For many months now, the prospect of lower interest rates has been shimmering like a mirage on the economic highway. And as mirages work, the closer we get to an interest rate inflection point, the timeline gets pushed further into the future. The seeming inability of high interest rates to crush inflation and slow the economy has many wondering whether “it’s different this time.”
As every economic cycle is subject to unique circumstances, we think the effect of higher interest rates is being tempered by unusually large government deficits that have an opposite impact. While central banks attempt to extinguish inflation with high interest rates, some governments are fanning inflationary flames by running enlarged deficits. In addition to these counter-reactionary forces, high interest rates themselves are contributing to higher observed inflation in the form of higher mortgage costs, constraining housing starts, and rising rental costs.
While the likelihood of interest rate cuts keep getting delayed in the U.S. (only one 25-basis-point (bps) rate cut is now anticipated in 2024 by the U.S. Federal Reserve versus 150 bps of cuts expected at the beginning of the year), decelerating economic data in Canada suggests the first rate cut could come as early as the next Bank of Canada rate announcement on June 5. Similarly, conditions in Europe point to a rate cut on June 6 when the European Central Bank meets next. Dare we say it, the mirage is lifting, and interest rate cuts could soon become reality.
Canada and Europe in the midst of a slowdown
Higher interest rates have started to sting economic activity in many regions. In Canada, year-over-year (YoY) real GDP growth clocked in at 1.1% in 2023 and consensus expectations call for a meagre 1.0% for 2024, about half the growth rate of the five years preceding the pandemic. Adjusting for rapid population growth, Canada’s per capital real GDP shrank 1.7% in 2023 and is projected to shrink again in 2024 by 1.1%. The eurozone is also in the throes of a slowdown with real GDP growth of only 0.4% in 2023 and 0.7% projected for 2024. All else equal, forecasts of imminent rate cuts in Canada and Europe appear warranted. (All statistical data in this newsletter is per Bloomberg unless otherwise stated).
We think an earlier timetable for interest rate cuts in Canada and Europe should plant the seeds of an economic rejuvenation over the next 12-24 months. While lower interest rates should start to provide much needed relief to consumers, the typical lag between rate cuts and recovery means that these economies could continue to decelerate in the near-term. As outlined in the portfolio positioning below, we have been reducing exposure to consumer-focused investments, concentrating instead on fixed income, high-dividend-yielding companies, select technology investments, and a reintroduction of international exposure.
U.S. economic exceptionalism?
With a projected real GDP growth rate of 2.4% in 2024, the U.S. is the only G7 country expected to have a growth rate above 1% this year. This may seem a head-scratcher considering that the U.S. also has the highest central bank interest rate of G-7 countries. Many strategists have touted this U.S. economic exceptionalism as a reason to remain bullish on the U.S. economy. Below the surface, however, the U.S. economy is also straining from the burden of high interest rates. U.S. retail sales, a barometer of consumer health, has decelerated to an annualized pace of 0.6% (using data from January to April). Credit card and auto loans delinquent for more than 90-days, an early warning sign of consumer stress, have now surpassed pre-pandemic levels and are on par with early-2008 levels. Surveys of consumer confidence have also turned downward.
Realtime data from restaurant reservation app OpenTable is showing that the number of seated diners in the U.S. have declined by an average of 5.9% YoY. A weekly measure of foot traffic (using a sample of 25 million mobile devices) shows a clear slowdown in consumer visits to discretionary retailers while traffic has increased at retailers focused on staples. Finally, anecdotal evidence from national retailers ranging from Walmart, Home Depot, McDonald’s, to Starbucks are all pointing to a decline in discretionary spending.
So, what is driving the outperformance of the U.S. economy? Better relative labour force productivity has been one factor, but even that is fading based on a Q1 2024 annualized productivity rate of only 0.3%. Another driver of U.S. economic growth has been large government deficits. Unlike most countries that have curtailed post-pandemic stimulus, the U.S. continues to aggressively borrow and spend. The U.S. government’s deficit-to-GDP ratio was 6.5% in 2023 (compared with Canada at 1.2% and Eurozone at 3.6%) and is forecast to be 5.8% in 2024 (compared with Canada at 1.3% and Eurozone at 2.9%). In dollar terms, this means that the U.S. will likely borrow an additional US$1.6 trillion in 2024 with much of it filtering into the economy and propping up growth. Considering that the U.S. is juicing its growth rate through aggressive borrowing, while others are being relatively prudent, its G7-leading growth rate is coming at a great cost and doesn’t appear that exceptional after all.
Given the first law of thermodynamics: that you can’t get something from nothing, large deficits and rising overall debt do have implications. A growing interest burden “crowds out” more productive spending/investment. Higher debt also impairs the ability to bail an economy out of future economic downturns, reduces future economic growth, increases the likelihood of future fiscal austerity, and could lead to a devaluation of the currency.
Early thoughts on upcoming U.S. election
With the U.S. election looming (November 5), some early fiscal policy positions have emerged. Chief among these include a general increase in taxes by Democrats (will let Trump era tax cuts expire, increase capital gains and estate taxes), while Trump-led Republicans intend to renew existing tax rates and push for protectionist trade policy (10% tariff on all imports and 60% tariff on all Chinese imports). While further details should emerge after party conventions this summer, we view both stances as potentially detrimental to economic growth. We intend to take a deeper dive into implications of the U.S. election in our next newsletter.
Maintaining defensive positioning
Our asset allocation decisions are based on our assessment of risk and reward. Given the current scenario of slowing growth and unattractive valuation levels, we are maintaining underweight equity exposure in our managed portfolios. Meanwhile, the fixed income weighting in our balanced portfolios is the highest in over four years.
The largest disconnect between economic outlook and equity market valuation appears to be in the U.S. where the Conference Board’s index of leading economic indicators continues to deteriorate even as the equity market hits fresh all-time highs. The pendulum of investor sentiment has swung too far toward the optimistic side, warranting caution in the near-term.
Market breadth, a measure of how many stocks are participating in a market trend, had been improving since the end of February, but the robust performance of select technology companies (namely NVIDIA) has once again narrowly concentrated performance of the S&P500 into a few index constituents. We attribute the decline in market breadth to diminishing prospects of a near-term interest rate cut by the Federal Reserve.
With anemic growth expected for most developed economies over the coming quarters, we have modestly trimmed Canadian and U.S. equity exposure and redeployed proceeds into Latin America and India, regions with favourable valuations and/or demographics. Specific portfolio changes are outlined below.
