The Canada – U.S. rate divergence and the implications for markets

The beginning of this month doesn't feel like that long ago, but markets were sitting at record highs. We've since had a pullback. Investors are considering the outlook for rates. So where do we go from here? Joining us now to discuss, Michael O'Brien, managing director and head of the core Canadian equity team at TD Asset Management. Great to have you back on the program.

Yeah. Thanks for having me.

Great day to have you on considering how the markets now are reacting to this idea that, perhaps, the Fed will be stuck at higher for longer. This has been a pretty dramatic reversal of fortunes of the past couple of weeks. How do you see it?

Yeah. You've hit the nail on the head. If you go back to when the markets were making highs only a couple of weeks ago, I think what really was driving that was a real sense of confidence among investors that we were going to get that soft landing that people were looking for. The economy south of the border was holding up quite well, and so people were looking for that kind of perfect outcome where growth remains solid, but inflation comes down, which leads to a series of interest rate cuts.

And so it wasn't that long ago markets were pricing in five, six, seven rate cuts out of the Federal Reserve down south of the border. I think what's rattled the markets is just-- it wasn't just today's print, which you mentioned, but that's a perfect illustration of what we've seen, which is the last couple inflation reports out of the States have come in a little bit hot. That's caused investors to question whether it was really going to be as easy as it looked a month or two ago.

People are starting to ponder, well, what if we don't get rate cuts? What does that mean for valuations? And today, the headline GDP number printed a bit soft. I kind of look past that. I don't think it's concerns about weakness, per se, in the economy.

I think it's more on the inflation side where, again, you saw the inflation component of that report today was, again, a little bit hot. So people are starting to rethink this whole idea of how many rate cuts and when are we going to get them south of the border. I think just before coming into the studio, the latest seems to be that the first rate cut has been moved right back out to December in the US. So that's a big change. And I think that's what's kind of rattled investors here. That's why we've got this little pullback.

Some people may be looking at today's data out of the States that, OK, a softer economic performance-- you say you're looking past that more to the inflationary stuff. But you put a soft economy together with sticky inflation, some people start using that word "stagflation." The markets don't like that. As citizens, we shouldn't like that word.

And if your starting point is markets pretty much across the globe that we're within ticks of all-time highs, which entering the month, that's where we were at, not just in the US, a lot of things have to go right. Personally, I think the notion that stagflation is a more likely outcome, I think that's not the case at all.

The balance of evidence that I'm seeing still suggests that the economy is in decent shape and inflation in the States hasn't cooperated quite like we would hope. But it's certainly not sending out alarm bells that things are re-accelerating to the upside, would be my take on this. So I would characterize this more as a healthy correction or a healthy rethinking of what had kind of gotten to be exuberant expectations a month or two ago.

In life, things usually aren't as easy as it seemed back then. And so I think this is just a bit of a reality check. But all things equal, I think we're at a pretty decent spot here, certainly relative to where most investors thought we'd be six months ago, nine months ago. Growth does look pretty decent in the States.

Inflation has made a lot of progress. It's just we're going to have to be patient, let this process play out. And I think, to their credit, that's what the FOMC members have been communicating for quite some time, even if we didn't want to hear it, is be patient. Things are trending in the right direction, but it's not a straight line.

And I think the market is finally kind of taking that to heart. And we're not necessarily going to get everything we want right away. But that still seems to be the most likely outcome. We've just got to be patient.

The petulant child in me hears, I'm not going to get everything I want right away? Come on. But obviously, this is--

Exactly. That's exactly the sentiment.

As you say, that's the way life works. Let's talk about the Canadian situation, though, because the Americans have seemed to be exceptional through all this. And Canada, we have a different setup.

Yeah. I think in Canada, it seems to be a little more of the conventional economics 101 playbook. The rate hikes that we saw in Canada, they have had that expected or intended impact, which is the economy has been slowing, a little more notably than south of the border. And the good part of this is that as the economy has slowed here, we are seeing inflation respond the way we would hope, which is, in contrast to the last few hotter-than-expected inflation reports south of the border, the Canadian CPI data has actually been quite well-behaved.

Tiff Macklem, the governor of the Bank of Canada, after the most recent CPI report last week, he made it very clear that the Bank of Canada is happy with what they're seeing. Good progress is being made. And so I think whereas south of the border, investors are kind of pricing out that first rate cut until much later this year, based on what I'm seeing and based on what I'm hearing out of the Bank of Canada, I think, whether it's this next meeting in June or the meeting after that in July, I think we're on the cusp of a rate-cutting cycle beginning here in Canada.

Talk about divergence. When Tiff Macklem was making those comments day of about our last inflation report, who was just on the other side of the desk but Jerome Powell, the head of the Fed. And Jerome Powell, that exact same thing, saying, well, we don't feel quite as good. That divergence is right on the map. If we start cutting, the Fed isn't cutting. At what point does the Bank of Canada have to say, we can only go so much without the Fed moving?

Well, you're right to hit on that, because there are limits. But the short answer is I don't think we're close to those limits today. Typically, the limiting factor here would be if there's too much of a divergence between the Bank of Canada and the US Federal Reserve, where that's going to show up most, obviously, is in the currency, the exchange rate. And that does have implications for inflation.

So Bank of Canada has worked very hard to get inflation to the point where it is today. They think it's on a good path. But if the Canadian dollar were to get unduly weak, you think about buying all those vegetables from California and fruits and vegetables-- and that's a way of importing inflation through a weaker currency.

So the Bank of Canada is going to be careful not to push this too far. But my view is that there's definitely room for at least a few cuts. The Bank of Canada does have some flexibility or autonomy here to go in a slightly different direction than the US if the economic data support that.

What does that mean for investors? If they're looking at arguably the world's most powerful central bank, the US Federal Reserve, perhaps on hold for longer, then we think but the Bank of Canada is starting to cut, does an investor take a look at that and say, certain opportunities in different asset classes?

Yeah, well, just bringing it to the Canadian market, obviously, there are a number of Canadian companies who generate if not the majority, certainly a large percentage of their revenues and their earnings south of the border. You think about the Canadian energy producers who pay their workers in Canadian dollars, but sell their barrels of oil in US dollars.

You think about some of the Canadian banks, for example, which have big franchises south of the border, or the Canadian railroads, which have big pieces of their business south of the border. They're benefiting from that stronger US dollar when you translate it or take it back into Canadian dollars. So there are definitely relative winners.

But at the same time, getting back to your first point, if the Canadian dollar is too weak, then we risk undoing the good news on the inflation front. And so at a micro level, there are definitely some companies that are positioned well for this-- you think of exporters in Southern Ontario and the auto industry. But too much of a good thing can undo some of that positive inflation data. So we don't want it to go too far.

And slip in one more thing before we end this part of the conversation. We are in the early days now, but we have had some big Canadian companies reports so far. Some of those conditions you're talking about, do you expect it to show up in Canadian company earnings this quarter? Or is that a later story?

Well, I think-- and, again, to your point, the US is a little bit ahead of Canada in terms of the cadence of earnings release-- and so we haven't seen that big a piece of the Canadian market report yet. But I would say the reports we've seen so far have been kind of meh, mixed, not great. Some hits, some misses. Some well-received, some not well-received.

But that shouldn't really be a big surprise given my comment earlier that I think the Canadian economy is showing some softness here. It is showing the impact of that 500 basis points of interest rate hikes over the last couple of years. So I wouldn't expect to see really strong results.

Looking forward, I think there is cause for some optimism among that 30% or so of the Canadian market, which is your traditional resource-based companies-- your oil producers, your miners-- copper, gold. You look at what commodity prices have done lately, kind of the other side of that coin with inflation heating back up, one of the traditional inflation beneficiaries is that commodity complex.

If you look at where oil prices are today, where gold prices are today, where copper prices are today, you've got to think the outlook for that 30% of the Canadian market that is exposed to this is pretty rosy. So if things stay the way they are today, Q2, Q3, you're going to see some nice earnings growth out of those companies, for sure.



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