Weekly market wrap

Paving the way for a pivot

Key takeaways:

• The Fed's and BoC's next move will likely be a rate cut instead of a hike, but the timing of when that might happen could be a source of volatility.
• The labour market remains strong but is gradually loosening, which, together with better inflation trends, supports a pivot to less restrictive central-bank policy in 2024.
• Our base-case scenario calls for three to four rate cuts in the back half of 2024, which should help bonds recover.
• Interest-rate stability could be the catalyst for a rotation from this year's equity winners to the laggards. We think the narrow market leadership and wide valuation gaps have created an opportunity in areas of the market that have been left behind.

With a few weeks left till the end of 2023, markets remain on track for a strong finish. Stocks are hovering near their highs for the year, and bonds are rebounding nicely after a tough three-year stretch. The overarching forces supporting balanced portfolio gains this year have been the easing in inflation pressures, a resilient economy that has avoided a recession, and enthusiasm around artificial intelligence (AI). 

As the torch passes to 2024, investors are counting on a successful central bank pivot away from restrictive policy to a more neutral stance to sustain and build on this year's gains. We think the Fed's and BoC's next move will be a rate cut instead of a hike, but the timing of when that might happen could be a source of volatility. Nonetheless, we see the potential end of tightening and the start of an easing cycle as a catalyst for further gains in bond prices and a broadening in equity-market leadership.  We offer three reasons why we expect a gradual shift in central bank policy ahead.
 

1) The labour market is gently cooling

• The spotlight was on the U.S. job market last week, with the data providing mixed takeaways but also not reversing the cooling trend that has emerged, which is likely welcomed by the Fed. The strong labour market has given consumers the confidence to spend in the face of high inflation and rising borrowing costs. But the tight conditions have also meant that the Fed might need to keep policy restrictive for longer to ensure higher labour costs don’t feed into higher inflation. For 2024, we see a better balance between supply and demand for workers, driven primarily by lower job openings rather than a surge in layoffs, and last week's data support this view. 
  • The U.S. economy added 199,000 jobs in November, slightly more than expected, the unemployment rate fell to 3.7% (a four-month low), and the labour-force participation ticked higher, all pointing to a healthy labour market¹.  However, the return of striking autoworkers and screen actors helped boost the payroll counts by 47,000. The three- and six-month averages are holding steady, consistent with a measured downshift in job creation¹.
  • Job openings in October fell for the third straight month to the lowest since March 2021. While on a clear downturn, the number of job openings remains above the 2019 pre-pandemic average, and at 8.7 million it still exceeds the 6.5 million unemployed workers¹. Meanwhile, the number of people quitting their jobs held steady, also suggesting a less tight labour market. The job-quits rate has historically led wage growth, and with the latest data being the lowest in almost two years, it points to slower wage increases ahead.
• In Canada, job creation has been slower than labour force growth and as a result the unemployment rate has risen from 4.9% to 5.8%. Wage growth remains too high for the BoC's comfort, but the ongoing decline in job vacancies suggests further normalization ahead.

2) Inflation is falling faster than the Fed and BoC projections

• Feeding into optimism for a soft landing in the economy, inflation has slowed sharply, even as the unemployment rate remains low and demand strong. In June, the Fed was projecting its preferred measure of inflation, the core personal consumption expenditures index (PCE), to end the year at 3.9%, which was then revised down to 3.7% in its September forecasts². With the actual October reading at 3.5%, Fed officials will likely again mark down their inflation estimates when they meet this week, possibly taking down their projections for the fed funds rate as well. Similarly in Canada, the recent headline and core inflation readings are all below the BoC's 3.9% projection that was included in its October monetary policy report.
• Policymakers tend to look through the volatility of commodity prices, which is why they focus on the core inflation indexes, which exclude food and energy. But prices at the pump are a significant driver of consumer expectations on inflation. On that front, the average nationwide gasoline price fell last week to $3.20 in the U.S. and 1.48 in Canada, the lowest since December and down 17% over the past two months¹. Despite the announced output cuts from OPEC+, slower growth in China and rising oil production in the U.S. have helped push prices for WTI oil down to $70. For perspective, U.S. crude exports averaged 4 million barrels per day so far this year, an all-time high and up 19% from last year³.

3) U.S. growth will likely slow from above- to below-trend in the quarters ahead; Canada growth to stall

• Third-quarter annualized GDP was up 5.2%, more than twice the U.S. economy's long-term potential¹. However, we don’t expect this performance to be repeated in 2024. In the early days of the pandemic, households were able to accumulate excess savings and lock in historically low mortgage rates. This has made the economy less sensitive to the sharp rise in borrowing costs. As shown below, despite the interest rate for new 30-year mortgages averaging around 7.5% currently, the effective rate on all mortgages outstanding is less than 4%¹.
• In Canada, households have been more sensitive to rising rates due to the structure of Canadian mortgages. At the end of September roughly 30% of outstanding mortgages were variable rate while another 30% were fixed rate mortgages with terms of five years or less.⁴ This has led to higher mortgage costs for Canadian households with the weighted average rate on outstanding mortgages rising to 4.4% in September. Additionally, the percentage of household disposable income spent to service mortgage payments rose to a 30-year high in the second quarter of 2023 at over 8%⁴.
• While buffers remain, the consumer is starting to show some fatigue as the excess savings are being depleted, credit is tight, and effective rates are moving slowly higher, catching up with market rates. 
• Economic growth is tracking lower in the fourth quarter in the U.S., with the Atlanta Fed's real-time GDP estimate at 1.2%. In Canada, GDP contracted 1.1% in the third quarter and consensus estimates call for a muted 0.2% growth in Q4¹. A potential soft patch in the economy in the quarters ahead could sap some of the optimism from the market, but it would also help inflation return to target sooner and support the start of a loosening in Fed and BoC policies.

Central banks vs. market expectations – A tug of war in the making?

• As inferred, economic data is laying the groundwork for central banks to pivot, and markets are taking notice. Fed-fund futures are now pricing in rate cuts as early as March, though July was expected just few weeks ago. While policymakers are likely interpreting the incoming data the same way, they will probably caution against pivoting to rate cuts too quickly, as that would risk unwinding some of the tightening in financial conditions that is helping apply pressure on inflation. That's exactly what the BoC did last week by stating that it is prepared to raise the policy rate further if needed.
• A potential tug of war between market pricing and central bank messaging could drive volatility in bond and equity markets, but we expect both forces to move in the same direction as the new year progresses. This week's Fed meeting and economic projections will provide a fresh read on how the path of rates might look. We suspect that policymakers might remove the one additional rate hike they had penciled in for this year as they likely trim their inflation forecasts. But Tuesday's CPI will likely weigh on that decision as well.
• If our base-case scenario of a couple of quarters of soft economic growth materializes, we expect the Fed to cut rates three to four times in the back half of 2024. As price pressures ease further, the real policy rate (after adjusting for inflation) will become more restrictive, which the Fed and BoC will try to offset by cutting rates more than it currently forecasts. In this scenario, we see the U.S. 10-year Treasury yield falling slightly below 4% and the GoC yield below 3% by the end of 2024.
• Two other scenarios that should not be dismissed but are less likely, in our view, are 1) that of a "no landing," where the economy stays strong and inflation persistent, in which case central banks holds rates steady for the full year, and 2) that of a more traditional recession, where central banks will cut rates aggressively to support the economy.

A central bank shift is a potential catalyst for laggards to start catching up

• Uncertainty about the economic and interest-rate outlooks, together with excitement around AI, has led investors to flock to U.S. mega-cap tech stocks. The Magnificent 7 (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) have driven most of the S&P 500 gains and have outperformed small-cap stocks by 100% this year¹.
• However, a subtle shift appears to be underway, as the rally has started to spread beyond big tech. Over the past month the Magnificent 7 have trailed small-cap stocks by 7%, while the "average" stock, proxied by the S&P 500 equal-weight index, has made up some of the lost ground¹.
• While a couple of weeks don’t make a trend, we think that interest-rate stability because of an upcoming Fed pivot could be the catalyst for a rotation from this year's winners to the laggards. In our view, narrow market leadership and wide valuation gaps have created an opportunity in areas of the market that have been left behind. These may include bond proxies like the traditional defensive sectors at first if the economy enters a soft patch early in 2024, and small-caps along with value-style investments later as growth reaccelerates.
• No doubt 2024 will bring its own twists and turns in the market narrative, but there are reasons for cautious optimism. Interest rates have likely peaked, as the Fed and BoC start paving the road for rate cuts, inflation continues to moderate, and valuations outside of the big year-to-date gainers remain reasonable.

Angelo Kourkafas, CFA
Investment Strategist

^{Sources: 1. Bloomberg, 2. FOMC Summary of Economic Projections, 3. Energy Information Administration 4. Statistics Canada, Edward Jones.}

Weekly market stats

^{Source: FactSet, 12/8/2023. Bonds represented by the S&P Canada Agg index. Past performance does not guarantee future results. *4-day performance ending on Thursday.}

The Week Ahead

Important economic data coming out this week includes domestic housing starts and U.S. CPI inflation data.