Q1- What’s the current economic outlook for the U.S., and the likelihood of a recession?

Well, there's certainly been plenty of threats facing the global economy, the U.S. economy over the last year, 18 months, even 2 years with rising interest rates, geopolitical instability, the threat of inflation and the last mile problem we run into. But when you look at growth over the last period, it’s held up reasonably well and leading indicators suggest that that's going to continue.

We're finally seeing some moderation in growth. And in the U.S., it's moderated earlier in the rest of the world, which is much actually much more vulnerable to higher interest rates than the U.S. has been. But you're starting to see household spending slow as they burn through the pile of savings that were built up through the pandemic. You know, wage rates are no longer expanding at too large a clip, so not enough there to suggest that the U.S. is headed for recession.

We don't think it is. We think the odds of a soft landing are sufficiently high that that's now our baseline forecast and has been for some time. So a slowing of the U.S. and world economy, but at levels sort of 2%, 2.5% growth going forward for the U.S., Canada more like 1.5% to 2% growth similar to those levels in Europe.

But nevertheless in the forecast horizon, which for us is a year, year and a half, no recession is likely.

Q2 - What’s your view on inflation and its economic impact?

Well, inflation has been a critical part of the forecast for really coming out of the pandemic period. Too much growth in the money supply is easing financial conditions everywhere. Surprised us all with the degree to which inflation took off. It came down quite quickly from 9.5% in the United States, but it stalled about a year ago and it's held around that 3.5% level.

Just this morning, we had some good news that the month over month rate fell to 0% and that brings it down to 3.3%. It kind of broke that range it's been in on a year on year basis. But it is a critical element of the go forward forecast for the economy. If inflation doesn't continue to decline towards call it 2.5% in the next year and then ultimately to 2%, then rates are going to stay higher for longer.

And in a worst case situation, if you have an acceleration of inflation from here, you know, central banks might be forced to actually raise rates and choke off whatever growth we're going to see in the economy. So this is a good news story right now. We appear to be back on track towards that ultimate 2% goal that central banks tend to sit on.

We're seeing relief in gas prices, some moderation in consumer pressures that were driving inflation. We want to see that trend continue. Our own forecast is something like 2.5% inflation over the next 12 months for the major economies, and that would keep the track towards improving economic conditions gradually over time and lower interest rates in the future.

Q3 - How are central banks responding to the current economic conditions?

Well, certainly all eyes in markets have been on central banks for some time now. Having let the inflation genie out of the bottle, they worked hard to get it back in there. Appears to have worked. You know, inflation declining from over 9% in the United States at its peak to 3.5% or 3.3% right now. That's good news.

And we believe that moderation, and hope that moderation will continue, lead us towards the 2% level. Initially, when markets saw the break in inflation and what appeared to be a pivot by the Fed, the U.S. central bank, last fall, the market immediately priced in six rate cuts for 2024. Well then it proved it was a last mile problem and inflation was really a problem.

We got stuck at 3.5% inflation for some time. Got moved all the way down to two cuts for 2024 expected by markets and some were talking actually zero. And in fact, at one point we heard people talk about maybe they actually had to raise rates, which would have been a problem for more than the interest rate markets.

We think we're back on track towards something like two cuts in short term interest rates by year-end. That would take it down towards a 4.75% level or something like that in the United States. But importantly, those economies that were most exposed to higher short term interest rates, and that would include Canada and Europe, have already started cutting interest rates because their economies responded most clearly to the higher interest rates.

So, you know, the leading edge of cuts has now started. It started in June with 25 basis points by Canada and then by the ECB. So I think the trend now is towards gradually lower short term interest rates.

Q4 - What’s your view on fixed income?

Fixed income markets have been facing two very large concerns over the last six months. We had a huge rally. Ten-year bond yields around the world, the United States taking us from 5% down to 3.75% and then back up to 4.7%. Well, the reason, of course, was is that inflation failed to follow through visibly in the spring and into the early summer of 2024.

And that left bond investors with, you know, two problems. Are we going to have higher for longer short rates and will that put a floor under long bond yields and maybe push them off back towards the 5% level and capital losses that would ensue. And the second one was that even if the Fed did start cutting interest rates, the stickiness of inflation and a variety of other factors, maybe we're going back to past levels of short rates.

You know, maybe the real rate of interest or the after inflation rate of interest was going to get stuck at a higher level than we've grown used to over the last 10 or 15 years. I think that part of it is a real concern. We've seen some relief on inflation now,  looks like the Fed will be allowed to cut interest rates later in the year.

So, you know, the higher for a longer scenario comes off the table a bit. But how low interest rates can go at the short end, which of course puts a floor under how low they can go at the longer term. Well, that's still an open question. You know, if you had asked us before the pandemic as to where real rates of interest would rest, we would have said 0 to 1%. Major demographic change around the world, a variety of different factors would hold them down to that 0 to 1% level.

They were, by the way, negative at that point. There's a very good argument that's coming now, though, that maybe 1% to 2% is where they should rest. You know, 2% is historically the average real rate of interest, but that's an average rather within a very wide range. You know, one of the things that's happened, of course, is that government deficits exploded.

You know, we're going to get slower growth, bigger deficits, bigger funding needs. And that puts a floor perhaps under real rates of interest. And this is important. It's not just theoretical. It's important because the real rate of interest is the base rate of return for all risk assets. Is the risk free right. So to that, you add, say, 2% for inflation, if you got a 0% real rate, you start at 2%.

There's your bill rate, add a 150 basis points, return premium up to a ten-year bond, got 3.5% bond yield. Well, let's say now we got a 2% real rate of interest. All of a sudden, that bond yield isn’t 3.5%. It's 5.5% or 4.5%.

So we're having to adjust our views as to where yields might ultimately settle as a result of this and where we thought originally that yields could perhaps hit 3% and 3.5%, 3.75% level is, you know, ultimate target during this cycle. We're raising that a bit. 4% to 4.5% might be the steady state for ten-year bond yields in the U.S., which sets the base rate for the rest of the world for the cycle ahead.

Q5 – What’s your view on equities?

Well, the major indices have had a terrific year so far, not just in the United States. I mean, the U.S. most noticeably, although it's been a very narrow part of that market that's delivered the biggest gains. A lot of focus on how narrow those returns are. Over half the returns coming from something like less than seven stocks of course from the very famous mag seven, which gets narrower and narrower to get to even mag 1 at some point.

But if you look below that, there are good gains though throughout the list. And that, of course, is being fueled by more than AI as it were, though it’s been the major theme driving this market. It's been fueled also by a view that we're not going to get a recession and that rates sooner or later are going to come down.

So PE’s have been high and earnings expectations have been solid. If you look at that market, what does it require to justify that kind of confidence? It's a higher hurdle now that needs to be passed. You know, we need more margin growth or higher nominal GDP than is currently reflected in reasonable economic expectations. It's a doable thing. If you add 100 basis points or one full point to margins this year or next year, if you have 5% nominal GDP growth in the United States, that's real growth plus inflation.

Then you can hit the kind of earnings numbers that would support the stock market at its current level and perhaps a little above. If inflation continues to come down towards 2%, 2.5% over the next year to 18 months and interest rates follow to the levels that we would expect consistent with that, well then you can get PE’s to the levels that would also justify a reasonable rate of return on stocks, call it 5% to 8%. Something like that.

But those things now kind of have to happen in order to sustain the life of the bull market. Having said that, the United States stock market is the major developed world's most expensive stock market. Kind of overstates what valuations are like outside of not just the United States, but even just outside those top seven or ten stocks.

You drop below it into the rest of the list in the United States, you see actually valuations aren't unreasonable, they seem consistent with the kind of economy we see unfolding, the level of rates and inflation we expect. And if you move outside of the United States, and you look to Canada, the United Kingdom, Europe and some parts of Asia, you see quite reasonable valuations.

So kind of a mixed picture. High expectations need to be validated by higher margins from growth in the economy, from nominal growth in the economy. Think it's doable, has to happen. Outside of the United States, much more reasonable valuations.

Q6 – How do adjusted risk expectations impact the return prospects for bonds compared to stocks?

After adjusting for risks and putting in the certainty equivalent to our expectations, we actually see similar rates of return and similar opportunities in the bond market as we do in the stock market. Began that change over two or three quarters ago after being underweight bonds for a very, very long period of time.

So you're up towards a 4.5% yield, and with inflation moderating and rates likely to come down later in the year, we think at the very least you're going to get to keep your coupon, that valuation risk isn't acute in the bond market and probably adds some capital gain to that. The stocks we'd look for slightly higher, but still single digit returns in a soft-landing outcome.

But again, after adjusting for risks and there are very real risks to that forecast as rates aren't really coming down that quickly, inflation hasn't shown for sure it's going to hit 2.5%. And so the equity risk premium, which is not large, might get threatened in that period. Adjusting for all of that and a neutral setting in equities, which is well below levels that we had set out earlier in the cycle and just slightly above neutral for bonds.