What is your outlook on the global economy?

Maximum headwinds from the past 18 months, the tighter monetary conditions are now starting to roll off, and we're already seeing rate cuts in much of the world that's going to be followed up in the next couple of weeks, mid-September, with rate cuts in the United States. So six months from now, not only are you benefiting from the roll off of past tightening, but you're actually starting to pick up some relief from lower interest rates.

We've looked for a soft landing for some time. And, you know, there are threats to that, but we're more convinced that that's going to happen. You know, the threats to that are evident in some of the economic data. The PMI’s are clearly below their peaks, although the service PMI is actually starting to take up higher. There are certainly delinquencies that we're seeing as a result of higher interest rates ticking up off their lows.

Employment conditions are less robust than they were, but putting all those things together, they look more like a normalization of economic conditions than a plunge into recession. As I said, as you roll off past tightening and eventually pick up the benefits of cuts and rates that we're already seeing in the rest of the world, we look at 35%, 40% of a recession over the year ahead.

That could sound high. Or you could say that's a 60% or 65% of a soft landing. And that's the way that we choose to look at it.

What are some of the risks that would upset an economic soft-landing outcome?

With monetary conditions becoming less of a risk to the outlook as we progress towards rate cuts, we can't take our eye off of the macro risks that exist to markets. And clearly front of mind has to be Russia, Ukraine, the Middle East. These are still unsettled and of course could escalate to even worse conditions. China has been a problem for a long time, with the slowdown of growth, with the backdrop of a massive amount of debt.

It still looks like muddle through to us. It doesn't appear to be intensifying. Might even do a 5% GDP growth. But, you know, with debt levels that they're at, we need to keep a very close eye on that as well. Of course, in the very near term, within the very short part of this forecast horizon, we're going to have a new administration in Washington, could be Democratic, could be Republican.

And they both come with very different policies that'll impact markets in the economy in very different ways. Those are famously very close elections that are coming up. And another thing that could destabilize markets. And I think for the longer term, we're going to spend a lot more time going forward focusing on sovereign debt levels, almost like we now that we're going to stop worrying so much about inflation dominating every conversation.

Maybe that gets squeezed out for sovereign debt levels. The cost of the pandemic relief is loaded to sovereign debt accounts. And notice that almost all G7 nations, like six of the seven G7 nations, have debt levels well above 90 to 100%. And past work that was done by Reinhard Rogoff shortly after the Global financial crisis, show that once you went through 100% or even 90% of debt to GDP, you lose 1 to 1.5% GDP growth annually.

So we're not going to have great GDP growth going forward anyway. And now this is going to be another burden to growth that we need to monitor. Those would be the four in the moving from the very short term to the very long term. That would be front of mind for us.

What is your view on inflation?

I think every one of these conversations over the last two years has been anchored in what's happening with inflation. We started with the historic mess where in 2022 and January 2022, if I recall, the consensus for inflation in that year was 2%, 2.5%. And by the time we had the final print on inflation in December, it came in at closer to 8% or 9%.

So that triggered a period of massive monetary policy response, jumbo rate hikes at the beginning and destabilizing the economy as the central banks were to do two things. Visibly bring down the inflation rate towards that 2% level that you consider optimal or sustainable, and secondly, rebuild their reputation as inflation fighters. It appears to have worked, you know, everywhere except the UK of the G7 nations.

We're now down below a 3% inflation rate, they’re only slightly above. Our own forecasts show that while we're concerned about this last mile problem - 8% to 7% is easy, 3% to 2% might be harder, but we think we'll be down below 2.5% by year end 2025. Probably closer to 2% sometime in 2026. So this is now moving off the stage as being a front of mine type of worry.

Importantly though, for the long term, when we look at inflation expectations which are actually more relevant than printed levels of inflation, they are well anchored. In the United States, long-term inflation premiums look like 2%, slightly below that in Canada. So central banks have won this war. They've beat inflation. They're bringing it down to the 2% sustainable levels.

They’re not far away, and they’ve rebuilt their reputation. It’s a very important element of macro policy.

What is your view on fixed income?

Two main themes likely to play out over in fixed income markets over the coming 12 months. The first is upon us already, rate cuts. Most central banks have already begun their rate cuts in late spring through the summer of this year. The United States will join that over the next several weeks. The futures strip looks like two full percentages of rate cuts at the short end over the over the coming 12 months in the United States, and that could be front end loaded, as the recent signs in the economy are of some softening.

We're looking for a little less than that, 150 basis points, or one and a half full percent. Important thing is the direction of short-term interest rates over the next 12 months is likely known already, and it's sharply lower. We no longer need that break on the economy to bring down inflation. That's all well in hand. When you look at the curve though.

We've seen two big moves over the last 12 months, 14 months in long-term interest rates. First, we had a fall from 5% on the ten-year T-bond yield, the world's benchmark yield, down below 4%. A surge back almost to that 5% level. And we're now back down below 4%. We think that the bottom of yields is not far from here, probably 3.75%. You know, rate cuts will help. That'll clear the way for somewhat lower yields. But when you look at the cycle of rate cuts and how that's impacted the longer term of the bond market we were a bit surprised when we looked at the data, you might think that the backdrop of falling short term interest rates will provide even further room for long bond yields to fall.

The history is that most of the decline is behind by the time that the Fed moves. You know, looking at cycles all the way back to the early 1950s demonstrates this. You know, if you time it from the date of the first rate cut, typically you have a bit of a follow through on long bond yields. They drift a little bit lower over month one and month two beyond that first rate cut.

The months two through seven, they do a whole lot of nothing, independent of what the economy's doing. You would think that a hard landing outcome, and that's not what we expect, but you think that a hard landing outcome would actually open up more scope for long bond yields to fall. But in most cases, that hasn't happened.

Whether it's a soft landing or a hard landing, by the end of month seven, you haven't really done much in yields. And typically you begin to rise even in a hard landing beyond month seven. The reason is the market's given up on what's happening in the current economy. And now looking forward to a recovery from whatever type of weakness that was experienced.

Patch that on to today it says that, if you're down around 4% or 3.75%, that might be as low as you get, which means you get to earn your coupon and a little bit of a capital gain. So our own modeling actually supports that. If we look at our fair value channels, equilibrium bands for fixed income, we say, you know, we've grown used to a negative real rate of interest over the last two or three years, but that was largely as a result of pandemic relief.

As we've moved away from the pandemic, we should expect real rates to return to the 0 to 1% position. If we have a 1% real rate of interest, a normal inflation premium and term premium, 3.5% is pretty much as low as you're going to get interest rates in the cycle ahead. Below 4%, you're in the final innings of long term interest rate relief. We think you'll earn your coupon maybe a bit of capital gain over the coming 12 months. But the end is near for big long term interest rate declines.

What is your view on Equities?

Volatility picked up twice over the summer after a long period of calm. The first was earlier in July with the partial unwind of the yen carry trade as the Bank of Japan raised Japanese interest rates. The second was the shake up in large cap tech. You know, the interest in AI, and its well-placed interest of course, has driven stocks like Nvidia to very, very high levels of valuation.

Another way of looking at that is a demanding level of valuation. as far as future earnings growth has produced. Most recent earnings gains are quite spectacular if we compare to any other company in the economy, but not enough, it appears, to have to have sustained the peak levels of valuations that they traded at. In fact, our own math says that even at the lower prices of these stocks in the Mag seven are now trading, there still is challenges just to produce the kind of earnings growth that will sustain those prices.

You move outside of the mag seven, though, you see something very different. You know, the U.S. market, which we tend to look at first for valuations around the world, is heavily dominated by the valuations in the mag seven. You strip that mag seven out of it, for example, if you look at the unweighted averages of valuations, you see the markets pretty close to what we calculate its fair value.

And if we look outside of the United States market to the rest of the world, whether we look at Canada, the United Kingdom, the eurozone, emerging markets, they actually continue to be below fair value, even though they've sustained pretty good returns. There's been pretty good returns over the past year. Nowhere near the returns of the mag seven or the cap weighted S&P 500, but better than historic average returns.

That's because they've grown their earnings reasonably well, and we expect that to continue through the end of 2024 and into 2025. So there is a scenario where this bull market can be sustained. Even in the absence of leadership by the Mag seven. And that scenario is that really even though we've come a long way, markets continue to be at or below what we calculate is fair value.

Analysts earnings estimates still show further earnings gains into 2025 and maybe even into 2026. And margins have come down through the pace. If we breathe new life into the economy as rate cuts kick in, margins could start to rise. Earnings could exceed analysts’ expectations because they're not all that aggressive. And that's on a base of reasonable valuations. In the event of that, as long as new leadership emerges, and it likely will, you sustain the bull market.

So we’ve been spending a lot of time looking at what might those new leaders be? You know, if the Mag seven can no longer lead the market, if AI is no longer attracting all the attention, what carries the baton going forward? Well, there's a number of places. First, maybe markets outside of the United States finally pick up relative to the United States.

Of course, there are at much more attractive valuation levels. Maybe after a dozen years of, you know, negative performance versus growth, value starts to get a bid. Maybe mid-caps and small caps start to move ahead of large caps after a similar decade of underperformance. So we're watching these very closely, the relative strength trends. So will they emerge as the new leaders that can sustain the bull market into 2025.

How is the recommended asset mix positioned in the current environment?

We've actually had quite a busy summer with regard to tactical asset mix. Leading into July, August of this year, we had a mild overweight in fixed income, expecting yields to fall as the Fed completed its campaign against inflation, etc.. Well, that move is largely through. And there is the risk the economy ultimately accelerates.

You don't get much of a lift any way out of subsequent rate cuts. And, you know, target level for bond yields is not much below our current levels. So we began taking our fixed income weighting down towards neutral and now even slightly below as the summer progressed. We put that money in cash, leaving our stock weighting at neutral and bonds underweight.

We actually debated putting some of that cash back into the stock market, as we could see a reasonable case and a soft landing outcome for the economy that the cycle could extend. What are we watching for? Well, we'd like to see if the mag seven can actually correct.

And we can have a clean transfer of leadership away from AI-dominated themes into other themes in the markets that could emerge with much more attractive valuation levels. Things like mid and small caps, things like international markets versus the U.S., and things like more value oriented versus growth oriented for the cycle ahead.