As expected, the Bank of Canada (“BoC”) cut interest rates again in late July which means Canada remains one of the leaders in easing monetary policy among developed countries (along with Switzerland). More importantly, the bank is leading the U.S. in cutting rates which has positive implications for the S&P/TSX given approximately 40% of the market is interest rate sensitive (Banks, Telecoms, Pipelines, Utilities, and REITs). While the Canadian market has lagged the S&P 500 in recent months, due to our lack of Tech behemoths, more broadly speaking, Canadian stocks could benefit from a lower rate environment. Meanwhile, the U.S. Presidential Election is also becoming top of mind for investors as it is now under 100 days away. It is important to note that where we are in the economic and interest rate cycle matters far more to investment returns than politics.
After much anticipation and discussion in the financial press, the Bank of Canada cut rates at it’s June meeting date, signaling a new direction in interest rates. “The first cut may not necessarily be the deepest, but it is the most significant, as it marked the official turning point after more than two years of restrictive policy,” wrote BMO Chief Economist Douglas Porter. The Bank cut it benchmark interest rate by 25 basis points to 4.75%, marking the first cut from a G7 central bank since interest rates were hiked worldwide in 2022 to help curb inflation. Looking ahead, the Bank has also indicated that if inflation continues to move towards it’s 2% target, its reasonable to expect further rate cuts this year. For reference, the most recent Canadian CPI rate was 2.9% in May, which was slightly higher than April’s 2.7% reading.
On the fixed income front, May saw Canadian bond yields fall as expectations increased for the Canadian central bank to cut overnight rates. While still showing a loss on a year-to-date basis, the Canadian Bond Universe Index was up about 1.8% in May. The Bank of Canada did not have a rate announcement in May but does in early June (as of this publication, the Bank of Canada did indeed cut rates on June 5th by 0.25%). Meanwhile in the US, the Federal Reserve announced at its May meeting that it would hold rates steady and that it may take “longer than expected” before cutting.
April saw us make a couple of minor changes within our North American portfolios. We exited our position in UnitedHealth Group and used the proceeds to purchase Merck & Co. Merck is a diversified global biopharmaceutical company that we believe is well positioned for growth. In another move, we took some profits from our position in Cameco and used the proceeds to add to Canadian Natural Resources and our position in an S&P/TSX Index ETF. On an asset allocation basis, we remain unchanged with an overweight to equities and slight underweight to fixed income.
As noted in previous editions, stocks typically post strong gains during interest rate easing cycles. Based on data collected by research firm NDR, going back to 1933 (post-depression), average returns have improved almost immediately following the first Fed rate cut. Additionally, the average annualized return 12-months after the first rate cut is 20%. This represents more than 10% better performance vs. the market’s historical return (i.e., including non-easing cycles). Expectations are for the Bank of Canada and the Fed to follow other world central banks by cutting rates later this year. March saw equity markets in Canada and the US continue to post robust performance, following up January and February’s strong numbers. In fact, the S&P 500 has just completed its best five-month rally in nearly four years and is in the midst of the longest stretch without a 2% pullback (closing basis) in more than six years. A common question we have been fielding is – “can this continue or is this as good as it gets?”.
While productivity growth gets less attention than other major macro variables, it increases long-term economic and corporate margin growth potential without stoking dangerous inflationary pressures. In the current context, investments in artificial intelligence, cloud computing, autonomous vehicles etc. is poised to have a real-world impact on economic activity. As an example, The Economist recently stated that AI is raising productivity for salespeople and coders by at least 1/3rd at tech start-ups. This is far from trivial for companies that typically burn cash and are racing to generate positive cash flow. In our portfolios we maintained individual positioning in February while keeping our portfolios slightly overweight equities and underweight fixed income.
Looking closer at the economic data, it could pose a risk to inflation numbers bouncing higher instead of continuing their trend lower. Economic growth, for one, continues to surprise to the upside with Q4 2023 GDP showing a faster pace than initially anticipated, prompting many to even revise 2024 expectations higher, including our BMO economists. Reports of tighter bank credit standards and higher credit card loan delinquencies are worth monitoring but are normal signs of the impact of higher interest rates and should help moderate economic growth.
As we enter 2024 we continue to see optimistic signals for both fixed income and equities. First, recession probability models continue to show improvements with odds of a downturn in economic activity ticking further down. Secondly, as mentioned in previous monthly updates, securities markets are primarily influenced not by absolute numbers, but by the trajectory of key macro variables. On that note, the situation for inflation has improved significantly with the Bank of Canada’s 2% target range in sights for 2024. Two areas which still have room for progress, but are expected to improve in 2024, are economic growth and housing momentum.
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