In addition to trekking the Inca Trail in Peru and attending a storybook wedding in Tuscany, the summer has been a busy period of portfolio adjustments and monitoring economic data. We think the much-anticipated inflection point in inflation is happening, albeit at a slower pace than we initially expected. While interest rates may rise further in the short-term, we think central banks are closer to the end of the rate hike cycle than the beginning.
In Canada, we think the Bank of Canada may raise interest rates by another 0.75% from the current 3.25%, bringing the terminal rate to 4.00% over the next few months. The U.S. Federal Reserve is widely expected to hike by 0.75% when it meets on September 21, taking its rate to 3.25% also. At this point, the market is pricing in a terminal rate of 4.00%-4.25% in the U.S by early 2023. We continue to expect both central banks to start cutting rates in the second half of 2023 as the current downward trajectory in many goods/services (see below) is reflected in the year-over-year data.
Our investment thesis for the next 6-12 months is built on expectations that inflation will continue to moderate, central banks will slow and eventually pause interest rate hikes, and investor confidence will recover from the current panicked state.
Although near-term volatility is expected to remain high, we view many segments of the equity and fixed income markets as attractively valued.
While headline inflation remains high in absolute terms, a decelerating trend has started to develop. The U.S. has now reported two consecutive months of decelerating Consumer Price Index, with August’s reading coming in at 8.3% compared with 8.5% in July and 9.1% in June. The U.S. Federal Reserve’s preferred inflation gauge, Core Personal Consumption Expenditure Price Index, peaked in February at 5.3% and has declined in four of the past five months with a recent reading of 4.6%. The Fed’s goal is to see this latter inflation gauge gradually return to a 2% target.
As we enter the latter stages of 2022, there is growing evidence that the perfect storm of excess demand and reduced supply that triggered the current inflationary cycle is receding. Signs of cooling inflation seem to be emerging across the economy. Home prices, gasoline, agriculture, used cars, airfare, and raw materials are among the categories that have developed convincing downward trends after peaking earlier this year.
In many cases, the drops are dramatic: average detached house price in Greater Toronto Area has declined 23% since February, crude oil is down 30% since its early-March peak, retail gasoline has dropped 27% since the June peak, used car prices have fallen 11% since January, wheat/corn/soybeans are 15%-40% lower than their highs and at or below pre-war levels, copper is well off its highs and 20% lower than pre-war level, steel has dropped to its lowest price in 12 months and is 57% lower than a year ago, lumber has plunged 65% from its March high and is now in line with 2018-2019 levels, the Baltic Dry Index which tracks the cost of marine shipping has declined 64% from its 2022 high and 79% from its pandemic era high and is now back to 2019 levels.*
Some categories such as rents and new cars remain at elevated levels but are expected to moderate as inventories recover. Overall, as these substantial price declines filter down to the consumer level, we think official inflation statistics will extend the recent downward trend, albeit with a lag.
*[All price data from Bloomberg, except GTA home prices from Toronto Real Estate Board]
Tightness in the labour market, which is the root of inflation in many service categories, is also showing signs of moderating as government stimulus has ended, pandemic restrictions fade, and some employers reduce staffing levels commensurate with slowing revenue trends. In the U.S., the labour force participation rate has been rebounding in 2022 after declining during the pandemic. The re-entry of workers resulted in an uptick in the U.S. unemployment rate and a lower-than-expected wage increase per August jobs data. In absolute terms, more people are working in the U.S. right now than prior to the pandemic. In Canada, the labour market appears to be softening at a faster pace as the country has lost jobs for three consecutive months and the unemployment rate has risen to 5.4% in August after bottoming at 4.9% in June. Ultimately, a slowdown in the labour market will help moderate the pace of wage inflation.
Although not back to pre-pandemic levels yet, the global supply chain continues to heal. The Global Supply Chain Pressure Index compiled by the Federal Reserve Bank of New York has eased in six of the last eight months and is contributing to the deceleration in inflation. The improvements have even extended to the semiconductor industry where wait times for chips have been gradually declining as supplies are increasing and demand for chips is decelerating. Again, the situation is not back to normal, but the trend is getting better. From a capital markets perspective, the trend is more important than absolute levels.
Rather than inflation, overtightening of monetary policy is becoming a risk
Desperate to regain credibility from the “transitory” inflation fiasco of 2021, it’s possible that central bankers could oversteer the current inflationary period by raising interest rates too aggressively and for too long. By their own admission, central banks “have no control over the supply shocks to food, energy, labor, or semiconductors” (Lael Brainard, Vice Chair of the Federal Reserve, September 7, 2022). Nevertheless, and perhaps due to mounting political pressure, central banks have zealously embarked on an inflation-fighting mission even as the patient is already showing signs of recovery. The risk of overtightening monetary policy is a severe economic slump.
However, in a potential prelude to pausing the current series of aggressive interest rate hikes, some central bankers have started to vocalize the risks of overtightening. In a recent speech, the Vice Chair of the Federal Reserve stated, “at some point in the tightening cycle, the risks will become more two-sided”. Governor Philip Lowe of the Reserve Bank of Australia went further by stating “we are conscious that there are lags in the operation of monetary policy and that interest rates have increased very quickly. And we recognize that, all else equal, the case for a slower pace of increase in interest rates becomes stronger as the level of [interest] rates rises”.
We think a central bank pivot to a slower pace of rate hikes and eventual pause will be a catalyst for improved investor sentiment. Provided that inflation data continues a downward glidepath, we expect this pivot to come in the next 3-6 months.
Our positive outlook is intact
Even as our managed portfolios have experienced higher than average volatility over the summer, performance is relatively unchanged since the beginning of June. While our overall asset mix has not varied materially in recent months, we have made several changes (outlined below) to better position for a slower pace of rate hikes ahead and the ensuing recovery in investor sentiment that is likely to follow. Chief among these was boosting exposure to long-term Canadian and U.S. government bonds which have attractive yields as well as outsized capital gain potential if interest rates pause and are eventually reduced sometime in 2023. We have also fine-tuned existing international exposure to tilt more defensively. Finally, we are comfortable with our neutral equity weighting that is comprised of a mix of higher dividend yielding companies such as Dream Industrial REIT, Citigroup, Enbridge, and Restaurant Brands International, and high-quality growth-oriented companies trading at attractive valuations such as Alphabet, Visa, Qualcomm, Ford, and Generac.
