Hopes of mild recession not likely to hold up

The October rebound in equity prices may have lulled investors into the false notion that if recession is coming, it will be a mild one, says Todd Mattina, senior vice-president and chief economist with Mackenzie Investments.

He said the late-year rally led some to believe that the negative impacts of restrictive interest rates are now largely priced into equities.

“I think investors, based on this rebound, are expecting a fairly mild economic slowdown in the coming year: a short and shallow recession; a very sharp disinflation,” he said. “Personally, I’m a little bit more cautious about the outlook over the near term.”

Speaking on the latest episode of the Soundbites podcast, the Toronto-based economist said central banks historically require rates to be much higher for longer in order to get inflationary pressures under control. That will lead to deep economic contraction and softness in the labour market.

“So, I think the market may be a little overly optimistic at this stage, thinking that a short and shallow recession will be enough to get inflation sustainably back down,” he said. “I think the market’s gotten ahead of itself a little bit.”

Mattina said that in a “pretty challenging year for the global economy,” Canada fared relatively well because inflation-bound goods like energy and food were among its top exports.

“The terms-of-trade improvement has been a boost to incomes in Canada, and given us a bit of a lift,” he explained.

He said there had also been concern from economists that housing construction activity would be interrupted due to the dramatic rise in interest rates, but that impact was muted. Overall, Mattina anticipated that real GDP growth for 2022 would come in around 3.25%.

“That compares in the U.S. to something more like 1.75%. So, Canada’s done relatively well,” he said.

As for this year, growth is widely expected to be much lower for both countries.

“I would say both Canada and the U.S. have a much more subdued — almost anemic — rate of growth expected by economists, something in the neighbourhood of a half percent, as the cumulative impact of restrictive interest rates really starts to slow down economic activity,” he said.

As a result, “we see opportunities for a long-horizon investor who is patient enough to have more exposure in international and emerging market equities and being a little more underweight North American equities, especially U.S. stocks where valuation still don’t look very attractive,” he said.

Canada also fared better than the U.S. on the inflation scale, seeing average inflation in 2022 of under 7%, while the U.S. saw closer to 8%. Economists expect both countries to see average inflation this year of around 3.5%.

The bond market

Mattina said conditions have improved for fixed-income investing and 60/40 portfolios.

“We saw a dramatic increase over 2022 in bond yields, especially long-term bond yields,” he said. “Suddenly fixed income is back to a place where it can play its traditional role that we’ve all grown accustomed to in a multi-asset portfolio of balancing equity risk.”

In particular, he sees fixed-income opportunities in Japan, where the central bank may soon need to revisit its yield curve control policy.

“Japan has been fighting deflation for at least two decades, and this inflation breakout has actually been an opportunity for Japan to try to achieve a 2% inflation target,” he said. “At some point, they’re going to face pressure to rein in the downward pressure on the Japanese yen and the need to be buying financial assets to stimulate the economy. When that happens, they are very likely to raise the cap on the 10-year Japanese government bond, currently at just 25 basis points.”

He describes this eventuality as offering “a one-way trade in terms of risk.”

Another opportunity can be found in currencies, where varying inflation sensitivities will produce winners and losers.

“Specifically we’re long a basket of commodity and energy-sensitive currencies — and we’re short a basket of energy and commodity-importing currencies,” he said.

While Mattina stressed that long-term investors should stay fully invested, he suggested that shorter-term investors should underweight stocks in favour of fixed income because the coming economic will weigh on corporate earnings.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.