Lester Asset Management, First Quarter 2024 Letter Excerpt

Lester Asset Management, First Quarter 2024 Letter Excerpt

April 22, 2024

MACROECONOMIC OUTLOOK 

Inflation continues to be the key to anticipating central bank policy, which in turn, affects the economic and financial environment. Through 2023, falling inflation created the expectation of large interest rate cuts and easier financial conditions in 2024. The bond market, which sold off sharply for a good part of last year, reversed course with the 10-year Government bond yield dropping sharply by over 100 bps. The first quarter of 2024 saw about 50% of this decline retrace due to inflation numbers coming in above expectations and the economy, particularly the U.S., showing signs of being stronger than expected. As a result, central bank policy easing has been put on hold for now and investors are left with uncertainty over whether or when the fall in inflation and interest rates will resume. Our view is that the North American economy will continue to do well, which is positive for equity markets, and that this should not reverse the longer-term trend of subsiding inflation. 

Wage inflation, which is the dominant factor in service sector inflation, has continued to soften due to a growing labour supply from immigration and higher labour force participation. Significantly, core goods inflation in the U.S. is already negative, supported by falling Chinese import prices. A new capital goods spending cycle is now apparent which promises to increase overall production capacity. This will increase the supply of goods and hence support moderating inflation. Productivity growth, which is key to reducing unit labor costs, is rebounding significantly in the U.S., due in part to AI. While Canadian productivity has lagged, it should eventually catch this upward trend due to spillover from the U.S. 

In Canada, core CPI, a key policy focus of the BOC, is running at around 2%, which is in the middle of its 1% to 3% target range. Canadian inflationary pressures are much weaker than in the U.S. because the Canadian economy has been softer. The BOC was not as reckless as the FED during the pandemic, while post-pandemic the U.S. has been running large budget deficits, averaging about 8% of GDP recently. On the other hand, Canada has been running a deficit of about 1.6% of GDP and this is projected to fall below 1%. Finally, Canadian housing has been very weak with average prices falling some 10%, while U.S. prices are still rising. The much-improved inflation outlook in Canada, both in absolute terms and relative to the U.S., bodes well for BOC policy easing. 

In short, it is likely that the concern over “sticky inflation” is a short-term issue. Inflation should, in due course, resume its softening trend and, in turn, bring interest rates down again. Due to prospects for stronger productivity growth, it is likely that the economy can grow well alongside lower inflation. Because central banks erred on the side of excessive easing during the pandemic and underestimated subsequent inflationary pressures, they will move slowly towards easing. Hence, investors will need to be patient for a bit longer. 

While Canada’s economy and stock market have lagged the U.S. for several years, some catch up is likely. The upswing in the global capital goods cycle, together with better growth in China, will support what looks like a new commodity cycle developing. This is good news for Canada’s growth and equity markets which continue to be very cheap by global standards. That, and the cheap Canadian dollar, make Canada’s capital markets look attractive to foreign investors.

Stephen Takacsy, Matthew Kaszel, Olivier Tardif-Loiselle, Tony Boeckh

--------------------------------------------

Source

https://lesterasset.com/news/