“The 50-50-90 rule: anytime you have a 50-50 chance of getting something right, there's a 90% probability you'll get it wrong.”
– Andy Rooney (1919 – 2011), American radio and television writer
Whew, its over! Equity market movements after the U.S. election saw U.S. markets responding strongly positive on the prospect of tax cuts (especially new corporate tax cuts) and increased fiscal spending. The Canadian equity market tagged along with a mild advance. Notably, since the end of September through November 6, the S&P/TSX Composite is up 2.7% versus 2.9% for the S&P 500.
Bond yields jumped higher, bringing losses to fixed income investors, a trend that began weeks before Election Day. As of November 6, the FTSE Canada Universe Bond Index is down 1.3% since September 30, but still up 2.9% for the year.
Trump 2.0
For capital markets, taxes and tariffs are most in focus following President-elect Donald Trump’s victory and the possibility of a GOP Congressional sweep. An added plus for U.S. businesses is the expectation of a lighter regulatory touch from the incoming Republican-controlled Senate, which is responsible for confirming the cabinet and regulators. Republicans will need full control of Congress to pass tax policy and fiscal spending measures. At the time of writing, House results were still pending.
Promises of corporate tax cuts are a positive for U.S. stocks. A quick calculation shows about a 5% bump to S&P 500 earnings per share if the corporate tax rate is lowered to 15% from 21% for companies that produce goods in the United States (including divisions of non-U.S. companies operating there).
This additional stimulus is not a one-way street, however. Tax cuts and spending proposals could see the fiscal budget deficit – already projected to be 6.5% of GDP in 2025 – explode to 8% or greater. Given higher deficits, tariffs, and more economic stimulus, it is possible that long-term bond yields could continue to push higher even as the Federal Reserve lowers short-term interest rates.
Bonds battered
In the election aftermath, the yield on the U.S. 10-year Treasury note rose above 4.4%, bringing this bellwether interest rate up more than 80 basis points since late September. If the 10-year Treasury yield remains below or around 5%, we see little spill-over effect on the broader equity market, but a significant push to 5.5% or beyond would likely result in a downward repricing of equities. This is not our base case, but we do see it as a tail-risk under a Republican sweep.
Canadian bond yields have been on the rise, too, but less than U.S. bond yields. The difference between Canadian and U.S. 10-year bond yields sits at a 35-year wide gap, breaching 1% (Canada’s being lower). As a result, Canadian bond investors have experienced a less severe blow, and the general level of borrowing costs in Canada remains in a safe zone. Important for the housing market, the mortgage-referencing Government of Canada 5-year bond yield is a tad above 3%, still down more than a full percentage point since last year.
Mid-September saw bond yields priced for too little inflation, too little growth and too many central bank rate cuts. Now they better reflect the realities of inflation, economic growth, and the likely paths for central banks. It’s good news for investors that this leaves more income in fixed income today.
Implications for Canada: Pressured, not snapped
Canada’s currency has taken a hit. The loonie sits below US72 cents, a multi-year low.
While tariffs and a softer loonie might add some upward pressure to prices, Canada’s economy, running below potential, should see inflation behave well enough for the Bank of Canada to stay in easing mode.
President-elect Trump fancies himself as a dealmaker and has talked about tariffs as a negotiation tool. Tariffs under a Trump administration could range from surprisingly benign (simply a tool to strike deals) to the opposite end of the spectrum where trade wars and drawn-out, tit-for-tat retaliation create economic disruptions. His approach to tariffs remains a significant source of uncertainty.
Canada is perhaps best positioned to navigate the upcoming four years of Trump 2.0 versus other major economies. Ultimately, a strong U.S. economy is the single most important factor for Canada, regardless of who is in charge. Nevertheless, Canada will likely have to address various pressure points to help maintain a mutually beneficial diplomatic and trading relationship with the U.S. It is by far our largest trading partner, with about 75% of our exports directed there.
Renegotiations of the United States-Mexico-Canada Agreement (USMCA), the successor to the North American Free Trade Agreement (NAFTA), in 2026 are likely to be bumpy given the scope to target Mexico’s rising trade surplus with the U.S., bringing the potential for Canada to suffer some collateral damage. Canada is benefitting from a trade surplus of over $8 billon with the U.S., largely commodities (oil, metals) and motor vehicles. The commodities are of strategic importance to the U.S. and the vehicles are produced by U.S.-owned companies. Based on past trade negotiations, the U.S. will likely force Canada to make some concessions (increasing our NATO spending could be one), but we expect them to be relatively benign versus the overall North-South trading relationship.
Mr. Trump’s plan to reduce regulation and corporate taxes can influence business investment decisions, making south of the border more attractive. This will amplify the conversation around Canadian industrial policy, business investment climate, capital gains taxes, and productivity problems, especially in the next Canadian election. All these fronts have room for improvement in Canada, and pressure from the U.S. may spur action. Implementing those that don’t cost money will be welcome (eliminating red tape). Larger deficits could be tolerated if the expenditures are truly productivity-enhancing investments (infrastructure). Emulating other aspects of our neighbour’s fiscal choices wouldn’t be advisable.
Back to business
Politics don’t define the economy; politics influence it at the margin. The trajectory of the global economy before November 5 continues and will drive capital market fortunes much more than politics. The fundamentals of economic growth and inflation, their relationship to corporate earnings and interest rates, remain our primary focus as we navigate investment decisions.
The biggest thing about the U.S. election: it’s over. Election uncertainty had paralyzed businesses and households. Companies have been saying they could manage whatever either administration might bring. They just need to know the particulars and will act accordingly. Some of this uncertainty is now removed.
Global growth is doing okay. Economies sensitive to rising interest rates have been weak, but this is poised to improve when interest-rate relief kicks in. Inflation is falling, as are borrowing costs. China might stimulate its economy aggressively. Expectations for corporate earnings growth remain solid; this is a good backdrop for equity markets going into 2025.
U.S. inflation continues to fall; employment and economic growth are cooling. October saw a recalibration of the speed and magnitude at which these factors are moving. Inflation fell less quickly, U.S. employment softened – but not dangerously so – and economic growth surprised to the upside. The early read on the impact of the Republican election victory is that inflation may stay a little higher, but so will economic growth. Under these circumstances, the Fed would be right to keep interest rates somewhat higher. The Fed isn’t saying “no more cuts,” just fewer and perhaps slower to arrive. Currently, the odds put the fed funds rate between 3.75% and 4% by September 2025. For Canada, the read is a benchmark rate between 2.75% to 3% six months sooner.
Earnings expectations remain robust
The latest round of U.S. corporate earnings results was fine but not great. European companies reported better-than-expected earnings growth. Still, European stock indices posted declines, leaving their valuations more attractive than those of their U.S. counterparts in an environment where expectations for European economic growth remain tepid.
Chinese markets fell the most. Some giveback isn’t surprising considering their torrid advance following the Chinese government’s September announcement that it would provide its most aggressive stimulus measures since the pandemic. However, a lack of follow-on details dampened initial enthusiasm. Chinese and European equities slumped after the U.S. election, a predictable reaction to Trump tariff threats.
Most economists see tariffs as bad policy. However, there are counterbalances that would dampen the impact. While tariffs are a tax on the country imposing them (Americans in this case), the strengthening U.S. dollar (on top of an already strong U.S. dollar) offsets that impact somewhat. Similarly, exporters subject to tariffs should see reduced demand, but earnings will be buffered somewhat by their currency’s weakness: U.S. dollars convert to more loonies, yen, and euros for non-U.S. companies who report earnings in their local currencies.
Valuations: Disciplined and discerning
Valuations (the relationship between share prices and company earnings) remain under scrutiny in equity markets that continue to push higher. Valuations are a voting machine in the short run; in the long run, they are a weighing machine. The idea here is that in the short run, valuations reflect sentiment – fear and greed. In the long run, valuations are important – what you pay for an asset does matter for your rate of return.
Valuations for the S&P 500 are elevated. But the numbers are skewed by the influence of the Magnificent Seven companies (Apple, Nvidia, Microsoft, Alphabet, Amazon, Meta and Tesla). Combined, these stocks trade at 34 times forward earnings. However, Tesla sits at 90 times and Nvidia at 43 times, while the others range between 20 times earnings for Alphabet and 30 for Apple. Two takeaways: not all companies (even the big names) are expensive, some companies are expensive for a reason (they are really good businesses).
Outside of these mega-companies, valuations are attractive in other parts of the U.S. stock market, along with equity markets in Canada, Europe, Japan and some areas of emerging markets.
We are not oblivious to the valuations in some U.S. stocks. Historically, valuations alone are not a useful guide to investment decision-making. Importantly, our portfolios are not exclusively U.S. equities, and our U.S. equity exposure is not solely to the S&P 500. Our managers allocate across a wide range of sectors and find opportunities in companies of varying sizes. We are disciplined and discerning with our U.S. equity exposure.
Our strategy: Balanced, with an equity bias
We are well positioned for the current environment. We resisted the temptation to try and trade the election, being especially mindful not to succumb to the voices of hyper-anxiety screaming everyone should run for cover. We trimmed pockets of strength and added to areas we felt were poised to benefit. We maintain our equity overweight to the U.S. and Canada, and have been patient with our small cap stocks that bolted higher by roughly 10% leading up to and through the election.
We are underweight fixed income, but overweight investment-grade corporate bonds, which have outperformed government bonds roughly two-to-one on the year.
The last word: Probabilities
We operate in a world of probabilities. Our tactical asset-mix decisions are based on expert analysis and research. They are vigorously debated among seasoned professionals, who assess and assign probabilities to various scenarios. Based on this probability-weighted scenario analysis, we make tactical asset-mix decisions to enhance return or reduce risk at the margin.
On a tactical basis, we have been overweight to Canadian and U.S. equities for many quarters. Recently, a Goldman Sachs analyst report received a great deal of attention, calling for a 3% annualized return for the next 10 years for the S&P 500. Aside from the many active stock-picking opportunities we see across a broad swath of U.S. companies, the probability of a 10-year annualized 3% rate of return is very low, happening only 9% of the time since 1935. We’ll stick with the other 91% of outcomes.
Perhaps the Goldman Sachs analysts are speaking to U.S.-centric, equity-only investors with all their eggs in the S&P 500 basket. That isn’t us.
Andy Rooney was teasing with his 90% wrong quip, but even if we thought he was on to something, that’s all right. We don’t coin-flip; we take a rational, unemotional, well-diversified, balanced approach to investing.
