Conflicting Signals Amid Brighter Outlook

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Luc de la Durantaye, Chief Investment Officer, CIBC Asset Management.

When we look at the global economic outlook, central banks have made some progress towards their goal of slowing economic activity and bringing inflation lower. For example, economic activity is now below trend growth, so that’s a necessary condition to bring down inflation. Inflation in the goods sector has come down, with supply chains that have improved. Commodity prices with that have lowered. At least headline inflation has improved. And we see tentative signs in the housing sector and the rental market, as housing prices have shown signs of declining. That’s on the positive progress that has been made in the economic background.

But there’s other parts of the economy that remain resilient. For example, especially in the service sector. The service sector remains robust, and this is keeping the labour market fairly strong. The unemployment rate in the US, for example, is still at historical lows. Wage growth is still higher than what would be considered as consistent with price stability.

So, as you can see right there, these are conflicting economic signals. On the one hand, you’ve made some progress towards lowering inflation, but you still have some uncertainty as to how far central banks will need to go in terms of bringing back inflation to their target. Central banks will likely continue to raise interest rates. Probably they will moderate the rate at which they hike, but they still haven’t seen complete evidence that inflation can be going towards their 2% target, because you’re still at an elevated level.

In sum, what we’re looking at is global economic forecast is global growth somewhere around 1.5%. We’ve just seen the World Bank bringing down the growth expectation around the levels that we’re thinking of, and you still have inflation that is still above central bank targets. As Powell himself would say, there’s still some work to do from an economic angle. It’s not all green lights, but it’s not all red lights that we had, for example, in early to mid 2022. We’ve made some progress, but there’s still some more progress to be done.

What are the risks in that economic background? There’s a number of risks, but those that are I think most important… Central banks seem to be continuing to affirm their focus towards bringing inflation back to targets. There has continued to be somewhat of a risk of them overshooting and triggering a more pronounced economic slowdown. We haven’t seen enough easing in the labour market and that’s where the services side is more sticky, and therefore, that’s where if you want to really hit your 2% target, you need services inflation and the labour market in particular to show more signs of weakness.

We see that as one of the major risks that remains, and that’s not just in the U.S., but that’s in Canada and that’s in Europe. We’ve seen the central bank in Europe showing their teeth. They had a particularly hawkish narrative so far. But on the other hand, what we’ve seen late in 2022, early this year, is we’re seeing signs of a soft landing scenario being maybe a bit more possible than initially expected. More specifically to that, think of China’s abrupt change regarding its Covid policy. That’s removing some downside risk to the world economy. Remember, China is the second largest economy in the world and the Covid lockdowns have had a material impact on economic activity in China and in Asia.

Also, China is relaxing its policy towards the real estate market. Think of it as that’s removing overall downside growth to the Chinese economy. That’s in China.

Europe benefits from China, so that’s one thing. But if we go over also to Europe, much warmer weather, so we’re talking about two standard deviation warmer than usual is reducing the risk of an energy crisis in Europe and therefore reducing the risk of a recession in Europe. So that’s helping the camp where people are expecting more of a soft landing. So you see that you have two unprecedented two-sided risks that will require investors to be nimble on the one hand and patient as you start to look at the data, per se, and see which way it’s going to fall.

So in terms of the financial market outlook, I think it may be a bit of an easy thing to say, but it is true that 2023 should be improving relative to 2022 for a few reasons. One is valuations of many asset classes have improved. For example, if you think of fixed income, nominal yields are starting higher than in 2022. Remember, you were somewhere around 1.5% in U.S. 10-year treasury yields at the start of 2022. We’re well above that, 3.60, 3.50 in ’23. Real yields, which is the difference between nominal yields and inflation, are now positive. Real yields were negative as you started 2022. So at least you’re able to maintain your purchasing power this year if you get into fixed income investment.

Spreads also, if you look at different credit risk, whether you look at high grade high yield rate and emerging market debt, spreads have improved. They’re not at bargain levels, but spreads have improved. Then generally in equity markets, the price earnings valuation has come down to more acceptable levels. So the bottom line is the starting point is better. The question becomes how much deceleration in inflation, how much that you see in terms of deceleration, and then therefore how much damage or not central banks will be doing to the real economy.

So assuming inflation continues to go down, that’s an environment that is becoming a bit more favourable to fixed income. So that we would recommend to be a bit more positive on fixed income and certain credit side, emerging markets, to a certain degree, government debt to balanced portfolios. We think that government debt will be playing a better role in 2023 than they did in 2022. So from that perspective, there’s a bit more optimism.

It’s the equity side that we need to continue to be prudent about we think as the new year, and this is because even though valuations have improved, the second leg remains to be seen for investing in equity. And by that we mean what is corporate profit going to look like? To lower inflation, that’s a good thing, but to lower inflation you have to bring down growth.

Then how much growth slowdown are we going to witness and how much profitability corporations will be hit. We think at this stage it still seems, given the economic environment, that the consensus earnings are still a bit too optimistic and therefore consensus earnings need to be revised lower.

So, it’ll be interesting to see fourth quarter earnings are going to be really interesting to analyze and see how much pain and how much forward-looking qualitative elements will be announced by corporations in the coming quarter. That’s where we think we need a bit more prudence there, but it will on the other hand, provide some opportunities as we head into the first and second quarter of this year.