The pandemic-induced chaos that started in 2020 continues to impact the global economy, albeit the ripples are getting smaller. With the worst of the healthcare crisis behind us, 2022 witnessed a broad economic reopening where the mismatch in supply and demand triggered generationally high inflation. Central banks worldwide responded with an unprecedented wave of interest rate hikes to contain the inflation tempest. Inflation has been decelerating for the past six months due mainly to the easing of supply chain pressure and partly to declining consumer demand. It is expected to return to “normal” bounds sometime this year or next. However, even as inflation shrinks in the rearview mirror, investors have another potential foe to face this year: recession.

We think the anticipatory nature of forward-looking markets did a credible job in 2022 of pricing in a potential recession in 2023. However, we view positive momentum in the early weeks of 2023 as a signal that inflation and recession concerns may have been overestimated. With our unwavering attention to valuation across various asset classes, we are optimistic about this year’s return profile, even as we expect performance to be accompanied by a dose of volatility to which we have become accustomed.

Peak inflation is behind us 

Just as election predictions are often made by news networks well before the final ballot is counted, for many months, we have believed that inflation could decelerate and return to normal bounds faster than many expected. We reasoned that pandemic-related supply chain disruptions for goods and services and a flood of monetary and fiscal stimulus were responsible for the spike in inflation. As these supply-demand conditions normalized, inflation would inevitably decelerate.

While inflation is typically referred to in year-over-year terms during normal economic cycles, the swiftness of the current cycle suggests that we must also pay attention to month-over-month trends. In the current cycle, we believe year-over-year measurements are tainted as the second half of 2021 and first half of 2022 were subject to severe supply chain disruptions, short-lived spikes in commodity prices due to the war in Ukraine, and massive government stimulus, all of which has been reversing course since mid-2022.

Using the past six months of month-over-month inflation statistics for Canada and the U.S. suggests that inflation is indeed decelerating. Annualizing data from the past six months indicates that Canadian inflation is running at 0.2% and U.S. at 1.8%, well within the central bank’s 2% target. The most promising signs of disinflation are currently in the goods sector, while prices in the service sector have only taken baby steps toward disinflation.

In its January 25 interest rate policy statement, the Bank of Canada pivoted to a similar conclusion: “inflation is projected to come down significantly this year. Lower energy prices, improvements in global supply conditions, and the effects of higher interest rates on demand are expected to bring CPI inflation down to around 3% in the middle of this year and back to the 2% target in 2024.” Despite increasing evidence to the contrary, the U.S. Federal Reserve has continued its hawkish inflation rhetoric, but we expect inflation data in the coming months will trigger a similar pivot.

Interest rates inching toward cyclical peak

The breadth of the current global rate hiking cycle is unlike any in the past, as virtually every major central bank has been raising interest rates to counter inflationary forces produced in the aftermath of the pandemic. While scholars will debate for years to come whether central banks initially underreacted and then overreacted, we note that rate-hiking cycles in Canada and the U.S. are inching closer to the end, which is a critical ingredient for restoring consumer, business, and market confidence.

Citing progress to date and known lags between interest rate policy and its impact on the economy, the Bank of Canada recently stated, “if economic developments evolve broadly in line with the Monetary Policy Report outlook, Governing Council expects to hold the policy rate at its current level [4.5%] while it assesses the impact of the cumulative interest rate increases.” (Emphasis added by the author)

In the U.S., the Fed slowed the pace of interest rate hikes to 0.25% at its February 1, 2023 meeting, bringing its widely followed short-term rate to 4.75%. This is a further downshift from a 0.5% increase in December 2022 and several 0.75% increases before that. At the time of writing, the market anticipated further 0.25% increases at the March 22 and May 3 Fed meetings, setting up a possible terminal rate of 5.25%.

With the Bank of Canada hitting the pause button and the Fed expected to follow in the coming months, incoming economic data will dictate how long the pause will last before rates start to decline. In the last five interest rate cycles since the early 1980s, rates plateaued for an average of eight months before cuts began. It is not surprising, then, that the interest rate futures market is pricing in cuts starting late this year for both Canada and the U.S. The prospect of these rate cuts on the horizon (some would call it a mirage, but that’s what makes a market) has contributed to improved investor confidence so far this year.

Strong job market is both blessing and curse 

As discussed later, a strong job market helps minimize the risk of a sharp economic slowdown. However, even as decelerating inflation data has been supportive of an imminent interest rate pause, some central banks have seemingly moved the goalpost and have become fixated on continued tightness in the labour market as a potential source of inflation flare-up. With the latest unemployment rate for January printing at 3.4% in the U.S. and 5.0% in Canada, both near all-time lows, the knee-jerk reaction is that further wage inflation is inevitable. However, a quick look at the pre-pandemic labour market, when unemployment was also near cyclical lows, shows no evidence of a wage spike or broad consumer price inflation. This suggests that low unemployment is not necessarily inflationary.

Despite anecdotal claims of being more productive during the pandemic, empirical data reveals that average worker productivity (measured as output per hour worked) declined in Canada in 2021, and the U.S. experienced a dip in 2022. These uncharacteristic drops in labour productivity have contributed to stubbornly tight labour conditions and related wage inflation, as employers are spending more on labour for each unit of output. However, gradual improvements in the labour force participation rate, return to in-person work, and rising layoff announcements suggest that disruptions triggered by the pandemic will soon start to ease, just as in the goods sector.

Soft landing, hard landing, or no landing?

The purpose of interest rate hikes is to combat inflation by slamming the brakes on demand. In past cycles, this has invariably caused an economic slowdown. With monetary policy typically taking 12-18 months to take full effect, the sonic boom of the current rate cycle (the fastest in decades) has yet to fully hit the economy. The raging debate amongst economists is whether the upcoming slowdown will take the form of a mild recession (“soft landing”), deep recession (“hard landing”), or escape a recession scenario altogether (“no landing”).

With unemployment near all-time lows, consumer and business balance sheets generally in good shape, healthy bank capital ratios, a broad restart to the global economy, and softening commodity prices, the risk of a hard landing remains low based on current economist consensus. That leaves most economists in either the soft landing or no landing camp, with the latter gaining more supporters in recent weeks. At the time of publication of this newsletter, consensus U.S. and Canada real GDP growth expectations for 2023 stood at +0.6% for both economies (upwardly revised from 0.3%-0.5% in January), followed by a modest improvement in 2024.

Upcoming debt ceiling debate is likely more bark than bite

The U.S. debt ceiling was reached in mid-January, and the U.S. Treasury has given Congress advance notice that it will run out of temporary maneuvers by summer, raising the possibility of a default. The change in control of the House of Representatives, and the slim Republican majority there, has complicated the debt ceiling debate this year. While politicians on both sides of the aisle overwhelmingly prefer to avoid a default, the debt ceiling debate could raise investor anxiety as the summer deadline approaches.

While we intend to monitor the situation closely, a historical assessment of the U.S. debt ceiling suggests that risks of a default remain low and do not currently warrant portfolio adjustments. According to the U.S. Treasury Department “Congress has always acted when called upon to raise the debt limit. Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit – 49 times under Republican presidents and 29 times under Democratic presidents.” On average, that’s once every ten months!

Markets building a bridge across short-term volatility

Equity and bond markets are forward-looking and are thus continually adjusting to an evolving view of future economic conditions. This means that markets sometimes move in a direction that may seem contrary to short-term data or risks. The present environment continues to be riddled with short-term uncertainties such as inflation, further rate hikes, economic slowdown, debt ceiling, and geopolitics. And yet markets have moved higher year-to-date despite these issues.

We attribute the improved tone so far this year to the market’s interpretation of how present uncertainties will evolve over the next 12-18 months. In the case of inflation, where wage-price spiral headlines dominate the media, consensus estimates peg U.S. and Canadian consumer prices to continue trending lower and end the year at 3.8% in both countries and then falling below 2.6% in 2024. The same applies to interest rates, where the short-term debate is whether there will be one, two, or three more rate hikes, whereas markets are looking further ahead and envision potential rate cuts a year from now. We agree with the market’s read on key variables and the willingness to look beyond the valley of short-term uncertainties to a period with more favourable fundamentals.

The equity market rebound from October 2022 lows, and lower 2023 earnings expectations have resulted in broad market valuation multiples returning to historical averages. While pockets of the equity market remain attractive to us, such as financials, real estate, and technology, we remain enthusiastic about the return profile of the bond market over the next 12-18 months. With interest rates expected to plateau soon and likely decline a year from now, bonds offer a unique opportunity to earn a high rate of interest and generate capital gains. This is especially true for bonds with longer maturity dates.

The exceptionally fast pace of interest rate hikes last year, which surprised everyone, including the very central bankers that set rates, had an outsized negative impact on equity, bond, and real estate prices. While short-term uncertainties will continue to drive volatility, we expect a steady tailwind for asset prices as the rate cycle reverses. Given this 12-18 month outlook and depressed asset prices, our managed portfolios have been moving steadily to deploy cash.