Is The Battle Won? Inflation and Interest Rates in 2024

2023 has been another roller coaster of a year – from the promise of generative artificial intelligence, to the US regional banking crisis and the downfall of international bank Credit Suisse, to a bond sell-off in October as investors started to believe in the “higher rates for longer” narrative. Now, market sentiment has flipped once more, with the S&P 500 ending the year just shy of its 2021 all-time high on expectations of rate cuts in 2024. Fuelling these expectations are signs of a cooling economy – the Eurozone has seen industrial production contract for four consecutive quarters while Canada’s GDP has remained frozen for three consecutive months. Less economic output, while generally a negative, would leave room for central bankers to reverse some of their contractionary hikes.

Stock investors wouldn’t be the only ones to celebrate an easing of central bank policy – higher mortgage rates have contributed to the worst Canadian housing affordability level in more than four decades according to the Bank of Canada, while an Angus Reid Institute poll found that 15 per cent of Canadians described their mortgages as “very difficult” to pay in October, up from 8 per cent in March. With the typical fixed Canadian mortgage term lasting 5 years, the prolonged pause in central bank action has many optimistic that rates may come down before a large swathe of cheaply-financed homebuyers are forced to renew at a meaningfully-higher interest rate.

Still, rate cuts in 2024 are far from guaranteed. While inflation is certainly far from the near double-digit peak of 2022, it remains uncomfortably above its 2.0 per cent target, with the rate refusing to drop below 3.0 per cent over the past six months. Central bankers likewise remain cautious of growing geopolitical risks – in addition to the ongoing war in Ukraine, the October 7th attack on Israel by Hamas and resulting bombing and ground invasion of Gaza have greatly heightened tensions in the Middle East, with cargo ships now being targeted by Houthi militants in the Red Sea. With all this, central banks have maintained that it is too early to consider rate cuts.

Once again, we are faced with conflicting narratives regarding what will happen in the year. While markets are optimistic that the battle against inflation is mostly won, it is impossible to predict what events will influence central bank decisions in 2024. Fortunately, the success of an investor is much more dependent on prudence, risk management, and time horizon than short-term predictions of recessions and interest rate cuts – and thank goodness for that.

As always, we thank you for your support and continued confidence in WDS.

Equities

The Canadian stock market, as gauged by the S&P/TSX Composite Index ($TSX), was up 8.1% for 2023. Add in dividends, and the total return for the index was 11.8%, a strong return by historical standards, but below other developed markets for the year. Once again, Information technology led the way with a sector price return of 68.8 per cent, but at an index weight of just 8.7 per cent, the stellar performance was offset by weaker sectors like energy (1.0 per cent growth) and materials (-3.3 per cent). Financials performed relatively well with a sector return of 9.1 per cent despite the strain of higher rates on mortgage borrowers, trouble in the commercial real estate space, and collateral turmoil from the U.S. regional banking crisis earlier this year.

Meanwhile, the US stock market had a stellar year, with the S&P 500 Index ($SPX) experiencing a total return of 26.3 per cent (22.9 per cent in Canadian dollar terms). IT and communications led the way, experiencing sector price returns of 56.4 and 54.4 per cent, respectively. Breakthroughs in the field of artificial intelligence (and the resulting buzz) appear to be behind the area’s strong performance.

Globally, developed markets likewise had a strong year, with the MSCI EAFE Index ($MSEAFE) seeing a total return of 18.2 per cent for 2023. This performance seems to fly in the face of recession fears among constituents, with Japan (the largest weight in the index) recently reporting a 1.4 per cent annualized contraction in GDP in November and Germany seemingly at risk of a “double-dip” recession in 2024, having itself just exited a recession earlier in 2023.

Fixed Income and Interest Rates

The Bank of Canada appears to be taking a wait-and-see approach with its rate hikes, having last hiked the central bank policy rate 25 basis points in July to 5.00 per cent, it’s highest level since 2001. With Bank of Canada Governor Tiff Macklem recently declaring at a Canadian Club meeting that “the economy is no longer overheated,” many economists are now forecasting rate cuts in 2024. The optimism may yet prove premature – in the same speech, Macklem maintained that “it’s still too early to consider cutting our policy rate,” with conflicts in the Middle East and Europe being among the risks that may stall inflation’s deceleration. With 2.2 million mortgages in Canada estimated to come due for renewal over the next two years, that is sure to disappoint homebuyers across the country.

Nonetheless, the yield curve remains staunchly inverted, with the 10-year Canadian bonds ending the year yielding just 3.1 per cent, compared to 2-year bonds at 3.9 per cent (short-term treasury bills are themselves yielding above 5 per cent). Despite Macklem’s call for caution, markets appear well-convinced rate cuts are on the horizon.

We are seeing a similar dynamic in the United States, where long-term yields have generally remained constrained and the federal funds target range has not been touched since its 25-basis point hike to 5.25 – 5.50 per cent in July. The year was not without its drama, however – a US bond sell-off pushed 10-year yields above 5 per cent in October before falling back down a whole percentage point by year-end.

Currencies

Despite the inflation rate dropping over 50 per cent in the first half of 2023, CPI has remained stubbornly above 3.0 for the second half of 2023, accelerating in December to 3.4 per cent thanks to gasoline, air travel, passenger vehicles and rent. Still, higher interest rates are having their impact - consumer and small/medium enterprise confidence indices have declined over the year and both remain below 50, signaling pessimism among participants. Given the lag between when central bank policy rates increase and when longer-term rates adjust accordingly, inflation may simply need time to cool further.

Meanwhile, we have seen a marginal strengthening of the loonie in 2023, with the Canadian dollar ($CDW) ending the year at $0.76 USD, up 2.4 per cent for the year. While rising Canadian employment (albeit outpaced by population growth) appears to be contributing, a weakening US dollar has likewise played a role, with the US Dollar Index falling slightly for the year. While inflation in the US matched Canada’s in November and December, Federal Reserve Chair Jerome Powell has seemingly struck a less cautious tone around future rate cuts than Canada.

Commodities

Oil prices saw a bumpy second half of 2023, with the West Texas Intermediate ($WTIC) rallying towards US$100 a barrel from July to October, only to reverse course and end the year at US$71.7, down 10.7 per cent for the year. While OPEC has announced further cuts to stem the decline, annual oil production in the US recently reached an all-time high. At the same time supply is rising, some analysts expect demand to fall in 2024 as the Eurozone, China, and other large economic players grapple with the possibility of a recession. Lower economic activity generally equates to less demand for crude and its derivatives.

Gold prices ($GOLD) meanwhile pushed past the US$2,000 level, ending 2023 at US$2,062.4 per troy ounce, up 13.8 per cent for the year. While a proposed gold-backed BRICS trade currency never did materialize last year (many expected the group to announce the hinted currency at its annual leader’s summit in August), rate cut expectations and pessimistic economic forecasts for 2024 have helped maintain investor appetite for the precious metal, which many view as a safe haven for both inflation and market downturns. This has not always held true, however – the metal was roughly flat in 2022 despite inflation peaking during the year.

This report is provided for your information. Conclusions and opinions given do not guarantee future events or performance. Facts and data provided are from sources we believe to be reliable, but we cannot guarantee they are complete or accurate. This report is not to be construed as an offer to sell or a solicitation of an offer to buy any securities. Before making an investment or adopting an investment strategy, each investor should review his investment objectives with their investment advisor. Watson Di Primio Steel (WDS) Investment Management Ltd. and individuals and companies who are related may, at any time, buy or sell securities that are hereby described in this report.