Fixed Income Outlook (H1 2025)

Key themes & positioning:

• Improvements in labour market trends coupled with the expected increase in capital spending¹ suggests continued expansion of real GDP growth for 2025, but below a potential rate.

• The base case for rates indicates a continued steepening of the yield curve, but with the market pricing in less easing for 2025 (relative to 2024), fiscal policy and its expected affects on growth and the supply of debt, is likely to be the key driver of yield curve changes, particularly in the mid-to-long-term segments of the yield curve.

¹Source: GCLP based on data from Bloomberg as of December 31, 2024.
²GCLP based on data from GCLP based on data from Bloomberg as of December 31, 2024.

• The diminishing yield advantage previously offered through money market securities, now subjected to reinvestment risks, coupled with continued rate volatility and tight cyclical credit spread levels, suggests that short-term higher quality investment grade corporate bonds may provide a more favourable risk/reward trade-off.

Avg. Quarterly Returns (Annualized) During Falling Rate Environment³

Risk-For-Yield Spectrum⁴

³Source: GCLP based on data from ICE BofA Indices and Bloomberg as of December 31, 2024. Falling interest environments represented by negative changes in the 2-year Government of Canada bond yield.
⁴GCLP based on data from FTSE Canada Bond Indices and Bloomberg as of December 31, 2024.

It’s like déjà vu all over again

They say the definition of insanity is doing the same thing over and over again and expecting different results. If so, it would seem that the post-pandemic era has driven economic forecasters a little insane.

In a dynamic that has now come to characterize the last four years, expectations at the start of last year were that the improved growth trajectory established at the end of 2023 would ultimately give way to a loss of momentum. There were better-than-even odds being assigned to the likelihood that a recession would materialize before the year was out.

Global growth, however, held firm in the early months of 2024, and, while there were some starts and stops mid-year, those gloomier forecasts were once again well off the mark. The aggregated world economy proved to be more resilient that anticipated.

In fairness, those pessimistic expectations were not exactly unfounded, as there have been a steady flow of potential catalysts for a downturn — including, but not limited to, the ebb and flow of the pandemic, rising geopolitical strife, rising prices pressures and rising interest rates.

It just so happens, the key lynchpin of the global economic cycle, that is the American consumer, has remained strong enough to keep forging forward in spite of the headwinds.

Which brings up another point of repetition in the narrative. While there has been an anticipated broadening out in growth momentum with countries outside the US gaining steam and narrowing the performance gap, last year once again saw that the upside surprise was primarily been a function of the US dragging the rest of the world behind it — though, it is worth noting, other regions, including Canada, did manage to outperform their dour start of the year expectations, just by lesser degrees.

Consensus real gross domestic product growth forecast, 2024
(year-over-year percent change)

Source: Guardian Capital using data from Bloomberg to January 17, 2025

The world’s largest economy, once again, handily outpaced its peers as the American consumer continued to show its resilience in the face of high costs of living and tighter financial conditions.

As the New Year, and second quarter-century of the millennium begins, there is little reason to anticipate that there will be a material shift in these key economic growth trends and the overall outlook now appears to suggest that 2025 will provide a general feeling of déjà vu all over again — and not just from a macroeconomic lens.

Play it again, Uncle Sam

With that said, there is one notable difference this year with respect to the story. Perhaps it is a case of fool me once, shame on you, but fool me twice (or thrice), shame on me, but the cadre of dismal scientists that form consensus expectations are assigning the lowest odds of a downturn since 2022.
Consensus estimated probability of a recession in next 12 months
(percent)

Source: Guardian Capital using data from Bloomberg to January 17, 2025

Instead, the broad expectation, as the calendar rolls over, is for more of the same — with a (widening) gap between growth stateside and elsewhere, but a general view of stable, if unspectacular, growth.

While this could seemingly represent a contrarian signal, it is hard to argue against the available facts.

The bellwether global composite Purchasing Managers’ Index (PMI; a forward-looking gauge of broad economic activity) ended 2024 at a six-month high and suggests the solid momentum will carry into the New Year — though, looking under the hood, there is a gulf between the pickup stateside and the more stagnant readings in other areas.

Composite purchasing managers’ index
(diffusion index; >50 denotes expansion)

Shaded regions represent periods of US recession; source: Guardian Capital using data from Bloomberg to December 2024

These signals are corroborated by the continued outperformance of the dataflow in the US while other regions have provided more disappointment than upside surprises based on the data aggregations.

One reason for the divide in performance is that goods-producing parts of the global economy (which carry comparably less weight in the US than they do in other jurisdictions) are facing more challenges and weaker demand that the service providers.

The industry-specific PMI point to general stagnation among the manufacturers, while the more economically-important service sector remains firmly entrenched in expansionary territory — and pulling the global composite gauge of activity up with it.

Stop me if you’ve heard this one before

Undoubtedly, a big driver of the strength in services is the willingness and capacity of consumers — and particularly those in the US — to spend.

Household expenditures account for nearly two-thirds of total economic output across Developed Markets (DM) and services spending accounts for roughly two-thirds of that, making it the biggest component of the gross domestic product add-up.

As such, the financial health of consumers and their ability to spend beyond the necessities of life remains the most important foundational aspect of the economic cycle — and the data continue to indicate that this foundation remains solid.

Household net worth (the value of assets less liabilities) is at all-time highs, thanks to the firmness in financial and housing markets that have recorded gains that have outpaced debt growth in the last two years in the face of higher rates.

And, while the US has registered the biggest improvements — and this spans the entire wealth spectrum rather than just the rich getting richer — it is also the case that wealth across the aggregated Eurozone, Canada and Japan is at all-time highs.

Household net worth
(index, Q1 2020 = 100; local currency basis)

*based on financial assets only; shaded regions represent periods of US recession; source: Guardian Capital using data from Statistics Canada, US Federal Reserve, European Central Bank, and Bank of Japan to Q3 2024

The presence of a decent (and growing) nest egg for households, especially those less-wealthy ones, stands in stark contrast to the pre-pandemic cycle where the need to rebuild savings following the housing market crash constrained spending — and provides a clear reason for the persistent resiliency in consumer spending in recent years.

Another reason why spending has held up well is that job markets globally remain firm. Unemployment rates broadly remain within arm’s reach of the recent all-time of generational lows.

Unemployment rate
(percent)

Shaded regions represent periods of US recession; source: Guardian Capital using data from Bloomberg to December 2024

With that said, it is the case that these measures of labour slack have softened over the last year, particularly in Canada. On the surface the rise in the unemployment rate is not a positive sign for the health of economy, however, the increase has been this has been a product of the huge immigration-driven surge in population over the last two years that has swelled the size of the workforce with people newly looking for work (largely those new to the labor force but also those returning after a period outside the labour force) accounting for the bulk of the overall rise in unemployment.

For example, Canada’s population aged 15 or older increased by a record high of 1.1 million people in 2024 against which the solid 384,000 net new jobs created in the economy in the year paled in comparison.

Growth in population & employment, Canada
(thousands of people per year)

Source: Guardian Capital using data from Statistics Canada to December 2024

In other words, the current environment is different that previous periods where unemployment rates rose because of a multitude of people lost their jobs (and incomes), which set off the negative demand spiral that typically results in recession.

Indeed, the data continue to point to net increases in overall employment, albeit at more modest rates than seen earlier in the cycle, while indicators of layoffs remain historically benign. As well, indicators of demand for workers continue to suggest that a material decline in job market prospects is not imminent.

There continue to be ample job vacancies that firms are looking to fill while forward-looking surveys of businesses indicate that hiring prospects are actually turning for the better in the year ahead.

The balance of opinion with respect to companies looking to add versus reduce their headcounts as per the latest Business Outlook Survey1 from the Bank of Canada continues to lean favourably for those seeking employment.

Business Outlook Survey hiring intentions, Canada
(share of firms expecting high employment levels over next year less the share expecting lower)

Source: Guardian Capital using data from the Bank of Canada to Q4 2024

A break in a pattern

These same business surveys are also showing something that has not been particularly present in recent years: plans to make bigger capital investments in their companies.

Business Outlook Survey capital investment intentions, Canada
(share of firms expecting high investment spending over next year less the share expecting lower)

Source: Guardian Capital using data from the Bank of Canada to Q4 2024

The abundance of uncertainty that has been omnipresent over the last five years combined with the sharp increase in interest rates restrained a lot of capital spending plans even in the face of robust demand, keeping expenditure just focused on maintenance rather than expansion.

A clearer outlook, lower rates, increasing government incentives and supports — including a slate of notable initiatives stateside — appear to be encouraging businesses to commit to investing.

More broadly, though, the boom in investment in artificial intelligence is very US-centric — for example, there are more data centers in the US than the rest of world combined, and Canada is in distant fifth place. Given the secular tailwinds for this area and the potential productivity gains and influence, this represents another differentiating factor between the US and everybody else.

Data centers in operation
(number)

Source: Guardian Capital using data from Statista as of March 2024

As well, lower rates and a household sector on solid financial footing suggests that housing markets that have generally stagnated over the last two years could also recover some verve — which, in turn, would support more ground-breaking on much needed added housing supply.

Add in the increased infrastructure spending being tabled by governments against the slew of elections and it looks as though there is scope for the factory sector to break out of its doldrums and for general investment to shoulder some of the burden of driving global economic growth.

Further, the signs of improvement in capital spending and continued strength from consumers is coinciding with a recovering in international trade, offering another support to growth and suggesting that the goods producing side of the economy may see better traction ahead — something that is particularly positive for small open economies such as Canada and those in EM.

International trade volumes, World
(year-over-year percent change in three-month moving average)

Shaded regions represent periods of US recession; source: Guardian Capital using data from CPB Netherlands Bureau for Economic Policy Analysis to October 2024

More of the same?

Trade is also benefitting from a normalization of pressures throughout the supply chain, which has resulted in the transitory pandemic-era surge in logistics costs fully abating.

Add in softer commodity prices (particularly crude oil), the lagged impact of the moderation in home prices and rents flowing into the calculation, as well as the impact of the earlier tightening of monetary policy and more anchored expectations and overall inflation rates have fallen back within arm’s reach of — or in the case of Canada modestly below — central bank targets and are anticipated to hold at more tolerable levels over the forecast horizon.

Consumer price index
(year-over-year percent change)

Dashed lines represent consensus forecasts as at January 17, 2025; shaded regions represent periods of US recession; source: Guardian Capital using data from Bloomberg to December 2024

The progress seen worldwide with respect to price pressures, and the expectations that inflation is on a sustainable path to target, have given monetary policymakers cause to begin to move away from their highly restrictive stances. Accordingly, central banks across the globe cut moved off the sidelines and cut policy rates, with the Bank of Canada’s 175 basis points worth of cuts in 2024 leading the way.

The direction for policy rates in general, going forward, appears likely to be lower still, however, mixed messaging from policymakers and the ongoing sign of underlying momentum still leaves considerable uncertainty about the speed of decline as well as the final end point — and this is especially the case for the market-driving US Federal Reserve. The issue is that as risks of a recession have ebbed, the risk of a re-acceleration in growth that could undo progress on inflation have increased.

While there is, arguably, a very high bar for a return to hikes in the year ahead, there is a possibility that rates may move more slowly and/or hold at a higher terminal level than previously assumed. As it stands, current baseline projections have the easing cycle ending at levels that are still elevated by the standards of the last decade and a half.

Central bank policy interest rates
(year-over-year percent change)

Dashed lines represent consensus forecasts as of January 17, 2025; shaded regions represent periods of US recession; source: Guardian Capital using data from Bloomberg to December 2024

Even with the easing of financial conditions over the last year on the back of broadening rate cuts, there are growing signs of stress in some areas of the economy — consumer insolvency rates in Canada, for example, have increased notably, though remain consistent with longer-term trends — and higher rates for longer would not help.

Consumer insolvency rates, Canada
(consumer proposals and bankruptcies per 1,000 people aged 15+)

Shaded regions represent periods of US recession; source: Guardian Capital using data from Office of the Superintendent of Bankruptcy Canada and Statistics Canada to November 2024

Here we go again

Monetary policy uncertainty therefore still represents a risk to the outlook, but the potential headwinds here are magnitudes lower, especially near-term, than those that are coming out of other policy areas.

The regime changes in the US and the accompanying heightened uncertainty about the returning Administration’s approach to economic policy, especially with respect to international relations and trade, has cast a significant pall over the outlook for not just the US but the entire world.

Policy uncertainty index, World
(index; pre-2015 average = 100)

Shaded regions represent periods of US recession; source: Guardian Capital based on data from PolicyUncertainy.com to December 2024

The potential introduction of new tariffs — whether they are sweeping levies on all goods imported into the US, more targeted taxes on goods produced in those countries viewed by the incoming President as the “greatest offenders”, which include Canada, Mexico and China, or a bit of both — and the prospect of retaliation would have a significant impact on broader growth given that the export of goods and services accounts for roughly one-third of global output as per data from the World Bank.

Of course, added two-way barriers that reduce the volume of trade would carry far less sting for the US, from a production standpoint, than it would for its counterparts, given that the American economy is far less dependent on exports than others.

In fact, of the world’s top 40 economies, exports accounted for the lowest share of gross domestic product (GDP) in 2023 in the US (11%), while countries in Europe and Southeast Asia find themselves at the other end of the spectrum and Canada (33%) and Mexico (36%) are somewhere in the middle — for its part, China (20%) is on the lower side. Even with respect to imports, the US economy (14% of GDP) is at the bottom of the list in terms of general exposure.

Imports & exports of goods & services as a share of gross domestic product
(percent)

Source: Guardian Capital using data from the World Bank for 2023

While a large and effectively closed economy like the US may not be overly reliant on trade as a driver of growth, it is still very much exposed to the global supply chain.

One of the major by-products of the movement toward global free trade over the last three decades is that production processes have become increasingly integrated. All of the value-added to the goods & services produced within a given economy does not necessarily originate from that country.

Inputs to production of goods can be imported from one country and the resulting finished product then shipped abroad. A country’s domestically-produced goods can also be exported and serve as an input to production for a foreign-produced finished goods. Economies are intertwined and any disruptions in trade flows or increase in costs will reverberate and compound throughout the supply chain and be felt throughout the world — including the US.

So, not only would Americans face higher costs on imported finished goods — of which pharmaceuticals, motor vehicles & parts, crude oil, computers and other electronics top the list — they would also feel the impact of tariffs on an array of goods that carry the “Made in America” label.

Moreover, while the goal of tariffs may be to punish exporters and support US production, there currently are not readily-available domestically-produced substitutes for many foreign goods.

Creating capacity takes time and likely will require shifting capital and labour from areas where the American economy has a competitive advantage (making computer software, for example) to one where it is comparatively weaker versus other countries (making computer hardware).

The ultimate result is that American businesses and end consumers are going to face higher costs for goods whether they are produced within the US borders or not — and it is worth highlighting that, despite what may regularly be stated, it is the ones doing the importing, not the exporters, that pay the tariffs on goods shipped stateside.

Flexible exchange rates do offer a mechanism to blunt the impact of tariffs on trade, as currency depreciation will partially offset the cost hit of the tariff, but that has negative spillover effects as it makes the costs of goods & services (think tourism) imported from the US more expensive in local terms, which, in turn, reduces their demand at the expense of the American economy.

A divergence of monetary and fiscal policies, where exporting countries adopt more expansionary stances, in an effort to replace US demand with domestic demand, would further weigh on foreign exchange rates.

The bottom line is that if the US follows through with aggressively taxing imports, there will be material implications for not just the exporting nations, but the American economy as well, and the bigger and broader the policy, the more significant the impact — not just the immediate weaker demand and higher costs associated with the tariffs, but policy uncertainty is also likely to weigh on investment and consumption decisions as well, at the detriment to growth.

Made in Canada Rates

The baseline outlook for modest but positive growth and still moderating inflation against a backdrop of persistent risks to the outlook would appear to be a constructive for fixed income.

Notwithstanding the likelihood that heightened near-term headline risk associated with politics and the still high degree of uncertainty around the near-term path for monetary policy keeps rate volatility somewhat elevated in the coming months, the ultimate path of least resistance for domestic market yields is likely to be lower as the central bank easing cycle exerts downward pressure on rates.

The impact, however, is likely to felt more at the front-end of the yield curve where rates are far more sensitive to monetary policy. The result is an expected further steepening of the curve into more “normal” territory after the spread between 10-year and 2-year government bond yields finally turn positive for the first time since 2022 in the Fall.

Government of Canada bond yields
(percent)

Shaded regions represent periods of US recession; dashed lines represent consensus forecasts as at January 17, 2025; source: Guardian Capital based on data from Bloomberg to January 17, 2025

The diminishing yield advantage offered by short-term bond issues, combined with the increasing reinvestment risk as short-term rates move lower, make these assets that have outperformed the broader market in recent years relatively less attractive.

History shows that a rising short-term interest rate environment (such as seen in recent years) is the only backdrop in which short-term bonds and cash outperform — flat-to-down rates eras have seen better performance out the curve.

Canadian fixed income average 12-month total return by change in interest rates
(percent; Canadian dollar basis)

*FTSE Canada bond indexes; source: Guardian Capital based on data from Bloomberg from January 1986 to December 2024

The prospect of a reallocation of even some of the massive stockpile of money sitting on the sidelines at the moment — there is more than C$700 billion in fixed-term deposits in Canada and another $85 billion in money market funds — would provide a significant tail-wind to other, longer duration, assets.

Fixed-term deposits and money market fund* net assets, Canada
(billions of Canadian dollars)

*Domestic mutual funds & exchange-traded funds; shaded regions represent periods of US recession; source: Guardian Capital based on data from the Investment Funds Institute of Canada and the Bank of Canada to December 2024

Canadian federal government budget deficit
(billions of dollars)

*projected as per the January 2025 Fall Economic Statement; source: Guardian Capital based on data from Finance Canada

Moving further out the risk spectrum into credit can provide additional yield carry, while also offering the potential for positive performance tied to improving credit fundamentals. High-grade corporate bonds appear to offer a somewhat better risk/return profile at the moment given current relative valuations and the outlook, while history shows quality credit issues have turned in the best performance against a backdrop of modestly declining rates.

Canadian fixed income average 12-month total return by change in interest rates
(percent; Canadian dollar basis)

*FTSE Canada bond indexes; source: Guardian Capital based on data from Bloomberg from January 1986 to December 2024

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