“Inflation is always and everywhere a monetary phenomenon.”
Milton Friedman, 1963
Grow versus slow remains the question for stocks and bonds – will a slowing economy descend into recession? The 1.5% decline in the U.S. economy for the first quarter of 2022 was unpleasant news. Inflation continues to be the key focus not only for capital markets but also for households, businesses, politicians and the media.
Heightened inflation complicates the grow vs. slow question. Stocks want growth, but they don’t want to pay the inflation price. On the other hand, after a brutal four months for bond investors, fixed income is better positioned to provide safety to balanced investors if central banks raise rates too high too fast. Central bankers must walk a fine line of hiking rates without sparking a recession. A recession is not our base case scenario, but the odds of it happening have risen. The mere fear of recession will heighten volatility for stocks and bonds.
May brought mixed data to support either the grow or slow argument. While most markets (stocks and bonds) ended roughly flat, earlier in the month equity markets dipped to fresh lows and North American bond yields hit new highs. Flat is certainly not cause for celebration. Capital markets remain on edge. However, the end to the tandem decline for stock and bond prices is a good sign that markets are stabilizing. Markets are pausing to assess how far prices for stocks and bonds have adjusted to 2022’s negative surprises. These are normal, healthy developments; you have to stop the bleeding before you can start to heal.
What has changed? U.S. Consumer Price Index (CPI) inflation slowed for the first time in seven months, falling to 8.3% year over year in April, down from 8.5% in March. One month is not a trend, but it is an encouraging sign that a soft landing for the U.S. economy remains possible.
A soft landing requires tightening monetary policy so that demand is dampened, but not extinguished. For red-hot housing markets, it is about increasing borrowing costs enough to lower the temperature – not put everything on ice. For labour markets, where the number of job openings sits at record highs, it means that slower growth will wipe out want-ads enough to cool wages but not destroy existing jobs. One hurts much less than the other. A cancelled job opening is foregone economic activity – much preferable to someone losing their job.
Central banks are determined to lower inflation even if they have to take harsh measures. Inflation is a three-pronged problem: goods, housing, and services. The first two are moderating, the third (services) is all about wages and is at risk of increasing.
COVID-19 reopenings, excess savings, rising employment, and wage gains are adding fuel to inflation fires. This is so-called good inflation, because all these are generally positive for the economy. Housing inflation is good if you own your home, bad if you don’t.
So-called bad inflation stems from supply-chain logjams and commodity shortages. Many factors are stoking bad inflation: extreme weather; war in Ukraine; geopolitics; and de-globalization (global economies becoming less integrated with each other). On the plus side, bottlenecks are showing signs of easing. For example, major retailers (Walmart, Target and others) are reporting that their inventories are beginning to pile up. Commodities remain a wildcard. Energy and food supplies are experiencing massive disruption due to fallout from the war. These pain points will also slow growth.
Thankfully, most of the world economy was in superior shape heading into 2022. This leaves room for growth to slow without sliding into an outright contraction. Broad indicators of economic health are weakening but remain encouraging. Even in Europe, the resiliency of consumers and businesses has been a pleasant surprise.
Canada — More grow than slow
The Canadian economy is still growing at a robust clip, an increasingly rare status in the global context. Real GDP growth came in at 0.7% in March, adding up to 3.1% annualized real GDP growth for Q1. Of the 35 sectors Statistics Canada tracks, 27 posted upswings, demonstrating Canada’s resilience.
Canadian bond yields rose: 2-year yields increased from 2.60% to 2.67% and 10-year yields went from 2.85% to 2.90%. On June 1, the Bank of Canada (BoC) hiked its benchmark interest rate 50 basis points to 1.5%. With April’s CPI inflation hitting a new high of 6.8%, well above the central bank’s forecast, there is an expectation that more hikes will come. However, the pace of the increase in bond yields is moderating. The views of the bond market and the BoC are now much more in sync. Our central bank believes its benchmark interest rate should be between 2% and 3%; bond yields are already in the 3% neighbourhood.
The S&P/TSX Composite rallied in May, but ended the month down slightly. Energy led the way and gained another 8%, up 41% compared to last year. The EU agreed to a partial embargo on Russian oil imports but not a complete ban. Volatility lingered in oil prices. West Texas Intermediate ranged between US$99.76 and US$114.67 per barrel, ending May on the high mark. Solid quarterly results and dividend increases from banks lifted the index’s performance.
United States — Tough call on grow vs. slow
The U.S. economy shrank by 1.5% during the first quarter of 2022. The consensus view is that the U.S. will escape a recession for at least this year – largely because the pullback was primarily due to trade and inventory adjustments. If it weren’t for this trade imbalance, Q1 GDP would have grown by 3.2%.
Consumer spending, responsible for over two-thirds of the U.S. economy, increased by a solid 0.9% in April. On the other hand, the savings rate dropped to 4.4%, the lowest level since September 2008. Consumers are being forced to dip into their savings as costs rise. Overall, accumulated savings are estimated at 9% of GDP, so plenty of support remains.
Bond yields on the 2-year treasury bill fell to 2.48%, approximately 30 basis points from their earlier year high of 2.78%. The current consensus is that inflation has peaked.
The S&P 500 rallied late month to a roughly flat 0.2% return. The index remains in correction territory and is down 12.8% this year. Earnings (the money companies make) and valuations (what investors are willing to pay for those earnings) combine to drive equity prices. Notably, the recent downturn in stock prices has come at the hands of valuations; earnings estimates have not yet fallen.
Europe — Less slow than expected
Russia’s war on Ukraine is negatively impacting the eurozone economy. Inflation set a new record of 8.1% in May, fuelled by surging food and energy costs. Given the economy's fragile state, the European Central Bank (ECB) is less hawkish than many and has lagged at raising its current ultra-low interest rates. However, the ECB will likely end its stimulus program in July. ECB policymakers are calling for a rate hike, the first in more than a decade. It needs to tighten policy, albeit at a much gentler and slower pace than elsewhere. Surprisingly, GDP forecasts for the region remain above 2% for this year and next.
The war brings considerable uncertainty to any European economic outlook. One potential bright spot is Europe’s strong export links to China. While Chinese growth is sluggish now, China’s central bank is cutting lending rates. Europe’s export engine will get a boost if China can successfully move out of its current slowdown.
Volatility remains elevated but is down from levels recorded at the onset of the war. U.K. and German benchmarks were relatively strong performers against global peers. The Euro Stoxx 50, FTSE 100, and DAX returned -0.4%, +1.1%, and +2.1%, respectively.
China — Slow heading toward grow
China’s economy has suffered huge disruptions under the weight of its zero-COVID approach. Industrial output in Shanghai nosedived 61.5% in April, and profits at China’s industrial firms fell 8.5% from a year earlier, the biggest slump since March 2020.
Beijing admitted that it was struggling to stay on track to hit the annual 5.5% growth target while battling Omicron outbreaks. First quarter GDP growth was 4.8%. President Xi Jinping and policymakers pledged to support the economy. In sharp contrast to the West, China's central bank is easing policy. It cut lending rates for a second straight month, and lowered its benchmark reference rate for mortgages for the first time in two years. June 1 brought further good news when Shanghai officially ended its COVID-19 lockdown.
China’s equity market, represented by the Shanghai Composite, was a top global performer. It gained 4.6% as investors looked past the lockdowns and expressed optimism that policies would stay stimulative.
The last word
Milton Freidman was correct to say that inflation is a monetary phenomenon. But his words were about causation, not consequences. Rapid price increases, especially for essentials such as food and energy, can have both positive and negative impacts. These price signals direct capital to flow to areas where it is needed: pump more oil; bring on alternative (hopefully clean) energy more quickly; and plant more crops. Yet, we should never forget that rapidly rising prices for food and energy come at a high humanitarian cost. Hunger, extreme heat, and life-threatening cold will bring disproportionate suffering to the globe’s most marginalized people. The world needs more kindness. An inexhaustible resource, it should not be scarce.
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