Slayed

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   By Guest Blogger Ryan Lewenza

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It’s official: the most significant inflation spike seen in Canada since the early 1980s has been slayed. This has big implications for the direction of interest rates, our economy, and financial markets. Let’s dig into this important development.

This week we got the critical Canadian inflation report, showing Canadian inflation slowed to 1.6% yoy in September, down from 2% in August. Since peaking at 8% in 2022, Canadian inflation has been trending consistently lower and last month’s level marked the lowest increase since February 2021. Clearly, the Bank of Canada’s (BoC) aggressive rate hikes have had the desired effect of addressing the worst inflation outbreak in decades.

A key driver of the slower inflation in September was the price of  gasoline, which fell 5.1% yoy. Now, it’s not all roses as shelter costs (rents and mortgage costs) remain elevated. Rents are up 8.2% yoy (down from 8.9% in August) and mortgage interest expenses are up 16.7%. Rent prices are likely to ease a bit but given Canada’s housing supply shortages, I don’t see a big drop coming there. In contrast, mortgage interest costs are directly linked to the high interest rates, so as the BoC keeps cutting rates, this expense will continue to drop, which should help on the overall inflation front.

Canadian inflation slowed to 1.6% in September

Source: Bloomberg, Turner Investments

Following this positive report, expectations for a ‘jumbo’ (i.e., 50 bps) rate cut from the BoC rose dramatically. Prior to the release odds for a 50 bps cut at the BoC meeting next week stood at 50%. After the release odds jumped to 75%. Doing a quick review of the big banks economics departments, I’m seeing RBC, TD and BMO are all calling for a large 50 bps cut at the upcoming October 23rd meeting. I ‘m in this camp and believe the BoC will follow the Fed’s recent decision to cut rates by 50 bps, with inflation now below their 2% target.

Looking out into 2025, the BoC looks set to keep cutting rates. Currently our overnight rate stands at 4.25% and is likely to close the year at 3.50%, assuming it followsthrough with a 50 bps cut next week and another 25 bps cut in December. As seen below, bond markets are pricing in six additional cuts by the summer of 2025, which would take the overnight rate down to 2.75% by next summer. That’s a big drop, with big implications for our economy and markets.

Rate futures are pricing in six cuts by next summer

Source: Bloomberg, Turner Investments

First, if interest rates continue to drop as we expect then this should help our stuttering economy. There is a lagged effect of interest rate cuts and economic activity, and we see these rate cuts (and the ones coming next year) providing a boost to our economy in 2025. We believe we’ll avoid a recession with these rate cuts and see stronger economic growth for next year.

Second, these rate cuts should provide a boost to our challenged housing market. We could see variable mortgage rates in the 3-4% range and fixed rates in the 3.5%-4% range next year, which should help to revive our ailing housing market. Add in the recent mortgage rules changes, which make it easier to qualify for a mortgage, we could see a nice spring rebound in our housing market.

Third, falling interest rates are generally good for stock prices. Declining interest rates help to boost corporate profits, and can lead to higher market valuations (i.e., P/Es). In particular, ‘interest sensitive’ stocks like banks, pipelines and telcos, and REITs, tend to do well when rates are declining. This is because there is less competition from GICs and bonds. We added to both REITs and dividend paying stocks late last year in anticipation of these lower interest rates and we’re happy we did as we’re up nicely on those positions.

Fourth, rate cuts are generally not good for our dollar. We’ve seen this recently with the Canadian dollar declining from $0.745 in late September to $0.728 currently. With the low inflation print in Canada and expectations of a larger 50 bps cut, the Canadian dollar has sold off versus the US dollar. In the short-term we could see some additional weakness, but we maintain our view that the Canadian dollar will remain rangebound between the low and high 70s and see the Canadian dollar rebounding next year as the Fed follows the BoC with additional rate cuts.

Finally, Canadian bonds could perform nicely in 2025 as the BoC continues to cut rates. Readers know that bond prices move inversely with bond yields. As interest rates decline, bond prices will rise, which is why we see bonds outperforming cash (i.e., HISAs) next year. We’ve been shifting to long-term bonds which are more sensitive to declining interest rates. We hold a bit of cash/HISA ETFs right now but see bonds doing better than cash next year.

It’s been a challenging few years, in part due to this big inflation scare. But that’s in the rearview mirror and with the lower inflation comes lower interest rates. To take advantage, we’re recommending variable mortgage rates for homeowners and positioning investment portfolios with ETFs that will benefit from these lower rates, like dividend stocks, REITs and long-term government bonds.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.

Source: https://www.greaterfool.ca/2024/10/19/slayed/