While central banks are not yet done with rate cuts, and North American labour markets faltered in November, investors should expect several difficult quarters before the upturn, experts say.
Despite fairly resilient growth in 2022, Swiss Re Institute estimates that the global economy will grow by only 1.7 percent in the coming year “as inflationary recessions approach major economies,” says its Sigma 6 study, published in November 2022. In the most advanced economies, Swiss Re Institute expects real gross domestic product (GDP) growth of a paltry 0.4 percent, the lowest since the 1980s, except during the 2008 crisis and COVID-19.
Swiss Re’s research institute cites inflation as the top concern for insurers from 2021 onward. “We continue to see upside risk in the next two years and expect it to prove sticky,” the study reads. This risk will be combined with downside risks to growth from the U.S. Federal Reserve’s interest rate hike. On a positive note, high interest rates may propel insurers’ returns on their fixed-income investments, the Institute continues.
Good signs domestically
Inflation appears to be stabilizing in Canada. It fell to 6.8 per cent in November 2022, according to Bank of Canada statistics. It had been at 6.9 per cent since September 2022, after peaking at 8.1 per cent in June. At press time, total CPI inflation data for December 2022 had not yet been released.
What’s more, pension plans are faring well, say actuarial firms Mercer and Aon. Aon seasoned its New Year’s greetings with good news. The aggregate funded ratio of Canadian pension plans in the S&P/TSX Composite Index has increased from 96.9 per cent to 100.8 per cent over the past 12 months ending December 31, 2022. It was at 98.7 per cent at the end of Q3 2022, Aon points out. The firm derives this finding from its pension risk tracking tool.
The actuarial firm mentions that asset performance was poor in 2022, but that rising interest rates offset this performance by decreasing liabilities, in particular the plans’ obligations to their participants. “Plan sponsors can use this favourable position to reduce risk in their asset allocations or through pension risk transfer activities,” said Jason Malone, Partner, Retirement Solutions, at Aon.
Plans healthier in 2023
Mercer also has a positive view of defined benefit (DB) pension plans. According to the Mercer Pension Health Pulse, DB plans are starting the year in a strong financial position “despite the significant volatility and market declines experienced in 2022.”
The Mercer Pension Health Pulse, which measures and tracks the median solvency ratio of the DB plans included in Mercer’s pension database, ended the year at 113 per cent, up from 108 per cent at September 30, 2022, and from 103 per cent at the beginning of 2022. Here again, the significant increase in interest rates lowered DB plan liabilities and offset poor asset returns. Of the plans in Mercer’s database, 79 per cent are estimated to be in a surplus position on a solvency basis at the end of 2022.
Uncertainty in 2023
Mercer points out that many of the risks and issues driving volatility in 2022 remain unresolved. They include high inflation, capital market headwinds and geopolitical tensions. The firm adds that 2023 could be a year of additional uncertainty and volatility.
For example, F. Hubert Tremblay, Wealth Management Principal at Mercer in Montreal, forecasts that inflation will continue to pose a risk to employees, employers and plan sponsors in 2023 and beyond. Employers will have to manage their employees’ wage increase expectations, he says, based on their ability to provide wage increases in line with actual inflation.
What’s more, employers must do this in a highly competitive labour market while facing higher borrowing costs and a possible recession, Mercer adds. To be successful, employers will need a strategy and accurate market data to make informed compensation decisions, the actuarial firm says.
Trough ahead
Sébastien McMahon, Vice President, Asset Allocation at iA Investment Management, a subsidiary of iA Financial Group, as well as Chief Strategist, Senior Economist and Portfolio Manager at iA, mentions that the consensus is for a recession. When will it happen in 2023? The iA economist shared his projections with The Insurance Portal.
McMahon has counted six market rebounds since the bear market began. History suggests that between eight and 10 bounces occur before the bottom is reached, he notes.
“The end of a bear market usually occurs in a capitulation event,” McMahon observes. “Whether or not there is a recession at the end of a bear market, the final pullback is often a panic move that hits the markets.” Stocks then become so affordable that the event ends the bear market.
This capitulation is overdue. The economist and portfolio manager cites the VIX (Volatility Index), which reflects the fear on the markets. He points out that since it was introduced in 1990, the VIX has exceeded 45 at the end of every bear market. “We are still far from that. In 2022, there wasn’t really a panic,” McMahon says.
He believes that the bottom of bear markets tends to coincide with a trough in economic data. While expectations dictate the direction of bull markets, McMahon points out that the current heavy tone and monetary policies are delaying the market bottom. “I’m more inclined to think that we’ll see the bottom in the second half of 2023,” he says.
Caution in the markets
2023 is expected to be a difficult year. “Stay cautious about the markets early in the year and stay invested, as you will need to be patient before you see the bottom,” Sébastien McMahon advises. This is a healthy attitude to have, he says, knowing that investors do not want to miss the first bounce after the ultimate bottom of a bear market. “In a bear market, you have to follow the game plan,” McMahon says.
For now, his management team’s positioning remains tilted away from equities and more toward sovereign bonds. In terms of asset valuation, Sebastien McMahon notes that stocks remain expensive relative to bonds, according to the equity risk premium derived from S&P 500 data. These data are based on 12-month net income expectations and 10-year U.S. yields at November 30, 2022.
Sébastien McMahon also recommends patience, especially when it comes to interest rate cuts. The iA senior economist foresees an imminent end to interest rate hikes in Canada. “There may be one more, maybe two if inflation is stubborn. I doubt it will be 0.50 per cent,” he says. Yet high rates will remain for a while, he adds. “That’s a clear message that the markets (investors) don’t seem to be hearing. They expect interest rates to be cut as early as the second half of 2023. That’s very early and very optimistic,” says McMahon.
McMahon says the end of the trough will be augured by a pivot from the Fed (short for Federal Reserve, the U.S. central bank). In the December 2022 issue of iA Investment Management’s Monthly Market & Strategy, iA’s chief strategist, senior economist and portfolio manager says a pivot occurs when a central bank begins to cut its leading rate.
Prudence in bonds
The bond market is another financial market segment where caution is urged. Some pension plan sponsors are considering taking more risk in their bond investments, but not Thomas Reithinger. “I have not changed our risk tolerances in our Canadian fixed-income funds,” says the fixed-income portfolio manager at Capital Group. “In fact, in general I am starting to become more concerned about investment grade bonds as the financial tightening by the Federal Reserve and Bank of Canada increases the likelihood of a hard landing of the economy in 2023 or 2024,” he continues.
In the Capital Group manager’s view, a hard landing is generally an environment where credit (investment grade bonds) tends to underperform. “Clients should have a well-diversified fixed-income portfolio for 2023. Fixed income underperformed in 2022 because of the aggressive rate hiking cycles by the Bank of Canada and other global central banks. However, when the economy slows down, that is when central banks are more likely to decrease interest rates, which would give a tailwind to fixed income―especially government and provincial bonds,” Reithinger explains.
Optimistic scenario
Thomas Reithinger believes the Bank of Canada will give fixed income a tailwind. “My base case is that the Canadian economy will slow enough for the Bank of Canada to stop hiking rates,” he predicts.
The fixed-income portfolio manager at Capital Group points out that the Canadian economy is being dragged by the rise in interest rates due to the Bank’s actions. “However, I am not certain if Canada will enter a recession because recessions happen when households and business lose confidence in the outlook. There are currently no signs of that happening yet but the probability is rising in 2023.”
Reithinger thinks fixed-income portfolios could perform very well if the Bank of Canada stops raising rates or even starts cutting interest rates, due to a slowdown or recession. “As a result, I have a sanguine outlook for fixed income returns in 2023, as the Canadian economy will likely slow further,” he says.
Dragged by the United States?
According to Reithinger, the two main factors that will affect Bank of Canada policy are the Canadian labour market and external economic forces, either from the US or Europe. “The labour market in Canada continues to be resilient but there are signs that hiring is slowing. If the unemployment rate starts increasing meaningfully, that will likely make the Bank of Canada more comfortable cutting rates to support the economy. Even a small 1.5 per cent increase of the unemployment rate has historically always led to a recession in Canada,” the manager points out.
As a small, open economy, external factors play a major role in Canada, Thomas Reithinger continues. “For example, there is a risk that Canada could slow down if Europe goes into recession due to the gas situation and war in Ukraine. There is no evidence of this yet but many examples of where Canada was pulled into recession because of either the US or other external forces. This would likely also cause the Bank of Canada to decrease interest rates to support the economy
However, if the labour market continues to be strong across the country over the next year, Reithinger sees that as more evidence that inflation will not decrease. “Hence the Bank of Canada will have to raise rates further. But this is not currently my base case,” he says.
In fact, the December employment figures for both Canada and the US show slight job growth and a modest decline in unemployment.
Spotlight on the US labour market
In its January 2023 issue of Monthly Market & Strategy, iA Investment Management writes that the Federal Reserve has labour market tightness in its sights. “Our deep dive suggests that clouds are starting to form and that the picture might be distorted.” Sébastien McMahon told The Insurance Portal that “this issue of the Monthly takes a slightly skeptical stance toward the U.S. labour market.”
The “R” word is on everyone’s mind, the monthly publication states. “The leading economic indicators are trending downward, and most of the U.S. yield curve is inverted. The Federal Reserve of Atlanta has a one-year-ahead recession probability of 70 per cent, which is in line with our own models.” An inverted yield curve occurs when long-term rates become lower than short-term rates. According to the publication, employment is one area of the economy that could be a headwind to U.S. gross domestic product (GDP).
