Questions about the direction of the economy, path of interest rates, impact of technological advances, political leadership, government policy, international relations and trade, and consumer confidence have converged recently and driven market volatility higher. While capital markets and uncertainty will always be constant companions, we are optimistic that some of the fog should start to clear soon, paving the way for better investor outcomes.
Interest rates, which we consider foundational to asset prices, have finally started to come down in most regions. While the pace and magnitude of future cuts are undecided, the change in direction is being applauded by equity and bond markets. The global economy is decelerating at a moderate pace and expectations remain tilted toward a soft-landing scenario. Political uncertainty in the world’s largest economy is reaching a fever pitch but should start to dissipate after the November 5 U.S. election.
Interest rates have reversed direction, finally!
The aggressive battle central banks have been waging against inflation has been successful. While high interest rates have curtailed consumer and business spending, recovery in the global supply chain has improved the availability of goods and services. Rising levels of slack in the economy, as evidenced by declining manufacturing capacity utilization and rising unemployment, suggest that inflation should continue to trend lower. With inflation targets almost achieved, many central banks are now becoming increasingly concerned about the slowing pace of economic growth and have embarked on an interest rate-cutting path.
After peaking at 5%, the Bank of Canada (BoC) has already cut rates three times since June by a cumulative 0.75%, and market pricing suggests that it could cut by another 1.5% over the next 12 months bringing the overnight rate to 2.75%. Following the most aggressive rate hiking cycle in decades and a 14-month hold at 5.5%, the U.S. Federal Reserve is the latest central bank to begin easing monetary policy. After its initial 0.50% cut on September 18, current market pricing is pointing to a steady decline to a level of 2.75% – 3.0% over the next 12 months. Similarly, the European Central Bank has already cut by 0.5% and is expected to reduce rates to 2.0% by next summer. (All current and forecast data in this newsletter is per Bloomberg as of September 18).
Could timely interest rate cuts enable a soft-landing?
Just as the surge in government spending and ultra-low interest rates fuelled economic growth during the pandemic, a reduced pace of government stimulus and high interest rates have had the opposite effect. The unemployment rate, an economic bellwether, has rebounded from cyclical lows and the pace of increase has economists debating if the economy is headed for a hard landing (i.e., recession).
The Canadian unemployment rate has spiked to 6.6% as of August from a low of 4.8% in July 2022. The cooling labour market has pushed annualized real GDP growth to an anemic level of only 0.9% over the past four quarters. Given elevated levels of population growth, per capita real GDP growth in Canada has been negative over this period.
The official definition of a recession is two consecutive quarters of negative GDP growth across the aggregate economy. By this definition, Canada has avoided a technical recession, although in practical terms, we may be within one already. With inflation coming under control and the economy sputtering, we are confident in forecasts calling for continued easing by the BoC. Based on the stimulatory impact of lower interest rates, especially for real estate and consumer spending, current consensus economist projections call for Canadian real GDP growth to improve to an annualized pace of 1.7% over the next four quarters, pointing to a potential soft landing.
In a sign of greater resiliency, the U.S. unemployment rate has risen modestly to 4.2% as of August from a low of 3.4% in January 2023. While there are widespread signs of economic deceleration, and the unemployment rate is expected to rise modestly from current levels, U.S. real GDP growth is expected to avoid a recession. Like Canada, this soft-landing scenario for the U.S. economy is premised on a steady rate-cutting path by the Federal Reserve.
Tight race for the White House: Material differences in campaign platforms
The drama of the current U.S. election cycle has already witnessed several surprising chapters. Two assassination attempts, an 11th hour candidate change, two vastly different debates, a criminal conviction, endorsements from the world’s richest person and world’s biggest celebrity, and a trend reversal in the polls. And there’s still time for a few more chapters, including whether one candidate will accept the results of the November 5 election. In short, plenty of uncertainty to fuel near-term market volatility.
At the time of writing, Vice President Kamala Harris was marginally ahead in national polls, but the race remains a virtual tie in the seven swing states that ultimately matter. Furthermore, the likelihood of a divided Congress is high, potentially softening the impact of campaign proposals. A close race implies heightened uncertainty and potentially higher market volatility, albeit for a few short weeks. Differences in campaign platforms mean market implications under various combinations of Presidential and Congressional outcomes can be material across asset classes. In highly generalistic terms, we think the U.S. equity market could react favourably to a Former President Donald Trump victory, while international markets and bonds could react favourably to a Harris victory.
While we have laid out the prominent campaign elements below, it is important to note that we are not making any portfolio positioning decisions based on candidate platforms at this time. The commentary below is not meant to be an exhaustive analysis of the topics.
Taxes – Trump has proposed a further reduction in corporate income tax and the renewal of all personal tax cuts initiated in 2017 that are set to expire at the end of 2025. Harris has indicated her support of the 2017 personal tax cuts but only for households with incomes below US$400,000/year. She also suggests a cornucopia of higher taxes aimed at wealthy households. Harris is also proposing to raise the corporate tax rate to 28%, but also allowing small businesses to accelerate the write-off of start-up expenses.
Regulation – Trump wants to reduce the regulatory burden across most sectors, including energy, financials, technology, and environmental. A Harris administration is expected to maintain the status quo of high regulation and anti-trust challenges.
International trade – Trump is proposing punitive tariffs to protect and grow domestic jobs: 50%-60% tariff on all Chinese imports, 10%-20% on all other countries, and 100% on countries that “leave the U.S. dollar.” He is also vowing to reopen the United States-Mexico-Canada Agreement (USMCA) in 2026, which could impact trade relations between the U.S., Canada, and Mexico. Harris is expected to maintain a status quo approach of targeted import/export restrictions.
Immigration – Trump is campaigning to limit the inflow of asylum seekers and to deport 15-20 million illegal residents over his term. Harris is proposing reinforcement of the border and diplomacy with Mexico to limit the number of asylum seekers.
Consumer – Harris has proposed a list of measures aimed at reducing consumer inflation and boosting housing supply.
Energy – Harris is expected to maintain the status quo which favours renewable energy and imposes emission restrictions on fossil fuel consumption, while Trump would favour the opposite.
Healthcare – Trump would again try to repeal or curtail enrollment in the Affordable Care Act. Harris would maintain the status quo and continue drug pricing negotiations to cap the cost of common prescription drugs.
Fiscal imbalances – Neither Trump nor Harris are proposing any measures to tackle enlarged deficits or national debt. Trump has committed to an efficiency audit across all federal departments but hasn’t quantified any potential cost savings. In a detailed analysis conducted by taxfoundation.org, the U.S. debt-to-GDP ratio is expected to rise under both candidates’ lists of proposals.
Getting ready to put the offence back on the field
Given the heightened level of uncertainty, our managed portfolios have been leaning cautiously in recent months with underweight equity exposure. The commencement of interest rate cuts has boosted the performance of bonds, interest-rate sensitive equity sectors, and resulted in increased market breadth. Indeed, since the end of June and up to September 13, the U.S. bond market (as measured by the iShares Core U.S. Aggregate Bond ETF), the S&P/TSX Composite, and the Russell 2000 small-cap index have all outperformed the technology-heavy S&P 500.
With enhanced visibility on the path of interest rates, increased confidence in a soft-landing scenario, and the expectation that some geopolitical uncertainty will subside after the U.S. election, we have become more constructive on equity markets and intend to boost equity exposure in the coming weeks as opportunities arise. We intend to fund equity purchases by gradually reducing select fixed-income positions that have performed well in recent months.
