Andrew Pease

Chief Investment Strategist

1990s nostalgia is back with the announcement of a reunion tour by Britpop band Oasis. Investors are hoping for another 1990s throwback in the shape of an economic soft landing: the last time the U.S. economy avoided a recession after aggressive Fed tightening was during the mid-1990s.

The stakes are high. Markets are priced for a soft landing, so even a mild recession is likely to trigger a significant equity-market correction. The economic data supports the soft-landing thesis, but a slowdown consistent with a soft landing could still be the pathway toward a recession.

For now, a soft landing looks the more likely outcome. Inflation is declining, growth in wages is moderating, and labor-market pressures are cooling. Importantly, the Fed has begun easing before clear signs of economic stress have emerged. We’re not yet out of the woods in terms of recession risk, and the slowdown could overshoot into a hard landing if Keyne’s paradox of thrift¹ takes hold. This is when jobs weakness makes consumers cautious and they spend less, causing firms to cut back on spending and jobs, which in turn triggers more consumer caution. What seems sensible for individual firms and households becomes calamitous in aggregate.

If we had to choose one indicator to watch over the next few months, it would be weekly initial jobless claims. These will provide the clearest real-time guidance on whether the U.S. economy is rebalancing or drifting towards recession. Initial jobless claims sustained above 260,000 per week would be a red flag that a more painful adjustment is underway. Conversely, jobless claims that remain below this level would be a sign that tight Fed policy hasn’t crashed the economy.

Key indicator: U.S. weekly initial jobless claims

Economic prospects are brightening in Europe and the United Kingdom after both regions experienced near-recession conditions during 2023. Stronger bank lending and rising incomes are boosting Europe. Germany, however, is the weak link, where the industrial sector is struggling due to its reliance on China and where the auto sector has fallen behind in the shift to electric vehicles. Overall, Europe is in a sweet spot where growth is picking up, while moderating inflation allows the European Central Bank to cut interest rates.

The UK economy is finally showing signs of life after being stagnant since the end of COVID-19 lockdowns. Consumer and business confidence are rising, while declining inflation has enabled the Bank of England to begin easing.

The different growth trajectories over the past couple of years mean the U.S. is out of sync with the economic cycles in Europe and the U.K. This makes it likely that Europe and the U.K. can continue to recover if the U.S. experiences a soft landing. A U.S. recession, however, would flow through to the rest of world given the impacts on global trade and confidence.

Japan’s economic performance remains patchy. Gross domestic product (GDP) growth is weak and household spending is under pressure from rising prices, but business confidence is rising. The Bank of Japan seems determined to swim against the global central bank trend and raise interest rates further. This risks a repeat of the policy mistakes made over the past 30 years of tightening monetary policy before long-term expectations for sustained 2% inflation became entrenched.

China’s outlook has taken a turn for the worse as the property-market problems remain unresolved, credit growth slows, and consumer confidence hovers near record lows. Large scale stimulus measures haven’t arrived and until the government decides to act, it is difficult to see a meaningful rebound in economic growth.

Former Fed chairman Alan Greenspan was dubbed “the maestro” for his skillful handling of monetary policy during the 1990s. Investors are hoping that Fed Chair Jay Powell’s timing of interest-rate adjustments is just as adept (or lucky). The economic data says soft landing, but as Oasis declared in the title of their 1994 debut album, it’s Definitely Maybe.

We are into the home stretch of the U.S. election cycle with very competitive races for president and control of Congress.

The democratic system of government in the U.S. which features checks and balances across the executive, legislative and judicial branches, makes it hard for individuals and parties to enact sweeping change. As a result, and over many decades, the impact of politics on U.S. markets has been limited. U.S. stocks, for example, have trended higher no matter which political party held office. And diversified, 60/40 portfolios have delivered positive returns in most presidential-election years—something we expect is on track again in 2024. Long-term investors are advised to keep it simple and stick to their strategic plan.

Impact of U.S. presidential elections on markets

However, there are a few risks that we are monitoring going into the November elections. First, tariffs. They are not as consequential as many investors believe. Paul Krugman—who won a Nobel Prize in economics for his contributions to trade theory—often says the dirty little secret of international trade economics is that moderate tariff rates do not have large growth effects. A 10% percent across-the-board tariff on all U.S. trading partners is probably fine. We have already been in a limited trade war since 2018 and it hasn’t been a systemic event for markets yet. However, 60% tariffs on all imports from China would be consequential.

Second, corporate taxes. Democratic presidential candidate Kamala Harris is proposing to increase the corporate tax rate from 21% to 28%, while Republican Donald Trump is proposing to decrease it to 15%. Corporate tax changes of this magnitude either way could impact S&P 500® earnings-per-share growth by 5-10 percentage points. Importantly, taxation law is the purview of the legislature and therefore hinges on whether the November vote delivers a wave election with one party winning both the presidency and control of Congress. Prediction markets² suggest a gridlocked, split-party Congress is just as likely as a wave outcome.

Third, the fiscal trajectory of the United States. Both major political parties have run unsustainably large fiscal deficits in recent years. If this persisted in a wave election scenario, U.S. Treasury yields could move higher—particularly if the U.S. economy remains resilient into a period of fiscal largesse.

Fourth, challenges to Fed independence. Former Fed chairman Alan Greenspan once noted he had never met a U.S. president who didn’t want lower interest rates. Jay Powell’s term as Chair of the Federal Reserve is up for renewal in May 2026. An appointment that calls into question the independence of the central bank risks de-anchoring inflation expectations and steepening the Treasury yield curve. While this is an important risk scenario for the medium-term, the confirmation process in the Senate and the fact that there are excellent candidates on the Board of Governors already—appointed by both the Trump and Biden administrations—push back on the likelihood of a more disruptive Fed chair.

The Japanese yen has been very cheap and oversold for some time: one of the factors driving this was the prevalence of a carry trade in the currency. A carry trade is where an investor borrows money in a currency with low interest rates and invests that money in another currency with higher yields or a higher expected return. This trade relies on a stable or depreciating currency and low volatility, given it typically involves a lot of leverage.

In late July 2024, this trade was hit by two catalysts which led to a dramatic increase in volatility. First, the Bank of Japan surprised markets by raising rates, and this led to a repricing of Japanese bond yields. Second, the U.S. July jobs report indicated a soft economy, which led to a repricing lower of U.S. bond yields.

The chart below shows this dynamic using the differential between the two-year U.S. and Japanese bond yields. The slide in rate differentials led to a large appreciation in the yen against the U.S. dollar. The impact on Japanese equities was dramatic, with the Tokyo Stock Price Index falling 20% over three days in the first week of August. A stronger yen reflects tighter domestic financial conditions and is a challenge to exporters.

U.S. dollar/Japanese yen yield spreads

We think the unwind in the Japanese yen carry trade is now largely complete. The Commodity Futures Trading Commission (CFTC), which provides positioning on futures and options on a weekly basis, shows there has been a full reversal of the short positioning, with the latest update showing traders are now slightly long the yen in aggregate.

Net positioning on Japanese yen

Despite the 12% appreciation in the JPY/USD currency exchange rate since early July, the yen is still cheap. It is, however, no longer oversold. The Bank of Japan will likely be more patient in raising rates, given the volatility that followed the July rate hike and the global central bank easing cycle underway. Japanese bonds at the beginning of Q4 are the least attractive in the G10³ universe, given expensive valuations.

Worsening living standards and rising joblessness have compelled the Bank of Canada (BoC) to cut its policy rate three times this year, the first G7 central bank to do so this cycle. We believe the BoC is just getting started, and a deterioration in either economic or job growth could push the bank to ease more aggressively. Per capita gross domestic product (GDP) has fallen 3.5% since the second quarter of 2022, despite headline GDP rising 2.2% over the same timeframe, highlighting the reduction in living standards. Meanwhile, the unemployment rate has risen 1.6% since 2023. The challenging business cycle outlook means yields on government bonds may move lower, raising bond prices. This could help offset potential downward pressure on Canadian equities if economic conditions deteriorate and turn recessionary.

The need for speed

The central bank’s measured pace of interest-rate cuts this year signals that the Canadian economy is unstable. The three consecutive cuts have occurred despite quarterly annualized GDP growth averaging roughly 2% over the first half of 2024, which is better than the BoC had anticipated in its July 2024 Monetary Policy Report. However, the economic data mask an otherwise worrying trend. For instance, stretch the horizon, and quarterly annualized GDP growth has averaged just 1.3% since the first quarter of 2023, less than half the average pace of 2.8% for the U.S. economy over the same period. Moreover, at its September 2024 policy meeting, the BoC was clear that there are "downside risks" to growth over the second half of this year, and if inflation continues to moderate as expected, it's "reasonable to expect further cuts."

Downside risks are clear and present in the labor market. The BoC acknowledged that "hiring has been weak," and the rise in youth unemployment is particularly concerning. BoC Governor Tiff Macklem indicated that stronger job growth is necessary to "absorb the slack" in the economy. And although job losses haven't mounted, the growing immigrant population has struggled to secure employment.

The combination of a weak economy and substantial population growth have contributed to the rise in the unemployment rate from 5% in January 2023 to 6.6% in August 2024. Historically, such a sharp increase in joblessness would have almost certainly been associated with a recession. While an official recession hasn't been declared yet, it's arguable that the Canadian standard of living is already in one. For instance, since the second quarter of 2022, headline GDP has expanded about 2%, aided in part by strong population growth. However, GDP per capita, a better proxy for living standards, has contracted by roughly 3.5%, as shown in Chart 1.

Chart 1: GDP vs GDP per capita

Source: LSEG DataStream, Russell Investments, as of Q2 2024.

In the near-term, the BoC could continue with its measured cuts of 25 basis points (bps) per meeting. However, the need for speed could become evident if growth trends further deteriorate or if the unemployment rate continues to rise. The unemployment rate reaching a psychologically important level of 7%, for instance, could provoke the bank to ease more aggressively, where cutting rates in 50 bps increments cannot be ruled out. The fact that the BoC has not shied away from bold moves in the past makes it entirely probable. Recall that the BoC hiked its policy rate by 100 bps in a single meeting in July 2022 as it worked to fight rising inflation.

Today's situation is very different. Inflation is no longer the pressing concern. Headline inflation is at the BoC’s 2% target as of August, while the average of the bank’s three preferred measures of core inflation is only modestly above target at 2.2% Meanwhile, economic conditions have been shaky. Although the BoC technically only has a single ‘price stability mandate,’ it also tries to minimize economic pain to the extent possible. So, while the BoC’s measured pace of rate cuts makes sense now, its data dependency means that it will not hesitate to quicken the pace if economic conditions worsen.

Financial markets outlook

The Canadian 10-year government treasury yield has declined by about 60 bps from June 30 to September 12 to 2.92%, in the vicinity of our fair value estimate. Still, our cautious view about the Canadian economy, and our expectation that the BoC may lower its policy rate toward its neutral range of 2.25-3.25% quicker than market expectations keep us somewhat positive on the outlook toward government bonds – not only as a source of income but, crucially, as an important diversifier in case the economy stumbles more than the consensus expects.

Canadian equities have outperformed U.S. equities over the third quarter (as of September 12). Falling yields have supported banks, and rate-sensitive sectors such as Real Estate Income Trusts (REITs) and utilities. Still, industry consensus estimates for 11% earnings per share (EPS) growth over the next 12 months seem ambitious, and recent data indicate that, except for materials, most market sectors are experiencing negative earnings revisions. The downward revisions are not surprising considering the economic backdrop. Therefore, while Canadian equity valuations are reasonable relative to the U.S., cycle concerns keep us cautious.

Global equities have taken a breather in the second half of 2024. We have seen a rotation into value stocks at the expense of growth stocks. After a very strong first half of the year, most of the U.S. mega-cap tech stocks have lost ground since the end of June despite fundamentals remaining relatively robust. U.S. small-cap equities have outperformed in the last three months on increasing expectations of the U.S. economy achieving a soft landing and lower interest rates.

Fixed income markets have been positive as inflation has faded to the background and the focus has shifted to growth. Sovereign yields are now down for the year, and the U.S. 10-year government bond yield has fallen by 0.7% since June. Shorter-end bond yields have fallen by more, as markets have increased conviction in central bank rate cuts. Credit spreads have been volatile but remain tight.

Asset-class performance year-to-date in 2024

What’s the outlook in equity and fixed income markets?

We use our cycle, valuation, and sentiment (CVS) framework to guide investment decision making. Our base case is for a U.S. soft landing, but recession risks remain elevated given concerns about potential lags in impact of monetary policy. Equity and credit market valuations are slightly expensive, and earnings expectations indicate the market is fully pricing a soft landing. Our sentiment indicator suggests that market psychology has become more balanced after being quite optimistic two months ago. Combining these building blocks, our CVS framework points to negative asymmetry⁶ in equity and credit markets and highlights the diversification role that government bonds can play in a multi-asset portfolio.

COMPOSITE CONTRARIAN INDICATOR:
Equity market sentiment is neutral

Our asset-class preferences at the beginning of Q4 2024 include:

• The tactical opportunity set in equity regions, sectors and styles is muted in our opinion. Across global equities, the value and momentum factors appear relatively cheap but are accompanied by higher economic sensitivity and poor sentiment, respectively. We prefer to maintain a balanced exposure and allow stock selection to be the key driver of portfolio outcomes.
• Government bonds are fairly valued and offer positive asymmetry if economic growth deteriorates further—however, some of the tactical opportunity has dissipated given the rally. We expect the yield curve to steepen from here, which means the gap between the 10-year bond and the two-year bond will increase. Credit spreads are pricing in a significantly lower recession risk than our own, making them unappealing.
• Real estate and listed infrastructure are both attractively priced relative to broader equities, although the valuation gap has narrowed. Listed real estate climbed more than 15% in third quarter⁷ as central banks began cutting interest rates. We expect that real estate and infrastructure can serve as important diversifying assets. Oil prices have fallen as concerns about weak Chinese economic growth have resurfaced. Geopolitical tensions could cause occasional spikes in oil prices, but weak demand is likely to keep prices below any level that would cause challenges for the global economy. While the prospect of interest rate cuts usually bodes well for gold, stretched valuations relative to real rates make the near-term path less certain.
• The U.S. dollar continues to look expensive, and we expect it will likely depreciate in a soft landing. The oversold reading on the Japanese yen has unwound since August given the unravelling of the yen carry trade.
• The interest rate-cutting cycle should help provide a floor under commercial real estate and may help unlock more mergers and acquisitions (M&A) opportunities. Even so, our expectation for a gradual pace of rate cuts also means that borrowing costs will still be somewhat elevated at the end of 2024. Management teams will need to focus on operational value-add. We expect the dispersion of outcomes within the private market universe will be high, in part because of ongoing macroeconomic uncertainty. This makes manager selection crucial for achieving favorable investment outcomes.