Economies have demonstrated resilience in the face of restrictive monetary conditions and inflation has now cooled sufficiently to prompt central-bank rate cuts. Investors have embraced this favourable backdrop, with stocks climbing to record levels. Valuations, however, are at a point where further gains are becoming increasingly dependent on lofty expectations being achieved and heightened investor confidence being sustained.
Economies to grow at modest pace
The global economy has managed to withstand higher interest rates and continue to grow, reinforcing our view that a recession can be avoided over the year ahead. We place the odds at 65% that economies manage a soft landing, with potentially two to five years of further expansion based on our business-cycle analysis. U.S. economic strength coming out of the pandemic was helped by robust consumer spending, bigger-than-expected fiscal stimulus and population growth, but now appears to be moderating while growth in other regions is accelerating. We forecast annualized growth rates of just under 2% across most developed regions and our growth forecasts are mostly a bit above the consensus outlook. For 2025, our growth outlook remains largely the same as a quarter ago and is approximately in line with the consensus. In emerging markets, our 2024 growth outlook has improved slightly and is ahead of the consensus due to superior expectations for growth in China and India, but we expect growth to decelerate somewhat into 2025. While our outlook is relatively benign, downside risks highlight why a hard landing remains possible. High interest rates continue to weigh on economic activity and there is a chance that inflation remains stuck at elevated levels. Geopolitical risks are also higher than normal with the U.S. election, conflict in the Middle East, China-U.S. tensions and the war in Ukraine all posing sources of uncertainty for economic growth as well as inflation.
Inflation has been sticky, but continues to moderate gradually
After impressive progress between the middle of 2022 and the end of 2023, inflation proved somewhat more stubborn over the first several months of 2024. Stickier prices resulted from higher gasoline costs, still-robust service-sector inflation and – in the U.S. – some seasonal distortions in the first quarter. It is undeniably a more difficult path downward for inflation if economies manage to avoid recession, as they have so far done. But the data improved in April and May and is moderating once again, if gradually. More-conservative consumers are starting to erode corporate pricing power and retail-level price cuts are becoming more common. We expect inflation to remain high in 2024 given recent upside inflation surprises, but for it to trend downward for the remainder of the year and into 2025. We expect to be well into next year before inflation falls to central bankers’ 2% targets.
U.S. dollar resilience is set to fade
We’ve argued for some time that the U.S. dollar is at the beginning of a longer-term decline that could continue for several years. The currency’s persistent overvaluation, relentless U.S. fiscal spending and the threats posed by a second Trump presidency seem to support this longer-term outlook. However, the impact of fiscal spending on short-term growth and inflation means that the Fed is likely to keep interest rates elevated. The U.S. interest-rate advantage over other regions has been the most important consideration for currency traders this year, and so the dollar’s descent is less likely to occur without a drop in interest rates. As government spending is exhausted and as inflation moderates, we expect that the U.S. Federal Reserve will start cutting rates later this year. In this context, any gains in the U.S. dollar from an overvalued starting point are likely to be limited. Over the course of our 12-month forecast horizon, we think the dollar will be pulled lower by a slowdown in fiscal spending, rate cuts and rich valuations.
Central-bank rate cuts have begun
Interest rates are now extremely high by the standards of the past decade and a half, but with inflation declining, central banks are beginning to ease policy rates. A variety of emerging-market central banks have already begun monetary easing and a mounting number of developed-world central banks including the European Central Bank, the Bank of Canada, the Swiss National Bank and Sweden’s Riksbank have also begun their rate-cutting journey. The Bank of England could begin easing as soon as August after the UK’s national elections take place. The Fed is patiently waiting given that inflation is higher in the U.S. than elsewhere, but it is likely that the U.S. joins the rate-cutting parade this fall. This pivot by central banks is meaningful, as high interest rates were the main threat to the global economy. The ultimate trajectory to lower rates will be paced by incoming economic and inflation data and, in our view, this rate-cutting cycle should be more gradual than past periods of easing in the absence of an imminent recession catalyst.
Sovereign bonds offer decent return potential, minimal valuation risk
Bond yields have risen slightly in the past quarter as investors weighed the possibility that central banks may ease policy at a more gradual pace than previously expected. At around 4.50%, the U.S. 10-year yield is situated well above the 2.50% level deemed appropriate by our model. But we recognize that our models could be understating the level of real interest rates because they are still picking up the deeply negative real rates experienced during the pandemic. Tighter monetary conditions and rising fiscal deficits suggest that real interest rates may settle at a higher level on a sustained basis. If we assume a 1% real interest rate instead of one near-zero or slightly negative, we could conclude that the U.S. 10-year yield is more or less appropriately priced for a gradual decline over the years ahead as inflation moderates toward the 2% target from just over 3% currently. We continue to evaluate how our modeling impacts our assessment of the bond market’s attractiveness, but we find it difficult to come up with assumptions that would make the bond market look particularly expensive. As a result, our view is that fixed income markets offer decent return potential in the mid single digits and with only modest valuation risk over the year ahead, especially in an environment where central banks are actively cutting rates.
Stocks extend gains, led by U.S. mega-cap technology
Equity markets climbed to new highs in the past quarter, although the biggest gains have been highly concentrated in a small group of mega-cap technology stocks that have benefited from trends in artificial intelligence. The Magnificent 7 were up 24.6% from the beginning of the year to the end of May, helping lift the market-cap-weighted S&P 500 by 10.6% over the same period. But the equal-weighted version of the S&P 500, which represents the performance of the average stock, is up slightly less than half that at 4.8%. Other areas underperformed the S&P 500, especially emerging markets, Canadian equities and U.S. small-cap stocks, all of which have delivered low single-digit returns so far this year in U.S.-dollar terms. While the S&P 500 is close to one standard deviation above our modelled estimate of fair value, other major indices in Europe, Canada, the UK and emerging markets are close to or more than one standard deviation below their own fair values. As a result, global equity markets could offer attractive returns should economic and corporate-profit growth remain positive. A lot of the good news is already priced into the U.S. large-cap equity market and expectations are high. The current combination of strong nominal earnings growth, continued expansion in profit margins and elevated investor confidence is becoming increasingly critical to sustaining the bull market.
Asset mix – maintaining positioning near strategic neutral, with slight tilt to fixed income
After considering the risks and opportunities, we have left our recommended asset allocation for balanced investors very close to a neutral setting this quarter, with a slight tilt to bonds. Our base case scenario has the economy experiencing a soft landing, inflation falling gradually toward central bankers’ 2% targets and central banks delivering modest monetary easing. Against this backdrop, prospective returns for fixed income appear pretty good, in the mid single digits with potential for further upside should the economy falter. Stocks still offer superior return potential versus bonds but the upside has been reduced as a result of the latest rally and the equity-risk premium is narrow. Recognizing the improved outlook for bonds and demanding valuations in stocks, as well as the wide range of potential outcomes for the economy and markets, we feel it is appropriate to maintain an asset allocation close to our neutral setting, with a slight tilt in bonds. We would consider increasing our exposure to stocks should the equity-risk premium widen, or if we saw a broadening in the equity-market rally beyond mega-cap technology and themes other than artificial intelligence. For a balanced global investor, we currently recommend an asset mix of 60.0 percent equities (strategic neutral position: 60.0 percent) and 38.5 percent fixed income (strategic neutral position: 38.0 percent), with the balance in cash.
Recommended asset mix RBC GAM Investment Strategy Committee
Note: As of May 31, 2024. Source: RBC GAM