We are mostly through another quarter of earnings reports in both Canada and the U.S., and the May month-end inflation data was reported this past Friday morning. It remains to be seen what the outcome will be for the current interest rate hiking cycle, whether inflation can be controlled and our economy can maintain some semblance of growth, or whether we’re heading for a recession. The waters are now getting muddied and our expectations for the path forward for markets and our economy is getting more complicated by the data that has recently been reported.
The inflation data is important to understand as it will have implications for both the markets and the economy over the coming 6 – 12 months, and it is dictating the policy decisions of central bankers and what tools are required to manage their mandate of stable economic growth and full employment. High inflation figures will create volatility in equity markets due to expectations for a weaker consumer and reduced corporate earnings, and will cause changes to equity and fixed income allocations for investors as interest rates rise and bonds become more attractive. The path of the inflation data is important also. Markets will anticipate growth in prices starting to slow, and inflation peaking will mark an important change in trend.
Coming in to this most recent quarterly reporting period, the number of companies that had issued negative pre-announcements – announcing results ahead of when they were expected to – exceeded the number of companies reporting positive pre-announcements by a wide margin. As a result, we had muted expectations, and would be watching for deteriorating demand, or rising costs, or worse yet, a combination of both.
Fortunately, the results have been somewhat reassuring. Earnings growth for the broader developed markets has been approximately 10%, nearly double the original estimate. In addition, some of the upside to corporate forecasts has been driven by margins, suggesting cost pressures have not been as severe as expected, at least not yet. There are clearly some industries where labour, commodities, and other inputs are either in short supply or experiencing meaningful pricing pressures. This has led some companies to reduce their guidance for future earnings. On average, however, the results suggest that companies are still seeing decent levels of demand, particularly from consumers, and are finding ways to navigate through the cost pressures with a degree of resiliency.
The results from a number of “big box” U.S. retailers was of particular interest as their results, along with commentary from senior management teams, has the potential to shed light on consumer behaviours as well as some of the influences that are pushing inflation data to record highs. While results varied from one to the next, there were some distinct takeaways. Reassuringly, consumer demand remains reasonably healthy, and some companies maintained their revenue forecasts. However, some are witnessing a notable shift in demand from larger household and durable goods, such as furniture, appliances and home improvement items, towards staples like food.
Some kind of change in demand mix has been anticipated, and I have written about this change for the better part of the past year. I have maintained that it will be a critical element to the inflation data eventually cresting and then subsiding. Demand for goods, which grew tremendously during the pandemic, has been expected to decline to more normal levels, while demand for services was expected to increase meaningfully as the travel, entertainment and hospitality sectors reopened. This appears to be underway. The earnings results from the retail industry also suggest change is happening among consumers starting to prioritize food and other necessities at the expense of more discretionary items.
The other important, yet less surprising, takeaway from recent results was with respect to costs. They continue to rise as a result of supply chain challenges and overall inflationary pressures. Freight, logistics, and labour expenses have been higher than planned, which is consistent with results reported across other industries. Many of the business owner clients I speak with have expressed the same challenges and pressures.
As a result, margins – a measure of profitability – have started to come under pressure. The resiliency of the retail industry that we have come to expect over the past several years is starting to change, and there is evidence across all industries of similar headwinds. It is going to have an impact on economic and earnings growth, and we will have to adjust our expectations and our investment positioning accordingly. This is a normal part of managing through the various phases of an economic cycle. We continue to monitor our indicators for the U.S. economy in particular, to determine whether the slowdown that is underway will turn into something more serious. However, our client portfolios will continue to be positioned for a range of potential outcomes and will continue to hold positions in those companies we believe are leaders in their sectors, those best able to continue to grow, pass on costs and maintain their margins, and those that can hold or even gain market share relative to their peers.
I remain optimistic that inflation will be controlled through the actions of central banks and the natural dynamics of the market. I remain optimistic that the second half of 2022 will see a recovery of most, if not all, of the equity markets losses thus far, as well as stable bond prices with higher yields. Both outcomes will be positive for our client portfolios.
The bond market now has an additional 10 – 12 interest rate increases of 0.25%, or 25 basis points, already priced in to expectations for the next 12 – 18 months. Any change to expectations that is less than this, an outcome I believe to highly probable, will be positive for both equity and bond markets. Central banks’ ability to use interest rates to control inflation and keep the economy growing, something referred to as a ‘soft landing’, will be critical to my optimistic outlook.
Higher interest rates will lead to tighter financial conditions, meaning availability and access to credit changes and the spending patterns of consumers and businesses become compromised. These conditions can result in a recession. Based on the recent stock market performance, the expectations for some form of recession seem to be priced in. I am still not convinced it is a certainty over the next 12-month period.
My sense of optimism is also based on the influence of various natural factors that I believe can, and are, helping to temper inflation. The retail disclosures and reports I noted earlier suggest inventories are building. This is not just the result of retailers adding product out of concern over the global supply chain, but also due to the changes in consumer demands – spending more on essential goods and altered goods vs. services spending patterns. Higher inventories will result in items being discounted to move, and therefore, a change to the trend of increasing prices. The supply constraints that have been so prevalent over the past 18 – 24 months, and have had a material impact on prices and inflation, are improving. Goods are moving closer to pre-pandemic levels as port congestion and transportation bottlenecks subside. Lockdowns in China are easing. And the production and distribution of many core inputs have increased materially recently to ease some of the manufacturing limitations that had been a concern. One of the main readings of inflation is the change in CPI, or Consumer Price Index. The goods portion of CPI data is a significantly higher influence than the services portion of CPI data. As consumer spending patterns continue to favour services over goods, there will be a natural impact to inflation data that I expect will lead to the peak and eventual decline in the trend line. Lastly, I remain hopeful for a peaceful and permanent resolution to the war in Ukraine. Assuming this happens, energy and food price inputs, in particular, will provide significant relief for the high inflation figures we have been experiencing.
I recognize that simply remaining optimistic doesn’t make the volatility and price declines over the past six months feel any better. But it does help to understand why we are invested the way we are, what the specific opportunities we are on the lookout for are, and how our strategy can and will be affected by any number of outcomes that unfold over the next year or two.
As always, we are available if you have questions or want to discuss any of this.