Outlook 2024: two expert perspectives

Martin Lefebvre
First let's talk about growth. The Federal Reserve is telling us that a soft landing is achievable. So what is a soft landing and what's your take on the current situation, Sonia? 

Sonia Meskin
Well, the Fed will never tell you that we're going to engineer a recession on purpose when there's some probability that they may achieve a soft landing. Of course, the soft landing is going to be their central scenario, right, because that's the goal here, right. What they've told us is that they're willing to risk the recession if that means bringing inflation back to target. So again, we're back to the question, how much do they need to kill demand? So the services component of inflation versus how much the goods component and parts of the services will come down on their own, right. So in terms of your question of I think what they're going to, what they're looking at next year, it's a tough situation because even from my perspective right when I talk to folks who primarily have a book of business that is levered towards corporates. They all say the corporates in the U.S. are healthy. We think if the problem will arise in 2024, it'll be on the consumer side. The folks who are leveraged in their book to the consumer side will say: “We think the problem is gonna come from the corporate side.” They're gonna have to refinance into high-rate environment in 2024. So the fact that people are not in their areas of expertise, other than commercial real estate perhaps, I'm not seeing significant signs of stress, despite the fact that there's been an enormous run up in rates gives you a pause, right. So I think you could identify potential pressure points. Yes, the student loan issue is going to weigh on the consumer. Yes, the, you know, higher loan rates on the auto side, consumer loan side, yes that's probably going to weigh on the consumer. But my guess is the net worth buildup for the U.S. consumer in the numbers and those numbers we know exactly and like excess savings which are an early estimate, that's really it's much bigger than it was pre-COVID and there's barely been a dent since the Fed started raising rates. On the corporate side. Again, there are various estimates as to when it is the wave of refinancing going to hit. So that is another important pressure point. But you gotta sort of, I think it's important to identify where do we think the recession is going to come from. And there's been a challenge. It's been a challenge for the, you know, investment side. It's been a challenge for economists as well.

Frances Donald
Can I add something that maybe is controversial?

Martin Lefebvre
Sure. Let's hear it.

Frances Donald
Sometimes on teams and either when I'm talking internally or externally, people are cheering the soft-landing narrative. Like, yes, this is so great, we're gonna achieve the soft landing. But I'm actually going to throw an idea out there which is that I don't think a soft landing is actually great for investors. Because if you think about the range of possibilities, a soft landing means no recession, no rise in the unemployment rate, but inflation never below 2%.

Martin Lefebvre
Like an infinite cycle.

Frances Donald
What is central bank going to do? They're going to hold rates at some of the highest and especially debt adjusted levels that we've ever seen in our lifetimes. I'm looking across all of you. Literally in our lifetimes we have not seen rates adjusted for debt as high as they are now. So right now we have a market that's expecting we could see some support in fixed income. We could see support in risk because we get to see rates moving downwards. A soft landing in GDP does not give you that. A mild recession, two quarters of GDP, which is what my model tells me is going to happen, is very difficult for many people who will lose their jobs but is short-term pain for longer-term gain. So I know that may seem like a strange idea because soft landing is supposed to be the bull case, but I don't think it is. I did, however, say this on CNBC last week and someone tweeted me I was the worst commentator on CNBC in its history. So you should add that part to my bio just to like offset it. So I acknowledge that might be a lunatic comment, but I think we should at least be asking the question.

Martin Lefebvre
And part of the strength we're seeing right now where the resilience in the U.S. is based on excess savings on the consumer part. And we were surprised by the revisions on those figures last week. So how much is that is a risk to consumption in 2024?

Frances Donald
I have a perspective. So my perspective is we don't actually know how much excess savings is in the system. So I look at different measures produced by the Fed, the Bank of Canada. We produce our own measure. Some studies will say there's zero excess savings left. Some studies say there's a trillion dollars. OK, so why did we all go and get Masters and PhD degrees and we can't decide between 0 or trillion dollars? There is no real way. Some people say it's very isolated in high-income consumers, but I think the takeaway is actually a little bit more kind of big picture philosophical, which is that what we experienced after COVID was one of the largest post-war government expenditures that we've ever seen. And then the U.S. kind of just kept going. Why do we see that long and bond backing up so aggressively? There are a couple reasons, but one of them is chaos in Washington is making people reconsider. If you ever took an Econ 101 class or suffered through that, you might remember we were all taught governments are supposed to spend in bad times and pull back in good times. Well, this amazing economy that everyone's saying is so great, we've still seen tremendous government spending, especially in the United States but also in Canada. And this worries me because it's not about the excess savings. Now it's if we do head into a more difficult environment, there is not fiscal room. And this is one of the reasons why the rates complex is creating such a large volatility, especially on the tail end. That question I think is more impactful to what's going forward than what is the level of excess savings. Although that too is an important question.

Martin Lefebvre
I’ve got to stop you because you’re front running, all my questions. OK, let's turn to the housing market. Knowing that in a normal cycle usually the housing market is the most sensitive to interest rates, why hasn't the housing market or real estate market in the U.S. come down as much as what was expected? What's behind that?

Sonia Meskin
Sure, sure. I mean if you look at the U.S. again, there's a lot less equity that's been taken out of the market, the run up since COVID in terms of prices. There's barely been a dent in that since rates started rising. People have jobs. This is what's important for the American consumer at the end of the day. The rise in net worth is something that we know exactly where the numbers are. That's been there exactly as in the housing market. That is, yes, it's affecting the higher income brackets more so than the lower income brackets. But the lower income brackets are really benefiting from this change in the balance between supply of labour and demand of labour. There's less supply than demand. This is why wages are growing way above what's consistent with 2% core PC (personal consumption) overtime in America today. And that's partly attributable to what's going on in the housing market. People are not selling but there's still demand because there are people who want to buy and there are people who are willing to pay up, in the meantime, for higher rents. What you saw in this, the CPI (consumer price index) numbers most recently is that rent prices, you know, were higher than I think the market was expecting. And that's when you have the basis effects still weighing on the shelter CPI from last year. It's only feeding through to the official numbers this year. Think about 2024. If we don't if, if the Fed actually just stays restrictive, how long will it potentially take them to get the demand to a point where you will have all these components of inflation that are most correlated with the strong labour market actually decelerate.

Martin Lefebvre
Canada is much different than the U.S. in terms of refinancing. How do you factor that in your model when you're trying to see the impact of housing?

Frances Donald
So first of all. You know half our team is in Boston and I head down there, I speak to our institutional retail clients in Boston. and I explain to them that in Canada we have a five-year mortgage and they are shocked. What? Americans often or many Americans would maybe don't recognize is that they are the anomaly with 30-year fixed mortgages. So prices are not down for a lot of the reasons…Martin LefebvreIt's tax deductible.

Frances Donald
Yeah. But housing activity in the United States is down 30% from its peak.

Sonia Meskin
Because no one is selling, because nobody is selling.

Frances Donald
Nobody would sell. Well, why would you not sell? Because they locked in at sub 3% mortgages for 30 years. We don't get that. That's not what we get. So the markets frozen and how does that feed through. Retail sales number last week, really strong in the United States, I was flabbergasted. Categories that were down, building materials, garden equipment, everything that had to do with housing activity because that market is frozen. And so what's the American response to that? Very industrious. Let's build more housing sales. So new home sales are rising as existing fall down. What that's doing is changing the composition of the market and how housing relates to the economy. But it also reduces the effectiveness of interest rates and makes the U.S. economy less sensitive than the Canadian economy. And if you're playing relative bond yield trades, that's very relevant. Canada, what's going on? We've got only 1/3 of Canadians have mortgages right now. A third own their home outright. The third are renters. The big issue in Canada is that our home prices are still rising, not because interest rates are not high enough, but because demand is overwhelming. We are adding a million new people to our economy every year and there are some estimates that say we are 4 million homes short just in our general population. And what that does to me is it calls into question, if we're trying to cool housing, why are we aggressively raising interest rates in a way that significantly harms a segment of the population without solving the underlying problem, which is that demand is excessively high for reasons outside of interest rates? And I think the composition of our mortgage market is really critical. I also think that the way in which variable rates were treated by extending amortization has slowed the impact of higher interest rates into the housing market. I can't be bullish the housing market, but even as bearish as I am about the Canadian economy in the next 12 months, it's hard for me to take that and transcribe it directly onto the housing market when demand and supply is so mismatched.

Martin Lefebvre
Yeah, you can't see going down that much. And to the U.S., Bob was telling me that folks in the U.S. can't stand stay in the same house for seven years. So I guess we're just delaying the inevitable. Well, well, we can talk about that later on. OK.

Sonia Meskin
We did have a lot in the past cycle, we did have a lot more variable mortgages than we do in the cycle, which speaks to your point.

Martin Lefebvre
OK, let's turn to possible risks to this forecast and starting with the banking crisis. We know what happened in March of last year and rapidly there was this credit facility that was created by the Fed and it seems that the problem was solved. But it very much reminded us of the late ’80s with the savings and loan crisis in the U.S. So is there and we see that rates keep going up. So are there risks for second round effect. How much do you…

Sonia Meskin
Sure, sure. Banks are sitting on negative carry. The fundamental business model is that you borrow short lend long in an inverted yield curve, you're sitting on negative carry. So how long you can sit on this negative carry is a different question. And of course, this facility obviously that the Fed rolled out very, very quickly helped said banks. Now there are, you know, the bigger banks I think have more diversified portfolios. They're not necessarily being helped by higher rates and the longer end of the curve, but they have more diversified portfolios. Some of the assets at least are floating rate. So higher rates are not necessarily hurting them. The smaller banks with more niche and less diversified business models are hurting more and we aren't, even though deposit outflows have slowed, I don't think the problem has necessarily been solved. The question is to the extent that it's contained and overtime they can get absorbed into bigger banks, this is not really a problem that should be front mine for the Fed. As much as inflation is only if this metastasizes into a financial crisis that it becomes a front and centre problem for Fed policy. And the Fed made it very, very clear in March and so far this has worked. Now how does this translate into credit creation and potentially contribute to a recession in 2024 in the U.S.? Of course, these smaller banks are not able to lend as much at this point. And they do tend to lend to small and medium sized businesses more. So to the extent that they get absorbed into bigger banks, will those bigger banks create, you know, maintain the same lending practices to smaller businesses? Small- and medium-size enterprises are responsible for a large chunk of jobs in America. At the same time, if this happens relatively slowly and we still have that buffer as we discussed all of excess demand for labour with supply falling short, you're not necessarily going to see the same effect in terms of the speed of the response economically that we would have seen in the previous cycle. So yes, I think it's definitely important to watch credit creation from that, from that sector and credit creation has very much slowed. But at the same time, as long as we even have some zombie banks, that's not necessarily a signal for an imminent recession.

Martin Lefebvre
Yes. So, if you only have a few of them, I guess it's fine. And it's true that the regional banks don't land as much as the big banks, but there are thousands of them. So I guess you need to keep an eye out.

Sonia Meskin
Right. And who is gonna take their place? Yeah, well, the bigger banks take their place.

Martin Lefebvre
Another thing that we're seeing is that those smaller banks or regional banks, they're the ones behind commercial loans. Do you see that as a risk, Frances?

Frances Donald
Yeah. So smaller banks are more exposed to commercial real estate, which we know has a so-called maturity wall as in they need to refinance pretty quickly in the next two to three years. They also are bigger funders of small businesses. Small businesses are the majority producer of jobs in the United States. So when I'm looking at risks and these are really kind of tail risk scenarios that you're describing, what I'm looking for is what are the tentacles that throw flow through the economy. But these scenarios that we're describing, these are not really the scenarios that worry me because we have a good amount of, Sonia and I have a good amount of visibility in the data that we have. We work with teams that are looking at company by company. What worries is not what hits us between our eyes is what hits us in the back of our head. So we're in the economy. Do we have less visibility than we maybe do in some of these banks that are going to be private equity, private credit, a lot of those types of environments where we can't see? There was a lot of economic data that started in 2009. And every time I see a series that starts in 2009, I think: “Whoops, that's something we realized after the fact. We should have known before the fact.” So these are the things that worry me. So what do you do as an asset manager or as an advisor or even in your own personal finances? Well, what I talked to a lot of our portfolio managers about is let's move away from point forecasts and high conviction views and let's have a plan for these tail risks as they come about, what we're going to be watching for and how we're going to act. If we start to go into a risk off environment, what do we need to be doing? And I really is, as much as I can really advise everybody to have a plan for tail risks. But it's very difficult and in some sense imprudent to be forecasting real risk events and incorporating them now. You can't do that. You could end up out of the money for months and months and months, if not longer.

Sonia Meskin
You can be aware that the tales of the distribution have gotten fatter.

Frances Donald
Yeah, great way to put it exactly. Tail risk higher. The risk of problems is larger. But I don't think, I don't want to speak for you, Sonia. Not our base case right now. Yeah.

Martin Lefebvre
Another is that we're seeing is with regards to fiscal policy. I mean, the economy's still doing fine. Clearly at unemployment rate near historical lows, no need for fiscal stimulus in the system. So do you see that add up as a problem going forward, owing to the debt ceiling issues and all of that?

Sonia Meskin
Well, I think the fiscal trajectory in the U.S. is part of the reason that the term premium is rising. It's not the only reason. Another reason, of course, is the Federal Reserve. The Federal Reserve is not rolling over its balance sheet into treasuries. The Federal Reserve is also giving a lot fewer if not negative remittances to the Treasury. If you look at the balance sheet of, you know, the fiscal balance of the Treasury, the fact that they're getting less money from the Fed on all fronts is actually a very important component as to why the term premium is rising. And now the reason, of course, is the BOJ (Bank of Japan), yet another reason is that emerging markets are recycling, you know, economies and maturing, they're recycling less of their profits into the treasury market. So all of those things combined, I think, have created a perfect storm. But against the background of that, of course, the fiscal dynamics and the, you know, the shutdown, the debt ceiling dynamics that the U.S. government routinely goes through becomes more of a problem. Now, I think if you watch how politics evolve this year, I think there's an understanding in Washington that this is a problem. How they fix the short-term problems of, you know, agreeing on the debt ceiling situation is, I think, very different than fixing the longer-term problems of having to rebalance the budget away from some spending towards other spending or even more constrained spending more generally. It's doable, but it's not a 2024 story. 2024 is an election year. It's not the story for 2024. All of those things combined, at least in my view, the fact that you know, probably the neutral rate for the economy is higher, not unprecedented. Look at the pre-GFC (Global Financial Crisis) cycle. The interest rates would not have appeared this high given the kind of activity that we have in America, they would have not appeared nearly as high pre-GFC as they do to us now post GFC. At the same time if you look at, again, the fiscal spending that we're doing, right, that's still percolating through the economy. Our manufacturing has perked up precisely for that reason, right. Even though you know, manufacturing globally - look at Germany - is not doing nearly as well. So it's a bit of a, I think idiosyncratic story in the U.S. But to your point, they have some time to figure out the fiscal situation. In the meantime, this is probably going to keep rates elevated unless those fat tails, one of those fat tails, actually that's one of those scenarios that unknown effectively, hits us in the back of the head as you put it.

Martin Lefebvre
Do you think benchmark yields in the U.S. will catch up to fed funds rate, We're a little below still where do you see the terminal rate in terms of benchmark yields in the U.S.?

Frances Donald
So, OK. So the most contentious question that I discuss every single day internally is what is that terminal rate because even 50 points of difference makes a large enough impact to our asset allocation decisions. And like Sonia, we have worked really hard to raise what we believed was 2%. And maybe the way - we should just clarify this- the neutral rate or the terminal rate… So the terminal rate is like where we think we're going, but the neutral rate for me and the terminal rate converge over a 5- to 10-year period. So what is that rate? That's the rate that is neither tightening nor easing in the economy. So it's the rate, it's kind of like the, it's like your kids perfect bedtime. You don't actually know when it is. You don't want to put them to bed too early because then they stall but you don't want to go too late. Is it 7:00 pm, 7:15 pm? We don't know. We're feeling it out. You don't know until you get there, which is what (Federal Reserve Chair Jerome) Powell says about the terminal rate, right. So we don't really know, but we know that it must be higher than it currently is. So we've raised our view of where the rates will end up from 2 to 2 ½, but we're thinking it might even be as high as three. The challenge is that based on the way we're looking at the world, we believe that in the next year we're going to be entering a cutting cycle. And that's going to be really exciting for a lot of people because we're going to start to see better fixed income return. We're going to start feeling less pressure if you have a mortgage. But I really urge - and I have to remind myself and give my team this discipline- that what the next 12 months looks like is going to be a distraction from that 5- to 10-year horizon. And for most people who are investing their savings, that 10-year horizon is much more important. And in that 10-year horizon, we are looking at interest rates that are probably going to be higher so that as Sonia said, the post-GFC, is an anomaly and that is what's so difficult. So Bob from - Bob and I were talking as well too, he's also my friend now - and he made an excellent point I'm going to steal from your panel, which is that everybody can be right now. And that's true. I feel terrible. I've stolen an excellent line from him, but it is his.

Martin Lefebvre
Oh, he's got a few others.

Frances Donald
OK, and I think this is a really brilliant comment because it speaks to, if you think rates are going to be higher, you can talk about that 5- to 10-year horizon. And if you think they're going to be lower than you could say 12 months from now, we're at lower rates than we are. So you have to get your timeline straight. You have to know what your client is thinking in terms of time horizons and really maintain, in my view, for most investors across this country, the longer-term perspective.