A different perspective

We’re now two months into 2024, so let’s take stock of what has transpired so far and where we’re now. First, US economic data has been stronger than anticipated, supporting the thesis that a soft landing is within reach. Second, inflation (while still falling) has been higher than anticipated. In reaction, futures markets have pared back aggressive rate cut expectations that were priced into the market in January, with the first cut by the US Federal Reserve (the Fed) being moved out from March to July. This caused interest rates to move modestly higher (as markets digest expectations of higher for longer) and par back some of the gains seen in the bond market in 2023.

Still, risk assets (both stocks and corporate bonds) continue to outperform this year. This is partially in response to stronger growth, a better-than-expected earnings season and ultimately the expectation that we will eventually see rate cuts later in the year. Both the Fed and the Bank of Canada (BoC) have pretty much confirmed these expectations. Last week even our Prime Minister noted he was “optimistic that the BoC will start bringing down interest rates sometime this year.”

As our readers are well aware, any action by the Fed or the BoC will be dependent on inflation continuing to ease. However, we’d argue that at this juncture, elevated inflation is no longer broad based and is largely related to elevated shelter costs. Unfortunately, that’s a structural problem that can’t be easily fixed—especially in Canada with our very aggressive immigration policies. Don’t get us wrong, immigration is critical, especially with our aging demographics and large job vacancies, but current levels are too aggressive and have created large structural supply/demand imbalances in the housing market that will take years to fix.?

So here lies the key debate amongst market experts: will central bankers emphasize these structural imbalances in the housing market when determining policy actions? Or will they look through them and recognize that monetary policy won’t materially dampen housing prices without seeing an economic contraction or policy error? We’d argue that policymakers should recognize this limitation to monetary policy soon, especially in Canada where economic growth has diverged from the US as consumers are more indebted and far more sensitive to interest rates.

Economic data

Another perspective worth highlighting is that alternative measures for inflation (those that put less emphasis on shelter costs) continue to normalize. This week we saw the US Personal Consumption Expenditures (PCE) deflator for January increase by 0.3% Month-over-Month (M/M), in line with expectations, binging the Year-over-Year (Y/Y) level down to 2.4% from 2.6%. This represents the fourth consecutive month below 3%. While the core metric (excluding food and energy) stands at 2.8% Y/Y, the 6-month annualized number has fallen to 2.3%, illustrating further progress. These data points, which are noted as being favoured by the Fed, are showing far more progress than the Consumer Price Index (CPI), which remains above 3%. The main difference between the two metrics is the PCE deflator assigns less weight to shelter costs relative to CPI.?

Other important data points this week include quarterly gross domestic product (GDP) data for Canada, which rose by 1.0% in Q4 (modestly ahead of expectations), while Q3 was revised higher to -0.5% from -1.1%.? The bulk of these improvements were attributed to easing of supply chain constraints helping exports and car sales, while domestic demand was muted, so we aren’t getting optimistic just yet. Last week Canadian CPI came in lower than anticipated at 2.9% Y/Y. However, if we look at just the last 6-month trend, CPI sits at only 0.4%. If we continue at the current pace, we’ll quickly see inflation fall below 2%.? ???

Bond market reaction: Fairly muted

Changes in bond yields were fairly muted this week as the market absorbed data that continued to support the thesis of a soft landing and will gradually normalize inflation. Futures markets also continued to price in rate cuts for 2024, with the first cuts now only being fully priced in for the US and Canada in July. Credit markets were fairly stable on the week. Canadian credit spreads were unchanged while US investment grade and high yield spreads moved modestly wider. Credit markets remain strong with new primary market issuance being well absorbed as demand outpaces supply.?

Stock market reaction: Mixed this week

Global equity markets were mixed this week with Japan making decisive all-time highs. In Canada, earnings season continues in full force with the Canadian banks posting results that were mostly in line to slightly better than expectations. Capital ratios are also seen as being at sufficient levels. In the US, Berkshire Hathaway filed its annual report over the weekend, which provided continued wisdom from Warren Buffett. While he cautioned on the company’s future ability to outperform the market, the company posted net profits that were up 21% Y/Y. Berkshire now sits on a cash pile of over US$160 billion. Talk about a fortress balance sheet.

What to watch in the market next week

Next week we’ll see the coveted monthly employment reports for February. In Canada, we’ll also get Q4? productivity, building permits, trade data and the next interest rate announcement by the BoC. In the US, we’ll see the ISM reports, durable goods orders, JOLTS and the ADP employment report.?

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Authors: Adam Ditkofsky, Pablo Martinez, Sandor Polgar, Steven Lampert, Craig Jerusalim and Rahul Bhambhani

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