How long will rates keep rising?
We believe that central banks will continue to increase rates. In particular, we expect a few more rate hikes from the U.S. Federal Reserve (the Fed) in the first half of the year, followed by a longer than anticipated pause to assess the effects – the Fed wants inflation to be under its upper target of 2%.
In Canada, we expect one more rate hike before the Bank of Canada pauses to assess the effects of higher rates. We believe the market is ahead of itself in anticipating a pivot to rate cuts as soon as later this year, and this represents a potential key risk for markets in the near term. We believe policy makers, both in the U.S. and Canada, will keep rates higher for longer as they reiterate their focus on fighting inflation even if it means that some parts of the economy suffer.
Some sectors may suffer
Also, as higher rates affect economic activity, we already see rate-sensitive sectors such as housing and manufacturing beginning to show a downturn. Housing has seen a sharp decline since both the Fed and the Bank of Canada began their tightening cycles. Home prices dropped from their highs, and indicators such as construction activity and builder’s confidence indexes are also slowing down sharply. When we look at one of our main global leading indicators of manufacturing activity, the Purchasing Managers Index (PMI), we clearly see a contraction due to tighter monetary conditions.
As the effects of higher rates are lagging in nature, we expect to see more pain, particularly in the labour market. A strong labour market means the economy is resilient, but on the flip side it also shows that wage inflation could continue to be problematic and feed into broader inflation.
Therefore, we lean our portfolio towards active management. Our active managers focus on investing in high quality companies that have defensive characteristics, which aim to benefit our portfolio allocation against a backdrop of global slowdown.