Participants:
Sabeen Saeed: Regional Director, Investments, BMO Private Investment Counsel
Douglas Porter: Chief Economist & Managing Director, BMO Financial Group
Richard Belley: Fixed Income Strategist & Portfolio Manager, BMO Private Wealth
Brent Joyce: Chief Investment Strategist, BMO Private Investment Counsel
On May 25, BMO Private Wealth held a virtual session on inflation and expectations for the future. The hot-button topic was hosted by Sabeen Saeed, Regional Director, Investments, BMO Private Investment Counsel. To begin, Saeed introduced Douglas Porter, Chief Economist & Managing Director, BMO Financial Group to discuss the economic landscape.
Taking the Financial Pulse
At the start of the year, Porter began, it was already the most complex economic environment he’d seen – and that was before the war in Ukraine. “From an economic standpoint, the invasion acted as a supply shock to the global economy, which increased pressure on inflation and dampened growth outlook,” he shared, adding that a weaker growth outlook added a new dimension to the conversation.
The most important implication to the financial markets is the runup in oil prices, Porter continued. Even with a minor retreat recently, the trend is clear: Oil jumped from $90/barrel to $110/barrel after the invasion. Long-term interest rates, in turn, climbed higher.
And, the all-important bond yield has gone up more than a percentage point due to the inflationary impulse. Now there’s weakness across the board in equity markets, most notably in the U.S. The Nasdaq is in a full-on bear market, while the S&P 500 has been flirting with that territory too.
Of note, there’s been little movement with the Canadian dollar since the invasion – and even over last the few years. It’s been remarkably stable, shared Porter. The dollar is not responding to commodity prices. “We believe the currency is more likely to strengthen over the next while, rather than weaken.”
Economic Outlook
The global growth forecast has been revised down, largely due to the war in Ukraine. The European and U.S. growth forecast has been revised too, as has China’s in response to rolling lockdowns. The Canadian economy should fare relatively well this year and next, Porter said. Despite talk of recession, he believes that the fundamentals of the Canadian economy are stronger than those of other countries. For one thing, we had some of the most intense COVID restrictions and the economy is still benefiting from opening. For another, Canada produces and exports similar products to Russia.
Jobless Rates: Back to Normal
The labour market and its capacity to fully heal has been impressive, Porter continued. Jobless rates are the lowest in 50 years and expected to drop further. In fact, the jobless rate of every major industrialized economy is close to, or below, where it was pre-pandemic. “That’s a huge story,” exclaimed Porter, adding the unemployment rate in Canada is sitting at approximately 5 percent, and at below 4 percent in the U.S. “It’s a major achievement.”
Inflation Jumps – For How Long?
On the flip side, however, we now have a very tight labour market which is putting serious upward pressure on wages and adding to a very fraught inflationary environment. Keep in mind that inflation was a serious issue even before the Ukraine invasion, with the U.S. inflation rate at 7 percent and Canada’s at almost 6 percent.
Of course, the inflation issue is a worldwide phenomenon. Britain has an inflation rate of 9 percent, while the rates in Mexico and Brazil are also high. Japan and China, though lower than other countries, are still higher than usual.
“I tend to agree with the view that supply chain issues are as much a symptom as a cause,” Porter stated. Inflation can be traced back to pandemic stimulus policies which juiced demand well beyond what the supply chain could handle. To fix the situation, we need to take some of the steam out of demand, he added.
Porter believes inflation will last longer than what other forecasters have predicted. The abundance of job openings in North America is driving up wages, which will sustain some of the inflation pressures. The interest rates have only just begun their increase, added Porter. “It will take a pretty serious increase in interest rates to bring inflation to heel.”
We’ve already seen a 3/4 percent interest rate increase with the Fed, and it’s climbing for the BoC too. Both interest rates will have to rise above two percent, he argued. If there’s any good news, it’s that longer-term interest rates have already taken these hikes on board; long-term bond yields are reflecting these increases.
Fiscal Policy
Another positive note, shared Porter, is that government finances are improving as revenues return to pre-pandemic levels. “We paid for the pandemic with one step up in Ottawa’s debt-to GDP ratio, and we will hopefully see that ratio come down further over the years.”
Richard Belley, Fixed Income Strategist & Portfolio Manager, BMO Private Wealth, discussed the challenging period it’s been for bond investors. “In anticipation of the aggressive response by central banks, we have seen interest rates move significantly higher in a short period.” There’s been an upward shift in yield curves in North America and the longer the securities, the greater the impact on performance.
Meanwhile, the shorter-term investments, such as treasury bills, were also impacted by the interest rate shock. And that’s led to negative bond returns, something we have rarely seen in 40 years.
Rise in Yields
Most yields have almost doubled in the short-term. Initially, the rise reflected inflation market expectation. But, while the recent expectation is moving beyond what’s respectable, 2022 is really a story of rising real yields (stripped of the inflation expectation). In Canada, real yields rose more than one percentage point – a hundred basis points – in a very short period.
The Perfect Storm
On top of inflation expectation and higher real yields, the widening of credit spreads added another shock to the fixed income portfolio, providing less protection to investors. These three factors resulted in the perfect storm, said, Belley, leading to the worst return and performance on record.
But we need to focus on long-term gains and silver linings, asserted Belley. First, despite the lower bond portfolio evaluation, there hasn’t been any permanent capital impairments – no major default in corporate bond markets, for example. Second, the rising interest rates are already priced in; the market has adjusted to what may come. Basically, the worst is behind us, Belley contended. Third, investors still have more than half their interest coupons to be earned this year.
Keep in mind that average yields are exceeding by 3 to 4 percent, while GIC rates have moved significantly higher and offering some of the best short-term rates we’ve seen in years. These higher rates should help mitigate the negative impact of portfolio performance today and in the future.
The combination of rising interest rates and risk premiums resulted in yields for most of the fixed income sector, now more attractive than equity dividends. Of course, Belley added, now is not the time to reduce and/or liquidate fixed income portfolios or reduce overall exposure.
Better Days
Brent Joyce, Chief Investment Strategist, BMO Private Investment Counsel, reiterated the importance of acknowledging recent developments. The economy has come a long way from the depths of the pandemic. Real yields rising is a sign that the economy no longer needs the life support central banks have been providing. In turn, income is returning to the equation for an important segment of capital markets: the savers.
“Better days are here,” claimed Joyce. To be sure, the war, supply chain challenges and inflation continue to cause challenges. But strong demand is not bad for equity investors, and supply chains can be repaired. Our speed just needs to move from “running too hot,” one key reason why we have high inflation, to one that is more sustainable.
The combination of weak equity markets and weak bond markets is rare, said Joyce. But don’t forget that earnings growth is the lifeblood of share price appreciation and earnings are continuing to grow. Damage from the first quarter has adjusted some of the imbalances within stocks and bonds, a development we should welcome as investors, Joyce said.
Finally, Canada will benefit from the commodity surge, with cyclicals likely to continue to lead in the short-term. The hawkish outlook will continue for fixed income portfolios, Joyce continued. “Equities can continue to perform despite hawkish policy and valuations are now more attractive.”
You can watch the full discussion here: https://www.odysseyproduction.ca/live/bmoinflation/
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