Navigating the Current Economic and Market Landscape

Roman Dubczak: Hello, everyone. I’m Roman Dubczak, Deputy Chair of CIBC Capital Markets. Thanks for joining us for a discussion on the current economic backdrop, as well as its impact on portfolio strategy. The Democratic convention is on. Full election-mode begins in the US right after Labour Day, the Jackson Hole fed meetings are taking place this week, setting the tone and the narrative on interest rates through the fall and beyond. Equity markets have found their leg, so to speak, after a brief period of volatility. They’re staging a late summer rally. The so-called ‘risk trade’ appears to be on having taken hold despite some reasonably material risks on the horizon, namely the US election, geopolitical crises in Europe and the Mideast, a seemingly rapid cooling off on the part of consumer spending… Are markets climbing a wall of worry?

Joining me here today to provide insights on the current landscape are my colleagues, Avery Shenfeld, Chief Economist at CIBC Capital Markets, and Ian de Verteuil, Head of Portfolio Strategy at CIBC. So Avery, we start with you. What’s your current view of the economic backdrop?

Avery Shenfeld: So I think that one of the biggest downside-risks that the market might have been worried about at one point has pretty much faded away. And that was the risk that inflation would be stubborn and that we would really need to beat up on the Canadian and US economies to get rid of it. Both countries are pretty much sounding the ‘all clear’ sign on inflation. And that’s very good news for investors, because it means that the Federal Reserve, the Bank of Canada, they really have no reason to forestall rate cuts as need be. It doesn’t mean that they’re going to move to cut rates rapidly. If the economy does okay, then the Fed looks like it’s going to move relatively slowly.

The Bank of Canada also has been on a gradualist path. But what we do know now is with inflation coming under much better control, that there’s no reason for them to hesitate to cut more aggressively should the economy start to need it. In terms of growth, while there have been some starting to again say, “Is there a recession on the horizon in the US?” We saw those calls in the wake of the upturn in unemployment in the last reading from the US. The numbers for the third quarter are shaping up more to be consistent with growth of around 1.5% in the US. In other words, slower, but not really bad. And in Canada, I think we’re in a similar pace right now. Growth likely to be around 1.5% in the third quarter or so, that’s not brilliant. It’s not been enough to keep the unemployment rate from ticking higher over time. But it’s not actually recession territory either. And we do expect that, that kind of environment will have both central banks easing rates over the balance of the year. Likely a quarter point at every meeting from both the Fed and the Bank of Canada.

And that interest rate relief and the prospect of a lot more to come in 2025 is, I think, what financial markets are looking at. Are they a little too optimistic? Maybe, because to some extent, if you look at the US equity market and you look at very tight US corporate bond spreads, the market is really priced for almost like what I would call a ‘no landing scenario’, where the economy doesn’t even slow down despite the fact that we’re getting rid of inflation. I think there is evidence of a slowdown. It will show up in corporate earnings. It might show up in some risks in the corporate bond market, particularly the high yield space. But overall, as I said at the outset, I think the worst outcomes have now been largely set aside. And it would take a big central bank error to find ourselves in a deeper downturn.

Roman Dubczak: Yeah, and kudos to you and your team. I know you put out a piece recently and you weren’t the bears, that many of your peers on both Bay and Wall Street were vis-a-vis, recession. So congrats on being right so far. But, say things were to turn. What would be the key indicators that might trigger a reconsideration of your view vis-a-vis a recession?

Avery Shenfeld: So in the US it is sort of a one-legged-stool at this point. It’s really just the consumer that’s powering growth. Housing is not going anywhere in the US. Exports and manufacturing are being held back, by still sluggish activity overseas and America’s trading partners. So there’s so heavily dependent on the consumer. That’s why the financial markets actually had a big sigh of relief when we saw the last retail number from the US. But it does make one uncomfortable if everything is riding on one part of the economy. So we’ll be watching for signs that the consumer somehow gets disengaged from that growth environment that we’re in now. We are expecting a bit of a slowdown in consumer spending, but hopefully nothing worse.

Here in Canada, it is fair to say that our economy has been a bit more struggling in the face of high interest rates. That explains why the Bank of Canada moved ahead of the Fed to cut rates. And we’re watching closely the jobs numbers in particular. Again, we’ve had a material rise in the unemployment rate. That’s what got the Bank of Canada a bit alarmed in the most recent decisions and moving more steadily. But we wouldn’t want to see much more than another couple of ticks on the unemployment rate. If it started to get worse than that, again, that would likely start to snowball into something a little materially weaker. Yeah, and likely confidence would be shaken as a result in things. One thing leads to another, so to speak. Yeah, we often stress things like interest rates and other factors in household decision making, but one thing we do know is, you lose your job, you pare back your spending. So the health of the job market is really critical to sustaining growth in consumption. Some growth in business capital spending, because we have other sectors of the Canadian economy, again like housing that are really struggling right now.

And the minor interest rate cuts we’ve had, even though, behind me there’s a bunch of cranes in the background, you know, the reality is that, particularly in multi-unit housing, condos aren’t selling. And so condo builders are not going to be starting new projects for a while.

Roman Dubczak: Yeah. Okay. Thanks Avery. So, Ian, slightly wobbly non-farm payroll three weeks ago takes the market down, I don’t know, a couple thousand points, so to speak. And now we find ourselves right back to almost where we started. You and your team put out a great piece not long ago about the rotation going on and how, you know, what’s going on in the economy is translating into the real dollars in the market and the investable dollars. So perhaps walk us through what your view is and what the stance is now from a portfolio strategy perspective.

Ian de Verteuil: Sure. I would say the most important thing is that most of us were on holiday that Monday when everything went tilt. So that was a very nice not to panic because you were on holiday at that point and that, you were absolutely right, that was that Monday when we really got that volatility that kicked in, to equity markets. I would say though, Avery and I are very much aligned on our views here, which is that, the economy is slowing down, but businesses particularly seem to be able to weather this. And, I do think there’s a bifurcation between large businesses and small businesses. So for example, if you look at the S&P-500 versus the 400 and the 600, the earnings growth on the S&P-500 remains very robust in this second quarter, we just came through.

And we’re talking about, 11-12% earnings growth year-over-year. And the second quarter of last year was not really that bad. And still very good growth forecasts as we go forward, focus are only worth the paper they’re written on, but management teams generally in the middle of the year have a good sense on what the full year looks like. And there’s no tempering of the optimism. So I do think, absolutely the economy slowing, but we are seeing a bifurcation. Big companies, somehow seem to be able to do it, either through some element of pricing power, some of which is fading. Avery talking about the inflation component coming back down, but also pivoting a bit now and we’re seeing job losses, which is companies turning the screws on the expense side, I think, as we move forward.

So I think the volatility we saw from our perspective was going to be transient if we have an equity market which can grow earnings and double digit rates, if we have an environment where rates look as if they’re coming down and we’re going to skirt a recession, it is hard to see equities come down meaningfully in that environment. So while I absolutely agree that there’s a sense of we’ve brought forward some of the, the yield reduction at the long end of the curve, brought forward some of the returns on equities. I still think we’re in reasonable shape as we move forward. Valuations are certainly somewhat stretched, particularly among those famous ‘Magnificent Seven’ that we always talk about. Interestingly, if you remove those, seven stocks from the S&P-500, the valuation, the forward PE is roughly in line with its long-term average, maybe a little bit above, but certainly not stretch for a world where we’re going to get some help from, Fed rate cuts and where earnings growth still appears to be double digit into the next 12 to 18 months.

Roman Dubczak: So, you know, with the implication of interest rates declining, certain equities are going to perform better than others. And you had a great piece out on ‘the rotation’. And at these inflection points, this is where portfolio strategy is, ‘Portfolio Strategy’, right? Where you actually have to pay attention. – Yeah. As to which stocks are going to be doing better over a period of time? So yeah, maybe touch on that. – Yeah, absolutely. What we’ve seen and I think we’ve kept trying to remind everyone is that, over the long-term, dividends and yield tends to be 20 or 30% of total returns.

Doesn’t feel like that over the course of the last couple of years, given what’s happened to the S&P-500 and even, the leaders on the TSX as we move forward. But we do think, as rates start to come back down here, we are going to see this wall of money that rotated into very basic products, money market, GICs, term deposits, high interest ETFs… that wall of money is out there and actually has to go somewhere if rates decline. I think, Avery, you’re calling for, the Bank of Canada to rate down as low as 250 at the end of next year. You know, it’s one thing if I come to you and say, “I’m going to give you 5% risk free money, that is incredibly liquid.” That’s one discussion.

It’s quite another when it’s 2.5% and inflation is, you know, 2%. That’s a very, very different, discussion. So we do think that rotation is is ahead of us here. We think high dividend paying equities, utilities, communications, real estate financials, those types of things which, financials haven’t done that badly, but certainly some of the others have been a real drag on performance of the equity market. We would expect a rotation coming back into those, I think as we move forward. And not only is it a rotation issue from a ‘chasing of yield’ component, but it also is simply because we have built in so much of that optimism into AI, technology on those types of names.

I think as we move forward and that shaking we got a couple of weeks ago was largely the valuations stretched on those names, really causing the market to move a bit. But I think this rotation has lengthst it and I think we’re really in the early innings of it.

Roman Dubczak: Okay. Thanks Ian. Avery, US election the so-called ‘elephant and donkey’ in the room, as it turns out right now, for everybody watching the news, etc.. How do you think that might impact, the forecast or the outlook for Canada?

Avery Shenfeld: So it’s a complicated question because it’s not just who wins the white House, but who takes the Senate, who takes the House. You’re hearing campaign proposals from both sides that sound a bit scary to those of us who believe in free trade and relatively unimpeded capitalism, I think that some of these are more likely threats or campaign type, agenda than reality. So, for example, on the Trump side, obviously Canadian investors would be worried about a major escalation of trade barriers, a cancellation of the Canada-US-Mexico deal. We do have to remember, first of all, that, that deal was negotiated by Donald Trump during his first term, and he claimed great success in that.

So I think we have something there. Also, the threat that they would put a 10% tariff on every country’s exports to the US. Again, if you read the Republican platform, some of that does sound like a bit of a negotiating stance. In other words, “we threaten you with that and you agree to take more American cheese”, or do other things that the US wants us to do, and then they give us the exemption. So it’s a worry and a risk on the other side of the Trump agenda. It does seem very prone to continued elevated budget deficits. That may keep US long-term interest rates more elevated than they would otherwise be. And some of that could spill over into the Canadian bond market as well.

On Harris’s side, we’ve only started to see her unveiling actual campaign platform material and some of it again, seems quite interventionist, you know, an idea that we’re going to solve inflation, which seems to be melting away anyway, by having a law against price gouging. I don’t know how that would be practical. You know, there are thousands and thousands of individual prices in the US economy. I’m not quite sure how you legislate how each one of those should behave. I tend to view this as a populist campaign idea, rather than something that will happen.

Again under the Democrats, no real progress, likely on the, budget deficit, because unless they really sweep the Senate and the House, they’ll have a tough time passing either the corporate tax hikes or the high income tax hikes that they want to use to finance some of their spending agenda and the spending agenda they’ll probably be able to pass. So there are some concerns. But again, overall, I think the bottom line is we won’t really know until we get the full makeup of not only the White House, but the Senate and the House.

Roman Dubczak: Okay. Thanks Avery. Ian, you’ve mentioned in some of your pieces about we’re in the early stages of an M&A cycle. And, you know, clearly M&A on many levels influences equity markets and, you know, portfolio strategy and whatnot. Perhaps give us a bit of a snapshot, if you will, as to how that might affect investment portfolios.

Ian de Verteuil: Sure, I do think, we’re in the early stages of an M&A cycle for a couple of reasons. One, I think we’ve gone through this period of time, you know, context is important. So we’ve come through Covid.

We weren’t really sure what the world was going to open up to look like. It opened up. We have this surge of inflation, hard for businesses to really know and manage properly. We’ve gone through that period of time. We’re now in an environment where if you announce a deal today and it takes 6 to 12 months to get approval, I might have cheaper financing ahead of me. That’s one of the incentives. But I also think, we’re into a period of time where there’s more visibility on, and I know you talked about how unstable the world is, but in a lot of ways, in the context of the two periods we’ve come through the rebound on Covid, this feels a lot clearer.

So I think businesses, getting to the point of, “we can no longer push prices through the way we did, we’ve done something on the cost cutting front, how else do I grow?” And I think M&A is going to be one of those things that, I think, kicks in from that point of view. And I believe it’s going to occur across the whole spectrum. We’re going to have expensive companies buying other expensive companies, and we’re going to have cheaper companies, old economy businesses consolidating as we move forward. The one caveat to that, then it comes back to the question of the US election is, we have under, the Democrats, under Biden, seen a Federal Trade Commission which oversees competitive dynamics, that has worked particularly hard, some would say unsuccessfully, to actually, restrain corporate power and corporate concentration. there isn’t any doubt in my mind that under Trump, some of those would go away.

And I would imagine that, that would be the one piece that would take a little bit of steam, I think, out of the M&A cycle. But falling rates, I think an environment where you can’t really price as much as you’d like and you’ve probably done all the cost cutting. History tells us that C-suite executives turn and say, “I’ve got to manufacture some growth, for my shareholders.” So I do think that’s what’s ahead of us here.

Roman Dubczak: And equity valuations aren’t bad.

Ian de Verteuil : Equity valuations… And it’s either going to be, expensive guys buying expensive guys, you know, the technology guys paying with you know a stock of 25 times earnings or it’s going to be other companies buying at 15 times earnings buying other companies at 11.

Roman Dubczak: Yeah, pretty much perfect zone, so to speak. Okay I’m going to close by asking the the wild card question, what are the wild cards that you foresee or might prognosticate ahead of us, say, for the next six months or so? Avery, why don’t we start with you?

Avery Shenfeld: So as we’re taping, we’re on the cusp of either having or not having a rail strike in Canada. A rail strike of a few days would not be a material event, but a rail strike of a month, until Parliament, for example, returns in mid-September, would be more disruptive. So we’re certainly watching for that. I think beyond that, you said at the outset there are still some things going on in the world. There’s still a war in Europe, there’s still conflict in the Middle East. If you look at how markets have been taking that, it’s sort of faded into the background. I mean, oil prices have actually retreated quite a bit despite the fact that Iran might be involved in this conflict. So I think that those geopolitical issues are still important to watch. And then post US election, both Trump and Harris, I think, are going to be fairly hawkish in terms of trade policy with China. Pushed to the edge, does China become more of a troublemaker? Again, that’s a risk that we need to keep an eye on.

Roman Dubczak: Okay. Thanks Avery. And, Ian?

Ian de Verteuil: We’ve all lived in a world of the US being the, rule maker and the determinant of ‘right’, and obviously ‘might makes right’, in most circumstances here. And I do think, in a lot of ways, the United States looks like a country that is stretched. It’s stretched in terms of supporting a variety of different wars on one side or the other. they’re stretched in terms of, really, I think how they interact with their trade partners, their traditional long-term allies.

You think about some of the things that that have occurred here. So I do think in that environment, a lot of the geopolitical risks become more concerning because we don’t have that, you know, global policeman that we believe has the ability. Whether through, its allies or whether it’s through its own military might. It does feel as if that is a less stable environment.

So I would absolutely agree outside of something like the, the, the rail strike, I think it is going to be this issue of the geopolitics and how that evolve over time. Because, we do need some sort of stability. We may or may not like the decisions that come out of the United States, but at least there was a sense of stability, and allies acting with allies. That to me, is probably the single biggest risk to, I would say, equity markets, but I would say capital markets generally.

Roman Dubczak: Yeah. Agreed. It’s, yeah. Geopolitics really are geopolitics in this case. Avery, Ian, thanks very much. And thank you for joining us, and I hope to see you again soon. Thanks.