A Bayesian process is a method that uses Bayes’ theorem to update the probability of a hypothesis as more evidence or information becomes available.
– Thomas Bayes, 1701 – 1761, English statistician, philosopher and Presbyterian minister known for the foundational work behind the theorem that bears his name.
Resiliency is the best way to describe the solid returns from equity and bond markets in the first half of 2025. Combining resiliency and patience was key to achieving success against the fluid – if not chaotic – backdrop that prevailed over the last six months. As long-term investors, we rigorously adhere to this approach.
Considering the magnitude of the shocks (and potential shocks) the global economy faced this year, the investment returns are a pleasant reward. A typical Canadian balanced investor has a year-to-date total return around 5%.
How can it be so positive?
We view these positive results as a function of three key factors. First, economies are in decent shape (better than initially anticipated). Second, thus far, many of the shocks are proposals, remaining on paper only, yet to be implemented, or are under review by policymakers themselves or the courts. The on-again, off-again U.S. policy narrative on numerous fronts – tarrifs, fiscal policy, including DOGE, and immigration – are too recent for the impacts to show meaningfully in the data. Lastly, the critical feedback loops inherent in modern economies sent messages (or revealed reality versus fiction) that prompted a scaling back of policy choices when they ventured into territory that was too risky.
Current conditions are very much wait and see. For the next few months, there will be heated debates about how the economy will eventually unfold and how policy choices (once settled) will reverberate. Expect the economic data to show some wear and tear from all the uncertainty alone.
Regular readers will recall our extensive discussions of important feedback loops. Policymakers’ actions bring consequences that can include legal challenges, public opinion backlash, and industry lobbying. Most relevant here, stock and bond markets may move enough to prompt a policymaker course correction. This action/consequences/reaction feedback loop is working effectively to help adjust not only the U.S. administration’s policy choices but also those of other governments. How the loop works is clearer now than it was on April 2. Looking forward, getting the mix just right may involve volatility as capital markets continue to exert their influence (along with influence from the judiciary and the court of public opinion). Nevertheless, we are optimistic that these feedback loops will temper actions, enabling the world to absorb and adapt to new developments, and capital markets and economies to soldier on.
Capital flows to jurisdictions where it’s treated best
Both financial and human capital are drawn to places that adhere to foundational principles that include safety, stability, predictability, fair taxation, and the rule of law. Additionally, public goods like adequate and sound infrastructure, quality education and healthcare are necessary for businesses to thrive and innovate. All of these are considerations why money and people are attracted to one place over another.
In addition to these table stakes, access to well-functioning capital markets is also key, making a stable bond market a prerequisite. All governments borrow money; feedback from the bond market can be crucial and swift. When policymakers floated ideas incongruent with treating capital well, rising bond yields sent a critical signal that prompted a quick policy adjustment. The other feedback loops may take more time. However, in modern, capitalist, democratic societies, all governments are (eventually) motivated to (or forced to) make choices that are consistent with these foundational principles.
Many governments are waking up to the need to be more self-reliant and secure – not just in defence but also in energy, cybersecurity, infrastructure, taxation, and the rest of these foundational principles that have not been repealed. Canada is a good example. The actions of our largest trading partner are a wake-up call to examine how we do business in this country. These actions are sparking conversations around pipelines and resource policy, trade relationships, interprovincial trade, taxation, and fiscal policy – then pointing them in constructive directions. Conversations today feel as though we may be ready to move forward on measures designed to drive economic growth, investment and productivity. Turning adversity to advantage, we have an opportunity to strengthen Canada as a place to invest, work and live.
Capital markets are getting better at seeing past the noise
Investors are becoming more adept at filtering out the noise. They are asking what each policy action means for the shares or bonds of the businesses they own. The answers of some corporations – and the choices they make – will have significant consequences for where economic activity occurs and how capital flows around the world.
At the local level, these considerations can dominate our psyche (or local news). Still, asking questions about a shift in the way business gets done is not the same as wondering if business will get done at all. For shareholders and bondholders, the question of where and how corporations generate revenue is distinct from whether they will make a profit.
The shifts occurring in the global order are significant. How these play out could slow the economy or raise prices. If the shifts are of reasonable size (which calibration from the feedback loop will ensure) and delivered with sufficient time to adjust, then households, corporations, and capital markets can navigate them.
Two sides to tariffs
To be clear, tariffs are an inefficient way to raise revenue, so some accounting for the drag of these increased costs (tariffs are taxes paid by corporations or consumers) is necessary. However, high deficits (leading to higher borrowing costs) are a bigger issue in America than taxes. Thus, increased tax revenue in the form of tariffs can be a positive if that helps rein in the U.S. fiscal trajectory.
We may not like or agree with certain policy choices. Yet capital markets and the economy have demonstrated their ability to adapt and be resilient, so we shouldn’t throw in the towel or make investment choices based on emotions.
Tale of the tape
Year to date, international developed markets lead the pack; the MSCI EAFE Index (Europe, Asia, Far East) is up 17.4%, driven by German stocks. The European Central Bank is in easing mode. Germany is ramping up government spending, especially on defence and critical infrastructure, which benefits German industrial companies.
Second is the MSCI Emerging Markets Index, up 13.7% as China accelerates its economic stimulus. The startling success of the Chinese AI company DeepSeek reminds investors that, not long ago, Chinese tech companies were market darlings. After a period of tightened regulations, Beijing is also turning friendlier toward the nation’s private enterprises. Perhaps this is a necessity in a world where their global reach may be tempered.
Canadian equity markets are also solid; the S&P/TSX Composite is up 8.6%. Remember, though, that the Canadian stock market is not the Canadian economy. The S&P/TSX Composite’s significant weightings are metals and mining at 12%, energy at 16%, and financials at 33%. While these sectors are essential to the Canadian economy, they have a disproportionately large footprint on the S&P/TSX. Resource companies are experiencing a lighter tariff impact, while financial services face none. Many Canadian companies in industries subject to tariffs have significant plants, facilities and operations inside the U.S.; none of these are subject to tariffs. An additional tailwind comes from the Bank of Canada easing monetary policy.
U.S. markets round out the majors as policy actions land where we always knew they would – more on the country imposing the tariffs than the exporters. After reaching new highs, the S&P 500 swung close to a bear market (-18.9% from February 19 to April 8). Policy pivots and resilience enabled the index to reach fresh highs; it sits up 5.5% for the year.
Bond markets have also padded balanced investors’ accounts; the FTSE Canada Universe Bond Index is up 1.4% for the year.
Our strategy – Balanced, with a slight equity bias
We believe that the list of things that could go right is longer than the list of things that could go wrong.
Major items on our list of potential risks include a return to threats of high tariffs; stagflation; an economic slowdown or recession; rising unemployment; geopolitical flare-ups; and higher bond yields resulting from profligate government spending.
Our list of things that could go well includes a milder inflation impact; tariff clarity; productivity gains from new technologies; lower interest rates; increased government efficiency; fiscal spending boosts in Canada, Europe and China; a better U.S. fiscal position; deregulation; decreased interprovincial trade barriers; increased trade diversification; infrastructure build (energy, data centres, resource extraction/ egress); and real wage growth.
Some of the things that could go wrong to some degree will likely happen; it is always a question of degree. Some of the things that could go right may not go as well as expected. However, the positive list is longer, and the impacts are more lasting than those of many of the potential negatives.
The negatives spark feedback loops that course correct markets, policies and economies. The positives spark virtuous circles that are the basis of capitalism: innovation and productivity, creative destruction, resilience and adaptation.
Uncertainty over the wait-and-see elements looming in the near term has us keeping our tactical asset mixes closer to neutral. We have taken profits on rebounds and outperforming assets. We remain slightly overweight Canadian and U.S. equities, with neutral weights to developed international markets and emerging markets. We continue to rely on our well-diversified approach to navigate and are confident that, being patient, we will achieve successful outcomes.
The last word: A Bayesian approach
Revisiting our base case from the beginning of the year (2025 Capital Markets Outlook), we saw a path to further (modest) gains. We also cautioned that we might face a growth scare leading to a normal correction that occurs in equity bull markets.
It was our belief that equities could deliver total returns in the mid-teens. Our targets were 28,600 for the S&P/TSX Composite and 6,600 for the S&P 500. These targets remain relevant. Given the disruptions the world must navigate, they may be early- to mid-2026 targets. On the other hand, by the fall markets might be looking ahead to 2026 and could potentially deliver these targets on time, pricing in further positive outcomes before they arrive.
For fixed income markets, we expected the Bank of Canada to lower the overnight rate from 3.75% (as of December 2024) to 2.5% by June 2025. We still see 2.5%, but pushed out to December.
In December 2024, we anticipated that the U.S. Federal Reserve would lower the fed funds rate from 4.75% to 3.5% by the end of 2025. Given a resilient U.S. economy and tariffs making some impact on inflation, we are sticking to 3.5% but are pushing this target date out to Q1 2026.
Importantly, despite minor changes to our central bank calls, the broader bond market is in line with our expectations. We called for a full-year Canadian bond market return of 4%. We have 1.4% in the books, so this number remains achievable. If we only get to 3%, we would be happy with the higher coupon income that implies as we head into 2026. Currently, our combined actively managed fixed income solution is delivering an annual income above 4%.
We continually incorporate new information and update our views, adopting a scientific approach in the spirit of Thomas Bayes. In essence, it is an iterative process of learning and updating. In this rapidly changing landscape, often accompanied by significant uncertainty regarding the longevity of macro- economic events or durability of policy action, we are exercising greater patience as we revise our views. Although it was tempting to adjust our outlook earlier this year, experience has taught us to be patient – an approach that continues to pay off. When we discuss process and discipline guiding us as stewards of your assets, this is one aspect of what we mean.
We wish you an enjoyable summer.
Please contact your Investment Counsellor if you have any questions or would like to discuss your investments.
