Martin Lefebvre
Hi everyone, I’m Martin Lefebvre, Chief Investment Officer at National Bank Investments. Thank you for tuning into our NBI Podcast series. Today our main topic is fixed income strategies in the context of slowing economies. We will talk about inflation, the timing of potential rate cuts, and the likeliness of recession. To do so, I’m joined today by Sébastien Rhéaume of AlphaFixe Capital. Sébastien, welcome.
Sébastien Rhéaume
Thank you, Martin.
Martin Lefebvre
So let’s start with the current state of the fixed income market. After a very difficult 2022 following unprecedented rate hikes by central banks, 2023 was the promise of a rebound that took a very long time to unfold. Why is that? Can you give us the lay of the land on the recent market action, please?
Sébastien Rhéaume
Yeah, so I think 2023 was actually, we kind of look at it in two different phases. The first phase was all about, you know, higher for longer. So we saw rates go higher. And then we kind of saw a pretty drastic change in the last quarter of 2023. And that was really just a reflection of the fact that we were witnessing a lot better news on the inflation front.
So inflation was actually falling down faster than anticipated. And that really changed the mind frame behind the bond market in that, okay, so we’ve probably reached the highs in terms of rates and then the next step is probably going to be cuts by the central banks.
So in the overall 2023 was a really good year. Well, I would say an average year in terms of returns, but it was really two phases. So the end, until the end of the third quarter, we were negative, but then that was all made up in the last quarter of 2023.
Martin Lefebvre
Yeah, which gave us a spectacular return almost in par with what the stock market gave us. So as you said, inflation came down significantly, I mean, from almost 9% to 3%, but it seemed to be sticky around that level. Why is that?
Sébastien Rhéaume
Yes. Yeah, so I mean, in hindsight, you know, the central banks were saying inflation was transitory, then they stopped using that. But when you look at the facts, they were probably right. So there’s a lot of inflation that was caused by the dislocation in supply chains. And that really is probably behind us. The big chunk of that is probably behind us right now. So we are seeing inflation kind of normalize at, you know, anywhere between two and three-ish percentages.
But that’s going to be the big challenge in 2024 is where will inflation normalize? And we are still seeing some stickiness on the service side, which is really driven mostly by the U.S. market imbalance on the labour side, where we still have a significant shortfall. That gives a lot of pricing power to labour. So we are seeing some stickiness on the service side, which is, again, that’s what it’s gonna be to watch in 2024.
Martin Lefebvre
Okay, but on the wage front, that was also a peak in 2020, somewhere in the beginning of 2023, and that’s come down. But now, same as inflation, there seems to be a little bit of stickiness, and you say that’s focused on the scarcity of labour and that resilience, right?
Sébastien Rhéaume
Yeah, exactly. So that’s not going to disappear. And I’ll talk maybe the U.S. versus Canada. So Canada has a very accommodative immigration policy. So we’re able to rebalance our labour market through immigration. The U.S., it’s more difficult for them to do that.
So which means that the U.S. probably needs to go through a real recession to be able to create some excess supply on the employment side. And that's really what we're seeing is that there still is, you know, a disbalance on the supply, a demand side on the labour side, and that's really favouring a fairly still stickiness in terms of overall inflation on the service side. So that's something that's probably going to stay in the U.S., not as much in Canada. Canada is kind of a different story because of the immigration policy.
Martin Lefebvre
I understand. Jay Powell, if we continue on the inflation theme, kind of told us at the last FOMC (Federal Open Market Committee) meeting that the Fed would probably not wait until inflation was at 2% to start thinking about cutting rates. So to you, is it a sure thing or are market expectations pricing in too much too early?
Sébastien Rhéaume
Yeah, I mean, again, if we look at the U.S., I think the markets are probably pricing a little bit too much. So at the end of the year, I think we're pricing like seven cuts in the U.S. I think we're pricing maybe six now. That seems pretty excessive because we look at the U.S. economy, it's still fairly resilient. We're not seeing any significant weaknesses anywhere. And like I said, the U.S. has to go, we think that the U.S. has to go through a recession to rebalance the employment market.
So we'd be surprised to see that the Fed would cut that much in 2024 given again that there's some stickiness in the service inflation. So you know maybe they should cut a bit you know five and a half is probably slightly higher than where the neutral rate is. I don't think the neutral rate is two and a half anymore probably higher but yeah so there's a justification if you're starting to see some weakness in the U.S. economy that you should probably reduce rates a bit, but again we're not seeing that weakness right now. It doesn't mean it's not going to happen, but certainly at the beginning of the year we're not seeing that weaknesses in the U.S. that would justify, you know, six or seven cuts.
Martin Lefebvre
Do you find that the U.S. or policymakers are cut between a rock and a hard place where if they cut rates too early, then there's the risk of a second-round effect and inflation, and if they cut too late, then there's the risk of a more traditional slowdown or worse recession?
Sébastien Rhéaume
Yeah, you're right. And that's always the dilemma that they're going to face. And I do think that they will be influenced by the experience of the last two to three years. Right. So I think early on, central bankers in general were severely criticized for being probably a bit too slow to raising rates. So that bias stays with them, right, for where they are now.
So if you are a central banker right now, you know, so yeah, it's not clear. And it's always kind of very foggy when you're at the end of a cycle as we are now. It's not clear if we're going to be in a recession or if the economy is going to continue to do well. But I think that if they're going to err on one side, it's going to be very prudent, not to your point. So I don't think they want to be in a situation where, okay, we think we're there, we cut rates and then three or four months later, oh, that was a wrong decision, we have to bring them back up. I think they're going to err on the side of let's just make sure once we start doing that, that we're very confident that we will not have to reverse that decision.
Martin Lefebvre
Absolutely. Turning to Canada, our economists always talk and you mentioned the immigration policies here in the country that we're kind of feeling the brunt of the negative effects of too much population growth and if you look at GDP per capita, it's been almost negative for the past two years. So is there a case where the Bank of Canada would have to move ahead of the Fed? Do you see a divergence in policy possible this time around?
Sébastien Rhéaume
Yeah, so when we look at the Canadian economy, so we've had north of 3% increase in population. So in that context, you would think that your economy could grow around 3%. That's not the case, right? So we're kind of flatlining, I guess, slightly positive in Canada. So what that tells us is that the Canadian economy has responded much faster to higher rates, right? So in Canada, we traditionally have higher indebtedness versus the U.S. and versus the world, actually. But we also have a much faster transmission mechanism of the monetary policy because of the way mortgages work in Canada. So the longest period you could get a mortgage is five years. So basically from February 2022, which is when the rates started to raise until February 2027, 100% of the mortgages will have reset at higher rates. At the end of December 2023, a little bit less than half was done, which is really fast. If you contrast that to the U.S., where you have 30-year mortgages, it's a very slower process to get higher rates into the economy.
So we have higher leverage and we have faster transmission of the monetary policy into the Canadian economy. When you put those together, you are seeing the debt service ratios in Canada being significantly high to the point where we actually hit a historical high on the debt service ratio in Canada at 15.2. And the unfortunate reality of that is that we're not the worst country in the world, but we're the third worst. So it's not a very favourable position to be in. So when we look at all those elements, we put them together, we look at the economy not growing fast, even if we have 3% increase in population.
For us in conclusion, we're either in a recession right now in Canada or very close to being in one. So what that means is that the Bank of Canada should probably start thinking about reducing rates to start stimulating the Canadian economy.
But again, it really depends on what happens in the U.S. also. But yes, to answer your question, I think that we will see the Bank of Canada acting before the Fed in terms of reducing rates, given what I explained in terms of economics scenario in Canada.
Martin Lefebvre
Interesting that's that would be almost sort of a first. We'd usually see the Bank of Canada wait for signal from the Fed to act So what about in the U.S. You mentioned possibility of a recession in Canada is recession inevitable in the U.S. Or is the soft landing still the main case or scenario for you guys?
Sébastien Rhéaume
Yeah, so like I said, I think the U.S. has to go through a recession to balance the employment market. Will the recession happen in 2024? You know, we would probably put 50-50 odds on that because again, we're not seeing the weakness, any weaknesses anywhere. But we're starting to see them slow down, but not significant slowdowns that usually are typical of a recession. And again, so the employment, the indebtedness situation in the U.S. is very different on the consumer side. So a lot less indebtedness, slower transmission mechanisms.
So, the debt service ratio in the U.S. is closer to 10%, which is at a historical low if we forget about the pandemic period. So very different starting point for the consumer. The government in the U.S. is spending as if we were in a recession, so they have significant deficits. And then if you look at just the traditional industries that bring you in a recession, manufacturing and construction, we are seeing some gains in those industries, which is very atypical if you're going to be starting in a recession.
So we put the odds at 50-50 in the U.S. of recession. And again, that's really important because if Canada goes into recession and the U.S. doesn't, then you have a divergence of monetary policy, which is somewhat more problematic for the banking academy in terms of its ability to then stimulate the Canadian economy.
Martin Lefebvre
So what should investors do in such an environment? Are you long duration? I mean, yields went from a recent peak of 5.5 in the U.S. to a low of 4. And now it's back up a little bit. So what's the main strategy at this time around?
Sébastien Rhéaume
Yeah, so I think that there's two ways to look at this. One is there's going to be a lot of volatility, right? So we're going to be pricing recessions, soft landing, no landings, and that's going to create a lot of volatility. And also, if you also take into consideration maybe the diversions in monetary policies. So there's moments that you want to be long, there's moments you don't want to be long. So the way I would answer that question is probably, the first answer is maybe.
This is a time to be fairly active in terms of fixed income strategy because it's not going to be just a one direction markets. I think you're going to be selling a lot of volatility. So this is probably one you want to be active. And the best tool I could leave you with is the way we look at fixed income. Just determine what a fair price is for a 10-year bond. And the way we do this is that, you know, when you buy a 10-year bond, you want to obviously make sure that you're covered for inflation. So if you think that the banking Canada is credible in returning at 2%, so minimum 2%.
And then you want a real return and the real return should be a function of how fast the economy should grow. So one and a half to two percent depending on how long our immigration policy stays the same. So you're anywhere between three and a half to four percent return. That's where you start to see value in the 10-year bond. So like you mentioned today, rates have gone down so we're below that threshold. Probably not much value so then you probably want to stay in the short end of the curve. But if we go back to four, four and a quarter like we saw in October of 2023. Then there's value you probably want to increase your duration. So really that's how we would play it. Now somebody who doesn't want to be active, where's the best place to protect yourself in the context that I just described? Probably the shorter end of the curve. That's where you get the most carry and that's where you have probably less volatility if rates go up, but you will still benefit if we do have a recession, because then you will see rates come down and if you're positioned there, then you should be able to not only get the higher yield, but also the incremental return from lower rates at the lower end of the curve.
Martin Lefebvre
What about credit? It seems that interest rates or corporate spreads are quite narrow and they're not certainly pointing to a slowdown in the economy. What do you make of that?
Sébastien Rhéaume
Yeah, so I think that's a really good point. So that again, especially in the context of the Canadian market, I think that there's a case to say that you need to be prudent on the credit side. This is not the time to take huge credit bets because as you mentioned, spreads are not necessarily reflecting the recession that we're seeing in Canada. But that being said, they're going to also be influenced by what's happening in the U.S., right.
So if the U.S. continues to do well, that's going to be relatively positive spread. So it really depends on where both economies go. But again, I would be a little bit prudent right now in terms of credit. There is some pockets of interesting opportunities on the credit side. But again, I think it's worth being somewhat conservative, especially on the lower quality credit. So if you look at the high yield right now, high yield for us is very, very expensive and it doesn't reflect at all the uncertainty that we think we're going to see in 2024.
Martin Lefebvre
Well, this is all the time that we had. Sébastien Rhéaume of AlphaFixe Capital. Thank you very much for participating in our NBI Podcast.
Sébastien Rhéaume
Thank you very much, Martin.
Martin Lefebvre
And for the rest of you who are listening, we'll talk again next month. Thank you for tuning in too.
Martin Lefebvre
