As inflation trends lower, financial markets are betting that interest rate cuts may not be far behind. Michael Craig, Head of Asset Allocation at TD Asset Management, discusses the outlook for rates and markets in the year ahead with MoneyTalk’s Greg Bonnell.
Originally published December 20, 2023
Markets are betting on rate cuts next year as inflation continues to come down closer to target levels. But of course, today's Canadian CPI report did show maybe a choppy road ahead, not a straight path to 2%. Joining us now with what investors need to be keeping in mind for the new year, Michael Craig, Managing Director and Head of Asset Allocation and Derivatives at TD Asset Management. Michael, great to have you back on the program.
Thanks, Craig. Thanks for having me.
It has been a year dominated with conversations about the cost of living, about central banks. Will they or won't they-- as we head into 2024, obviously, we're not done with that story. But surely, there's a few more things we need to keep in mind. Well, what are you thinking about?
Yeah. In many ways, this is the tail end of the kind of Santa Claus rally, if you will. Markets are, I think, for all intents and purposes, pretty shut down now for the year. Most people are taking time off, and their liquidity has fallen.
As we head into the next year, I think the disinflationary theme continues. I would expect, on any given month, you get a print that could be a little bit higher than expectations or whatever. But, I mean, since we have been deflating now for a year and a half-- like, the peak inflation was June of '22 at nine. Now, we're at three.
I would expect to see that continue to go lower next year as really the cost of living does hamper people's spending and people-- demand continues to get destroyed as people are not able to spend as much as they were previously.
So as that story continues to play itself out, can I then, and can the audience, just sit back and say, well, I got nothing more to worry about? Inflation is coming back down to 2% target. We'll get there eventually. You know, sunny days ahead. There's always things to worry about.
I guess the point I'm trying to get at, there's always things to worry about. [LAUGHS]
It was a pretty stiff dose of medicine to get us there.
And I would say that when we reflect on this period of time, we probably didn't need as much hikes as we did. But what happened is you had both-- you had central banks fighting with governments, if you will, whereby governments continued to have excessive fiscal policy that drove inflation far higher than it needed to be post-pandemic.
And therefore, this is going to, I think, to lead to some challenges next year as we see inflation fall rapidly and we are stuck at still very restrictive levels of inflation. So I don't think the market is incorrect by thinking about cuts next year. And I think that it's been our view for some time that timing these things is a bit of a mug's game.
I'll be totally frank, the expectations for cuts throughout this year have been quite all over the place. I mean, the market was expecting massive cuts last June after the various US banks fell. But I would say that when cuts come, they will be fairly sharp. I don't think, you know, a trimming here and there is really going to be what the story is. I think it's going to be a pretty sharp cutting cycle as we start to deal with an economy that just can't operate at 5% money.
So we have seen a pretty healthy rally since October for a lot of the main benchmark indices. Is the sense there that they're pricing in all of that, or could we get further runs in equities next year if all of that plays out?
I mean, certainly, the tape is pretty strong right now, so it's hard to fight that tape. Market is priced quite rich. I think we're priced for perfection, if you will. I think the earnings story in the US next year isn't awesome. But if I put that aside for a minute, we have been basically in a trading range for two years now. And so from a technical perspective, breaking out of that range could be quite powerful.
So I would say that we're not super bullish at this point. We're kind of fairly balanced in our mix. Bonds have had a great run. Stocks have had a great run. Cash is soon to be paying a lot less because I believe rate cuts are coming. And so for us, it's we've increased our liquidity. We've increased our ability to make rapid decisions.
And I think that there's a wide array of outcomes that could happen in the first quarter, first half of next year. And our approach is not to say this is what the market's doing. It's these are the possible paths you could take and what's our plan under each scenario.
When I think back on the year that we've had so far, and I think perhaps the S&P 500, definitely the Nasdaq, performed a lot better than a lot of people thought heading into the year, but the criticism is market breath, right? If you pick the right seven names-- the magnificent seven-- then you're smiling. If you didn't pick those names, maybe you feel like you've been on hold and waiting. Do we see a bit more breath--
-- next year.
Yeah, well, actually, in this recent rally, the breath hasn't picked up materially. So you know, small caps, for example, hit 52 week lows a couple of months ago. Now they're on 52 week highs. Quickest reversal in, like, since I've been alive.
So you have seen a degree of this kind of-- you know, European equities, which in Europe is basically almost deindustrializing right now. I mean, the PMI data is terrible. Germany is in a really tough spot, but European equities have had a great run.
So I think there has been much more abrupt to this rally. It's been a bit of a land grab. I think a lot of this is clients who have been sitting on excess cash piling into the market. You're starting to see, in the US, money market funds starting to lose assets, which is a good sign that markets are-- people are starting to reallocate to the stock market.
So I think some of this has been people coming back to the market and saying, I don't want to pay up for what's worked. And so you've seen other-- companies that have been kind of left in the dust, if you will, this year catch a bid in this last quarter.
On the fixed income side, let's talk about that, because, obviously, they had a pretty good run starting in October when we got up to that 5% on a 10-year Treasury yield mountain and started coming down the other side of it. A lot of people-- and people will ask us here at the show, you know, what is to come? Have I missed the run? They saw a bit of a run in fixed income, and they're wondering what kind of year 2024 will be.
So I would say, I was surprised by us getting to 5%. I think many participants were. And so part of this rally has really been a function that we probably were way too high in yields in the first place. But looking at the fixed income market, it's come a long way. A period of consolidation would be healthy.
Remember, you're still earning, on a run of the mill bond fund, just under 5%, all in yield, if you include credit. So if it goes nowhere, no big deal. You're still getting relatively good income.
I would say real interest rates, or the interest rate you think of-- kind of government bond or you just use US treasuries, for example-- they're trading at 4% right now. If we take into account the market's expectations for inflation over the next 10 years and take the difference of that, your guess-- you're getting real yields, still well above 1%, call it 1.5%. That is still very high.
I mean, I would expect real yields to trade in a 0% to 1% range longer term. And so my sense is, as we sit here a year from now, the bond market will have had a pretty good year in terms of-- again, the backdrop is cuts are likely coming. You're probably going to get more than what the Fed is talking about.
And inflation is coming off. And the only thing holding up inflation right now is rents, which is very much-- a lagged series. If you actually look at real rents, like online, or Zillow, or whatever, rents are deflating as well. So my sense is we see a pretty precipitous fall in inflation, which then makes bonds all that more attractive as we head into '24.
I can't remember the exact quote-- and it's more, I guess, a misquote of, like, knowns unknowns, and the knowns unknown. What could trip us up next year that perhaps we aren't putting a spotlight on right now?
I would say there's two ways to answer that question. On the bullish side, the known unknown is that, you know, market participants, myself included, use a lot of empirical analysis to try to understand the future. And a lot of that analysis will lead you to, oh, my gosh, we're going to recession. Like, yield curve is inverted. Bank credit is becoming less available. You're seeing stress in the auto finance, if you will.
But, you have to be open to the realization that this could just be a normalization from an incredibly bizarre period of time in our lives where we've gone through a global pandemic, an epic bout of monetary stimulus, followed by an epic bout of inflation, and we just get back to kind of square one, right? And ultimately, that is the soft landing scenario.
And I think that-- if there's one thing I've learned this year, what keeps you sane and employed in this business is a huge amount of humility. Knowing that we have a view on the world, but it might often-- things happen-- like AI this year. A lot of the strategists here who are bullish weren't saying it's going to be AI that lifts it. But it was really Artificial Intelligence, or really the artificial intelligence coming kind of the prime time that drove the market for much of this year. No one was calling that a year ago.
So there's that side. On the side where it's things to watch for, it is the kind of lagged, you know, monetary policy operates in a-- in an unknown, but varied lag. And I think people now are like, oh, my gosh, my mortgage rates are too high. They're looking at the price-- prices are higher. Now, inflation-- the increasing of prices has slowed down, but prices are still materially higher than they were a couple of years ago. And we start to go into a retrenchment, which ultimately does trip you into recession.
So these are the two angles where I'd say we're bouncing. And there is a not so immaterial election coming in the US next year. And right now, it's a coin toss between the two incumbents. That also creates a tremendous amount of uncertainty.
So I would say there's a few things to look into next year. I wouldn't say it's all smooth sailing, I'd also say that the distribution of outcomes are quite wide both in the positive and the negative side.