Calling the BoC’s bluff

Market Recap

• Equity markets were mixed this week alongside sturdy U.S. labour market data, and a bond market that continues to price in rate cuts next year.

• The S&P 500 inched up 0.2%, with banks and telecom services leading the pack.

• The TSX dipped 0.6% as weakness in energy and materials weighed on the index.

Interest Rates

Last week, the Bank of Canada (BoC) held interest rates steady but warned that more hikes are possible. Meanwhile, the U.S. Federal Reserve (Fed) seems content to hold steady, and the European Central Bank (ECB) may be poised to cut rates given better-than-expected inflation numbers. Against this landscape, are markets too bullish on rate cuts in 2024? In general, we think they are. To be clear, we continue to believe that rate cuts from all three central banks—the Fed, the BoC, and the ECB—are likely in the new year, and rate hikes are essentially off the table. But markets may be overestimating the number and magnitude of those cuts. It’s likely that we’ll continue to hear commentary from the central banks emphasizing that they still haven’t reached their inflation target. That’s what the BoC said recently, likely believing that a relatively hawkish statement may help curtail spending and serve a similar function as an actual rate increase. Looking ahead, our expectation is that the BoC will ease rates late in the first half of 2024, while the Fed is most likely to move in the second half of the year, though they could wait until 2025. Behind closed doors, central banks are probably content with 3% inflation in the near term, but reminding investors of the 2% target can still be useful as a way of keeping spending and market expectations in line.

Bottom Line: While markets may be too optimistic about interest rate cuts, central banks’ messaging indicates that we’re at a pivot point, and that’s been fuelling rallies in equity and bond markets.

Consumers

The holiday spending season is upon us, and as I mentioned in this space last week, we’re closely monitoring the state of the consumer for signs of how the first quarter of 2024 may play out. The good news is that people are continuing to spend; Amazon confirmed as much in comments last week. But there has been an adjustment in what consumers are spending on—a trade down from higher-priced items to lower-priced ones. We expect that trend to continue as the new year approaches. Despite this adjustment, the fact that people are still spending is significant, because a retrenchment of consumer spending would be the first sign of a possible recession. As I’ve mentioned before, there are cracks in the consumer and they’re eating into people’s excess savings. This doesn’t necessarily mean that they’ll stop spending, however—it’s likely that they’ll just add more credit card debt. The sticker shock will come in January, and that’s when consumers may tighten their belts for a couple of months.

Bottom Line: We’ll continue to watch the data to see if cracks in the consumer get bigger, but so far, holiday spending—including Black Friday—has been fairly good.

Oil

We continue to believe that oil is undervalued. Last week, West Texas Intermediate (WTI) crude briefly dropped below $70 per barrel before rebounding somewhat. We think that fair value is somewhere in the $80-$90 per barrel range. There are likely to be short-term price fluctuations, but if consensus expectations are right and we don’t experience a long and painful recession, then we suspect energy demand could surprise on the upside. On the supply side, we’re also seeing production cuts come through from the Organization of the Petroleum Exporting Countries (OPEC) and OPEC+, which could also cause prices to move higher. Geopolitical risks may also cause shocks that would help boost prices, though our expectation is that they wouldn’t be long-lasting.

Bottom Line: Oil is likely undervalued, though patience may be required to achieve that value.

Positioning

For a detailed breakdown of our portfolio positioning, check out the latest BMO GAM House View Report, titled Stocking Up for a Holiday Rally.