The Bank of Canada made headlines in the media when it raised its benchmark interest rate to five per cent on July 12, 2023. Many analysts questioned the increase, as inflation is on the decline. Inflation measured by the Consumer Price Index (CPI) stood at 2.8 per cent in June 2023, after reaching a peak of 8.1 per cent a year earlier.
Meanwhile, mixed signals are accumulating in the economy, and uncertainty remains. Although Canada's real Gross Domestic Product (GDP) increased in May 2023, the Conference Board of Canada expects it to contract in June, according to its Economic Quick Take overview on July 28, 2023.
Among the challenges weighing on the Canadian GDP, the Conference Board first points to ongoing wildfires across the country. The independent think tank notes that damages caused by extreme weather events are now costlier and spreading to previously unaffected areas. "While wildfires have been present in Western Canada for several years, the problem has now emerged in Ontario, Quebec, and Nova Scotia," comments the independent research group.
The Conference Board of Canada is also concerned about declining productivity in Canada, which continues despite encouraging immigration statistics. According to them, the lack of competitiveness in major industrial sectors will continue to fuel the downward spiral of productivity.
Risk of recession
The think tank also highlights that the Canadian economy is approaching the 18-month mark since the Bank of Canada began its series of interest rate hikes in March 2022. It observes that the effects of monetary policy take an average of 18 months to be felt. However, the effects were already being felt in May 2023, after only 15 months, the Conference Board notes.
According to them, rate hikes have already slowed inflation and increased the unemployment rate. The higher interest rates and the expected decline in GDP also led them to believe that a persistent economic slowdown is likely in the next two months.
The Fed weighs the data
In its overview of the economy for the week ending on July 28, 2023, Sébastien McMahon, iA Financial Group chief strategist and senior economist points out that the Federal Reserve (Fed) is getting very close to the end of its own tightening cycle. That said, the economic impact of this tightening is yet to come. "The Fed raised its benchmark interest rate again this week to 5.5 per cent, which is a peak not seen in over 22 years for the U.S. central bank," he reports.
According to the economist, the current economic data does not provide much incentive for the U.S. central bank to lower rates, "but probably nothing that will convince them to make several more hikes either." He does not dismiss the possibility that one or two more rate increases will be implemented by the end of the year but believes that successive rate hikes are "very close to the end."
The course of action will depend on the data the Fed receives, such as inflation and job market figures. "Wage pressures are a very important variable that the Federal Reserve looks at. The world is watching the U.S. labor market. The core Consumer Price Index for basic services is the curve that is most difficult to bring back to inflation target levels," notes the chief strategist and senior economist. This curve is relatively correlated to that of the private sector wage cost index, which stands at 5.5 per cent, he adds.
High rates
McMahon forecasts that rates will remain high and fairly stable. "We need to give all these rate hikes time to do their job," he says. McMahon points out that the timeframe for the effects of rate increases to be felt is unpredictable. "All the money that was injected into the economy during the pandemic and household savings suggest that the timeframes could be longer than usual,” he says.
"The job market is a lagging economic indicator, reacting to the end of signals," McMahon emphasizes. When the economic cycle has already slowed for a while, the job market slows down in turn, he explains. "Then it slowly picks up again when the economic cycle resumes."
McMahon adds that one of the labor market indicators that reacts first is new unemployment claims. He notes that this indicator started to react (increase) 15 months after the first interest rate hikes by the Fed in March 2022. "We should see unemployment claims increase, and labor market data should begin to deteriorate slowly, but steadily, over the next 10 to 15 months."
High volatility
Meanwhile, the markets are uncertain. The VIX level is high, around 13.14, warns McMahon. (VIX is short for the Chicago Board Options Exchange Volatility Index.) "It's an environment where we could be sensitive to negative news," he explains. McMahon emphasizes the importance of the U.S. labor market for the global economy and for investor sentiment.
"The unpredictability of the timelines (to feel the effect of interest rate hikes will have) is a very important piece of a macroeconomic strategy," he insists. "We have been constructive and cautious for a while. We are now looking more towards taking profits and adding more defensive positions to portfolios. The good news is that the Federal Reserve has probably completed its monetary policy tightening cycle."
Optimistic managers
Asset managers have also shared their reactions with the Insurance Portal. Some say the current period is still favorable for investors.
Among them, Capital Group writes in its semi-annual Perspectives Bulletin 2023 that the second half of the year offers a market full of targets for investors, despite significant uncertainty and changes. "In reality, this is the perfect time to be an active investor. It is more important than ever to search for opportunities globally but also to keep an eye on growing risks in markets, the economy, and the world," says Martin Romo, portfolio manager with the Capital Group U.S. Equity Fund.
"At mid-2023, it is clear that we are going through a period of transition in the global economy, financial markets, and individual sectors. What used to be a binary market is now more balanced," he writes in Perspectives Bulletin 2023.
Romo believes that times have changed since investors could cling to a few internet-related stocks and borrow money at nearly zero per cent interest without fearing inflation or rising rates. "Times have changed and this is a good thing from an investor's perspective," he says.
The world has changed
According to the Capital Group portfolio manager, the market is no longer going in just one direction. "It presents a more attractive environment. The horizon has expanded to include U.S. and international companies, growth stocks and value stocks, the technology sector, healthcare, industries and energy, short-term and long-term bonds, government bonds and corporate bonds," lists Romo.
"We live in a world where there are both cyclical and secular opportunities for investors willing to do their homework," he adds.
Importance of dividends
Among these opportunities, Romo keeps an eye out for undervalued stocks. "We are looking for opportunities where the baby has been thrown out with the bathwater, companies that were humbled by the 2022 sell-off but still deserve our attention," he adds.
He emphasizes that company business models remain intact. "Profits are maintained, and the potential for appreciation of stock prices remains high. So far this year, we have seen impressive rebounds from companies in the technology and consumer sectors," the manager observes.
In its second-half bulletin, Capital Group emphasizes the importance of dividends, among other factors. "Dividends will be of greater importance for investors in the coming period. In a context of relative instability and rising debt costs, it is essential to focus on the quality of dividend payers," the report reads.
Return of bonds
The manager also observes that "income is back in fixed-income securities." According to the manager, higher interest rates pave the way for higher income and can offer protection against bond market volatility.
Bonds can also be a strength as the economy weakens. "With inflation approaching normal and the Fed likely to pause, it is time for investors to consider returning to a balanced strategy. Valuations across a range of stocks are more attractive and bonds now offer higher income and return potential," the report reads.
The current environment also allows Capital Group to continue its momentum while celebrating its 50th anniversary. Over the past decade, Capital Group says it has more than doubled the size of its fixed-income holdings under management globally, reaching approximately USD $470-billion, or about CAD $619-billion at the current exchange rate.
Since its inception in the United States in 1973, the manager has specialized in investing in fixed-income securities. Its assets under management currently amount to around USD $2.3-trillion, or over CAD $3-trillion at the current exchange rate.
