Bond traders’ expectations surrounding future policy moves by central banks has acted as a compass and provided direction for equity markets. In late 2023, bond yields tumbled as expectations of near-term rate cuts climbed, which propelled equity markets higher.
To get an economic and market perspective from an economist at a leading fixed income investment firm, the Globe and Mail reached out to PIMCO economist Tiffany Wilding. PIMCO is a global leader in the fixed income market with approximately U.S. $1.9 trillion of assets under administration.
Ms. Wilding shared her Canadian macroeconomic and policy rate outlooks as well as her thoughts on how investors can position their portfolios for success in this uncertain economic environment.
In January, you published a six-to-12 month outlook report and within it stated, “cuts tend to coincide with rising unemployment and a falling output gap, when an economy is already in a recession.” Based on this observation, when do you anticipate a rate cut by the Bank of Canada will occur?
That was the observation historically. We looked over 14 developed markets from the 1960′s until today. The conclusions that we found in this analysis were twofold. The first is that central banks usually aren’t preemptive in their cutting cycles. They’re cutting when they’re pretty sure their economy is in a recession. The second point is that when they do start cutting, they’re cutting more aggressively than what forecasters expect and what the markets usually price.
Now, the caveat to that is that there are a handful of cycles, historically, that did realize central bank cuts, which did not coincide with the recession. With these ‘soft landing’ cutting cycles, the central bank is cutting about 200 basis points, on average, in the first year of easing. That’s the historical precedent.
Now, I do think that there are some things that are a little bit difficult today and the big thing for Canada is the immigration boom that we’ve seen over the last couple of years. Immigration, we think, is adding more to demand than it is to the supply side of the economy. So, you’re seeing more near-term inflationary effects from that, particularly in the housing sector because you just can’t get enough housing supply to satiate this immigration demand without prices increasing.
You also have seen wages in Canada that are sticky despite these immigrants coming in, and that’s, in our view, because a lot of them are student related or they’re not really adding to labour supply in the way that you would traditionally think.
Ultimately, the growth fundamentals in the Canadian economy still look very weak. You are getting a lot of pass-through of higher interest rates, higher interest payments that people have. Consumption in Canada is looking very weak. If you look on a per capita basis, the economy’s already contracting so you already have kind of a stealth recession happening in Canada.
With all of that taken into consideration, we would say a mid-year start to the cutting cycle for the Bank of Canada and something like 100 basis points of cuts in the first year makes sense to us.
The Bank of Canada’s policy rate was 1.75 per cent prior to the pandemic, where do you see the overnight rate settling?
In our view, the neutral interest rate in the economy hasn’t really changed that much, so call it like a 2 per cent type of rate. But, that 2 per cent rate assumes that inflation’s back to target and labour markets are at neutral.
If we are going into scenarios where the economy weakens more than central banks expect then you could actually see the rate falling below that because they actually need to provide accommodation again. And we think that is definitely a risk in Canada because of the faster pass-through rate of monetary policy to consumers.
When do you see inflation returning to the Bank of Canada’s 2% target?
I think sometime in 2024 is a very reasonable forecast.
Your real GDP forecasts, what are they for Canada?
For 2024 as a whole, we’re looking at stagnant growth fundamentals so near 0 to 1 per cent.
Stagnant but not recessionary?
Certainly, a recession is possible. We would argue that if we do get a recession, it will probably be mild.
Shifting to investors’ portfolios, where do you see the greatest investment opportunities for Canadian investors?
We really think that the economic outlook that we have is one where investors are better served to stay in high-quality bond markets, in general.
From an asset allocation perspective, we don’t see a lot of value in the equity market more broadly. We would argue with equity valuations not really pricing in increased risk of recession and equity valuations that aren’t really that compelling, we just don’t see a lot of value.
You can get equity-like returns by staying in highly rated fixed income assets at this point given that central banks have raised rates so much. Even outside of the government bond market, if you look at AAA securities, AAA corporate credit or even some securitized securities, those provide you with equity-like returns, 7 per cent type of yields.
I think having a broader global opportunity set is quite compelling and interesting right now and could provide much more value for investors. And one of the reasons is that we saw central banks in a very correlated way raise rates. Because monetary policy passes through at different rates in different economies, we think that economies that are more interest rate sensitive will slow faster. Ultimately, there’s more capital appreciation potential for bonds in those economies. Canada is more interest rate sensitive than the U.S. We also really like Europe, Australia, New Zealand, as well, places that are more interest rate sensitive.
The other thing is that the pass-through of monetary policy in the US is obviously slower but nevertheless, there are opportunities in the United States, as well. In particular, the non-agency MBS [mortgage-based securities] market in the U.S. looks extraordinarily attractive, more attractive than where it was after the 2008 financial crisis. Part of the reason for that is investors’ fears of regional banks having to sell. They own a lot of this agency MBS paper. The market has priced in these fears that you could see some fire sale and that has not been realized. It’s provided a huge opportunity for investors to get equity-like returns by buying a bond that has no credit risk, it’s government guaranteed, where you basically just have prepayment risk and there’s very strong underlying fundamentals within the housing sector in the U.S.
This interview has been edited and condensed.
Jennifer Dowty