Mind the Bumps!

North American equity and fixed income markets rallied in December 2023, as expectations that the Central Banks stopped interest rate hikes for this cycle increased. In monetary policy meetings held during December, the Bank of Canada and the US Federal Reserve decided to keep policy rates unchanged at +5.0% and +5.5%, respectively. This was the third consecutive meeting where the outcome was to maintain interest rates. Consequently, the positive sentiment prevailed in the capital markets as investors increased their expectations that interest rate hikes are now behind us. It is noteworthy that price action ensued despite continued caution expressed by the banks on inflation.

Stats to note for the month of November (reported in December):

• Inflation in Canada was at +3.1% (higher-than-expected +2.9%) and in the US was at +3.1% (in line-with-expected +3.1%).

• The core inflation was higher-than-expected in Canada (+3.5% against expected +3.4%) and was in line in the US (+4.0% against expected +4.0%).

• Unemployment data in Canada advanced to +5.8% from +5.7% (expected 5.8%) and declined in the US to +3.7% from +3.9% (expected +3.9%).

This mixed data could not dent market enthusiasm as investors determined that while it could be bumpy in the near term, the overall trajectory of inflation remains downwards. Furthermore, if unemployment numbers do not decrease (which could raise concerns of hard landing) or upshift (could imply renewed inflationary pressures) significantly, progress on inflation should be enough to support the markets.

We also note that the US Fed Funds Futures are now discounting about six rate cuts by the Federal Reserve during the year 2024 starting as early as March (see Figure 1). We believe that such a scenario could unfold if the economy contracts significantly. Given the evidence from economic data so far suggests the contrary, the positioning of the fixed income market appears to be taking a pessimistic view of the economy, which could cause a bumpy ride for the asset class, in our opinion. The dot plot after the December meeting indicates the Federal Reserve authorities expected only three rate cuts during 2024 (see figure 2).

Figure 1: Fed Funds Futures - expected number of rate cuts and implied policy rates (%)

(as of 29th December 2023) 

Source: Bloomberg

Figure 2: Fed Funds Target Rate – Median, %

(December 2023 meeting)

Source: Bloomberg

Price action in equity markets was lopsided as a handful of stocks carried most of the weight of the indices in the year 2023, resulting in a high expectation for them to deliver on the earnings front. Should earnings expectations from these mega caps prove to be high, equity markets could also be bumpy in 2024. The geopolitical risks across the globe have continued to simmer, however, they have not adversely impacted the markets. Given that 2024 is an election year in many of these geographies, uncertainty could stay high and be a source of volatility. 

Despite some potential bumps along the ride, we think the positives should outweigh the negatives over the course of the year. Our optimism stems from our expectations of continued easing of inflation, normalization of policy rates, and broadening of market performance through 2024.  

We wish our readers a very Happy New Year!