Signs of slowdowns appear to buoy odds of a Bank of Canada cut this week, spurring rotations away from mega-caps, but volatility is expected
The economic slowdown and onset of interest rate cuts that analysts predicted from the start of 2023 seems to finally have come to the US and Canada. A few months of CPI data, unemployment numbers, and GDP growth reports have begun to show enough of a trend. The Canadian and US economies are slowing down — albeit at different paces — at a consistent enough rate to support the beginning of interest rate cuts in the United States and the continuation of cuts in Canada.
On Wednesday, the Bank of Canada will make its next interest rate decision, and Greg Taylor believes they will cut again. The Chief Investment Officer at Purpose Investments explained that the combination of slowing inflation, rising unemployment, and weakening consumer and business sentiment should be enough to support a second interest rate cut. He noted, too, that weakness in the US should inform cuts by the US Fed in September, which may give BoC governor Tiff Macklem more cover to cut now. As cutting begins in earnest, Taylor believes it could be a signal for a shift in equity markets as well.
“The big thing that I’m looking at for the second half of the year is going to be a pickup in volatility,” Taylor says. “We’ve got to be ready for volatility, whether that’s around central bank uncertainty, or the election, or questions about this AI/semiconductor leadership and mega-caps. We’re heading into a more tricky environment for investors going forward.”
Much of the market sentiment up to this point has been one of ‘bad news is good news.’ When economic numbers came in showing weakness, investors took heart because a slowing US or Canadian economy should prompt interest rate cuts. As cuts come and economic news continues to show weakness, however, Taylor expects that markets may shift back to a ‘bad news is bad news’ position, bringing greater volatility with it.
Taylor is already seeing signs of this shift with a rotation away from the mega-cap stocks that have dominated market performance for the past 18 months towards some of the value smaller-cap names which have underperformed. While he thinks that AI will remain a big factor going forward, he says that some investors are beginning to wonder if the trend has overrun somewhat. Economic weakening, he says, may have signalled to equity investors that the time for the rotation is now.
That rotation may already be reflected in the recent run we’ve seen in the TSX. After lagging US markets for years, the TSX outpaced the S&P 500 slightly in the past few weeks. Taylor says that’s largely reflective of investors taking a more favourable view towards the sectors overrepresented in Canada like energy and financials, and away from the tech names which Canada still has a dearth of.
Taylor’s current outlook for interest rate cuts is that the Bank of Canada will likely cut this week and pause in September to see what the US Fed does. The Fed, he says, is more likely to hold interest rates at its meeting next week before cutting in September.
Following the BoC meeting this week, Taylor is listening for Macklem to acknowledge that the Canadian consumer is feeling some weakness. Macklem’s overall view of the economy and the housing market will be key as well. Next week he’ll be listening for Fed Chair Jerome Powell to talk about fiscal policy and the role that spending plays on inflation.
As the market prices in cuts and reacts to economic news differently now, investors may be forgiven for feeling like they’re out of the frying pan and into the fire. Inflation was the problem of the day, but solving it just opens up new sources of volatility from weakness in employment and consumer confidence. Exhausted as some investors may feel in this environment, Taylor emphasizes that there are still opportunities to be found.
“You don’t want to be too bearish or bullish anytime and trying to time the market is always dangerous,” Taylor says. “I think people need to acknowledge that the risk in the broader market is that we’ve gotten too concentrated on certain themes…But if you take out the magnificent seven, I think there are good opportunities in the other 493. I think it’s worth stepping back and realizing that we might get a bit of a correction, but that’s not the end of the world and there are probably good opportunities out there.”
