Inflation, interest rates, and monetary policies: February 2022

Martin Lefebvre (ML) and Louis Lajoie (LL)

(ML)

Hi, everyone. Welcome and thank you for tuning in this podcast. My name is Martin Lefebvre. I’m Chief Investment Officer at National Bank Investments. And today I have the pleasure of being with Louis Lajoie, our Senior Investment Strategist and Portfolio Manager of our asset allocation mandates to talk about the top-of-mind topics such as inflation, rising rates and market opportunities. First things first, Louis, welcome, and thank you for being with us.

(LL)

Thanks Martin. Happy to be here.

(ML)

Excellent. Louis, last summer, central banks were telling us or suggesting that the rise in inflation would be transitory and at that time we were hovering around 5% in the U.S. and suddenly, we’re up to 7.5% of 40-year highs. What’s going on? What’s your take on the matter?

(LL)

Right, indeed. I think it’s fair to say that the situation didn’t evolve in the direction desired by central banks. As you said, CPI at 7.5% is quite something, but perhaps I think more interestingly is the fact that its inflation price pressures became much more broad-based over the past few months than they were back last summer. That’s the message that we see from other inflation measures such as the one from the Cleveland Fed, trim mean inflation that excludes the most volatile components from the CPI baskets that now stands at 5.4%, quite a change in just a few months and a question we get asked a lot is are we in the camp of those that think that inflation is transitory or persistent and that’s a debate that’s really polarizing within the investment and investors and economists’ communities. As is often the case, I think you know there are elements of truth in both camps, and given the fact that there’s, you know, multiple inflation data dynamics at play simultaneously.

I think there’s no doubt that there are transitory elements behind the surge inflation. But the persistence of the pandemic has clearly an effect on spending patterns, namely concentrating them into consumer goods just as supply of goods was affected by a succession port closures, factory closures given the pandemic. So that has led to multiple supply chains issues. Consequently, if you look under the headline CPI figure, you will see that durable goods prices are actually up 18% year over year, which is something that we have literally never seen, not even during the 1970s and an example of that 18% is the 40% increase in use cars and trucks. Substantial movements in terms of price of goods, and just to give a bit of perspective on that front. If you look at durable goods historically, over the past 20 years before the pandemic, its average inflation was minus 1%. It’s hard to argue against the idea that there is a transitory impact at play here behind the surge in goods.

We did see some price pressure easing in Q3 following the peak from the Delta wave. With the arrival of the Omicron wave, we saw several high frequency indicators price such as the cost of shipping containers from China and the price of semiconductors as well. They had moved back up quite substantially to record highs. Unsurprisingly, we saw the price of goods still quite high. Now when we look ahead, I think it’s reasonable to expect that these trends will eventually abate over the course of the year. It’s certainly not going to happen overnight, perhaps not even this quarter, but if the pandemic finally takes the backseat and stops having a material impact on your day-to-day life, I think it’s reasonable to expect consumption patterns to start to migrate from goods to services to get towards a more sustainable balance that will ultimately ease pressure on overall prices and in any event, we’re already starting to see inventories picking up quite substantially.

Companies clearly have been able to adapt to some extent to these challenges on the supply chain fronts. And so even if demands for goods remains relatively strong for still a few more months, I think it’s quite clear that prices will eventually stabilize as supply picks up this year.

(ML)

Thank you, Louis, for that. It’s very interesting and what we hear from central bankers most of the time is that they don’t have much grab on supply shock issues, which is clearly the case here with this pandemic-led shock on many items. Are there more persistent factors to think about holding that forward guidance from central banks, it’s clear that there will start increasing interest rates soon?

(LL)

There are other factors at play here and just to be clear, even though goods inflation will come down this year, overall inflation is likely to settle at a relatively high level from a historical perspective a year from now, certainly lower than today, but probably higher than in the last 10 years. And the reason for that is, as you said, more persistent or structural factors at play, one of which is the cost of shelter that is almost certainly going to continue to rise over the course of the year. We see a historical lagging relationship between housing prices and the cost of shelter that carries a significant weight in inflation baskets. So, so that’s going to remain well supported this year, given the sharp rise in house prices that we are all aware of and that took place over the past two years or so. But more interesting I think and more important factors to keep an eye on this year and even beyond as the impact of labour scarcity on wages.

Now, virtually all indicators we look at in terms of labour demand are at peaks. But even beyond that in the very real world, I think we just need to take a walk in any downtown or talked to any business owner and you’ll see a clear situation of labour scarcity on both ends. If we look at in the U.S., we see that this has already started to have an impact on wage growth. Wages are up at a record pace that we haven’t seen in the past 20 years. And again, this situation is also to some extent exacerbated by the pandemic, given that many workers moved up their retirement plan, decided to change careers, simply took their time, given the amount of excess savings that they had accumulated during the pandemic. There is also a transitory part to that story. But even beyond that, demographic trends don’t lie with a larger share of population moving from primary workers to primary consumers or retired.
That should continue to put a tailwind on wages over many years, which in turn impacts mostly services inflation. Labour scarcity is going to be challenged for years to come, but there are also positive things at play here. It’s not only bad news. Obviously, we’re coming out of a decade of low wage growth, so seeing it picking up is good news to some extent. And what’s also interesting is if you look under the hood, you’ll see that it’s mostly the lower wages part of the income distribution that we’re seeing. They’re the strongest growth, which in turn helps reduce income inequality that is again super important for social cohesion. There is ground for optimism, but for as long obviously as overall wage growth remains at reasonable levels. That’s the case for now and we must keep an eye on it just to ensure that it remains the case. But I think there are valid reasons to believe so.

(ML)

OK, perfect. A little bit of transitory factors that are easing, but some persistent wage push kind of inflation. It’s not surprising to see that central bankers have sort of increase their expectations of rate hikes. We went from, you know, not so long ago only three rate hikes to almost six rate hikes now expected by the markets. Is that a reasonable expectation?

(LL)

Indeed, it is quite a pivot from Mr. Powell, the Fed chairman, that we’ve witnessed over the past few months. In his defence, his approach that he labelled as wait and see over most of 2020 and 2021, it was just a fireball given just how unprecedented the post-pandemic economy was and when we had very little visibility on the near-term cores for the economy. But that’s no longer the case. Not only we better understand the virus now, and we’ve largely adapted accordingly, but we’ve also seen inflation rise substantially, but especially the labour market has recovered almost entirely over recent weeks and months. For instance, with the unemployment rate in the U.S. that currently stands at 4%. It’s essentially within the range that the Fed deems to be in line with its full employment mandate.

It’s obvious that the time has come for interest rates and policy rates to normalize, and we would be worried if central banks weren’t projecting rate hikes over the coming months. Now is it going to be 6 as markets currently expects for the next 12 months or is it going to be 4 as economists here at National Bank expect for 2022 or five if you include early 2023? Honestly, I don’t know which number it’s going to be. What I do know is that the speed and magnitude of rate hike expectations that have been priced in over the past few weeks, it leaves little room for markets to discount even more tightening from this point. And more importantly, I think we’re starting to see some yellow flags show up on markets that should limit the potential for more aggressive monetary tightening on the part of federal reserves. Thinking about long-term inflation expectations: even though we’ve seen, you know, CPI at 7.5%, the reality is that over the recent weeks, long-term inflation expectations have moved significantly lower and even below the Fed targeted range over the long run.

That’s something to keep in mind. And the other thing that we saw in markets is this yield curve flattening that that we’ve seen. We’re not yet at an inversion as historically signalled when the Fed had gone too far. But when we look at forward rates, we see that this could very well happen a year from now should the Fed be too aggressive. We’ll have more information with regards to the Fed’s intentions at its next policy meeting on March 16. They’ll hike rates at this meeting. But more interestingly, I think they also provide an update under projections and markets will be very attentive. But at this point, I think we were due for normalization of rates. It’s necessary. I’m just not sure that the economy really requires the Fed to slam the brakes on demand. What the economy mostly needs is simply time for the demand to start to migrate and be better distributed between goods and services.

(ML)

We’re not too sure about how many rate hikes will be necessary, but one thing is sure is that we will probably see interest rate hikes starting in March. What does it mean for a client asset allocation?

(LL)

For investors, as we’ve seen earlier this year, 2022 will certainly not be as comfortable as 2021 and that holds for both the bond market and stock markets. I think investors must temper their return expectations. We are coming out of a period quite profitable, especially on the stock market. We should also expect more volatility against this background. But we still think pro-risk asset allocation is warranted. At this stage in the cycle, if we look at equity markets, we’ve seen that, historically, whenever the Fed started a rate hike cycle, stocks have always been more volatile in the months around that first-rate hike with pullbacks in the range from 5 to 10%. But what we also see is that beyond these fluctuations in the near term, in every case since the 1990s where the Fed started rate hike cycle, 12 months afterwards stocks were carried higher by earnings growth, which shows that whenever the Fed starts to hike rates, it’s certainly because the economy is showing great strength, great momentum. That’s the case at this stage and we expect the stock market to remain well supported.

For bonds, the backdrop should remain challenging. It’s been quite challenging for a few months, but I think a lot appears to be discounted at current levels. I think it’s fair to say that the worst is probably behind us for the bond market. If you take for instance 10-year U.S. Treasury yields given how fast they moved all the way up from 1.42% since the beginning of the year, I think it’s due for a consolidation phase and beyond that in this cycle we would be surprised to see them rise above 2.5%. In other words, if you start from the low point of the 0.5% reached in the summer of 2020 and assuming that the ceiling in this cycle is 2.5%, that means that we’ve already gone through at least 3/4 of the normalization process of long yields. So, this background still argues for shorter duration position. It still makes sense tactically. We hold a cash position notably for this reason. But again, stagnation is probably a better expectation of the near future than sustained drop for bonds.

Finally, within equities, we still like the Canadian market for its cyclical properties and against this background of inflation that should peak but remain above average economic growth and is also expected to remain above the average, even though it should taper a bit coming off the strong figures we saw last year. So that that’s still arguing for a cyclical stance within the equity market. The Canadian stock market should farewell because of that. But I think it’s important to keep an eye on diversification as well and avoid overly aggressive deviation. So, for instance, would still like the USA equity market as well, even though it’s clearly less cyclical than Canada, but it has the advantage of having many quality large-cap stocks that went in that quality factor, I think it’s going to be an important asset. This year, and even beyond, considering the pressure on profit margins and the pressure on the cost of debt, quality is an asset important for the U.S. equity market and it’s something that we don’t see as much abroad.

(ML)

Thank you very much, Louis. That’s all the time that we’ve got today. Thanks again for sharing your thoughts on the market with us and everyone, thank you once again for tuning in. We will be back with another top of mind my topic very shortly.