Introduction
Verus Financial
Family Wealth Management firm servicing multigenerational families since 1985.
In this edition of our Verus Wealth Notes, we highlight key concerns about the Bank of Canada’s (BoC) handling of interest rates, and how they remain behind the curve. Despite inflation cooling to 1.6% in September 2024, the central bank has maintained restrictive policies. This is particularly problematic given Canada’s high household debt, which makes the economy more sensitive to interest rates than in the past.
Canada’s productivity slump is another concern, with labor productivity stagnant since 2018 and the gap between Canadian and U.S. output widening. This decline in productivity has led to a significant drop in global competitiveness, and without structural reforms, Canada risks falling behind its G7 peers.
Despite these economic challenges, Canada’s S&P/TSX Index posted impressive gains in Q3 2024, rising 9.7%—its best performance since 2019. This rally was driven by strong performances in the Financials, Real Estate, and Utilities sectors, fuelled by global central banks moving toward synchronized monetary easing. However, Verus remains cautious, as signs of slowing growth and earnings downgrades are starting to emerge in Canada.
In the U.S., the third quarter of 2024 was a roller coaster for the S&P 500. Recession fears triggered by the Sahm Rule led to an 8.5% drop in July, but the market rebounded 11% after the Federal Reserve hinted at potential rate cuts. By the end of Q3, the S&P 500 was up 5.53% for the quarter and 20.8% year-to-date—the best nine-month stretch since 1997. Verus remains cautious, noting that elevated stock valuations could pose risks if corporate earnings fall short of expectations.
With volatility across the board, now’s the time for strategic positioning.
Economics
The Bank of Canada - Behind the Curve as Always
During the COVID-19 pandemic, the Bank of Canada took decisive action to cut interest rates to 0.5% in April 2020. At the time, this move was widely seen as necessary to support the economy during an unprecedented crisis. However, the problem wasn’t in the initial rate cut, but in how long the Bank left rates at this historically low level. For almost two full years, the Bank of Canada kept rates unchanged, making money essentially free and flooding the economy with cheap capital. The first rate increase didn’t come until March 2022, and even then, it was a modest 0.25% hike. By that time, inflation was already surging, and risky assets were seeing lofty valuations that many considered unsustainable.
This delay meant the Bank of Canada was behind the curve, and when it finally recognized the need to tighten monetary policy, it had to play catch-up. The result was one of the most aggressive rate-hiking cycles in over a decade. As the central bank scrambled to rein in inflation, it raised rates at a rapid pace, increasing borrowing costs across the board. However, by the time these hikes were fully underway, the damage was already done—prices were rising rapidly, and inflation had taken hold of the economy.
Fast forward to today, and the Bank of Canada finds itself in a different, yet equally concerning situation. This time, the issue is that rates are being held at overly restrictive levels for too long. In September 2023, Canada’s annual inflation rate stood at just 1.6%, the lowest it has been since February 2021. Despite this, the central bank has shown little sign of easing up on its tight monetary policy. What’s more, when you exclude the housing component from the inflation calculation, the rate of inflation is a mere 0.4% year-over-year. The ongoing drag from housing, especially mortgage interest costs—which are directly influenced by central bank rate hikes—continues to weigh heavily on the inflation basket. Without these mortgage-related costs, inflation is much lower, indicating that the broader price pressures have largely subsided.
This brings us to another important point: real policy rates. When adjusted for inflation, and especially when excluding mortgage interest costs, the current stance of monetary policy is the most restrictive it’s been since 2007. This is particularly worrisome because today’s economy is far more sensitive to interest rates than it was back then. Household debt in Canada has skyrocketed over the past decade, reaching 175% of disposable income, up from 142% in 2007. This means that Canadian households are much more vulnerable to interest rate increases, and yet the central bank’s policies remain excessively tight.
The consequences of this overcorrection are already being felt. Economic growth has been below potential GDP since 2022, and preliminary third-quarter data shows that this trend is continuing. At the same time, the labor market has yet to show signs of stabilizing, adding another layer of uncertainty to the outlook. Inflation may be under control, but the cost of keeping it there could be higher than the Bank of Canada anticipates.
As David Rosenberg, the founder and president of Rosenberg Research, said in an interview “They just swung the pendulum the other way. So I think that most if not all of the aggressive rate hikes that we had in 2022 (and) 2023 are going to be unwound…. I’m not saying we’re going back to zero… but I think we’re going back to the levels we were at before COVID”.
Canada's Productivity Slump Continues: A Deepening Economic Worry
Canada’s productivity struggles are deepening, and the ripple effects are becoming harder to ignore. We’ve discussed in previous editions of our Wealth Notes how Canada is caught in a population trap, where rapid population growth eats up resources that could otherwise enhance living standards. This trap, combined with ongoing issues in the housing and labor markets, is dragging down Canada’s economic performance, particularly when compared to the US.
The gap in productivity between Canada and the US has hit one of its widest points ever, with Canadian workers producing significantly less than their American counterparts. But what’s even more alarming is how this productivity decline is eroding Canada’s global competitiveness. According to the Institute for Management Development’s (IMD) annual rankings, Canada has fallen from 8th place in 2020 to 19th in 2024, a steep drop driven largely by productivity woes.
Recent data from Statistics Canada underscores the severity of the issue. Labor productivity in the business sector has dropped in 14 out of the last 16 quarters, leaving output per worker no higher than it was in 2018. That’s six years of stagnant productivity—an unprecedented slump. The construction industry, in particular, is struggling, with productivity levels now lower than they were 30 years ago. This comes at a time when Canada desperately needs more housing, and it raises serious concerns about the effectiveness of the government’s planned investments in housing development.
There’s no quick fix for Canada’s productivity problem, as the challenges are widespread. Common solutions—boosting competition, retaining skilled labor, reducing trade barriers, and encouraging technology adoption—are well-known but difficult to implement. Without serious progress, Canada risks becoming the under performer among its G7 peers. The stakes are high, and so far, the path forward remains unclear.'
The Fiscal Dilemma: Inflationary?
We’ve entered an era of fiscal dominance, where soaring government debt is not only putting pressure on major currencies like the U.S. dollar but also diminishing the effectiveness of?traditional monetary policies. Today’s economy mirrors a wartime economy in some ways, with fiscal deficits soaring beyond 8% and debt-to-GDP ratios nearing 125%. At the current pace of borrowing—$1 trillion every 100 days—the U.S. national debt is on track to surpass $50 trillion by 2028. This unchecked accumulation of debt risks eroding confidence in the dollar and limits the ability of central banks to manage the economy through conventional interest rate adjustments and other tools.
Although this fiscal dilemma is quite inflationary, it’s crucial to consider the deflationary pressures that continue to shape the global economy. Several key factors suggest that we haven’t entered a new era of runaway inflation just yet.
Ultimately, unresolved structural issues like secular stagnation and deflation remain serious threats. If policymakers don’t address these problems, we risk falling back into a cycle of debt deflation and stagnation.
Markets
Performance Update
The third quarter of 2024 delivered plenty of market drama, particularly for the S&P 500, which saw sharp declines followed by an impressive recovery. It all began when the Sahm Rule, a recession indicator tied to unemployment data, flashed red in July, sending the index down 8.5% amid investor panic. The Fed then swooped in with dovish signals, sparking an 11% rebound and closing the quarter up 5.5%, marking the best nine-month stretch since 1997. However, elevated stock valuations and lofty earnings expectations suggest storm clouds could be on the horizon.
Meanwhile, Canada’s S&P/TSX Composite Index surged 9.7%, its best performance in five years, fuelled by central banks’ monetary easing and a broad-based rally. Despite this, the Canadian economy shows signs of slowing, with GDP stagnating and key sectors flashing warning signs. At Verus Financial, we remain cautious on both U.S. and Canadian equities, trimming exposure in light of elevated risks.
International markets followed a similar playbook, with the MSCI ACWI gaining 4.5% after an early-quarter dip. But with global economic data missing the mark and geopolitical tensions on the rise, we expect more turbulence ahead.
Lastly, Canada’s sluggish economy could prompt faster-than-expected rate cuts, offering potential upside in Canadian bonds as we enter 2025.?
With volatility across the board, now’s the time for strategic positioning.
US Markets
The third quarter of 2024 was anything but smooth for the US stock markets, particularly the S&P 500. The quarter began on a turbulent note, driven largely by a key recession signal called the "Sahm Rule." Developed by economist Claudia Sahm in 2019, this real-time recession indicator is widely used by economists and policymakers to assess whether the economy is entering a recession. The Sahm Rule is triggered when the three-month moving average of the unemployment rate rises by at least 0.5 percentage points compared to its lowest point in the past 12 months. While this rule does not predict recessions, it has historically been triggered early in a recession's onset, suggesting that the economy is already experiencing a downturn.
In July 2024, the Sahm Rule was activated, sending shockwaves through the market. From July 16th to August 5th, the S&P 500 experienced a sharp 8.49% drop as investors feared the economy might be slipping into a recession. During this period, investor sentiment soured significantly, and the US market's vulnerability was laid bare as traders grappled with the implications of the Sahm Rule’s signal.
However, the bleeding in the market came to a halt when the Federal Reserve stepped in with more accommodative rhetoric. The Fed softened its previously hawkish stance, signalling potential rate cuts on the horizon. This dovish shift sent the S&P 500 soaring by over 11%, allowing the index to close out the third quarter up 5.53%. The takeaway: once again, it reinforced the notion that “you don’t fight the Fed.”
Despite the rough summer months, the S&P 500 managed to defy gravity and posted remarkable performance on a year-to-date basis. As of the end of the third quarter, the S&P 500 was up 20.8%, marking the best performance for the first nine months of any year since 1997.?
However, there are reasons to be cautious. The recent easing cycle has taken place in an environment characterized by unusually high stock market valuations. Except for the 2001 easing cycle, which coincided with the bursting of the dot-com bubble, the Federal Reserve has rarely initiated rate cuts with such elevated valuations. Notably, during the 2001 cycle, forward price-to-earnings (P/E) ratios had already started to decline from their peak levels, whereas today’s valuations remain near their highs.
As of September 2024, most sectors—except for Energy and Telecommunications—had higher 12-month forward P/E ratios than the median levels seen at the start of previous rate-cutting cycles. These elevated valuations create a potential risk for increased volatility, especially if corporate earnings fall short of expectations.
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Investors appear overly complacent about the likelihood of downward earnings revisions, despite several key risk indicators flashing warning signs. Expectations for earnings-per-share (EPS) growth are unusually high, while the S&P 500 has not experienced the kind of correction typically seen in similar periods. Both the bond market volatility index (MOVE) and the stock market volatility index (VIX) were lower than expected in September when the Fed cut rates, signaling that the market may be underpricing risk. Additionally, corporate spreads were at historically low levels, another sign of potential complacency among investors.
At Verus Financial, we believe that the current investor optimism is overdone. We remain cautious, particularly regarding the concentration risk within the S&P 500, where a small number of large-cap stocks have driven much of the index's performance. Given the elevated valuations and potential for increased volatility, we took profits in early 2024, capitalizing on market gains. At this juncture, we are comfortable maintaining a slightly underweight allocation to US equities, as we prefer to take a more conservative stance amid growing risks in the broader market environment.
Canadian Markets
The S&P/TSX Composite Index delivered a strong 9.7% gain in Q3 2024, its best performance since the first quarter of 2019 (excluding the pandemic recovery period). The rally was broad-based across sectors, with Real Estate surging 21.9%, Financials and Health Care both up 15.8%, Utilities rising 15.3%, and IT climbing 14%. Several key factors fueled this growth, including global expectations for reflation as central banks around the world moved toward synchronized monetary easing. Financials benefited from a steepening yield curve, while the resource sector saw support from Chinese fiscal stimulus and geopolitical tensions. Despite the strong rally, the S&P/TSX remains fairly valued, with a price-to-earnings (P/E) ratio in line with its decade-long average.
Looking ahead, however, the Canadian market faces challenges. While certain sectors like energy and gold may still benefit from global tensions, the broader Canadian economy remains under pressure. GDP growth was just 0.2% in July, and preliminary data suggests no growth in August. The outlook for September is equally concerning, with the S&P Composite PMI for Canada dropping from 47.8 in August to 47.0 in September, signaling the fourth consecutive month of contraction in private sector activity.
These economic concerns are already translating into earnings downgrades. Twelve-month forward earnings per share (EPS) growth estimates have been revised down by 2 percentage points in recent weeks, and with economic growth likely to slow further, additional downward revisions appear likely. As the economy weakens, there’s also a risk of rising unemployment, which could further weigh on corporate earnings and cap potential upside for Canadian equities.
At Verus Financial, we remain proactive rather than reactive. In late September, after our Verus High Income (VHIN) mandate achieved a 19% year-to-date return, which is more than one standard deviation from its average return, we proactively trimmed our Canadian equity exposure. Given the economic backdrop, we currently remain underweight in Canadian equities, preparing for further downward earnings pressure and potential volatility ahead.
International Markets
The third quarter of 2024 was marked by heightened volatility in international equities, with the MSCI All Country World Index (ACWI) navigating several challenges. The most significant event occurred in early August when global equities dropped 8.8% in response to a weaker-than-expected U.S. jobs report and Japan’s surprise policy rate hike, which triggered a dramatic unwinding of the Yen carry trade. However, this bout of panic was short-lived. By the end of the quarter, the MSCI ACWI posted a 4.5% gain—its fourth consecutive quarter of growth—bringing the index to a new record high in September.
The optimism in global markets was largely driven by expectations that central banks around the world would soon begin cutting interest rates, given progress in controlling inflation. Lower rates could support higher stock valuations, but we remain cautious. Despite this positive outlook, economic data since mid-2024 has persistently fallen short of expectations, raising concerns about the broader health of the global economy. We believe these weak fundamentals could weigh on corporate earnings in the months ahead.
Further complicating the outlook is rising geopolitical risk, particularly in the Middle East, which has driven up oil prices. West Texas Intermediate (WTI) crude prices surged by $10 per barrel from their multi-year lows, now hovering around $75. This increase could pressure corporate profits, drive up inflation, and influence central banks' future policy decisions.
In this environment, we at Verus Financial are skeptical of the double-digit earnings growth expectations that some analysts continue to project (chart above). While the international stock market has been resilient, we anticipate more turbulence in the months ahead as these economic and geopolitical challenges continue to unfold. Investors should be prepared for potential volatility as we move into the final quarter of 2024.
Fixed Income
Through this newsletter, it should be apparent that Canada’s sluggish economy is in need of a boost. To no surprise, the Bank of Canada (BoC) is signalling that interest rate cuts may come sooner than expected. With below-potential growth, a widening output gap, and a soft labor market, the BoC appears ready to take more aggressive action to ease monetary conditions, just as we have been alluding to over the last six months. Both headline and core inflation are within the central bank’s target range, which could support a quicker move towards policy rate neutrality.
We anticipate a 50-basis-point rate cut at the BoC’s next meeting on October 23rd, with another 50 bps reduction likely in December. By early 2025, the target rate could reach 3.25%, a faster pace of cuts than originally anticipated. Governor Tiff Macklem hinted at this possibility in a September interview, stating that quicker rate reductions could be appropriate if economic growth continues to falter.
Though some market participants may point to the U.S. labor market's resilience as a reason for the BoC to proceed cautiously, Macklem has emphasized that Canada’s economic conditions are distinct from those in the U.S. While a more aggressive BoC stance may weaken the Canadian dollar, it’s unlikely to cause a significant rise in domestic prices. We believe the BoC is expected to remain focused on Canada’s specific needs, even as the Fed takes a more gradual approach. Short-term divergences in policy rates between Canada and the U.S. are not uncommon, as illustrated by the chart below.
As we approach year-end, Canadian bonds remain attractive, particularly relative to U.S. Treasuries. However, as the Federal Reserve accelerates its own rate cuts in early 2025, the advantage may shift in favour of U.S. debt. We’ll remain vigilant, but for now, Canadian fixed income offers more upside.
Alternatives
Challenges Ahead for Private Credit
Private credit, a rapidly growing $1.7 trillion market, faces mounting risks as it struggles to deploy excess capital. With record levels of uninvested cash, or "dry powder," competition among lenders has become fierce. This imbalance is pressuring private credit managers to lower pricing and ease underwriting standards, raising concerns about investor protection.
Managers are increasingly bypassing traditional club deals and issuing larger, more concentrated loans, often taking bigger slices of financings to secure deals. This desperation to deploy funds can lead to riskier loans with reduced safeguards, exposing investors to potential losses.
While the demand for private credit remains strong, the oversupply of capital threatens to diminish returns and heighten vulnerabilities. Borrowers are taking advantage of this by securing historically low rates, and private credit funds are being forced to compromise on terms to outbid competitors.
Should economic conditions deteriorate, bankruptcies may rise, putting these loans at risk. We've already seen large private credit funds face significant distress, signalling the potential dangers ahead for the market.
Infrastructure's Moment of Resilience
Infrastructure is proving its strength amid high inflation and volatile markets, emerging as a steady asset class. The global energy transition and decarbonization efforts are driving massive investment needs across sectors, while digital infrastructure—like fiber broadband and data centers—is rapidly expanding to meet rising demand.
Geopolitical fragmentation is also reshaping supply chains, fueling fresh investment in critical logistics like ports and railways. With these long-term trends, infrastructure continues to offer stable income and capital appreciation, making it an appealing choice across market cycles.
Commentary
As we reflect on the past quarter and assess our forward-looking strategy, maintaining discipline in the face of market volatility continues to be a core principle of our investment approach. The year has brought about positive returns, thanks in large part to our focus on staying strategically composed amidst heightened market exuberance. However, as we look to the next 6 to 9 months, caution will be paramount as we navigate a landscape filled with potential risks.
Earlier this year, in February, we made the tactical decision to reduce our positions in the Verus US Focus Growth (VUFG) and Verus International Growth (VING) mandates. This adjustment marked the beginning of a more defensive positioning within our portfolios. Then, in late September, we saw our Verus High Income (VHIN) mandate achieve an impressive 19% return year-to-date, which was well above historical averages. Given that this performance was more than one standard deviation from its mean, we took a proactive step to reduce Canadian equity exposure, securing gains and mitigating risk.
Overall, we’ve reduced equity exposure by approximately 5% across the board and have redeployed those assets into more conservative instruments such as cash and fixed income. This shift reflects our belief that global markets are nearing a pivotal turning point. A grim economic backdrop, elevated fiscal debt levels across major economies, and a prevailing sense of investor overconfidence all point toward increased uncertainty ahead.
In line with Benjamin Graham’s philosophy, we believe that markets oscillate between unsustainable optimism and unjustified pessimism. At present, we see market sentiment leaning heavily towards the former. While this optimism has driven recent gains, we expect the pendulum to begin swinging back, bringing with it a more cautious and potentially volatile market environment.
As such, we have positioned our portfolios to reflect a more defensive stance, while remaining vigilant for potential opportunities that may arise. This strategic conservatism, combined with tactical flexibility, allows us to protect client capital while seeking growth opportunities as market conditions evolve over the coming months.
This isn’t investing, it’s family–invested
Verus Financial Wealth Notes