Knowledge Centre

A wholesale central bank easing cycle is happening around the world and is likely to pick up steam in the quarters ahead. The global economy looks likely to register a modest uptick in 2024 from last year’s pace as most broad based indicators have surprised to the upside. Inflation continues to moderate and is becoming yesterday’s news worry. The greatest challenges currently are headwinds from ongoing geopolitical tensions as politics could topple global markets from their record peaks in the months ahead.

Many Canadians believe that the economy could slide into recession which is highly unlikely as it was helped by strength in the retail sector and also in oil and gas production. In fact, Canadians are generally wealthier than they think with household net worth exceeding pre-pandemic levels by more than 25%. Inflation in Canada hit the central bank’s 2% target, reaching its lowest level since February 2021. As a result, the Bank of Canada has now cut rates for the third consecutive meeting and is signalling that more cuts may come soon. The future looks bright and could be pointing to even better performance in the years to come.

Inflation in the U.S. cooled meaningfully and is getting close to the Federal Reserve’s target level, a sign that the worst price spike in four decades has faded. This has allowed them to begin a long awaited easing cycle with a 0.50% rate cut in September, after keeping rates unchanged for nearly a year. Lower rates will fuel a recovery of job growth, a new focus now that inflation has largely been tamed. While the U.S. economy is growing at a healthy pace and remains resilient, a sustained period of lower rates is needed to achieve a soft landing.

In Europe, growth has remained sluggish as high interest rates have killed off a long rally in house prices and loans to consumers and businesses. Fading inflationary pressure combined with fading growth momentum offer an almost perfect backdrop for rate cuts, and the European Central Bank did not hold back, cutting in June and again in September. Europe appears to have finally turned the corner as unemployment rates remain low and trade growth continues to be robust, raising real incomes and the prospect for further significant declines in interest rates.

2024 is the year of politics as nearly half the globe is going through elections, and results so far show large shifts in mood: Taiwan elected a president who is detested in Beijing, voters moved to the right in France and installed the largest left wing majority in Britain for decades. Japan has just elected a new PM, and the Bank of Japan has remained hawkish after decades of slow deflation by increasing its key rate. Of course, the elephant in the room is the United States.

Stock markets around the world achieved record highs during the quarter and in many cases kept repeatedly setting the new peaks. For a change, Canadian stocks were at the vanguard of the climb, gaining 10.5% in the third quarter and 17.2% year to date. U.S. stock rose 4.6% (all figures in Canadian dollar terms) in the quarter, and a staggering 25.0% return for the year thus far. International stocks grew 6.0% in Q3 and 16.2% YTD; while emerging market stocks surged at the end of the quarter to 7.5% and 20.0% YTD. Bonds continued to generate good results, climbing 4.7% for the quarter and 4.3% for the year after an equally strong 2023 gain of 6.7%.

The bottom line is we are unlikely heading towards a recession. Interest rates should fall further, and sharply; personal disposable income will likely keep climbing allowing world economies to expand as a result. Inflation will likely rest at a higher bound in the future than it did before COVID-19, as deglobalization, decarbonization and changing demographics become more pressing. However, markets are forward looking, remarkably resilient, and now focused on growth so the pressure from the recent turmoil is fading.

The Canadian economy has managed to post positive GDP numbers since the beginning of this year despite a restrictive interest rate environment. As of the second quarter, the economy grew 2.1% on an annualized basis, outperforming the Bank of Canada’s (BOC’s) as well as most analysts’ forecasts. However, on a per capita basis, the GDP growth has been on a downward spiral due to the staggering change in demographics Canada has added more than 1 million people within a year as of April 2024. The job market, the area of most concern lately, saw the unemployment rate ticking up two percentage points in August to 6.6% – the highest since 2017 outside of the pandemic. Higher rates and population growth appear to be the main culprits for the deterioration in job numbers. Despite this, the markets have charted a different course with the S&P / TSX setting a new all time high in late September at 24,033.83. Although the index shed some value at the close of the quarter, it notched its best quarter in four years with a 10.5% gain. Year to date the S&P / TSX has gained 17.2%, a remarkable comeback as it is now only a few points shy away from its U.S. counterpart, the S&P500.

Gains in 2024 so far have been broad based as all sectors but one were in positive territory for the quarter and year to date. Financials, Health Care and Utilities led the pack in the third quarter with 15.8%, 15.4% and 15.3% returns respectively, while Energy was the sole detractor with a 7.1% loss. Financials have rebounded nicely in Q3, reversing their flat performance in the first two quarters amid growing investor confidence that big bank loan losses have been adequately provisioned. The latest set of’ bank earnings in August saw most of them topping estimates, another catalyst for their strong performance. Materials lost some ground but was strong in the third quarter . However, Materials are the top performing sector YTD with a spectacular 25.8% gain. Most of this performance can be attributed to gold as the precious metal reached its all time high in August at 2,500/oz, spurred by central bank buying sprees. On the flip side, Energy posted a -7.1% return in the quarter, a stark contrast to the rally in other commodities. Energy was well supported by strong benchmark prices for most of the first half of 2024 but lost momentum in the third quarter as the WTI (West Texas Intermediate) benchmark fell below $70 / barrel. However, year to date, Energy is still in positive territory with an 8.8% gain.

The fight against inflation appears to be heading in the right direction and central banks around the world expect inflation to reach their target levels by the end of 2025. In Canada, apart from the lacklustre job market mainly due to youth unemployment and population growth, the GDP numbers have been resilient although at a decreasing rate. International organizations such as the OECD (Organization for Economic Co-operation and Development) and IMF (International Monetary Fund) estimate that the Canadian economy, along with its global peers, have turned the corner on inflation while achieving a soft landing. Over the last few months in the financial markets there has been renewed investor appetite for the S&P / TSX. More than half of 2024’s gains occurred during the third quarter, outperforming the S&P500 by a wide margin over the period. As the BOC’s disinflation cycle is well underway, a jumbo rate cut in the range of 50 bps is also on the table if the job market deteriorates further. This could be a perfect scenario to support the current broad based rally for Canadian equities.

The Canadian Bond market continued its forward momentum from the second quarter, climbing 4.7% for the quarter and bringing its year to date return to 4.3%. This came after a strong 2023 which saw bonds rise 6.7%. Within the bond market, long duration bonds were the standout performers followed by mid duration and corporate bonds. Investors have been waiting for a reduction in interest rates in both Canada and U.S. There is an inverse relationship between bond prices and interest rates. As interest rates continue to fall, spurring economic growth, corporate bonds and more sensitive (longer duration) bonds should outperform shorter, less sensitive government bonds.

Both the Canadian and U.S. markets are making progress towards their respective central bank mandates of stabilizing prices. The annual inflation rate in Canada decelerated for the third consecutive month, coming in at 2%. This is the figure that policymakers and investors have desired, and for the first time in three years, they have found it. The slowdown in inflation comes from drops in gasoline prices and to a greater extent, rent inflation. Rent growth in Canada has generally slowed due to a combination of increased housing supply coupled with lower rent demand. Condominium and housing construction projects which were launched during the pandemic when interest rates were at their lows, are now coming into the market and vacancies are higher than expected. At the same time, the Canadian government introduced a new set of restrictions on international students and temporary workers which has succeeded in curbing immigration and as a result inflation.

Employment is a slightly different story. Canada’s unemployment remains relatively high at 6.6% as of August due to a sharp growth in population and unemployment among new graduates and new Canadians. South of the border the rate of unemployment came down to 4.2% in August and although this rate has been steady through the calendar year, it is a significant improvement from the pandemic highs.

In our previous commentary, we highlighted that the Bank of Canada (BOC) was reluctant to lower interest rates in the face of stubborn inflation, but that changed in July when the BOC announced a 25bps cut to lower the overnight rate to 4.50%. At this time, it does appear that the BOC has been successful in their rate changes as Canada looks to be on track for a soft landing. Despite the higher interest rates of the first half of the year, the Canadian economy managed to post positive GDP growth. There is a larger, 50 bps cut on the table and Canadians could see that go into effect if the Canadian economy continues its progression for price stability and growth.

South of the border, on March 20th, the Federal Reserve cut the Federal Funds Rate by 50bps in September. The latest rate cut brings the Federal Funds Rate down to 4.75% – 5.00%, the lowest since the first quarter of 2023. This was the first lowering of interest rates since March 2020 when the Fed cut the rate by 150bps amid the outbreak of COVID-19 and an unemployment rate which spiked to a staggering 14.7%.

Moving forward, it is clear that interest rates should continue trending downward. Investors need to be careful not to get too ahead of themselves in setting their own expectations of when the cuts will take place in anticipation of in a surge for bond prices. As always, there could be some unexpected twists in the road to normalization. There is an upcoming U.S. Presidential election, calls for a no confidence vote in the Canada’s House of Commons and a spike in violence in the Middle East. Amongst the ongoing political and economic turmoil, as always, opportunities continue to present themselves to investors who are disciplined, patient and forward looking.

U.S. equities continued their ascent through the third quarter of 2024 with the S&P500 rising 5.9%, bringing the year to date total return up to an impressive 22%. This was the fourth consecutive quarter of positive returns for the index. The normalization of the rate of inflation has been a catalyst for the market with the Federal Reserve cutting the Federal Funds Rate by 50bps in September. The latest rate cut brings the Federal Funds Rate down to 4.75% – 5.00%, the lowest since the first quarter of 2023. This was the first lowering of interest rates since March 2020, when the Fed cut the rate by 150bps amid the outbreak of Covid-19 and an unemployment rate which spiked to a staggering 14.7%. Although the stock market was already in a swift recovery during this time, the fallout from the economic measures enacted to deal with the pandemic is still being felt today. Remember, the dual mandate of the Federal Reserve is to keep prices stable and to maximize employment.

The unemployment rate came down to 4.2% in August and although this rate has been steady through the calendar year, it is a significant improvement from the pandemic highs. The steadiness of unemployment is a positive signal for the Fed as it lessens the possibility of rapid wage growth leading to further inflation. More on inflation; price increases have been steady at 3% overall. However, food inflation is trending in the right direction with prices easing to 2.1% in August 2024, a massive change from the food inflation rate of 11.2% in September 2022. Analysts project a 4.6% year over year increase in earnings, a fifth consecutive quarter for growth as the U.S. GDP value has grown to over 25% of the world economy. Many predicted that the world’s largest economy would dip into a recession this year but the data has proved otherwise.

The Fed moving forward with interest rate cuts is a clear signal of their confidence in their progression of taming inflation. After years of rock bottom interest rates, Japan raised its interest rates, triggering a large scale unwinding of the yen version of the carry trade (borrowing from a low interest rate territory and investing the proceeds in a higher yielding asset elsewhere). This sparked a selling spree of U.S. stocks through the month of July only for the S&P500 to recover swiftly. The resiliency of the U.S. economy is vital to a well diversified portfolio. 2024 is an election year and historically the election result has little impact on investment returns despite how partisan America is.

The S&P500 closed the quarter at a record high of $5,762.48 and represents approximately 50% of the global equity market capitalization. The information technology sector and the emergence of AI (artificial intelligence) has dominated financial market headlines, but their momentum was tempered through the third quarter as value stocks outperformed growth stocks in July & August. The lack of market breadth has been a concern for investors but each of the eleven index sectors has delivered positive returns through the first three quarter of the year. Although Information Technology continues to lead the way, Utilities and Communication Services are not far behind in their performance for 2024.

As we look forward to the final quarter of 2024, it should be eventful with an upcoming Presidential election, a spike in violence in the Middle East, and potentially more interest rate cuts. The U.S. will need to continue to show its resilience and earning power along with a broadening of outperformers for the index to push itself into new highs. We are seeing some of the early benefits of lower rates already. Real estate values, lending activity, personal spending, and construction are all on the rise. As mentioned in previous commentaries, this progression will need to take a gradual, healthy route to avoid becoming inflationary . The U.S. stock market continues to beat expectations as analysts have repeatedly called for a recession since 2022 only for the S&P500 index to continue its charge forward.

Cautiously optimistic is the tone that global markets have adopted. Strengthening growth and decelerating inflation is the perfect combination for equity markets. Markets have responded to a deceleration of persistent inflation with a vengeance, jumping to new or near new highs. The global economic recovery is not only strengthening but also broadening to more countries as the markets have taken their cues predominantly from the growth outlook. As central banks continue to transition from being a growth inhibitor to becoming a tailwind for growth, the markets are expected to move upward.

Europe appears to have dodged the bullet of fiscal excess and is poised for growth, albeit at a relatively slow pace. The economy grew modestly in the second quarter but the jobs market remained strong with low unemployment levels. Inflation fell below the European Central Bank’s (ECB’s) target for the first time in more than three years as falling energy prices gave consumers relief from a burst of inflation that at one point reached into double digits. The ECB has made two interest rate cuts so far and the markets are pricing in almost two more cuts this year; and a little more than five moves by in 2025 to prop up tepid growth.

The U.K. election results have had very little impact on markets in the short term and are unlikely to trigger any major changes to policy given current fiscal restraints. This poses a challenge to an economy that has been the second weakest in the G7 since the pandemic. Living standards have stagnated since 2010, public debt is at almost 100 per cent of national economic output, and tax as a share of GDP is at the highest level since WWII. The Bank of England has started to cut interest rates from a 16 year high to fix the foundations of the economy, but after years of low growth, to increase spending on public services while honouring a pledge not to raise the taxes will be a tall order.

Japan had a unique problem as its weakened currency which had been inflating corporate profits and valuations was beginning to appreciate at an alarming rate. The Bank of Japan responded by ending eight years of negative interest rates in March. Then they unexpectedly raised rates again for only the second time in nearly two decades. The resulting turmoil has threatened one the most enduring stock rallies in Japan in decades, as the market experienced its most severe two and three day trading drops since the 1950s with more expected. Japan’s economic growth is on relatively solid ground despite pressures from a declining workforce and deflation that previously dragged on for years.

International equities have been on a tear in the third quarter, climbing 7.3% and up 13.5% for the year to date (all figures in U.S. dollar terms). European stocks essentially matched these numbers, gaining 6.6% in Q3 and 13.4% YTD. Germany and Spain lead the pack this quarter rising 10.7% and 13.7% respectively. The U.K. jumped 7.9% while Japan generated a meager 5.9% in the quarter. Not to be outdone, Asian stocks were roughly in the same ballpark, jumping 7.8% in Q3 and 13.3% for 2024 so far.

Despite mixed results, overall headline inflation declined in most countries. Each central bank must juggle the need to make sure inflation is under control, which would mean waiting longer to lower rates, against concerns over slow economic growth, which would argue for swifter cuts. No central bank wants to belatedly discover that inflation is more stubborn than they thought and reverse course, a mistake that would make inflation harder to wring out of its economy.

Over the last five years the results from Emerging Markets have been weak and risk continues to be high; driven by elections, geopolitical risks and fundamental changes in corporations. Decreasing inflation has been a welcome respite for the markets, allowing central banks to start cutting rates while remaining cautious about being too aggressive due to a potential rebound in inflationary pressures. It is noteworthy that most emerging market countries have recently registered some of the strongest growth rates over the last two decades.

Since the beginning of this year China’s economy has expanded at a slower rate than forecasted. There are many difficulties and challenges, and policies to address these problems have been cautious and ineffective. The results thus far have weighed on the economy with weak consumer demand, reduced government spending, a prolonged slump in the property market and sticky inflation. China’s leaders have steered clear of the sort of massive stimulus that other major economies deployed during the pandemic. Then out of the blue during the last weeks of this quarter, the government unleased a stimulus blitz designed to produce blockbuster growth in the coming months. The result was almost instantaneous with Chinese equities leaping 25% in nine days. The rally could be derailed if the government’s fiscal stimulus package misses its expectations but for now the markets are cheering.

China remains a central player in the emerging market space representing the largest region of the index at 22%. India and Taiwan are emerging as bright spots, making up 19.3% and 18.9% of the index respectively. India, now the most populous nation in the world, has seen robust earnings growth and has largely stayed out of geopolitical conflicts, adding to its attractiveness as an investment destination. Taiwan is a big tech player and a hub of technological innovation, particularly in the semiconductor industry. South Korea is moving up the ranks despite corporate governance issues, on the back of sectors like Financials, Industrials and Automotive.

At the other end of the spectrum is Turkey where the President has politicized monetary policy and implemented a policy to reduce interest rates during an economic crisis. The result was predictable as inflation soared to 85% and the Turkish lira crashed to historic lows. Even though the central bank reversed course and raised interest rates 50%, inflation is still running rampant and the lira continues to slide.

Brazil and Mexico have shown significant improvements in growth rates through challenging periods. Mexico in particular is poised to benefit from nearshoring, a growing trend that’s encouraging U.S. firms to manufacture goods close to home; they now account for 15% of total U.S. imports. Many of its industrial and manufacturing plants are at 100% capacity. It has leapfrog ahead of others in the region like Colombia and Chile which are seeing declining post-pandemic growth.

Emerging equities have been on a tear lately due to China’s rally, climbing 8.9% in Q3 and up 17.2% for the year to date (all figures in U.S. dollar terms). Asian stocks jumped 9.6% in Q3 and 21.9% for 2024 so far. China led the way by closing the third quarter up 23.6% and 29.6% YTD. European stocks fell 2.3% in Q3 but managed to hold much of their earlier year gains and were up 13.1% YTD. Latin American stocks eked out a small 3.9% gain in the quarter but have dropped 12.1% for 2024, so far.

There are many risks lurking in the background of Emerging Markets. However, as their economies diversify and move away from resources their outlook brightens. Most have democratic governments or are moving in that direction which reduces the possibility of uprisings. Importantly, they have sustainable population growth and a growing middle class with governments that are willing to make investments in education and innovation. Emerging markets may be set for a resurgence.

The third quarter started with a strong rebound in the REITs sector as investor sentiment is positive compared to late 2023 on the backdrop of falling inflation and the Bank of Canada’s (BOC’s) dovish monetary policy. As of September 2024, the BOC has reduced its key rate three times to 4.25% and indicated a bias towards further cuts. The new interest rate cycle has been the main catalyst for the resurgence of REITs, gaining an impressive 23.2% in the third quarter, a standout performance compared to the 10.5% gain in the broader S&P / TSX. Although the global REIT sector had been under pressure by higher rates for most of the first half, early signs of an inflection point emerged in the third quarter. Bouncing back from bear territory, the MSCI Global REIT index returned 14.9% in Q3 and 14.9% year to date (in Canadian dollar terms); while the MSCI World returned 5% for the quarter and 16.6% YTD. Investors expect this trend to continue as global central banks pivot to a rate cutting cycle.

Canadian REITs across the board appear to exhibit some bottoming as there has been increased activities within the worst performing office segment. Although the segment is experiencing a vacancy rate uptick, that rate has hovered in a tight 30 bps (basis points) range over the last few quarters. This year, the office segment reported back to back positive absorption in the first and second quarter for the first time since 2020. There is growing optimism that the office segment has bottomed out. A recent survey conducted by CBRE (A commercial real estate services & investment company) revealed that about 40% of office portfolios in the U.S., Canada and Latin America should see some office space expansion in the next three years, a substantial improvement over the 20% predicted last year.

The retail segment has been in short supply and posted one of its best average occupancy rates in years at more than 97% despite higher inflation and a slowing job market. The tight supply has been a direct result of increased construction costs due to higher rates. Although Canada is showing a decent level of retail construction, the overall trend for North America is a rising demand and retail rent appreciation, especially in larger cities.

The residential segment has reported reduced investment activities in recent months compared to its peaks of 2021 and 2022, although asking rents continue to rise to all time highs. Insolvency, which has been one of the biggest concerns during the rising interest rate cycle, appears to be creeping up. According to data from the federal office of the Superintendent of Bankruptcy, the insolvency rate in Canadian residential REITs is on course to overtake the levels of the 2008 global financial crisis. This distress is concentrated in residential REIT projects as developers have been caught off guard by higher rates and increased expenses.

Although 2024 saw a rise in office segment delinquencies globally, particularly in the U.S., most segments have reported solid operational performance along with disciplined balanced sheets and low leverage ratios. The Federal Reserve’s (Fed’s) bold move in September to cut rates by 50 bps is long awaited, welcomed news for global REIT investors on the sidelines and on the lookout for reentry into the sector.

As the markets embark into Q4 and the year draws to a close, the Canadian and global REIT environment will primarily be shaped by central bank policy. A key message in both the BOC’s and Fed’s latest communications appears to imply that short term rates have peaked while long term rates might be trending lower. Historically, markets entering this phase present outstanding opportunities for REITs and the case for quality REITs selling at deep discount has not been this compelling in decades.