Connor, Clark & Lunn Investment Management logo.

Commentary

Forecast – 2025

January 21, 2025

Woman sitting on top of a mountain during a colorful winter sunset. Taken on Tunnel Bluffs Hike, Anmore, BC, Canada.

This year’s Forecast begins with a synopsis of 2024 before delving into the secular themes shaping our outlook, and then examines the shorter-term cyclical factors affecting the economy, inflation and monetary policy. We assess market valuations and, considering these elements, establish our portfolio strategy.

Throughout the next year, updates to our forecasts will be highlighted in our quarterly newsletter Outlook.

Introduction

“While wars divide, the world unites in easing policy” was the overarching investment theme in our 2024 Forecast, which guided our asset class forecasts and positioning. Disinflation was achieved more rapidly across numerous countries and occurred more easily than expected. Global supply shocks eased, and tighter financial conditions reduced inflation pressures uniformly across the world. Geopolitics and domestic politics were enduring and critical themes. Countries engaged in wars on multiple fronts, as the interconnected trade’s unipolarity and peace dividend fractured. Many governments faced immense pressure, with around 40% of the global population heading to the polls, and the outcome a widespread rejection of the status quo due to inflation concerns which pressured cost of living for the populace.

The second half of the year was dominated by the US Presidential election. We had correctly believed that US monetary and fiscal policy stimulus would persist in a resilient growth environment. That combination of stimulus led to an upside surprise to growth in the US, allowing it to outpace other countries. We were caught off guard by how incongruent the upside surprise to growth would allow for persistent disinflation throughout the year. We were, however, right on with regard to our call on Canadian consumers’ inability to stretch given their already high debt loads. We believed any downturn would be mitigated by savings, cash balances and accumulated wealth.

Financial markets experienced a number of jittery periods, such as when the Sahm Rule was triggered raising recession alarms, and later the Bank of Japan’s rate hike led to a significant unwinding of the yen carry trade. The Federal Reserve’s (Fed’s) September rate cut provided some relief, but the prospect of a trade war with Mexico, Canada and China in November caused an end-of-year retracement.

Our forecast saw balanced risks after the rise in equity market valuations in 2023. As it turned out, we were correct on the continued room for earnings growth, but there was also room for multiples to continue to expand. Our expectations were conservative and globally, equity markets posted strong advances. The Nasdaq led the charge with a 30% gain after the 43% surge in 2023. We expected the S&P 500 to end the year at about 4975, and instead the index gained 24% to reach a high of over 6000 before a modest cooling to end the year. The S&P 500 posted a similar gain in 2023, marking the first back-to-back gains in excess of 20% since 1997-98. Despite the continued tech-heavy leadership, the optimism of investors broadened out to encompass more sectors and regions. Ten of the 11 GICS sectors posted advances with only the materials sector ending 1.8% lower. The MSCI ACWI gained 26% led by US stocks but was bolstered by gains across nearly all regions. Japan’s Nikkei finally eclipsed its 1989 high, posting its second straight annual gain of 16%. In Canada, the S&P/TSX Composite also benefited from investor enthusiasm with an 18% jump to hit a high of 25,691, bettering our expectation for 22,000 at year end.

Strong returns across geographies
Total returns in local currency rebased at 01/01/2024 = 100
Line graph illustrating total returns for the S&P/TSX Composite Index, the S&P 500, and MSCI ACWI in local currency rebased at 01/01/2024 = 100. Each index is in a rising trend in 2024.Source: TMX, S&P Global, MSCI, Macrobond

Rate cuts from central banks took longer to begin than many anticipated, leaving sovereign bond markets struggling to advance. However, even when central banks cut rates, longer-term yields did not fall. In Canada, 10-year yields finished the year 15 bps higher, even though the Bank of Canada (BoC) was among the most the aggressive in the world with easing policy, reducing rates 175 bps in 6 months to bring the overnight rate back into its neutral range. The US actually saw 10-year Treasury yields increase 60 bps as the Fed cut the overnight Fed Funds Rate by 100 bps. US long-term interest rates moved higher for a fourth straight year, the first time since 1977-81. As the year came to a close, two main features were the normalization of yield curves – which are now positively sloped after over two years of inversion – and the deep negative gap in Canada-US yields. Bond returns benefited from a decent yield this year, as well as strong credit markets that took spreads to their tightest levels since before the 2008-09 Great Financial Crisis (GFC). We were on the mark expecting modest returns of 3-6% this year for the FTSE Canada Universe Bond Index, which ultimately returned 4.23%. Our strategies had a good year, as each of the quantitative factors, yield curve and rates call, as well as security selection contributed to performance.

A normalization finally
Line graph illustrating Canadian 3-month yield declining lower than the 10-year bond yield, indicating a normalization in the yield curve.Source: Macrobond

The asset allocation strategy for balanced portfolios considered the high valuations of US equities and an overall conservative call for equity markets which led us to underweight global equities against Canadian equities to start the year, although this gradually moved towards a more neutral stance. Our call to overweight cash and underweight bonds was appropriate given the persistent inverted yield curve. It took some time for us to gain confidence in the easing trajectory as central banks defied expectations of accommodation until mid-year. Balanced portfolios exceeded their benchmarks largely due to security selection across each of the asset classes as asset mix positioning was broadly neutral.

In summary, the year will likely be remembered for the political circumstances and beneficial macro backdrop of easy policy in a resilient economy. Those conditions laid the foundation for the very strong returns from equities and positive returns from bonds, capped off by strong risk-on investor sentiment that saw gains broaden out over geographies and asset classes which all rewarded investors.

The secular environment

The era of secular stagnation is behind us and for several years now, our secular themes recognized the shift away from a broad disinflation environment to one where inflation is once again a key risk. This past year, electorates voted out incumbent governments, dissatisfied with inflation and immigration. Policymakers face a material challenge in answering those calls for action. Our first secular theme recognizes the potential that inflation is not only cyclical in nature, responding to an immediate imbalance between supply and demand, but could also return in force as a result of determined policy actions.

As we enter into 2025, we revisit our secular themes while assessing the cyclical influences in the foreground. As we have for the past five years, we believe there continue to be upside secular pressures to inflation, and now note the potential for a cyclical upside to inflation as well. These include the potential for tariffs (and retaliatory action), and the expected reduction in overall in migration. After three years, avoiding a recession has now become consensus. A lot of good news is priced into markets. We also note that it is often the normalization of yield curves that actually portends a recession, as short rates drop to stimulate the economy.

1. Inflation resurgence is an underappreciated risk to valuations

  • The high inflation of the 2021-22 period has been tamed with remarkable success. Historically, whenever inflation hits 5%, it has typically taken more than a year, along with a recession, to bring it to heel. We now have inflation around central bank targets, without having experienced a material downturn. This is partly due to positive offsets from fiscal policy, the offsetting benefits of higher interest rates to savers, and the positive wealth effects to owners of real estate and stock portfolios. Indeed, across dozens of countries and cycles over the past century, a second wave of high inflation is the norm. Intuitively, this is because workers or businesses that operate on fixed contracts attempt to catch up with new higher priced contracts well after the first wave of inflation has passed. This disinflationary cycle is not over, and, in the US in particular, the main policies for the incoming administration will ultimately prove inflationary. The pressures could come from several potential sources: increased demand driven by lower taxes, continued infrastructure investments, lower supply resulting from the imposition of large tariffs on incoming goods or large-scale deportations of workers.
  • The path of inflation has similarities to the mid 1960-80 period when a second inflation surge hit the US economy as the economy was recovering from the 1973 oil shock. Indeed, following any major global shock such as pandemic or war, the extended periods of rebuilding have led to volatile periods of inflation. Central banks recognize these risks. For the past five years, markets have been underestimating the Fed’s hawkishness, pricing in rate cuts early and recalling the recent zero interest rate periods. Notably, in the December 2024 Summary of Economic Projections, the long-term dots for the Fed Funds target rate actually went up for the first time in over a year.

Inflation path has similarities to history
Line graph illustrating that current US CPI inflation from 2014 onward, plotted against the path of CPI inflation from 1966 to 1982. The current path is following a similar trend relative to the historical period, which suggests a reacceleration to come.Source: BLS, Macrobond

2. Interest rate volatility rises between push of fiscal dominance and pull of bond vigilantes 

  • Governments have embraced fiscal spending as a powerful approach to managing crises and gaining favour with the electorate. Federal debt levels have surged in recent years at a faster pace than economic output, thereby sharply increasing the basic metric of a country’s fiscal health: debt-to-GDP. In the US, the debt-to-GDP ratio has soared from about 33% during the GFC in 2008-09 to about 100% today and the Congressional Budget Office (CBO) forecasts that will grow to 160% in 2050.

US debt projected to grow
Line graph showing US federal debt to GDP is projected to grow significantly over time.Source: CBO, Macrobond

  • While debt at 160% of GDP sounds unsustainable, there is no clear level at which investors balk. Indeed, Japan’s debt-to-GDP currently at 157% is not far off that level. Nonetheless, there have been plenty of examples in recent years of growing concerns amongst investors globally. The September 2022 UK budget under Liz Truss triggered bond market upheaval and the 2024 budget under Reeves was also declared overly inflationary. French spreads have also widened over other EU countries as debt levels have risen to 110% of GDP, and its debt was downgraded in mid-December. The bottom line is that bond issuance is likely to grow to meet the deficits, and investors will demand a rise in term premiums.
  • This creates a vicious circle that will see debt service costs overtake all aspects of discretionary spending in the US federal budget (i.e. excluding the 2/3 of the budget that is Medicare and social security). In order to meet the cost of servicing all that debt, the Fed may face pressure to limit rate hikes and fund deficits through bond purchases, subjugating monetary policy to fiscal dominance. The ultimate outcome is higher interest rates but equally important, increased volatility in rates that will force a rethink on the valuation of risk assets.

3. Artificial intelligence (AI) and the capital investment cycle

  • AI burst into the public consciousness in 2023 and expectations for its impact on the world were high. These expectations haven’t waned and according to Morgan Stanley, to capture the AI benefits, businesses are projected to invest $1.5T between 2024-27 as they look for ways to integrate AI into operations in the hope of productivity surges and improvements in margins. We are reminded that new technologies often take longer than expected to bear fruit; a study conducted by the Census Bureau last year found that only about 5% of American businesses said they are using AI. However, improvements can come with stepwise breakthroughs and investments will persist as firms search for AI-driven productivity enhancements.
  • The focus on AI has already been a major feature of the resurgence of private sector business investment. Kick-started by fiscal stimulus to support private sector investment through infrastructure (Infrastructure Investment and Jobs Act), clean energy (Inflation Reduction Act) and domestic high-tech manufacturing (CHIPS and Science Act), an outcome of the AI arms race is the disruption that is underway in the industries required to support its development. Specifically, data centre construction, development and manufacturing of computer chips, cooling systems and servers as well as electricity production and distribution. AI has compounded the need for both augmenting and creating resilience in electricity generation on top of the already surging growth emanating from decarbonization initiatives and electric powered vehicles. The International Energy Agency estimates global investment in grid infrastructure was $400B in 2024, up 1/3 from 2020, and will rise to $600B annually by 2030.

Grid investment expected to surge
Bar graph forecasting a surge in energy grid investments over the next five years.Source: IEA

The cyclical environment

World: The big adjustments to come

  • Elections across countries covering half the population of the world last year broadly yielded changeovers in government. Incumbents were defeated and new policies are set to begin. Against this backdrop, positive and in some cases resilient growth, easing monetary policy, profligate fiscal policy and easing inflation pressures are creating the conditions of a ‘goldilocks’ scenario. Disinflation has come more quickly, across more countries, and has been achieved more easily than expected. Global supply shocks have eased and, combined with tighter financial conditions, have reduced inflation pressures across the world. While services inflation is broadly higher, goods prices have done a lot of the work. The International Monetary Fund (IMF) projects the world economy to grow at a 3.2% pace in 2025, just mildly slower than the long-term average.
  • Looking ahead, two main challenges remain. First, as the world faced down the pandemic, rebounded from deep recessions and successfully tamed inflation, many Western economies now face the challenge of having to remedy the massive fiscal deficits brought on to deal with those challenges. The choices will be some combination of revenue growth, cutting spending or finding a way to produce non-inflationary growth. At the same time, governments are also under pressure to raise defense budgets, lower taxes or increase spending on aging populations. Large budget deficits, and the cost of servicing that debt, could restrain growth across the globe.
  • Secondly, one of the most consequential shifts in global markets over the next year and next cycle will be assessing where neutral rates are, which may, in turn, lead to a broad repricing higher in long-term interest rates. For nearly 15 years, most investors and central banks have held neutral policy rates in the US at around 2.25-3.25%, but given increasing evidence of the resilience to higher rates, neutral may in fact be above 4%. With the rise in population, productivity and business investment in the US, the post-pandemic level of neutral could be markedly different than pre-pandemic.

Canada: Political winds of change – it’s our turn

  • The Canadian economy has exceeded expectations, avoiding a recession in 2024. However, Canada faces a number of well understood issues, from the lack of political leadership and high debt levels, to trade uncertainty. Most recently, the high-profile resignation of Finance Minister Freeland last December followed by Prime Minister Trudeau in early January have taken centre stage. While the headlines in the first quarter will be filled with the leadership race of the Liberal party, the markets will rightly assume the main opposition, the Conservative Party led by Pierre Poilievre, will form the next government, given the massive 20-point plus lead in the polls.
  • On some policies, a Poilievre government would simply continue with the status quo. An example is the recent proposal to limit immigration from 2025-27 and to reduce temporary residents to 5% of the population. Population growth gave a big assist to the Canadian economy in helping to avert a recession in the last two years. Looking forward, the capping of in migration will reduce labour supply, and businesses may adapt by taking advantage of the lower interest rates to increase spending on productivity-enhancing business investment.
  • Trade uncertainty was already on the docket, as the sunset clause on the CUSMA free trade agreement was set for 2026. The new US Administration has already threatened new and expansive tariffs on its three major trading partners including Canada, looking to apply pressure on a number of unrelated fronts such as border crossings. It remains to be seen how much is bluster and negotiating, but we can be certain that levying tariffs would be detrimental to growth and raise US inflation.
  • Finally, consumer balance sheets look markedly different depending on which side of the border you reside and these differences will result in further policy rate divergence between the BoC and Fed. The BoC has now lowered rates to a neutral range, but we believe it will push ahead with two more cuts in the first half of the year. Any external shocks will force the BoC to ease policy to an accommodative stance. Canada was early and aggressive in cutting rates. Already, the highest interest rate sensitive sectors, such as housing, have begun to see interest rekindled, with pent-up demand, tight housing supply and better affordability bringing buyers back into the market.

Policy is now at top end of neutral range
Chart illustrating that the Bank of Canada policy rate is now at top end of its neutral range.Source: BoC, Macrobond

US: An outperforming economy faces the test of new policy directions

  • The US continues to lead the developed world in economic momentum. This exceptionalism is now well understood. The economy absorbed the 2021-22 rate hikes and kept on growing. It is now the only major economy where output is above pre-pandemic trend levels. The picture continues to remain bright with inflation returning to the 2% target and the unemployment rate stable around 4%.
  • The next four years will be dominated by the incoming administration’s policies and reactions from the rest of the world. The incoming cabinet looks different than in the first Trump term, with fewer foreign policy hawks and more pro-US business members. Nonetheless, the policy agenda is relatively clear, if light on details. Two policies are aimed at boosting growth: extending earlier temporary tax cuts (in an environment of already large Federal deficits) and deregulating the energy, finance and technology industries. Two other important policies centre on “America First.” The first is to dismantle global trade by imposing tariffs and promoting foreign investment in domestic manufacturing to bring jobs to the US. The second is to deport illegal immigrants, reducing the supply of labour.
  • Interestingly, while the tax cuts and tariffs garner the most attention, it may be deregulation and deportations that are ultimately more impactful. Many migrants have been working in labour-intensive industries that could face upward wage pressure. This will be passed through to consumers in necessities such as food and housing costs. The Peterson Institute’s research suggests that deportations will lower US GDP by between 0.5% to nearly 2% each year for the next four years. Indeed, with the US labour market tighter now than during the first year of the first Trump presidency (unemployment rate of 4.2% vs 4.7% in January 2017), reducing labour supply will cause upside pressure on wages. Meanwhile, deregulation and the associated substantial cuts to the public sector through the new Department of Government Efficiency, has generated some optimism over a streamlining of the entire government apparatus. US small business confidence has soared.
  • As a result, the Fed has reduced its guidance for 2025 rate cuts. We believe this flatter path of rate reduction will not significantly hurt growth prospects as the current consumer spending strength is not arising out of credit expansion, but instead, strong household net worth growth. Indeed, we believe a key risk to growth is asset price volatility that could have the effect of dampening consumer spending.

US net worth in rising trend
Line graph illustrating a rising trend in US net worth as a share of disposable personal income.Source: Fed, Macrobond

Europe: Not all bad news

  • Political and fiscal challenges within Europe’s largest economies compound geopolitical frictions. The German government led by Olaf Scholz and Emmanuel Macron’s government in France both fell in 2024. Sovereign bond spreads in France have risen and the euro has declined over 5% against the USD, appearing to be on the way to USD-parity. Real GDP will be challenged to rise, given the structural headwinds from trade policy. That includes US tariffs, competition from China in many areas (including autos, where Europe has historically played a leadership role), as well as a weak Japanese yen.
  • There is reason for optimism elsewhere in the eurozone. First, fiscal consolidation has been widely expected, with the most recent plan to return to neutral fiscal stance this year. However, given the problems in recent months, talk of fiscal restraint by reintroducing the EU fiscal framework that limits debt and deficits as a percent of GDP has now died down. Thus, concerns over a fiscal drag are easing. This is particularly true in Germany as even Bundesbank head Joachim Nagel said in early December that they need to loosen the “debt brake” that limits borrowing to 0.35 percent of GDP, in order to address structural threats. He has suggested measures such as boosting infrastructure and defense spending. This will support growth in the coming year.
  • Separately, inflation is slowing, which will help real incomes as wages remain decent, and allow the European Central Bank to continue gradually providing stimulus. Finally, solid growth is being recorded in other European countries, notably Spain and Italy. In a turn of stability, Italy will be the only G7 country with no change in leadership these two years.

Euro area wages have not eased
Line graph showing that Euro area wages have spiked to record highs in recent readings.Source: ECB, Macrobond

China: No preemptive fiscal plans, readying for negotiations on global trade

  • Much in China has changed in the eight years since the beginning of the first Trump presidency. Notably, the real estate crash has resulted in a severe balance sheet recession that persists today. The government has taken a hands-off approach and not stepped in with fiscal stimulus or rescue packages. As a result, interest rates have dropped materially, hitting 1.6% and falling below Japanese yields. Elsewhere, however, economic data has surprised to the upside. Export growth remains strong, with manufacturing PMIs now back in expansionary territory at the end of 2024. Some of this is likely front-loading and inventory building with tariffs on the horizon. Nonetheless, it is worth noting that since 2017, Chinese exports to the US dropped from roughly one fifth of overall exports to just 15%, and trade partnerships have instead expanded in LatAm and ASEAN.
  • Fiscal spending, whenever the government chooses to deploy it, should lead to improved growth prospects. For instance, a surprise People’s Bank of China policy package in September last year included CNY800B of liquidity support for the stock market. It produced a short-term reaction with the CSI surging 30% in a few days, but has since eased back. Into this year, the Chinese government is unlikely to engage in significant preemptive large fiscal support for consumers in the same way, instead reserving firepower for upcoming negotiations through the second Trump presidency.

Bond yields in China fall below Japan
Line graph showing 30-year bond yields in China falling below those in Japan, closing a previously wide gap that had persisted for the last ten years.Source: JBT, Macrobond

Valuation

VALUATIONS: Earnings growth will be vital in 2025 

  • The growth of corporate profits in Canada was modestly positive in 2024, impacted by higher interest rates, lower energy prices, sluggish productivity and a weakening economy, all of which combined to exert pressure on earnings growth. Conversely, US corporate profits exhibited strong, high single-digit growth, driven by robust consumer activity, a stable labour market and a resilient non-manufacturing sector, underscoring US exceptionalism.
  • For 2025, we anticipate continued growth in company earnings within the US, alongside an acceleration in Canada. Less restrictive monetary policy is expected to ease financial conditions, supporting GDP and earnings. We foresee earnings growth extending to more sectors, fostering a more stable environment in both the US and Canada. In Canada, the high consumer savings rate and lower interest rates should support spending. Furthermore, a federal election could stimulate economic activity under new leadership. However, the risk of tariffs persists, and the extent of their impact remains uncertain.
  • Corporate profit margins in 2024 remained steady in Canada and expanded moderately in the US. In 2025, we anticipate margin growth in both countries due to gradually declining labour and other input costs, diminishing regulatory and interest expenses and broadening revenue growth across a wider range of sectors compared to 2024.
  • In the US, we see a 12% rise in earnings per share (EPS) for the S&P 500 this year. With broader stability expected across sectors in the Canadian economy, we expect 8% earnings growth for the S&P/TSX Composite. Our 2025 EPS forecasts are $268 per share for the US – modestly ahead of consensus forecasts of $263 – and $1,540 per share for Canada – modestly behind consensus forecasts of $1,600.
  • Global earnings growth for the MSCI ACWI is projected to be slightly lower compared to Canada and the US. The highest earnings growth globally is anticipated to come from the US and emerging markets. However, with muted growth in China and persistent challenges in Europe, these regions are expected to weigh on the overall rate of global earnings growth.

Earnings growth to rise further
Trailing earnings growth
Line graph showing the annual growth rate in trailing earnings for the S&P 500 and the S&P/TSX Composite indices.Source: I/B/E/S, Bloomberg, Macrobond

VALUATIONS: Multiples to remain stable

  • In 2024, valuation multiples saw steady expansion through the year, reaching exceptionally high levels in the US and multi-year highs in Canada. The combination of resilient economic activity and decelerating inflation supported the “soft landing” narrative, which was conducive to multiple expansion. Additionally, the US presidential election contributed to the positive market sentiment that drove this expansion.
  • In 2025, price-to-earnings ratios (P/Es) in Canada and the US are likely to remain broadly unchanged at about 17.3x and 24.4x, respectively, on a trailing basis. Valuation multiples are currently higher than average, especially in the US. Although less restrictive monetary policy and positive economic activity support multiple expansion, these factors are largely accounted for in current levels, suggesting limited potential for further upside from here. Our year-end index estimates are 6,545 for the S&P 500 and 26,700 for the S&P/TSX Composite, driven by earnings growth. These forecasts are modestly lower than the market’s current projections and imply a low double-digit return in the US, and a high single-digit return in Canada from year-end 2024 levels.
  • Global equity market valuations have expanded, though to a lesser extent. P/E multiples in regions outside of the US, such as EAFE and EM, have risen but remain below or near historical averages. Multiple expansion is expected to be limited in these regions in 2025, although accommodative monetary policy and stimulus measures in China suggest more capacity for expansion relative to North American markets. Mid-to-high single-digit returns are anticipated for global equities, with expectations that EM equities will outperform other global regions, although Europe may see a rebound in the second half of 2025.

Valuation multiples show little room for expansion
Line graph showing trailing price-to-earnings multiples for the S&P 500 and the S&P/TSX Composite indices. The multiple for the S&P 500 has surged recently is near record high levels, while the multiple for the S&P/TSX Composite index is lower.Source: I/B/E/S, Bloomberg, Macrobond

VALUATIONS: Bonds subject to macro volatility

  • Bonds performed well in 2024 during the easing cycle. Looking forward, ongoing macro uncertainty is likely to keep policy rates fairly stable, as the Fed and the BoC adopt a more gradual approach to monetary easing. The Fed in particular, will need to proceed cautiously. Although interest rate cuts are still projected, monetary policymakers appear to be nearing the conclusion of their easing cycles, barring a further slowdown. During this transitional phase for policy, market narratives are expected to fluctuate, and bond yields are likely to trade with some volatility but within a contained range. Outside of this range, bond yields either stimulate the economy or become restrictive enough to cause a pullback. If rates remain in this current range, the “soft landing” narrative should prevail.
  • In 2024, the yield on Canadian 10-year bonds increased by 0.11% to reach 3.24%. This modest rise conceals significant intra-year volatility, during which the 10-year yield hit a low of 2.89% and a high of 3.47%. We anticipate that yields will continue to trade within this broad range, provided that economic growth remains positive and inflation is well-managed. In our assessment, bond yields are likely to break higher in the event of a sustained resurgence in inflation or lower in the case of a pronounced recession – scenarios which we do not consider highly probable at this time. As a result, for 2025, we expect the 10-year Government of Canada bond yield to trade in the 2.9% to 3.5% range, with the yield at the start of the year near the middle of this range.
  • We have a positive outlook for bonds in 2025, expecting yields to remain range-bound across the curve. Credit spreads have narrowed significantly, and credit markets are expensive compared to historical levels. The current macroeconomic environment supports credit fundamentals, and tight valuations may persist in this context, although there is limited scope for further tightening. We expect a return of 2% to 5% for the FTSE Canada Universe Bond Index in 2025, compared to the current running yield of 3.58%.

10Y Yield near middle of recent range
Line graph illustrating that the Canadian 10-year Government Bond yield is near middle of its trading range since January 2023.Source: Macrobond

Portfolio strategy and structure

Equity markets experienced another robust year in 2024, building upon the gains achieved in 2023. A lot of these gains were attributed to multiple expansion, with significant contributions from the Mag 7 stocks (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla) for the second consecutive year. Notably, however, market breadth improved in 2024, with all but two sectors in Canada and all but one sector in the US posting positive returns for the year. It is noteworthy though, that in the US, the largest ten firms now account for 40% of the market capitalization of the S&P 500 index, the highest proportion since 1980. This represents a substantial increase in market concentration from less than 25% only five years ago.

Market sentiment indicators have surged in response to the outcome of the US election, combined with a resilient macroeconomic environment and monetary easing. Sentiment now reflects considerable optimism regarding the continued upward trajectory of stock markets. The momentum behind these movements has been strong, and the fundamental landscape supports ongoing equity market strength.

However, we recognize that stock markets are now at all-time highs, and the overwhelmingly bullish sentiment leaves little room for negative surprises, indicating an increasing probability of a near-term correction; we view the Fed as a potential catalyst for this correction. Considering the robust performance of the US economy, the diminishing disinflationary pressures in recent months and financial conditions suggesting that monetary policy is already accommodative, the Fed may choose to slow or halt its easing. Nevertheless, the Fed must navigate carefully; a sudden shift to a more hawkish stance could significantly dampen consumer and business sentiment, as well as asset valuations. Conversely, further accommodation may risk a resurgence in inflation. Either scenario would likely result in a surge in longer-term bond yields, adversely affecting the valuations of risk assets. Even so, given the ongoing strong economic backdrop, a short-term correction should offer a favourable buying opportunity, as we expect positive – though more volatile – equity market returns in 2025.

Regionally, we forecast positive equity returns in both developed and emerging markets, with emerging markets expected to perform similarly to the US. Economic activity in China remains subdued; however, government policy in the region is aimed at stabilizing economic growth and addressing the oversupplied property market. It remains to be seen whether these measures will be effective. A mitigating factor to the slower economic growth is more attractive valuations, offering greater potential for multiple expansion relative to developed market equities. Canadian equities are poised to benefit from a recovery in earnings growth following a subdued year, with some potential for multiple expansion.

Smaller capitalization stocks posted a positive return in 2024 but lagged their large capitalization counterparts. Small-cap stocks tend to outperform in an early-cycle environment, and usually lag in a late-cycle environment, driven by a flight to liquidity. We also recognize that small-cap stocks demonstrate higher volatility compared to large-cap stocks. As we enter 2025, we hold a cautious outlook for small-cap stocks, as we are in a more late-cycle environment and expect greater volatility. Investor expectations are high at the start of the year. With consensus opinion that we have avoided a recession, the consensus outlook calls for strong earnings growth, stable inflation and more accommodative monetary policy. Any developments that counter these predictions should lead to an increase in volatility.

Bond market valuations in Canada began 2025 neutral and range-bound, indicating neither overbought nor oversold conditions. However, with most of the monetary easing already implemented, there is limited potential for bond yields to decline meaningfully outside of a recession scenario. Consequently, bonds appear less attractive in 2025 compared to 2024.

Asset allocation

  • Despite positive return expectations for both bonds and stocks, we begin the year with portfolio asset allocation at benchmark weights (a neutral position). We recently covered an underweight position in fixed income, removing an overweight position in cash. Bond yields backed up in December to a level at which we want to be neutral in our fixed income exposure. We remain mindful of expensive equity market valuations, and look for a more attractive opportunity to increase equities.

Stock and sector selection

  • As the risk of recession has declined, we have added high-quality cyclical stocks that will benefit from a broadening of growth across the economy. We have also reduced lower-growth and interest rate-sensitive companies on the expectation we will see volatility of bond yields.
  • We also added significant exposure to companies capable of delivering above-average earnings growth regardless of economic conditions. The portfolio is now more balanced between quality cyclicals and these resilient growth companies, offering potential upside should our view of stronger growth come to pass. We have also added exposure to utility and industrial companies. Each of these is expected to benefit from AI-related capital expenditures.

Corporate credit

  • Corporate spreads tightened to multi-year lows (to the tightest levels in decades in the US). Resilient growth, decelerating inflation and reduced policy rates, along with strong corporate balance sheets and strong investor demand for attractive all-in yields, supported credit markets.
  • Canadian corporate credit spreads are currently at their tightest level since early 2018. Typically, a recession triggers significant spread widening. However, given the lower probability of an imminent recession, credit markets should remain stable. In addition, current credit spreads suggest limited tolerance for negative surprises, with considerable potential for widening in the face of increased macroeconomic volatility. While we do not expect a substantial widening, further compression of spreads is unlikely, and the associated risks are asymmetrical.
  • Fixed-income portfolios are currently modestly underweight corporate credit, and market weight provincial credit, relative to their benchmarks. In the near term, we expect outperformance from domestic banks, as lower interest rates start to stimulate loan growth and mortgage renewals are becoming more manageable with declining interest rates.

Credit valuations are expensive
Line graph showing Canadian and US investment grade corporate credit spreads. Both series have tightened to extreme levels, indicating that credit valuations are expensive.Source: FTSE Global Debt Capital Markets Inc., Connor, Clark & Lunn Investment Management Ltd., ICE BofA Indices

Duration and yield curve

  • We expect economic uncertainty to create opportunities as market participants adjust their narratives and reassess central bank expectations. Barring any external shocks, bond yields should stay within a volatile but contained range. We will manage duration opportunistically within this range. Entering 2025, bond yields are in the middle of the recent trading range, justifying a neutral exposure.
  • Following over two years of inversion, the yield curve normalized in late 2024. In Canada, this normalization was primarily driven by a significant decline in short-term yields due to monetary easing from the BoC, while longer-term yields increased during the year. The portfolio maintained a steepening bias for much of 2024, although this positioning was adjusted as the yield curve normalized. With central banks now slowing the pace of interest rate reductions, we believe that the potential for further yield curve steepening is minimal, and consequently, we have eliminated this bias from the portfolio.

Summary

  • Last year’s political headlines should come through in policy moves in 2025 with new governments taking shape. On the horizon, new immigration and trade policy have the potential to make significant changes to the supply of labour and goods, creating a possible second wave of inflation. Private sector business investment should continue at a strong pace, as companies work to adopt new technology. Public sector finances remain a key risk for bond markets. Large deficits at a time of full employment add to the risk of higher interest rates. These themes shape our 2025 market outlook. Central banks will be assessing the range of outcomes from these policies, US growth is likely to remain strong, supported by solid labour markets, while Canada’s economy is likely to avoid a recession, bringing low but positive growth after an aggressive easing cycle. Earnings for both countries should grow further, valuation multiples are expected to remain steady, and we expect positive equity returns. Our outlook is generally positive for bonds, though they are now fairly valued and credit spreads are at tight levels. We will continue to adjust portfolio positioning to capitalize on opportunities throughout the year.
CC&L Investment Management Ltd.
January 21st, 2025