinds will turn to headwinds with GDP moderating to 1.5% driven by elevated inflation, high interest rates, savings, rising consumer debt and the resumption of mandatory student loan repayments.
While the near-term economic outlook is complex, the good news is that higher interest rates and slower demand are working to ease inflation pressures. In particular, the level and breadth of inflation in Canada and U.S. have subsided from their highs in 2022. This combined with projected softer economic growth in 2024 have increased the odds that both the Fed and the Bank of Canada (BoC) will pivot to interest rate cuts in the year ahead (see chart).
The Fed kept the Fed Funds Rate unchanged at 5.5% as expected in December. What surprised market participants were how willing policymakers were to soften their tone/stance on inflation. Specifically, the Federal Reserve Open Market Committee’s (FOMC) accompanying statement and projections pointed to a shift toward easing in 2024 (see chart below). In addition, Fed Chair Jerome Powell's comments during his press conference confirmed, that most members of the committee believe that the hiking cycle is over, and the committee discussed the path to lower interest rates. Markets moved quickly beyond the Fed’s forecast, pricing in up to six rate cuts in 2024. In our view given the strength of the U.S. economy, we expect the Fed to gradually bring interest rates into less restrictive territory with three to four rate cuts next year in the second half.
On December 6th, the BoC held the overnight rate steady at 5%, after 10 rate increases since March 2022. The central bank did maintain a hawkish tone, noting that another rate hike could be on the table if inflation reaccelerates. We anticipate that the Bank of Canada will begin lowering its key rate as early as Q2 (April) and will deliver 100 basis points of rate relief next year. However, the BoC is unlikely to bring interest rates down to 2.5%, before 2025. Ultimately, the magnitude of rate relief will be dependent on the path of inflation and the strength of the economy.
While we expect a soft landing for the Canadian economy in 2024, the outlook is highly contingent on interest rates and inflation. Three factors could impact the Canadian economy in 2024. These include:
Geopolitical Conflict: Growing geopolitical tensions could distort energy markets and reignite inflation. This could lead to further rate increases by central banks.
Persistent Inflation: Strong demand driven by population growth contributed to the resilience of the Canadian economy in 2023. While population growth will continue in 2024, excessively strong demand could fuel inflation; upholding its “stickiness”.
Collapsing Demand: In the absence of additional rate hikes, current interest rates are at restrictive levels that could prove more challenging to overcome than expected for consumers and businesses. Specifically, Canadian households are more vulnerable to higher interest rates than other major economies, notably the U.S. Currently, Canadians are directing more of their disposable income to pay down debt as mortgage interest payments have nearly doubled since the Bank of Canada began hiking interest rates in early 2022.
With respect to our fixed income strategy, we can say with confidence interest rates will finish lower in 2024 than they stand today (Government of Canada 10-year bond yield 3.10%). As a result, we continue to look for opportunities to lock in attractive yields by extending term (duration). Given the wide range of potential economic outcomes in the near-term, we favour intermediate-term bonds that lock in improved yields while providing a cushion to future volatility without taking on excessive interest rate risk.