Peak Inflation Delayed?
In June 2022, inflation, the most closely watched, and potentially the most important economic datapoint(s) from an investors’ standpoint, disappointed. Reports for the twelve months ending in May 2022 showed that inflation increased to +8.6% in the US and to +7.7% in Canada. As both readings were above initial projections, market participants realized that the expectations of having reached peak inflation were premature, which brought in a turbulent market over the month of June.
The US Federal Reserve followed up with a +75 basis points hike in policy rates, against the previously indicated +50 basis points hike. The Bank of Canada increased policy rates by +50 basis points at the start of the month. However, due to the higher-than-expected inflation numbers, the market expectations of a jumbo-sized hike (i.e., +75 basis points) during the mid-July policy meeting- have increased.
The North American markets reacted to the above developments, with the S&P 500 Index and the S&P TSX Index declining by ~-9.0% and ~-8.4% for the month, respectively. Fixed income markets showed strain against the faster-than-expected pace of policy rate hikes. Bond yields increased by +43 and +39 basis points on 2-year term, and ~33 and ~16 basis points on 10-year term for Canada and US, respectively.
We note that the industrials, metals, agricultural commodities, and crude oil prices have come off their recent highs (See chart 1) and US total manufacturing and trade inventories have been increasing (See chart 2). Does that mean the inflation numbers could veer to the downside in the next month’s report? We think it is possible, but even if it does, it will only support markets for a short-term as they are unlikely to react convincingly unless the data shows continuous improvement for a few consecutive months.
Chart 1: Commodities have come off their recent highs
Daily prices indexed to 100, June 29 2021 to June 28 2022
Chart 2: US Manufacturing & Trade Inventories, year/year %age change (MTIBYOY Index) vs. US Manufacturing & Trade Inventories, US$ billions (MTIB Index)
Jan 2000 to April 2022
We believe a decline in inflation, along with some moderation in economic growth, are the necessary pre-conditions for the markets to react constructively. This would indicate that the Central Banks’ actions are yielding results, and that things are finally heading in the right direction. The messaging from the Central Bank authorities indicates that they believe such an outcome is possible, though the path to achieve this outcome is becoming increasingly more challenging.
If Central banks achieve the above conditions, this will normally justify a slowed pace or pausing of rate hikes. We now think the odds have shifted in favour of them not taking their foot completely off the brakes due to a lingering risk of inflation beginning to rise again. The data on the underlying components of the latest inflation report indicated that inflation is becoming broad-based, thereby increasing the likelihood of becoming sticky. Since inflation expectations will be more difficult to contain the second time around, we think the probability of central banks erring on the side of caution is now elevated. The only exception to this would be if something breaks due to high interest rates, or the risk of something breaking in the economy becomes too great.
Given the above backdrop, we continue to advocate for a defensive stance in portfolios by overweighting companies that are generating high cash flows, paying dividends, have defensive business models, and have low debt burden. Furthermore, adding alternative strategies with low correlation to traditional strategies and building some optionality to pick assets at bargain prices as the challenging macroeconomic environment plays out in the coming months should place investors in a better position as they come out on the other side of the cycle.
