Stu Morrow, chief investment strategist at Morgan Stanley Wealth Management Canada in Toronto.Handout
In this challenging macroeconomic environment, it remains unclear how rapid hikes in interest rates will ultimately affect the economy and consumers, and just how quickly elevated inflation levels will retreat.
Under such conditions, many investors have turned away from stocks and sought the safety of short-term, high-yielding investments. In 2023, net sales into money market mutual funds have tripled year-over-year, according to a report issued by the Investment Funds Institute of Canada last month. Money remains on the sidelines until there is greater confidence in improving economic conditions and corporate earnings.
The Globe and Mail recently spoke with Stu Morrow, chief investment strategist at Morgan Stanley Wealth Management Canada, who provided his insights on the economy, markets and asset-mix recommendations.
Let’s begin with your Canadian macroeconomic outlook. Looking at your base-case scenario, what are your expectations for GDP, inflation, employment and the policy rate?
Our base case for Canada is no recession or slowing growth ahead. We expect inflation will continue to fall, though don’t expect it to be a straight line back toward the midpoint of the Bank of Canada’s 1-to-3-per-cent target until we get out to late 2024, 2025. Our official year-end core inflation outlook is 3.7 per cent for this year, 2.4 per cent for next year. The base case for unemployment, [we] see that starting to rise a little bit in 2024 as demand starts to soften. We see potential for rate cuts somewhere in 2024. Our official real GDP forecast for the end of this year is 1.4 per cent and the same for next year.
Rising interest rates and higher equity markets typically don’t coincide. Yet, 2023 has been a positive year for many major equity markets globally. What’s your assessment of this situation?
It’s interesting because there is a disconnect between what real interest rates have been doing, which is going higher, and valuations have been expanding, especially in the U.S. market. That’s a disconnect that we see as a risk. We are tactically underweight U.S. equities for that reason. We also see risk to the earnings outlook in the U.S.
Europe has done well this year, as well as other parts of the international markets, like Japan. For Europe, we’re market weight. We see the economy continuing to slow. We’re tactically positive on the Japanese equity market, seeing domestic companies as beneficiaries [of] the return to positive GDP growth, potentially higher inflation that should fuel return on equity expansion as well. And then, fund flows haven’t really gotten to a euphoric state yet in Japan, so there’s still some room to go there.
Elsewhere in the world, we’re more market weight emerging markets given the weight of China within emerging markets – that’s where we’re a little bit cautious.
But we’re seeing some attractive opportunities elsewhere in emerging markets like India, which is the second-largest emerging market weight, next to China. And Mexico, which should benefit from more reshoring activity from overseas back to North America. Given close ties to the U.S., they should benefit.
How about the Canadian market?
Longer term, thinking about growth of immigration flows, also other factors like additional investment in the infrastructure around green technology and materials for the transition towards electric vehicles. All of those things are positive for the longer-term outlook for Canada.
Near term, we see opportunities here from a valuation perspective. The equity risk premium is the premium you get for taking earnings risk, and in Canada, that’s significantly higher than it is in the U.S.
What’s your official call then for the Canadian stock market?
It would be neutral.
What sectors do you believe will be the leaders in the current environment?
Energy and materials, those would be the top two sectors that we would look at in Canada.
We’re positive on the commodity side as well as food and agriculture – so think about the fertilizers. And on the energy side, there is a risk that if this transition away from fossil fuels towards EVs is an elongated cycle, then the underinvestment in the energy sector and tight inventories could lead to more oil price volatility.
What about the laggards?
Financials, from a bank perspective, without calling out individual banks. Given the potential risk of a higher-for-longer interest-rate environment, that could be a risk for the consumer, the housing market and provisions for credit losses could remain elevated, which is a risk to the earnings outlook for the banks.
We just saw earnings come out a couple of weeks ago and we did see provisions for loan losses start to pick up. And if we do get a much slower economy, there is risk that loan growth overall declines and banks will start to have to rationalize expenses and those sorts of things. We would probably think of them as laggards in the next six to 12 months.
What do you think about the relative value of Canadian stocks to bonds?
Over all, we are overweight fixed income in the portfolios.
As we approach the end of the rate-hiking cycle, investors may want to consider using dollar-cost averaging to extend the duration of fixed-income positions beyond just the short end to include intermediate-duration bonds.
Today, if you look at the return-versus-risk ratio for stocks versus bonds, it’s pretty attractive to be in bonds versus stocks.
Looking ahead, what key takeaways do you believe may emerge from the upcoming third-quarter earnings season?
We’d look for signs of margin pressures. In the financial space, what happens to net interest margins, especially on their U.S. businesses and what’s happening on the Canadian side as well. Thinking about consumer, industrial names, looking for signs that real volumes and pricing power are either sustained or at risk.
Leading indicators suggest to us that we’re late cycle. So top-line volumes and inflation-adjusted revenue is really what we’re watching for. And if those start to decline, that’s a signal to us that there’s more earnings risk ahead.
What we would need to see for us to get more constructive, at least on the Canadian and the U.S. side, is some more realistic numbers for next year, at least in terms of estimates. And then to see that multiple on the U.S. side come down as well. That’s something that we think could happen in the next short while. That would get us a little bit more positive on the equity side of the portfolio relative to bonds.
Do you see generative AI as a secular growth opportunity that’s just in the early innings?
We have a positive long-term view. There’s a capital expenditure cycle and resulting productivity gains that over the long-term will be disinflationary.
We’re cautious in the short-term. From a market perspective, when we look at what’s largely been priced in are some of these long-term benefits and the execution of AI adoption has been priced in. A lot has to go right for market expectations to be met.
But longer-term, what we think investors should be thinking about are those companies that are going to take advantage of some of those new infrastructures that are going to be built and paid for by others. Go back to the internet build-out in 1999, 2000 and the winners of that cycle were really the ones who came after that. So, you really don’t know who those companies are yet.
What’s your No. 1 piece of advice to investors who manage their own portfolios?
The No. 1 message that’s worked for me throughout my career has always been staying invested and not trying to time the market.
From a behavioral perspective, I think that people tend to want to play with the portfolio quite a bit.
Someone said to me once, it’s kind of like bar soap, the more you put your hands on it, the smaller it gets.
And a good practice in portfolio management is being diversified by asset class, by region, by currency, by style, by manager, dollar-cost averaging and just staying invested. It’s not exciting but it works.
Jennifer Dowty