In this challenging macroeconomic environment, it remains unclear to what extent rapid interest rate increases will ultimately affect the economy and consumers, nor how quickly high inflation levels will recede.
Under such conditions, many investors turned away from stocks and sought the safety of short-term, high-yielding investments. In 2023, net sales of money market mutual funds will triple year over year, according to a report released last month by the Investment Funds Institute of Canada. Money remains on the sidelines until there is greater confidence in improving economic conditions and corporate profits.
The Globe and Mail recently spoke with Stu Morrow, Chief Investment Strategist at Morgan Stanley Wealth Management Canada, who gave his views on the economy, markets and his asset allocation recommendations .
Let’s start with your macroeconomic outlook for Canada. Looking at your base case scenario, what are your expectations for GDP, inflation, employment and the policy rate?
Our base case scenario for Canada predicts that there will be no recession or slowdown in growth. We expect inflation to continue to fall, but do not expect it to return in a straight line toward the midpoint of the Bank of Canada’s 1 to 3 percent target before the end of 2024 or 2025. The underlying inflation outlook for the end of the year is 3.7 percent for this year and 2.4 percent for next year. The reference scenario for unemployment, [we] we will see this start to increase a little in 2024 as demand begins to weaken. We see potential for a rate cut somewhere in 2024. Our official real GDP forecast for the end of this year is 1.4 percent and the same for next year.
Rising interest rates and rising stock markets generally do not coincide. Still, 2023 was a positive year for many major stock markets globally. What assessment do you make of this situation?
This is interesting because there is a gap between the evolution of real interest rates, which are increasing, and the rise in valuations, particularly in the American market. It’s a disconnect that we view as a risk. This is why we are tactically underweight US equities. We also see risk to the US earnings outlook.
Europe has performed well this year, as have other parts of international markets, such as Japan. For Europe, we have the weight of the market. We see the economy continuing to slow down. We are tactically positive on the Japanese equity market, viewing domestic companies as beneficiaries [of] the return to positive GDP growth, potentially higher inflation which should also fuel the expansion of return on equity. And then, fund flows haven’t really reached a state of euphoria in Japan yet, so there’s still room.
Elsewhere in the world, we weight emerging markets more given China’s weight within emerging markets – this is where we are a little cautious.
But we see interesting opportunities elsewhere in emerging markets, such as India, which is the second largest emerging market after China. And Mexico, which is expected to benefit from increased overseas relocation activity to North America. Given their close ties with the United States, they should benefit.
What about the Canadian market?
Longer term, when thinking about growing immigration flows, one must also consider other factors such as additional investments in infrastructure around green technologies and materials for the transition to electric vehicles. All of these are positive for Canada’s long-term outlook.
In the short term, we see opportunities here from a valuation perspective. The equity risk premium is the premium you get for taking an earnings risk, and in Canada it is significantly higher than in the United States.
So, what is your official opinion for the Canadian stock market?
It would be neutral.
Which sectors do you think will be the leaders in the current environment?
Energy and materials would be the two main sectors we would look at in Canada.
We are positive on raw materials as well as food and agriculture – so consider fertilizers. And on the energy side, there is a risk that if this transition from fossil fuels to electric vehicles continues, underinvestment in the energy sector and tight inventories could lead to greater volatility in oil prices.
And the latecomers?
Finance, from a banking point of view, without calling on individual banks. Given the potential risk of a higher interest rate environment for an extended period of time, this could pose a risk to the consumer, the real estate market and provisions for credit losses could remain high, which would constitute a risk to the outlook for bank profits.
We saw the earnings come out a few weeks ago and we saw the loan loss provisions start to recover. And if we get a much slower economy, there is a risk that overall loan growth will decline and banks will start to rationalize their spending and that sort of thing. We would probably consider them laggards over the next six to twelve months.
What do you think of the relative value of Canadian stocks versus bonds?
Overall, we are overweight fixed income in the portfolios.
As we approach the end of the rate hike cycle, investors might consider using cost averaging to extend the duration of fixed income positions beyond the short end to include bonds of intermediate duration.
Today, if we consider the risk/reward ratio of stocks versus bonds, it is quite attractive to invest in bonds versus stocks.
This report has been edited for length and clarity. An extended version is available online at tgam.ca/inside the market.