On May 11th 2023, following a period of nearly three and a half years, the World Health Organization made the official declaration that the pandemic is no longer a global health emergency. While Covid-19 continues to spread and the virus undergoes evolutionary changes, it remains a global health concern but with a diminished level of alarm on account of the widespread immunity and acquired antibodies. As a result, policymakers are now reluctant to impose economic restrictions, understanding the limitations they may have on their economies. However, considering the enduring economic and financial repercussions of the past 40 months, central banks worldwide are persistently treading cautiously, striving to strike a delicate equilibrium between managing inflation and preventing a recession.
In this economic update, we will share our insight on the many facets shaping the current macroeconomic environment, their impact on financial markets and our plan for the remainder of 2023.
A new paradigm for policy rates to control inflation.
In April, the headline inflation rate in the United States decreased marginally from 5.0% to 4.9% year-over-year (YoY), with a monthly price increase of +0.4%, which roughly translates to an annualized pace of around 5%. Although there has been a slight slowdown in the job market, indicated by a decline in job openings and an increase in unemployment benefit applications, wage gains are not aligning with the central bank's inflation target. Consequently, it is likely that the central bank will maintain current policy rates for some time as they await data indicating a movement of inflation toward the desired 2% target. We believe that rate cuts are improbable in the near future, as they contradict the primary objective of controlling inflation. In our estimation, the first interest rate cut is anticipated to occur between the first and second quarters of 2024.
The course of Federal Reserve (Fed) policy is anticipated to be significantly influenced by inflation. Although inflation rates continue to remain relatively high compared to the Fed's targets, there has been a positive trend suggesting a movement in the desired direction. Several factors contribute to this trend, including higher interest rates, lower commodity prices, improved supply chains, and reduced producer prices in China. During the pandemic, consumers accumulated excess savings, which, coupled with a strong labor market and real income gains, allowed them to sustain spending despite high inflation. However, a considerable portion of the excess savings cushion has been depleted, and there is a limit to how long spending can outpace income before consumers need to tighten their spending habits. Although it seems that inflationary pressures are easing, we remain cautious about it as a risk factor, considering the strength of the labor market and the recent increase in housing prices that we will discuss below.
The housing market in Canada and the U.S
The Bank of Canada predicts that Canadians could face mortgage payment increases ranging from 20% to 40% by 2026. This will particularly impact homeowners who purchased their houses during the pandemic before interest rates began to rise. Those who do not have sufficient capital available will face significant challenges in meeting their debt obligations. The underlying assumption is that, with a robust labor market, Canadians should be able to maintain their mortgage payments. However, if the Bank of Canada continues to raise interest rates, there could be an increase in layoffs and a higher risk of mortgage payment defaults. As more households refinance their mortgages at higher rates in the next two years, the true impact on the Canadian housing market and the overall economy will become clearer. In contrast, in the United States, where 30-year mortgage terms are more common, rising interest rates have had less severe consequences. Recent housing data in both countries indicates a rise in prices. A continued revival in the housing market reduces the likelihood of a recession due to the significant role of housing in the economy. Conversely, if home prices continue to increase, it will be more challenging to control inflation in the coming years, potentially leading central banks to further raise policy rates. It is worth noting that it is not uncommon for housing markets to experience seasonal strength in the spring followed by a cooling-off period in the summer. Over a more extended period, the housing market's trajectory and price movements may deviate from the seasonal fluctuations. Analyzing the long-term trends allows for a more comprehensive understanding of the market's overall implications for the broader economy in the years ahead.
GDP; Corporate earnings and recession
The US real GDP experienced a notable slowdown in the first quarter of 2023, expanding at an annualized rate of 1.1% compared to the 2.6% growth recorded in the previous quarter of 2022. Despite this slowdown, there were some diverging trends: Private consumption growth saw a significant surge, reaching 3.7% on an annualized basis, a substantial increase from the 1% growth seen in the final quarter of 2022. Nonetheless, this positive development was largely offset by a sharp decline in private inventory investment. Despite the possibility of the next GDP growth rate falling below 1.1%, which would technically classify as a recession, there are promising indications that it would not be an extended downturn. Moreover, while the first quarter earnings season brought some positive news for the S&P 500, it is important to maintain perspective. Despite sales surpassing expectations and achieving 3% annual growth in Q1 2023, profits still experienced a 5% year-over-year decline, marking the most significant drop since 2020. Additionally, the consensus EPS for the S&P 500 has plummeted by 13% since June 2022, indicating that a decline was already anticipated. Corporate earnings and fundamentals may face challenges due to weakening demand, margin pressures, and higher input costs, which could limit the potential for earnings growth. The recent occurrence of several U.S. bank failures is expected to tighten credit conditions, making capital more expensive for companies, particularly in the realm of commercial real estate (CRE) loans.
Source: Goldman Sachs Global Investment Research and Goldman Sachs Asset Management. As of April 30, 2023.
Geopolitical outlook
In China, the rebound driven by consumer activity has exceeded expectations following months of a zero-Covid policy. However, it is important to acknowledge that the initial starting point was relatively low, and when beginning from such a bottom position, showcasing growth becomes relatively easier. In May, factory activity in China experienced a decline to its lowest level since the country ended its zero-Covid policy in December, indicating a slowdown in its economic recovery. The official manufacturing Purchasing Managers' Index (PMI) dropped to 48.8 this month, down from 49.2 in April (a reading below 50 indicates a contraction). This marks the second consecutive contraction in as many months. As a result, the domestically driven recovery in China may not serve as the primary driver of global economic growth, as observed during previous Chinese expansions.
In Europe, the European Central Bank (ECB) raised interest rates to 3.25% in May due to persistent inflationary pressures. Notably, food price inflation in Europe is significantly higher compared to the United States and Canada, constituting a larger portion of European households' budgets. Several countries are grappling with food inflation rates approximately twice as high as those experienced in North America, with little immediate relief in sight. Despite Germany, the largest economy in the eurozone, witnessing a 0.3% decline in gross domestic product (GDP) in the first quarter of the year, following a 0.5% contraction in the previous quarter (theoretical recession), the country's weekly activity index, which reflects real economic activity, has been consistently trending upward for several quarters. This demonstrates that different sets of economic indicators can provide contrasting narratives for the same economy. The key takeaway is to avoid overreacting to isolated data points and instead adhere to investment fundamentals focused on long-term capital appreciation.
The Biden administration unveiled a fresh $300 million allocation of weaponry and equipment to Ukraine, aimed at bolstering its defense capabilities against Russian aerial attacks. Following a period of gradual territorial advancements by Russia, the situation may be shifting in favor of Ukraine. Despite China's recent attempts to mediate between the two nations, it remains prudent to anticipate an extended conflict.
China considers Taiwan as a renegade province that should be governed by Beijing, while Taiwan views itself as a separate entity with its own constitution and democratically elected officials. Tensions between Taiwan and China escalated significantly after a visit by former US House Speaker Nancy Pelosi in August 2022. While the possibility of a military intervention by China to reclaim Taiwan seems unlikely, given the crucial role of the Taiwanese semiconductor market on a global scale, any such aggression would likely intensify the ongoing East-West conflict seen in Ukraine.
Market outlook and our portfolio management approach
Based on the information provided in the economic update, caution and prudence continue to guide our portfolio management strategy for 2023. Despite an initial bearish sentiment, the market has exhibited resilience in the face of ongoing macroeconomic factors. Reflected in the graph below, the forward valuation of the S&P 500 has remained within a specific range as investors carefully assess the optimal strategic asset allocation for their portfolios.
The current market environment does not fully account for the possibility of a recession, which leaves it exposed to potential downside risks. Additionally, market liquidity challenges could further contribute to increased market volatility. To mitigate these risks, we have constructed our portfolios with a focus on downside protection. This includes investments in government bonds and a structured note that benefits from an inverse relationship with the performance of the S&P 500 (short position). Moreover, we maintain sufficient cash reserves to capitalize on opportune investments in stocks with significant upside potential. Our approach goes beyond mere index exposure, as our team diligently seeks attractive investment opportunities. This is demonstrated by our notable profits thus far in gold stocks.
Conclusion
Our team has over 35 years combined in wealth management and has dealt with many market cycles. We understand the mechanics of both bear and bull markets and how to invest money accordingly to maximise value while offering adequate downside protection.
We thank you for your continued trust, and we remain available to answer any questions you may have.
The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. The opinions expressed do not necessarily reflect those of NBF. I have prepared this report to the best of my judgment and professional experience to give you my thoughts on various financial aspects and considerations. The securities or sectors mentioned in this letter are not suitable for all types of investors and should not be considered as recommendations. Please consult your investment advisor to verify whether the security or sector is suitable for you and to obtain complete information, including the main risk factors. Some of the securities or sectors mentioned may not be followed by the analysts of NBF.