Inflation continues to hold the most sway over capital markets, and its direction will determine the path of interest rates, asset prices, and geopolitical stability.
The absolute level of inflation, the highest in decades, is inflicting pain on consumers and investors alike. For those old enough to remember the last time inflation was this high, it rekindles memories of labour strife, double-digit mortgage rates, price controls, and economic instability. As every economic cycle has its own unique drivers, we think the current inflationary period may trigger similar symptoms, but their intensity is likely to differ. Ultimately, the toll that inflation will exert on the economy and capital markets will be driven by its altitude and duration. While we need a few more data points over the next few months to confirm our thesis, we believe inflation has peaked or is close to peaking.
In most cases, the price of goods and services is based on the economic principles of supply and demand. Prices rise and fall to reflect the shifting equilibrium between purchasers’ and suppliers’ willingness to transact at a given price. Prices appreciate when demand exceeds supply and depreciate when supply exceeds demand. The current bout of inflation (YoY April consumer price inflation was 6.8% in Canada, and 8.3% in the U.S.) has been fueled by a confluence of factors that have elevated demand while curtailing supply, leading to a perfect inflationary storm.
On the demand side, aggressive government spending during the pandemic, ultra-low interest rates, the wealth effect from rising real estate and financial assets, and varying speeds of economic reopening have all contributed to a rise in demand for goods and services.
Meanwhile, pandemic-related shutdowns reduced supply, global distribution systems developed kinks, and the labour force participation rate has yet to fully recover resulting in widespread staffing shortages. While inflation was already rising, the Russian invasion of Ukraine has aggravated the supply-demand equation across various industries, particularly energy and agriculture.
Finally, China’s zero-Covid policy and renewed lockdowns of critical economic zones have crimped manufacturing and distribution of goods as the rest of the world’s reopening has raised demand.
Maintaining price stability is one of the primary responsibilities of central banks, and interest rate policy is the tool that they wield. Interest rates are increased during periods of elevated inflation with the goal of reducing aggregate demand. During slower economic periods, central banks reduce interest rates to encourage spending. Given the complex nature of the current supply-demand imbalances, we think interest rates are a blunt instrument at best as they do little to address the supply-driven factors fueling inflation.
After shrugging off inflation as “transitory” in 2021, the U.S. Federal Reserve and other central banks have reversed course in 2022 and intend to combat inflation by aggressively raising interest rates. Since asset prices are inversely correlated to interest rates, capital markets have become volatile this year as it remains uncertain how high interest rates will go during this current cycle, and whether central banks will make a “policy mistake” by tightening too much.
With inflation being the primary culprit behind the equity and bond market decline this year, inflation statistics in the coming weeks and months will be crucial not only for central bank interest rate policy but also for investor sentiment (which has deteriorated to the March 2009 Financial Crisis lows per weekly survey data that we monitor). A convincing inflection point in inflation statistics would soothe fears that interest rates need not rise to alarmingly high levels. April U.S. CPI of 8.3% did decelerate modestly from March’s 8.5% reading, but additional data points for May and June are needed to confirm that a decelerating trend has developed. A consensus of economist forecasts, which expects CPI to decline to 7.9% by June, 7.1% by September, and 5.8% by December, lends credence to the thesis that inflation has peaked or is close to peaking.
Evidence is emerging that a combination of high prices and higher interest rates are starting to have an impact on consumer demand. Weaker than expected earnings reports of major retailers such as Walmart and Target suggest that consumer demand is downshifting. Residential home prices, the largest constituent in the consumer inflation basket, are also showing moderation as higher mortgage rates crimp demand (as an example, average GTA detached home prices declined 9% from the February peak to April according to the Toronto Real Estate Board). Again, further time is needed for a convincing pattern of declining demand to emerge.
There is also optimism that some of the issues on the supply side of the equation will start to contribute to lower inflation in the coming months. The extremely tight labour market, where many employers are operating below capacity and having to raise wages to retain workers, is showing early signs of improvement. This evidence comes in the form of weekly unemployment insurance filings, which have been gradually rising over the past 8 weeks. A new gauge measuring constraints in the global supply chain (Global Supply Chain Pressure Index reported monthly by the Federal Reserve Bank of New York) indicates that issues peaked in December 2021 and have been gradually improving since. A reopening of Chinese cities is underway and shipping ports have resumed operations. The supply of oil and gas, however, remains a global issue and may take somewhat longer to resolve.
Valuation has become attractive, decelerating inflation is a catalyst
With numerous corrective forces working on both supply and demand, we think economist forecasts calling for a deceleration in inflation and the economy over the next several months are credible. The government bond market, which is highly sensitive to inflation expectations, has also stabilized in recent weeks and is perhaps the most important signal that the future path of central bank interest rates may be shallower than feared. The interest rate yield on the much-watched 10-year U.S. Treasury bond has declined to 2.78% after reaching a peak of 3.13% on May 6. This suggests that central banks are likely to slow the pace of interest rate hikes later this year and may stop raising sometime in 2023. Depending on how fast the economy cools from the effects of higher interest rates, some economists are expecting central banks to begin reducing interest rates mid-to-late-2023.
Equity markets had become accustomed to lower interest rates during the height of the pandemic and valuation had risen to cyclical highs. In some corners of the equity market, valuation became frothy and is undergoing a severe contraction. Shopify, which had once overtaken Royal Bank as the most valuable company in Canada, has declined 80% from its November 2021 high and is likely still overvalued in our opinion.
With a sharp focus on valuation, we managed to avoid the speculative bubble in technology, “meme stocks”, and cryptocurrency. However, the overall reduction of valuation multiples brought on by higher interest rates hasn’t left our portfolio unaffected (the price-earnings ratio for the S&P500 has declined 25% from 21.6x in December 2021 to 16.3x currently). With an expected moderation in inflation and interest rates as a catalyst, and a focus on high-quality companies with low valuations, solid balance sheets, dividends, and earnings growth, we believe the investment return profile of our managed portfolio over the next 12-18 months is attractive.
With an elevated cash weighting in our managed portfolios at the end of 2021, we have been deploying liquidity into various investment opportunities so far in 2022. While our entry points may not have been at the lows, we believe that we will be rewarded over time as investor confidence recovers from its current panicked state. In addition to raising the equity weighting in our primary managed portfolio to 61% currently from 55% in December 2021, we have been adding long-term U.S. and Canadian government bond exposure that we expect will also benefit from stabilization and eventual decline in interest rates.*
