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Equity markets posted strong returns at the end of last year on expectations of potential rate cuts as early as March. Michael O’Brien, Head of the Core Canadian Equity Team, TD Asset Management, explains why he thinks investors should manage their expectations for equities as 2024 gets underway.
Transcript
Kim Parlee: Welcome to MoneyTalk. I’m Kim Parlee. Great to have you with us. Thanks so much for joining us. The new trading year is underway, but will it be able to capture the momentum that we saw at the end of 2023? Markets posted strong returns at the end of last year, much of that coming from expectations the Fed could start cutting interest rates as early as March. But my next guest says investors may want to manage their expectations as 2024 gets underway. Michael O’Brien is Managing Director and head of the Canadian Core Equity Team at TD Asset Management, joins me now. Nice to see you. Happy New Year.
Michael O’Brien: Thank you very much. Happy New Year to you, too, Kim.
Kim Parlee: So you’re saying we need to manage our expectations?
Michael O’Brien: Well, if you put it in perspective, we had a pretty strong finish to last year, November and December, just across the board. Tremendous run. So I guess what I’m thinking is that we pulled forward — some of those returns that one would reasonably expect to achieve in 2024, I think we brought them forward. I think we got an early Christmas present.
Kim Parlee: OK, then what is that going to mean then for when maybe the action finally does happen in interest rates? Maybe just to back up a bit, what do you expect to see happen with interest rates next year?
Michael O’Brien: Yeah. Well, I think obviously, the change in investors’ views of where interest rates were headed, that’s what drove that big year-end run. We went from investors being quite pessimistic about interest rates were going to continue to rise. People were worried they were going to go through 5%. Somewhere around the end of October, you had a couple of economic data points that were a little more reassuring, inflation that was printing positively.
And then the US Federal Reserve, Chairman Powell, gave what was perceived to be a very dovish press conference in early December. It kind of cemented this view that — you know what? Inflation’s coming down, but without really having a huge impact on the jobs market, the soft landing is in sight. I think that’s really what set off the rally. But as markets do, I think they might have taken that a little bit too far in the short term.
So when I think about the start of the year — I’m a little cautious on the start to the year. It doesn’t mean I’m negative on 2024 as a whole. It’s just, look, let’s be realistic. We pulled forward some of those returns into November and December on the expectation that we’re going to get a lot of good news in 2024.
One piece of good news that investors are expecting and pricing in is they think the US Federal Reserve is going to actually start cutting rates in March. When I look at it, the unemployment rate is 3.7% in the US. Inflation is actually higher than the unemployment rate. It seems like an odd time for people to be pricing in rate cuts that quickly.
What I’m saying, at least to start the year, is let’s expect a bit of a digestion phase or a consolidation phase as maybe people get a little more realistic about how many interest rate cuts we’re going to get in the US and how quickly they’re going to be delivered. Because I suspect, as the clock is ticking between now and March, I think it’s going to become more apparent that maybe they aren’t going to be in quite the same rush to cut rates as investors wish they were.
Kim Parlee: Yes. So you expect the data to be a bit stronger then?
Michael O’Brien: Yeah. And it wouldn’t surprise me to see maybe interest rates back up a little bit here as they re-triangulate on when rates are going to be cut, how many interest rate cuts we can expect. So I just think it’s going to be a little bit of volatility or a little choppy the first couple of months of the year. That’s what I’m thinking.
Kim Parlee: Yeah. That’s how I feel. You know, after Christmas dinner, I’m still digesting and doing that, and things are still choppy. So I feel the same right now. What about the Bank of Canada? What do you see in terms of maybe what the Fed’s going to do, what Canada’s going to do? And maybe just extrapolate that out a bit, in terms of what that could mean for currencies, as well.
Michael O’Brien: Yeah, absolutely. So it’s interesting. I think if you look at investors’ expectations of the US central bank, the Federal Reserve, they’re quite optimistic that the Fed will start cutting earlier than they’re communicating and more than they’re communicating, despite what’s right now still a pretty solid jobs market. Canada, I would say the sentiment towards the Canadian economy, whether you call it much more sober or much more downbeat, I think investors clearly view the Canadian economy as being in a weaker spot than the US economy today. I think investors are rightly perceiving that the Canadian consumer is proving to be much more interest rate-sensitive than the US consumer.
So I think investors’ expectations of the Canadian economic backdrop are pretty subdued. Whereas in the US, I think we’re in a position where most people seem to believe now that a soft landing is certainly within sight, if not in the bag. So very different trajectories. That would, in and of itself, argue for the Bank of Canada to be cutting before the US.
I think the thing that’s holding the Bank of Canada, or may hold the Bank of Canada back a little bit here in the short term is we’re still printing some pretty sticky wage numbers, in terms of wage growth, and inflation. So the inflation situation in Canada, even though our economy is a little bit softer and our job market is a little bit softer than the US, the inflation reports we’ve been seeing lately haven’t really been cooperating.
So my guess is the Bank of Canada wants a little more air cover. They’d like to see a little bit more softening of wage increases, and a little bit more softening on those CPI reports to give them the cover to start cutting. But I think when all is said and done, by the end of 2024, the Bank of Canada will have cut more and deeply than the US will.
Kim Parlee: Yeah. Just we have to wait a little while to actually see it. What about the banks? I’ve only got about a minute here. But when you look at the Canadian banks, it was an eventful year, I’d say, last year for many of them. What do you expect to see this year?
Michael O’Brien: Kind of like my comments about the Canadian economy, expectations are subdued. The Canadian banks’ expectations, I would say, are realistic, that they’re facing a challenging backdrop. There are a lot of earnings headwinds facing the Canadian banks. But the good news here is that everybody’s very aware of those headwinds. We’re not priced for super-duper outcomes here. So I think that realistic take on things means that even if we struggle a little bit in terms of the macro, the Canadian banks are kind of priced for that. If we get a little bit of good news, if we get some positive surprises, then I think that’s where there’s some potential upside.
Kim Parlee: Let’s pivot now to energy, which you’ve been following for quite a while, oil and natural gas. It was pretty sluggish last year. And oil, wow. What a year to start, it’s been like — it’s been choppy.
Michael O’Brien: Absolutely. It’s always a volatile commodity. It seems like it’s getting more so as the years have gone on. 2023 was quite a roller coaster. You go back to late summer, early fall and people had convinced themselves oil was on its way to $100 a barrel. And now today, sentiment is terrible. You hear people talking $60, sub $60 oil. As always, take it with a grain of salt. This is such a volatile commodity. The paper market for oil tends to move the price a lot more than the supply and demand fundamentals would justify. That’s just a fact of the oil market. It gives us ulcers, but we’re starting to get used to it.
Kim Parlee: Yeah. And you expect that volatility to continue in 2024?
Michael O’Brien: Well, I think you’re going to have your ups and your downs. I think we’re starting the year with very subdued expectations, which actually, in a more contrarian way, that’s a positive. Investor expectations of where oil prices are going this year are pretty modest, in my opinion. There’s a view today that there’s ample supply on the market, and demand is questionable because people are concerned about the economic backdrop.
I think as we go through the year – if you go back to 2023, one of the reasons why oil never got to $100 a barrel, why it ended on a sour note, was a lot of things went right, in terms of supply. A lot of these countries that have been very suspect or not dependable in the past – places like Libya, places like Nigeria, Iran with the sanctions – a lot of positive things happened there. They actually produced more. Everything went right for them. That hardly ever happens.
So my guess is in 2024, are we going to get another perfect year where everything goes right? US shale hums along, no accidents. I doubt it. Something will go wrong somewhere. I think given how negative sentiment is today, on the margin, it’s that potential to surprise positively when the market all of a sudden is a lot tighter than people think. So I think there will be days when oil actually goes up again. And my bet is from oil in the low 70s here today, I suspect it finishes the year higher, as opposed to lower.
Kim Parlee: What about natty gas? I mean, it’s been so warm out. There’s no snow hardly anywhere in Canada.
Michael O’Brien: This is the second non-winter in a row for the northern hemisphere, which obviously is disastrous for gas prices. I mean, as frustrating as oil can be sometimes, in terms of the gyrations, natural gas in North America has been very, very tough for quite some time. Just too much supply. The key in the natural gas market in North America is too much supply here, but a whole bunch of people need it elsewhere in the world. So it’s getting those LNG facilities built and functioning so that you can export that natural gas and get it to the places where they’ll actually pay up.
So again, we saw a year where no winter, not a lot of fundamental support from those types of drivers. Some of the big LNG projects that we’re going to take supply offshore have been pushed out. So obviously, very dismal sentiment. The prices reflect that. NYMEX in New York is well below $3. AECO Gas out in Western Canada is very weak. So we’re starting, again, from a very low starting point. So in a contrarian vein, that’s actually a positive, because potentially things can go right. And some of the things that can go right that are sitting in front of us are that those LNG facilities start to get completed.
Kim Parlee: And then suddenly demand skyrockets.
Michael O’Brien: Exactly. So it seemed like this LNG Canada was forever in the distance, but by this time next year, it might actually be functioning. It might be up and running. Those are real important events for the natural gas market. So again, it’s one of those things where directionally, you understand why natural gas prices are weak, but sentiment-wise, you can see that people have almost thrown in the towel. So there are legitimate, fundamental structural improvements that are 12 to 18 months away. So that’s where it becomes interesting for the stocks.
Kim Parlee: Interesting. Well, let’s talk about some stocks that are on your radar. We’ve got about a minute and a half here. But let’s talk with CNQ.
Michael O’Brien: So CNQ, the thing that we need to remember about oil prices is that Canadian producers have been through some very difficult years. $70 to $80 oil for these Canadian producers, they’re still going to generate a lot of money, and their balance sheets are in better shape than they’ve been in years.
So I think one of the themes for the Canadian producers is going to be as these companies, for example, CNQ, they’re going to hit their net debt target of $10 billion sometime first half of this year. Beyond that, all of their free cash flow is going to go to buybacks and dividends. That’s a big positive. And without oil at $100, that will happen. So one of the themes that we’re looking at is underappreciated return of capital opportunity from some of the big Canadian players.
Kim Parlee: And the risks with these guys would just be oil price and their own expenses, I assume, how they manage that. MEG Energy.
Michael O’Brien: So MEG, they fall into that same bucket, where they’re about to hit their net debt target, $600 million, upon which they’re going to buy back a lot more stock. And that’s their preferred way of returning capital, is buying back shares. And also, MEG is the poster child for light-heavy differentials. They produce those heavy Western Canadian barrels that sometimes have traded at very wide discounts.
Trans Mountain Pipeline. Again, the Trans Mountain expansion, it has been one of these things that just seems like forever to reach the finish line. That will hit the finish line later this year. That has the potential to really narrow those light/heavy differentials. MEG is a huge beneficiary of that. So it’s another one of these structural things that at the moment we’re overlooking. Sentiment is poor. But structurally, this will change the Canadian market for the better for many years to come.
