First of all, Happy New Year everyone.  Here’s hoping 2025 will bring good health, joy and prosperity to you and your families. Our last newsletter of 2024 focused on how the new year would likely see higher volatility on average, but that markets would probably not undergo any major shifts until after the incoming US president was sworn in on January 20th.  Well, with just the first full trading week under our belts, 2025 has already proven the volatility call correct. 

There have been two main sources of heightened anxiety this month. Economic data for the US that has shown a worryingly more robust economic backdrop and hence elevated inflation pressure. This has materialized in a stronger US dollar but more importantly, a continued uptrend in government bond yields on both sides of the Atlantic. Back in December, I discussed that the 10yr US treasury yield was in danger of reaching 5% after breaking through 4.5%.

For countries in a weaker fiscal position, the damage has been even more acute.  Take the UK, where the gilt market has seen its worst performance since the mini-budget crisis in 2022. The new Labour government had included in its mandate a return to fiscal discipline, compared to what we witnessed back in 2022, but a weak economy has prevented any material improvements in revenue and there has been no alignment of spending to contain the deficit. Add to that the pressure on spending from higher borrowing costs and it’s no wonder that investors are feeling a sense of déjà vu.

Higher bond yields in the US also threaten to choke off the rally in equities and over the course of the last month, we are already seeing the major indices in the red. One would think that if the economy is still humming along, that stocks would be in a good place but with the outlook made more uncertain by potential policy effects, higher borrowing costs for businesses and consumers could take us from a situation of above-trend growth to one where things stall out.  In addition, higher yields on bonds can start to look more attractive relative to the dividend yields on income-generating stocks and produce a negative discounting effect on growth stocks, including tech.

And then there’s Donald Trump. It’s not that anyone is really shocked by what comes out of his mouth and we have been preparing for a possible trade and tariff war for weeks. What we didn’t expect was that the rhetoric two weeks ahead of inauguration would include Trump calling Canada a threat to US energy security and that it should become the 51st state, for the US to acquire Greenland and establish military bases there and calling the UK a fading power.

As with most of what he says, the recent banter is beyond incredulous. These statements are viewed as creating leverage to achieve results on trade and the border and what ends up being policy after January 20th will probably be more bark than bite. My comments from last month still hold that, at the end, there will be pushback by Congress and his own advisors that his key economic cabinet secretaries will advise that if tariff intimidations were followed through with, the negative hit to the US economy would not only threaten the economy but create a backslide in equities.

That said, for Canada the claim of being labelled an “energy security threat” is still concerning, as are the calls for 25% tariffs. The situation is made worse by the fact that Canada is dealing with an effective political void in Ottawa following Prime Minister Trudeau’s decision to step down this week and suspend parliament until March. Where we once thought we could get through to October before the next election, it now looks more likely that a vote will take place in the Spring.

Based on the polls, the conservatives look set to form at least a minority government, but this is all going to happen against the backdrop of incredible uncertainty as to what is going to transpire on the trade front. This week, the Globe and Mail reported that the federal government was putting together a list of US products that Canada would hit with retaliatory tariffs, including orange juice, glassware, plastics and some steel products. Again, it is not clear what tariffs, if any, are going to be imposed by Washington so we shouldn’t overthink potential retaliatory scenarios.

Some may be surprised that Canadian stocks haven’t displayed a significant degree of concern in the wake of the last several days. At the time of wiriting, the TSX60 was up 1.2% since the end of December – outperforming the US aggregates – thanks to strength in energy and materials.  Equities north of the border have also garnered support from continued weakness in the Canadian dollar, in similar fashion to the UK where the sharp decline in the pound has hurt bonds but lifted stocks. This is the third time in the last decade that the Loonie has spent time below 70 US cents and there are both positive and negative implications.

Export competitiveness will generally be enhanced by a weaker dollar and given that US demand is still healthy, then Canada could see an export windfall from this. That, of course, depends on whether tariffs are imposed in the coming weeks and months.  For those companies with a sizable share of revenues and earnings coming from sales in the US, the weaker Loonie will help inflate this quarter’s results once translated back into Canadian dollars.  This would be another key tailwind on top of the sharp decline in borrowing costs since this time last year.

On the flip side, a weaker dollar makes imported goods and services more expensive, which will negatively impact companies that have a relatively small or no export footprint in the US. Some of this impact will be passed along to the end user and that could show up in higher inflation and/or weaker demand growth. Either outcome is not good, but this also complicates things for the Bank of Canada beyond what might be happening with monetary policy south of the border.

With recent US figures pointing to better-than-expected growth, market participants have carved back their expectations for additional Fed rate cuts. Instead of a further percent being chopped off the fed funds rate in 2025, the consensus view has shifted to perhaps just one more quarter-point move. One of the reasons why the Canadian dollar has fallen is because rates have been cut faster than in the US.  If the Fed does follow a shallower trajectory for additional cuts, the Bank is going to have to be mindful of pushing that gap in rates wider.

We have had years where equity markets kick off January in a very negative fashion, but that isn’t the case this time around, even though the news and developments might make it feel like things are chaotic. Major developed equity indices are up on the month and volatility has only edged higher. That be a sign of complacency, but it is more a reflection of how the investment community is basing decisions on observable facts and not banter and speculation. That’s exactly what long-term investors need to be doing, while also looking for opportunities amidst the noise.

On behalf of the Pyle Wealth Advisory team, have a wonderful weekend.

Andrew Pyle