Investment Strategy and Interest Rate Analysis – A Fog in Financial Markets

President Trump has outlined a slew of economic objectives, with a core unifying theme of US protectionism. The consistent messaging throughout the almost ten years of Trump’s association with the White House is that he is concerned about US self-sufficiency. Today, these policies are coming in the form of restrictive immigration policies, expansion of domestic energy production and the implementation of sizable tariffs on the US’s most significant trading partners to reorient trade flows. The hope is that these policies benefit the US in the long run by reducing reliance on international trade. However, such drastic structural shifts are unlikely to come without a painful period of adjustment.

Growth outside of the US has remained subpar, with many countries one shock away from entering recession. Over 75% of developed market central banks are now easing policy rates, and rates are likely headed even lower with growth risks clearly skewed to the downside in most regions (graph 1). The good news is that inflation is largely under control in most developed markets, giving central bankers the ability to respond to growth shocks if needed. Some central banks, like the Bank of Canada, have front-loaded their easing and are thus expected to see fewer rate cuts this year than last. In other countries, where officials have been more cautious on easing monetary policy, such as Australia, Norway, the UK and the eurozone, traders see more scope for cuts (graph 2). 

Inflation is under control in Canada, and the central bank views the risks around its 2% target as balanced. Growth is also showing nascent signs of rebounding but remains disappointing. As such, Canadian central bankers will likely respond to any growth shocks that are to come from the implementation of tariffs with lower rates. How long these tariffs remain in place will dictate the severity of the growth shock. The market has correctly interpreted the Bank of Canada’s reaction function, with Government of Canada bonds outperforming and yield curves steeper relative to other developed markets. Given the recent de-escalation, our base case, which sees the Bank of Canada easing its policy rate down to 2.00%, is once again the most likely scenario (graph 3). In the event of an escalation, the Bank of Canada may need to lower its policy rate further.

Inflation in the US is still above target, and economic growth, particularly on the consumer spending side, remains resilient. As a result, the potential growth shocks that may come from a trade war with Canada and Mexico likely don’t outweigh the upward pressures on inflation that will come down the pike. While the bar for the Fed to raise rates is still quite high, the countervailing forces of US trade policy are likely to result in an FOMC that is going to exhibit more caution in lowering rates. As such, we don't expect the Fed to lower its policy rate again until at least the middle of the year, and only expect two cuts in 2025 (graph 4).

However, as inflationary pressures ease later in the year, our base case sees 2-year spreads gradually compressing by 30 basis points by the end of 2025 as the FOMC begins to ease its policy rate.

However, it has since regained some ground after a tentative agreement was reached between US and Canadian leaders. This surge in volatility underscores the ongoing impact of President Trump's tariff policies on currency markets.

Our year-end USDCAD forecast of 1.48, one of the highest on the Street, factors in a 10% tariff hike in the second half of the year. Should the tariff increase be larger or occur sooner, it would present an upside risk to our forecast. Our analysis indicates that the Canadian dollar (CAD) would depreciate by 5% against the USD for every 10% permanent increase in the effective tariff rate.

It’s typical to see positive performance this time of year as many investors put cash to work in the new year (graph 5). Still, equities have outperformed relative to what historical averages would suggest. Part of this positive performance has come on the back of relentless buying, with global equities raking in a total of US$95 billion in flows over the month, one of the strongest Januaries on record. Flows were mostly concentrated in US equities as participants continue to buy into the US exceptionalism narrative in global markets.

Authorized buybacks should approach the US$1.4T mark, with actual executions expected to come in around US$1.1T. These levels would see buybacks accelerating from the prior year and hovering near record highs. These flows should begin to hit the market in February and could offer some much-needed support or cushion to markets as equities grapple with incoming headlines relating to tariffs.

US-listed companies with high international revenue exposure have underperformed companies that source most of their revenue within the US. This trend is similar to the one seen in 2018 when President Trump increasingly put pressure on China (graph 6). 

During his 2018 tariff dispute with China, the performance of the stock market didn’t push the president to waver on his policy goals with China. Equities suffered a nearly 20% drawdown, driven by a myriad of factors, but trade policy was in part to blame. 

The Magnificent 7 account for over 30% of the US equity market. Within the MSCI Developed World Index, the Magnificent 7 account for over 20% of the index, and US-listed names account for over 65% of the broader index. This historic level of concentration is the result of several years of tech dominance that has seen market caps swell 445% since 2019. That tech dominance came into question earlier this year when new Chinese technology challenged the US-centric AI ecosystem narrative with implications for pricing power, capex trends, market valuations and the current leadership in the space. While the tech sector has stabilized for now, the sector remains vulnerable to more news relating to Chinese technology or other alternatives and could be an important factor driving our outlook for equities long term if viable, cheaper alternatives to the US begin to emerge.

The heavy lean towards the growth-oriented Magnificent 7 names is one of the reasons for the lofty valuations on the S&P 500 when looking at P/E ratios. With less exposure to technology names that might be facing more competition this year, there’s some scope for Canadian equities to outperform in the event of a further breakdown in the US AI dominance narrative.