Episode 90: Darkest before dawn—are investors nearing an inflection point?

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Kevin Headland:

Commentary is for general information purposes only. Clients should seek professional advice for their particular situation.

Frances Donald:

I think it's been a couple of years since I've been able to join you in this forum, so I'm pretty excited. And I'll pretend it has nothing to do with the fact that it's bonus season.

Macan Nia:

Well, that had nothing to do with-

Frances Donald:

The timing is suspicious, Macan and Kevin. The timing is suspicious.

Macan Nia:

Welcome back to Investments Unplugged. I'm Macan Nia, Co-Chief Investment Strategist Manulife Investment Management, and joined here as always, my partner in crime, Kevin Headland.

Kevin Headland:

How's it going, Macan?

Macan Nia:

Good, how are you?

Kevin Headland:

I'm good.

Macan Nia:

Before we get started, I'd like to think that this is a special podcast recording. We have a very, very special guest, Frances Donald, Global Chief Economist, Global Chief Macro-strategist, and more importantly, Kevin and I's boss, joining us on the call to really talk to us about the five macro themes that her and her broader team have set out for 2024. Welcome to the podcast, Frances.

Frances Donald:

Thanks Macan. I am honestly super honored to be here, because even if I'm your boss, that's just not enough to land a spot on this podcast. You all have great guests. I think it's been a couple of years since I've been able to join you in this forum, so I'm pretty excited. And I'll pretend it has nothing to do with the fact that it's bonus season.

Macan Nia:

Well, that had nothing to do with-

Frances Donald:

Timing is suspicious, Macan and Kevin. The timing is suspicious.

Macan Nia:

[Inaudible 00:01:37] very suspicious. So Frances you and your broader macro team in early January, no, excuse me, mid-December, released your five macro themes for 2024, taking a very big holistic approach in terms of what you see, the big themes that you see unfolding for 2024. We thought it would be a good time. We recorded two podcasts, Kevin and I, in January, talking about our investment themes for the remainder of the year. We thought it would be a good opportunity to invite you on the podcast to discuss your team's five macro views. And let's start, and we'll give the plug to it afterwards, but talk to us the first one. So the first one is, and I love this, because I just watched Dark Knight, is, "Darkest before the dawn."

Frances Donald:

So first of all, I really wanted to be an English major, and my parents suggested that would not be as lucrative as some other thing. So I like to inject some poetry into our themes. Darkest before dawn. So Macan, Kev, there's a lot of focus on recession or no recession this year. And I think I've talked a lot about how I think this is really a false binary way of looking at the world. That it's not just recession or no recession, risk-on versus risk-off. The more important theme is that growth is going to slow a lot, especially in the first two or three quarters of 2024. That's going to be a little bit more challenging for companies that have gotten used to some pretty powerful growth and earnings. It's probably going to provide some better opportunities for fixed income. And it's going to mean you've got to rely on portfolio managers who can find great companies. We've got a lot of them here at Manulife who do that for us.

But there's another element to this, which is that sometimes there's so much focus on the slowdown in growth over a six to nine month period, that we forget one of the best investment opportunities actually comes right after recession. So when you get about halfway through recession periods, or slowdowns in growth, that's generally a good time to start putting money back to work. 2009 is a really good example of that. So we talk about darkest before dawn, because we want to allude to the idea that yeah, growth is going to slow and there's recession risk for this year, but it also means that at some point in 2024, the three of us are going to be on the road, we're going to be on podcasts, we're going to be on TV, talking about now is the moment to jump back in.

So I think we always need to keep those two dynamics together in play. Which is that the market runs in cycles, and you've got to look between two corners at all times. Just focusing on some of the downside risks right now could end up blinding you towards the opportunities that, I think, are really going to come pretty substantially for risk assets in the later part of the year. So darkest before dawn is my attempt to put emphasis on both of these corners, the trade after the trade.

Macan Nia:

Yeah, and one thing that Kevin and I have been talking to with clients, is as well as, yes, we're getting towards the end of a cycle, and you're not going to sell down your equities, but it's holding the right equities. What our work has suggested, there's certain factors that work better at this point in the cycle. Some of them being hot companies with high return on invested capital, companies with high return on equity, ones with high profit margins. You're seeing that unfold in the recent earnings, where those companies, it's been a dichotomy, right? A tale of two type of companies, as it usually is at this point in the cycle, and those that are beating on earnings, increasing their revenue projections, but we're finding that quality is starting to outperform. That makes a lot of sense at this point in the cycle. So it's not about decreasing your equity weight very materially, it's about if your equity weight isn't defensive in nature, it might be a good time to start thinking about equities from that lens.

Frances Donald:

Yeah, that's exactly it. These inflection points are really important inflection points, but they're not necessarily game changers in terms of your asset allocation. It's just a moment where you have to be a little bit more careful, and look just a little bit more under the hood than you might have historically. You've got to do the same thing in fixed income too. Fixed income is going to be much more attractive now, especially compared to the past two years. But there are areas of fixed income that maybe you've got to be a little bit more cautious about. So unfortunately, 2024 more difficult year for a lot of us in the sense that it's not going to be an easy call, but there's still plenty of opportunities that exist in this context.

Kevin Headland:

Frances, can I just take it back one second, and just look, when we talk about recession, and we've said the call is, as macro strategists, as chief economist, you have to have a call. It's soft landing or hard landing, and recession or no recession. I know it's hard to have a binary call there. What do you mean when you say, "Recession?" Is the National Bureau of Economic Research going to come and declare recession? Are we going to see it headlines and say, "We're in a recession," or, "We were in a recession?"

Frances Donald:

So the typical definition of a recession is two quarters of negative GDP, with some accompanying factors. So actually we did have two quarters of negative GDP last year, but they were dismissed, because they didn't come with a rise in the unemployment rate for example, and a variety of other factors that come through. So when we say we have a recession in our forecast, it's because our model says, in the United States, Q2 and Q3 have negative GDP, and a rise in the unemployment rate. The NBER can usually take up to a year before they officially declare that. But what you'd see in the headlines on the front page of the newspapers is something like, "We had one quarter of negative GDP, there's recession risk for the second." What I find amusing about this, if you look at Germany for example, they had a negative quarter of GDP, and then they had a 0% quarter of GDP. And everyone said, "They skirted recession, they didn't have a recession." They could have literally been one, like a 10th of a decimal point lower-

Kevin Headland:

[Inaudible 00:07:51].

Frances Donald:

... and it would have been in recession. So this is why I have a little bit of an issue with it. I think when we talk about recession, we've also got to talk about magnitude of recession, and where the recession is actually manifesting. So for example, when we look at Canada and the United States, what we're expecting is that the manufacturing sector actually begins to improve, and services sector is what brings down growth. It could be be that the math of that works out to one quarter of negative GDP, and then one 0% quarter. Then I'll get a bunch of mean tweets saying, "You said there was a recession and there wasn't one." That's why yes, as a chief economist you have to have a GDP forecast, and our GDP forecast happens to have two quarters of negative GDP, which means we technically have a recession.

But most of the portfolio managers that we work with every day, they don't ask me, "Do you have a recession?" They asked me, "What is the direction of growth? Where are the weaknesses in growth? Which sectors do we need to be paying more attention to in this particular environment? And how are central banks going to respond to it?" So I have felt over the years that recession or no recession is a way to grab headlines in the media. I think governments pay a lot of attention to this. It tends to be very political commentary.

It is less of an investment call than maybe it's made to seem on a lot of our financial news media spots. Now, I'll just put this one asterisk, a deep recession. So if you're calling for 2008, or 2001, which we are not, let me be clear, we are not, yeah, that is a really important risk-off event. But there is a place in the middle between soft landing and hard landing. There is a place in the middle between, "Recession, scary," and, "No recession, everything's good." And realistically in 2024, that's what we see as the most probable outcome. I'm not going to get a CNBC headline with that.

Kevin Headland:

I joke often when I'm talking to clients and say, "We almost need this term, 'A softish-hard landing,' something in the middle." It's like it's not really a hard landing, but we didn't skirt the recession, or the weakness in the economy. I believe, well, you came up with this term and I want to bring it back. It was like a year or so ago or maybe two years, "Recessionette."

Frances Donald:

Recessionette? Oh that was such a good one-

Kevin Headland:

Remember that?

Frances Donald:

See that's the poetry that I should have put in the 2024 outlook, recessionette. Yeah, and that's the issue, is what does, "Soft landing," mean? What does, "Hard landing," mean? I don't know. I think most of the time we're talking about a rise in the unemployment rate, but if we are rising in unemployment rate by one percentage point, it's super different than if the unemployment rate goes to 10%. So these are words that are impractical for most investors, I think, and we could just be a little more nuanced about it.

Macan Nia:

So it's fair to say that the broader team envisions a slowdown, probably more similar to the slowdown or recession that we experienced in the early '90s, then one that we experienced, whether it was .com or Financial Crisis. And really not to generalize it, but we don't see a sharp increase in the unemployment rate. Also, financial conditions, despite rates being higher, are not aggressively tightened. They're tight today. So we factored all of these in. We see a slowdown, because the narrative in the market has changed in the past three months, where now when we're really speaking with advisors, everyone seems to think that we're going to avoid a recession altogether. But our team's broader view, or material slowdown, our team's broader view is it's still too early to wave the flag in terms of us avoiding a recession, or even a slowdown.

Frances Donald:

Okay, so let's do a little like, "How the sausage is made," on these forecasts. Because how it works for us is how it works for most Economics teams. I'll just clarify here for our listeners that there are effectively, I have the privilege of leading two teams. One is the more traditional Economics team, so it's what we call the Macroeconomics team. This team is incredibly well-skilled in terms of models and forecasts, and they really come to work every day to get a sense of what the future holds in terms of the economy. Then I have the wonderfully charismatic, dare I say, good-looking, hilarious Capital Markets and Strategy team led by Kevin Headland and Macan Nia, whose job is to translate that to what it means for markets. So step one is what is the economic forecast? And we've got a whole team that sits at their desks all day trying to figure that out. Then provides that handoff so that you can focus on the real investment implications.

Now when you're making an economic forecast, even though we say, "We see a recession," the hard truth is that you actually develop a range of different possible outlooks and you put probabilities on each one. Right now the one that has the highest probability is this recession at two quarters of negative GDP in the US, three in Canada, with a mild rise in the unemployment rate. Part of this comes from the very clear historical precedence that the average time, the average time between the first rate hike and its impact on the economy is two years. That is the average lag. Two years is now, it is literally January, February. That is what two years is. Now, the average lags between the inversion of the yield curve, the average lags between the tightening of credit conditions, those all imply based on historical precedent that there will be weakness in the economy in the next few quarters.

The problem is that we have offsetting factors in this economy. One of them is the extent of government spending globally that is providing an offset. So in Canada and the United States government jobs and jobs in healthcare and education have been the predominant drivers of job growth. If we didn't have them, we would have flat-ish private sector job growth in both the US and Canada. People would not be saying, "We're going to skirt things altogether." So the US is definitely, or the government spending is modifying our conviction in these traditional indicators moving forward. But what we have a lot of trouble doing, is saying there is no impact of higher interest rates on the economy. We have a lot of times saying that traditional economic relationships are completely useless. We're willing to say that they'll be modified, and I should just say, the extent of rate hikes that we've seen would historically create a much deeper and longer recession than what we currently have.

So we're already offsetting it with some of these post-COVID factors. But if we just look at the data, every single leading indicator, the historical precedent, they tell us that growth is lower in 2024. So it's really difficult when you're data-based, when you're looking at the traditional models, even when you're aware of offsetting factors, to throw out these economic relationships entirely. But, is it possible this time is different? It is, and we have to apply some probability to that. That's why active management that can be very dynamic, is really important in these environments. Too much conviction, all-in big bets, also inappropriate in this environment. Because the smartest people in this industry that I've ever known also have lower conviction than they've ever had. I don't think that anybody can look right now and have the tools to predict what will happen with higher conviction than what we've seen historically.

Kevin Headland:

I think it's so important, as you said, this time is maybe different, and I think it's important not to throw out the traditional factors, and all the data we've seen, and saying it's, "Pop the champagne." I think that's key there. But again, looking at other things, and trying to find the narrative there. So let's move to a second outlook piece you have, and you call it, Critical Concessions. We talk about inflation and central bank rates. Walk us through that point?

Frances Donald:

So again, getting poetic with it, Critical Concessions, we wrote our annual outlook, which by the way tends to get done at the end of November, because it has to go through digital designs and compliance, the way of the world, the idea that we would see rate cuts in 2024 was more contentious than it is now. Now it's fully consensus view, and we have been of the view that central banks would start cutting in the spring. So define your spring. I'm in Montreal. So spring is basically October ... Joking. So May, June, July is when the cuts start to happen. We had put in four or five or eight cuts. Again, at the time this was, people could not believe that this would possibly come through, inflation was still really high. And our view was that the economy would slow and that inflation was start coming down really quickly back towards 2%. And if the Federal Reserve and the Bank of Canada stayed at really restrictive interest rates, it would cause undue damage on the economy.

Now we have to remember, and I forget this too, is that a lot of central banks think in terms of real rates. So what is their interest rate minus inflation? As inflation gets smaller, the real rate gets larger. So the central bank philosophy is really that as inflation declined, if you don't cut rates, your policy gets tighter even by doing nothing. So our view is that even though inflation had not yet reached 2%, central banks would begin an easing cycle. I'll speak a little bit about scenarios as well here, because there is a risk that the recession is worse, that there is a financial accident. We had one more regional bank last week that was running into trouble. There are some ghosts of Silicon Valley Bank that are floating around, and there is some possibility of financial accidents.

In that case we could have central banks go much faster, and more with historical precedent. Right now, we have a gentle easing cycle. But again, I really think that the core story for most investors is not, "Does the Fed go in May or June?" It's not, "Do they go five times or seven times?" It's that the rate hike cycle is over. Every single central bank globally has now taken away their tightening [inaudible 00:18:13], from the Bank of Korea, to the Bank of England, to the Bank of Canada, to the Federal Reserve, they've all said, "We're done." And that is a more important story than some of the semantics around timing and number of rates.

Macan Nia:

So let me ask you this. So right now, last time I checked, market expectations for the Federal Reserve is that they'll basically cut five to six times overall, roughly a percent and a half, whereas in Canada it's roughly between three and four with only roughly 1%, which one of those, which investors are likely going to be disappointed, and disappointed by not seeing as many cuts?

Frances Donald:

So which bond investors? I do think that Canada has scope to cut faster, sooner, and for a longer period. That's just the economy is so much more sensitive to interest rates than the United States. A lot of it has to do with the housing sector, Macan. So as you know, many of your listeners as well, the US has 30-year fixed mortgages. So when the Fed cuts rates, it cuts them with a 30-year impact. For 30 years, people who locked in at sub 3% mortgages will have sub 3% mortgages. In Canada, we don't have that, and we've only seen about a one third of Canadians refinance at higher rates. There's two thirds to go. So we already seen the Canadian economy slow substantially more than the US, consumer confidence is much worse than the US. I think the cost of living crisis in Canada is much worse than in the United States.

You might think, "Well, that means the Bank of Canada has to hike more." But what's become clear is that the cost of living increases in Canada have very little to do with interest rates. They have to do with global factors and structural factors. So for me, more likely to go much more, but I continue to feel even though our base case is five to six cuts, that the balance of risks is really for a lot more easing this year than what is currently priced. So I would say worst case for bond investors, you're getting five cuts, best cases, you're getting substantially more than that.

Kevin Headland:

I'm sorry, five cuts, is that on the Federal Reserve, Bank of Canada that you're just talking there?

Frances Donald:

Federal Reserve, yeah, I think we have equivalent for Canada and the US maybe with one difference. The fact that I don't know that sometimes shocks me, because how could you not know specifically how many cuts you have? That's the economist bread and butter, right? Like, "Well, he has four, he has five. Let's get them for a bull/bear battle on BNN." But actually again, I work every day with portfolio managers, and they don't ask me those questions, "Is it four or five?" That's actually immaterial. "Is it four or 10?" That's a bigger question.

Kevin Headland:

The key is that the rate cuts, as you said, the rate cuts are coming, the timing is almost immaterial, but that the hikes are over, the pause is here, the cuts are coming, and that's the key. Also I think there's a lot of fear out there as well that the Bank of Canada is going to go so much faster and so much deeper in terms of the rate cuts than the Federal Reserve and it's going to cause some material impact to their Canadian dollar, currency. When you talk about inflation, a weaker Canadian dollars is in inflationary. So I'd like to think the Bank of Canada is aware of that as well, and will have some insight into that, and make sure they don't go.

Frances Donald:

The Bank of Canada is hyper aware of the currency. But I tend to push back against this argument, because what we've seen over the past few years, I mean, historically, when we looked at the Canadian dollar, it was driven by two things. It was driven by oil prices, and it was driven by the rate differential between the US and Canada. I remember working on very sophisticated FX desks, where we would talk about making more sophisticated models of the Canadian dollar, and it was always useless, because it was these two factors.

But more recently since COVID, we've seen the Canadian dollar get driven by other factors. One of them is just broad risk sentiment. So even when we've had rate differentials between Canada and the United States, the Canadian dollar has been whipsawed back and forth by broad US dollar movements. So I don't think that if Canada's economy requires easing because it's falling into a recession, it is much worse for the Canadian dollar, for the Bank of Canada to just wait, create a worse recession, and have to cut a lot more later on. So I don't always buy into the language that the Bank of Canada can't cut because it's constrained by the Canadian dollar. It's actually, if the Bank of Canada doesn't cut rates in response to a recession, it is probably worse for the Canadian dollar. That's what global investors will see.

Macan Nia:

So let's talk about the third theme of five, the big shift from a demand-driven world to one that is supply-driven.

Frances Donald:

So this one is, it's a little bit more structural in nature, and I can't say that it had immediate investment implications, but it's something we should all be really aware of. And actually this is really, started a little bit before COVID, but is really a new economic factor with COVID. That is that we're really seeing inflation and growth being driven by not how much you, Kevin, and I want to or can afford to go to restaurants or on vacations. And a lot more to do with are there enough people working at restaurants to keep the restaurant open? Do we have enough planes to send you on the vacation?

So the limits of our economy are becoming about the supply of things and labor and services. And much less about can we afford. What that means effectively is that governments probably need to shift their thinking away from, "Well, if we want to help the economy, let's give people more money," and move towards, "If we want to help the economy, let's help build out supply of things." Just supply chains, freedom of movement of trade. Making sure we unlock more labor in the system. And this is going to be really important for companies who are able to capitalize on that, and recognize that they're actually drivers of supply.

But the really big problem with this, and why it was a really important theme for me to put into this outlook, is that it also means that our economy and our inflation is less interest rate sensitive. So right now we still have a significant amount of inflation in the system even though it's come down, and food costs are not high because Kevin eats too much. That's not why prices are really high right now. Prices are really high for a range of reasons, including wars, massive weather events, bugs and pests that are destroying agricultural crops. These are not Kevin's fault, and they're also not interest rate sensitive.

So in a world where inflation and prices are being driven by factors that are not interest rate sensitive, the relationship between inflation and interest rates breaks down to a certain extent. That's in part why we say central banks are probably going to accept that inflation is going to run above 2%, and there's not much that they could do about it from their end. I think a little bit of our view of central banks as omnipotent beings who control our cycles. And if something's wrong, that Daddy Central Bank will come in and fix it for us, we're going to have to start questioning that a lot more.

Macan Nia:

I think that's a really interesting one, because climate change is always brought up in this conversation, and its impact on economies and so on and so forth. So I was reading a report, it was basically saying, in the next five years, based on where the temperature, this is from NASA too, where temperatures are going to be heading, which is not material over the next really five years, is they estimate basically that corn crop yields are going to decline by 25%. While wheat is going to potentially see a decline of 15%. That's going to have impacts on food inflation. Because we know corn is one of the primary things used in feed, and if the crop yields are declining by 25, it means the cost is going up.

We're also seeing it from a active management perspective too. When it comes to stock picking, you might say how? Well for anyone that skis you've noticed the past couple years, the ski season has been horrible. Those images last winter, really of Europe, you show there, and it's basically the mountain is, it's green. And companies like Vale, or anyone attached to the ski industry is going to see a decline in revenue. They say actually they expect ski seasons to be declining by 50% in the next couple of decades. So these are not pie in the sky ideas without investment implications, there are investment implications, and we're already seeing them today, whether it's from an inflation lens, or whether it's from an earnings perspective.

Kevin Headland:

Adding to that, I think it's one of the important aspects, is finding alternative asset classes, rather than the traditional fixed inequities like infrastructure and other areas in farmland and timber and whatnot. To look at these impacts and perhaps take advantage, or reduce the risk as well. So it'll be interesting to see as we go forward, is as we start taking climate change into consideration, and not ... Everyone says ESG, and people will go, "It doesn't really matter." It's like the impact of actual these events happening on our livelihood, our data, not necessarily looking at CPI all the time, and, "Oh, it's elevated," but what are the other aspects? How does it hit the real world, shall we say, versus just the traditional economic data?

Macan Nia:

And Frances, you mentioned the demand and supply. Well think about the supply of labor, and there's been multiple reports of countries that are more vulnerable to climate change. When you look at the map, it's China, it's India, it's Bangladesh, it's Indonesia, it's these countries that are along these coastal lines. If there's a weather event, or sea levels increase, it's just the supply. I think back to Manulife, we have a call center in Manila, and they were unfortunately hit by a tsunami, I believe. For a week, 10 days they weren't able to be at the call center. So it's these types of impacts. I think people think of climate change as these big aspects, but more often than not we see the impacts of it on a day-to-day basis.

Kevin Headland:

I think it's a great segue, especially because we talked about near-shoring, onshoring, friend-shoring, and perhaps diversifying supply chain management to perhaps protect or insulate ourselves from the traditional risks that may exist, whether it's trade or weather events. This is our fourth theme that you have, Frances, it's Out Of Sync, desynchronization.

Frances Donald:

Yeah, so I think for years people have had in their outlook something about de-globalization, and it's clear that the pace of globalization has slowed considerably, if not reversed. Hard to measure this concept, it's like almost a philosophical concept. But every textbook that any of us and probably any of you listeners listening to us today, ever read said, "Free trade is better for everybody. If you trade with the lowest cost provider, everybody wins." Then in 2016 we started to see some pushback against that. Brexit, President Trump, tariffs. We've begun to see this decoupling of certain trade nations, companies that say, "We don't want to have a single provider of," let's say, "This widget that's part of our resource because something like COVID can happen, and then you can't get access to it, in your whole production line is shut down. So we're going to have two providers or three providers." Some of them are going to be a little bit more expensive, but it's an insurance policy against potential disruption.

I think we're evolving now, so de-globalization is still in play, but what the end result of that is, is actually desynchronization. In the past, if you had two islands trading together, one island started to do really well, the second island would do really well too. But now what we're witnessing, is that there are pockets of the world that did terribly in 2023, Europe for example, sank into recessions or almost recession because they were really exposed to manufacturing activity globally. Now what we're seeing is manufacturing activities starting to improve, and these economies that were really suffering last year are actually starting to do a little bit better. We're seeing that the decoupling of certain trading partners is leading to desynchronization.

Some of you may have noticed that Chinese equities are in this terrible tailspin, and there are times at which that would've bled into US or other providers, or other countries, and that just hasn't happened to the same extent this time. There's another word for desynchronization though, and it's, "Opportunities," because it means that they say a rising tide lifts all boats. Well, a sinking tide could sink all boats, but when you have this desynchronization, we're all playing in different oceans, and as one tide might be going down, another one might be going up. That's why I actually, I don't just say this because I work for an active manager, but this desynchronized world is one in which active management can really shine, because you are going to have pockets that are doing better than other pockets. This is the natural follow-on from a de-globalized world, is a desynchronized world.

Kevin Headland:

I think that's key where you say, "Active manager," there is also, it's not also about the geography that the company may exist in, or where their head offices are, or where they're listed on a stock exchange. Looking at companies, and not only are there opportunity where they can take advantage of something, but also companies that may be more at risk, with companies that are slow to diversify their supply chains. Or we'll get companies that are less sensitive to some of the risks out there, that maybe, I think, maybe this is where technology and AI and those companies can benefit, because perhaps they're less sensitive to some of the change in the actual physical world, and more in, I don't want to say the, "Meta world," but the technology world.

Frances Donald:

And critical, Kevin, is that what made a company a great company even four years ago may be different now. When we talk about a new economy rising, which is the whole big picture theme of this, effectively what we're trying to say is we are at an inflection point cyclically, but also structurally, where interest rates and inflation are changing, the regional pockets are better. We have new drivers like AI that are going to change what makes a company, what makes a sector, what makes an index valuable in this context. So my big ask from strategists on my team, and also my clients, is not to always get it right, but to recognize that factors are changing. If we are going to get it right, it starts with understanding it is a new market than it was four years ago, 10 years ago, definitely 30 years ago.

Macan Nia:

That's a good transition to the last theme, which is Fiscal Dominance. And you mentioned earlier on the podcast how there's been a lot of government, federal, provincial support, and that may have tempered the actual pain that we would have felt if there wasn't that support. I look at Canada as a perfect example. The federal debt interest costs nearly doubled to roughly 47 billion. You have this same dynamic in the US, where for the first time, net interest expense is the fourth-largest expense for the US government, at I think it's like 220 billion. It trails only Social Security, National Defense, and Health. So moving forward, talk to us about this fiscal dominance, but also with the backdrop of most of these governments may not have the flexibility or room to spend as much as they have historically, based on the absolute measure of their debt, but also given what interest rates are today. They're going down, yes, but they're not going down to levels that we saw pre-COVID.

Frances Donald:

Yeah, so I really snuck this theme in there.

Macan Nia:

It's a sneaky theme, sneaky number five?

Frances Donald:

It's a sneaky theme. Actually if I'd had my way, I might've put it as the first theme, but it's a bit of a sneaky theme. And I also can't believe that I managed to get away with calling it, "Fiscal Dominance." So that's a feather in my cap there. So why did we talk about this? So a few reasons is that the size of governments is growing so substantially and in every economy globally. That's really important, because sometimes I'm asked, even by governments themselves, "What's the limit on our spending?" The limit on spending is actually often a function of how much money can you borrow? How much money you can borrow when you're a government is in part based on your own credit-worthiness. But it's also like are you the cleanest dirty shirt? Are you the best person to lend to? You may remember last year, we got some downgrades on US debt, because as exciting as we think Canadian politics are, they're not nearly as exciting as US politics, and debt ceiling debates and shutdowns.

Remember when we had to stay up late thinking about whether we're going to write a government shutdown note again, dusting off those pieces. So the question of can governments keep spending, is they can if they're all spending. But the main reason that I think big governments is important, is because it's actually really messing with the way that we track economy for two reasons. The first is that I don't know if governments just forgot they're Keynesian textbooks, or if they threw them out, but historically, what we were all taught, is that governments can do the best for their economies when they spend in bad times, and pull back in good times. So in good times you let the private sector run. And in bad times when the private sector pulls back, you step in, because guess what? We're not all heartless. I don't want single moms who can't pay, or can't feed their kids, or are worried about rent. We step in bad times.

In the past three years following COVID, we saw extensive expansion of deficits in government spending, again, almost every major economy around the world, particularly in the US and Canada. What this did is it provided juice to the economy that it probably didn't need, and it muddied our leading indicators. So because this is atypical, a lot of the ways in which we would monitor growth would say, well, private sector growth should be slowing, and it did, but it was offset by government spending. So we have to reconsider how public sectors work in these economies. Now I suspect that this was a one-off.

The second reason is that we have a significant contribution in government workers growing, and that this is providing offset for private sector jobs and making the economy appear healthier than it really is. So if governments are larger on a permanent basis, it's going to mute our economic cycles. It's going to mean that our highs are not as high, and our lows are not as low, and that's important. It could mean that we go longer between recessions than we have historically, and it could mean that we don't get growth that's as big or as productive as it has been historically. These are factors that really weigh on the way I think about the world differently. I don't worry about failed bond auctions, I don't worry about governments running out of money in the next, particularly not in 2024, but there will be political pressure of course on all governments to rein it in. I have been on other podcasts where I've said it doesn't make sense to say governments should just stop spending as much money. It really depends on what they're spending on.

So for example, in Canada, if the federal government said, "Hey, we're going to expand our deficit by building a heck of a ton more houses for everybody," that would be deflationary. It would bring down house prices, probably boost the economy, and I bet you bond markets would reward Canada for two weeks. If the Canadian government said, "We're going to spend exactly the same amount of money, and we're just going to give it out in checks to people who want to buy homes," it would increase prices, because there'd be more bidders for every house, worsen the economy, and the bond market would penalize you for it. So the idea that large governments are by themselves a problem, I'm not so sure, I believe that. It's really about what they're spending on that matters a lot more, especially in the context of a supply drip.

Kevin Headland:

I think it's so important there, because the whole idea of the Keynesian economics. And the idea is you spend to grow, right? You spend money because ... And the cost of that spend, so your interest cost is less than the return on invested capital, which is your economic growth. Debt can be a good thing as long as you benefit from that debt. It seems like especially COVID, of course, it was a natural reaction. We had to just throw money at the problem. We didn't know what was going on, but it's almost like this has changed the way people are thinking now.

Now can governments just do the same thing next time there's a slowdown, regardless of what it is. It's almost like the public sector, which should take, or the private sector, excuse me, which should take the lead on the good times, was like, "Yeah, I don't have to do it. The government will step in and support me." It's like you have that child who's like, "My parents will bail me out." And are we getting that factor where it's like, "Yeah, we don't have to do as much, let the government help us out?"

Frances Donald:

Out. Are we going to do a spinoff podcast called Politics Unplugged?

Macan Nia:

Yeah, Conservative Leaning came out in that response right there.

Frances Donald:

Look, I don't know, I'm an economist who looks at numbers, but what we do know, is there is such a thing as infrastructure. And one of the things that was established with things like CERB, or stimulus checks that were handed out over COVID, is the infrastructure for really fast support that goes directly to households. Another thing that is related to this, Kevin, is central bank digital currencies, which might sound like a crazy Elon Musk idea, but every major central bank has a CBDC, not CBD, CBDC department that's effectively exploring the idea that we all have digital wallets, and instead of central banks issuing quantitative easing, or sending stimulus through the banking sector, that they would just send it to our digital wallets more directly.

Macan Nia:

Amazing.

Frances Donald:

Now, there are some people who are huge believers in that, because they say, "Well, why are we relying on the banking system?" Because over COVID, a lot of that liquidity just went into the stock market. It didn't benefit individuals. So when I think about how do we help people in bad times, which I think even one who might be conservative-leaning would be interested in understanding. But in that type of environment, building out infrastructures that are superior to the ones we've had in the past, I think, is going to become really important. COVID established a lot of new support infrastructure that we didn't have before.

Macan Nia:

Yeah, I think that di. I think we could do a podcast in itself on the Central Bank digital currencies. Because I think it's very misunderstood, but I think there's a lot of misconceptions in terms of these central bank digital currencies, and the mechanisms of why they're looking into it as opposed to just being a cryptocurrency alternative. But we'll save that for another time. But I think that's a good place to stop, really good overview in terms of the five macro themes, if you want to go more into detail, I know Frances and her team have published it on the Manulife Investment Management website. It's readily available, more details, but any other closing comments, either Frances or Kevin before we log off?

Frances Donald:

First of all, I want to thank you for having me on to talk about these themes. We really made a choice to avoid making an outlook that was like, "This is our GDP point forecast, this is what we think the inflation number is going to be," because this is a really uncertain year, and there's a lot of focus on the headline-grabbers, the decimal points. For most of us in 2024, it's going to be about the direction of growth, the direction of interest rates, having a plan for a couple of different scenarios, and looking under the hood a lot more when it comes to your individual asset classes. Recession or no recession, relief cycle, and interest rates are going to be coming down, and that's the most important thing to remember. May, June, July, semantics. It's the big trends that matter this year.

Kevin Headland:

I think that's a key comment there. It's not about getting things perfectly right, because that doesn't really matter. We talk often about the balance of risks. And if we can identify the balance of risks, that we already are well ahead of our plan and our strategy for investments and allocating our assets. I think that's key, is identifying where those risks lie and where we're headed.

Macan Nia:

I heard many years ago, and I live by, "Don't fight the Fed," when central banks generally are easing markets like that, whether their bonds or equities, and I think this year we all agree, don't fight the Fed. Now, to your point, the details are semantics, Frances, but for our clients that look back at their 2024 returns, given that these themes that we all envision unfolding, it looks like it will be likely a good year for equities, and for bonds again. So with that Frances, I know you're extremely busy, so thank you for making the time and joining Kevin and I. Kev, as always, thank you so much. And on behalf of Investments Unplugged, this is Macan Nia.

Kevin Headland:

And Kevin Headland. Take care.

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