The Fed’s monetary medicine, however, is having its intended impact. Inflation slowed for the sixth straight month in December, falling to 6.5%. While this inflation downtrend is encouraging, we believe that it will take more time to achieve the Fed’s targeted upper limit of 2%. That’s because even as goods inflation has fallen, the stickier services inflation could prove a challenge for the Fed.
In 2023, we expect the markets’ focus to shift towards slowing growth. With easy money policies ending, interest-rate sensitive sectors like housing and manufacturing are feeling the impact. Overheated housing markets across the U.S. and Canada are slowing, and indicators of global manufacturing trends are showing signs of a contraction. Consumer sentiment and confidence is waning across developed markets. Despite all these downtrends, labor markets across the U.S. and Canada have stayed resilient.
We believe the Fed will continue to focus on driving inflation down over employment. While markets expect a quick Fed ‘pivot’ – a shift from the current rate hiking phase to a rate cutting one – we think the Fed will pause rate hikes and hold them at current levels to suppress prices and regain their inflation fighting credibility.
Modestly underweight equities
Tactically we remain modestly underweight equities. While 2022 reset valuations to realistic levels, we expect 2023 to do the same with earnings. We believe estimates for earnings haven’t been revised down enough to reflect a possible growth slowdown in the coming quarters. Also, the boost to corporate earnings from inflation is likely to dissipate over the next few quarters, which would put pressure on profit margins. We are underweight international developed equities, especially Europe, where the monetary tightening cycle could linger longer than in North America. We remain neutral on emerging market equities as China’s economy could get a lift with the end of the ‘Zero-Covid’ policy. We also believe a weaker U.S. dollar could provide a boost to economic conditions in emerging markets.
Positive on high quality and investment grade fixed income
We continue to favor bonds and maintain our overweight position in Canadian bonds and in U.S. investment grade (IG) bonds. We believe that the Canadian IG sector, with higher exposure to government over corporate securities, can better withstand slower economic growth. We are underweight high yield bonds. We estimate the compensation provided by the current level of yields to be inadequate for a possible scenario of slowing growth or recession.
