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Goldilocks or In Limbo?

The North American equity and fixed income markets foreshadowed differing views in June. Equity markets advanced even in face of hawkish comments from the Central Banks. The yield curve inversion deepened on both sides of the border suggesting an increased risk of a recession as the Central Banks continued to emphasize a need to do more. The Bank of Canada restarted hiking interest rates during the month and the US Federal Reserve chairman, Jerome Powell, reemphasized that the committee foresees at least two more hikes this year. Stronger-than-expected economic data raised hopes that a potential recession can probably be avoided and simultaneously reduced expectations of any immediate pause in the rate hikes and any potential cuts later during the year.

The headline inflation in Canada aligned with expectations of +3.4% during the month of May (reported in June), down from +4.4% in April (reported in May). In the US, the headline inflation was at +4.0% for the month of May (reported in June), down from +4.9% in April (reported in May) and expected +4.1%. The US inflation number (to be reported on 12 July) is expected to fall to +3.1%. While these numbers indicate movement in the right direction, the progress has been slower than what the US Federal Reserve would like. Layer on a very strong labor market, we have a Fed committee that is prepared to err on the side of caution as any premature hints of a policy pivot could blunt the impact of policy measures taken thus far. The monetary policy works with long and variable lags, and the lag seems to be longer this time. The housing starts, building permits, new home sales, durable goods orders, and the conference board’s consumer confidence numbers were all better-than-expected during the month, indicating economic reacceleration instead of a slowdown as one would have expected after the rate hikes over the last year. The US unemployment rate declined to +3.6% in June (reported in July) from +3.7% in May (reported in June).

Half-way through the year, the Central Banks’ fight against inflation is still dragging on. Nevertheless, the equity markets price action in June was more broad-based in the face of better-than-expected economic momentum suggesting equity investors believed the inflation problem can be solved without having to incur substantial economic damage. We believe there is some merit to this narrative. The Fed has consistently pointed to core inflation and tight labor market as reasons for concern. Core inflation has remained stubbornly high between +5.3%-to +5.6%, year-to date. The job markets are exceptionally strong with 1.6 job openings for every unemployed worker in the labor force.

It is noteworthy that the ‘shelter’ component of inflation constitutes about ~35% weight of the headline inflation and ~43% weight of the core inflation. This component has been on an increase for most part of the last couple of years but has begun to level off recently. As per’s rent estimates and vacancy index, the year-over-year growth in rents is back to historical levels and vacancies have been on a rise. (See Figure 1).

Figure 1: CPI Urban Consumers Shelter Index and’s median rent and vacancy Index, year-over-year %

Source:, Bloomberg

We think as the shelter component of the headline inflation calculations begins to factor in more recent growth rate in rents, the core inflation numbers should also begin to moderate. Moderating inflation numbers coinciding with healthy economic data in coming months could strengthen the narrative that a potential recession could be avoided and thus support risk assets. That said, the risks remain that impact of monetary policy tightening begins to show with a lag and the Fed continues with hawkish posture even as inflation recedes due to strong labor markets. The second-quarter earnings season and the economic data over next few months with bring more clarity and set the tone for markets.

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