Inflation, the Economy and Markets

It has been a busy couple of weeks since we last sent out a missive, so let’s get to it.

Canadian inflation basically comes from three sources: 1) housing; 2) stuff we produce and consume domestically that’s not housing related and 3) stuff we buy from foreign sources. All three have been contributing to inflation, which remains at 40-year highs:

As you can see, foreign sources, which include some percentage of gasoline and food, have been the biggest sources, while domestic sources – both housing and non-housing, have steadily been on the rise as well. Some may be surprised that the housing component is the smallest contributor, but keep in mind that housing overall is still a relatively small piece of the overall economy, so the fact that it’s contributing more than 1% to ~7% total year-over-year inflation is a sign that housing is punching well above its weight.

The good news is that we have begun to see some of these components roll-over. Gasoline prices have begun to drop and many other commodities have also begun to decline after the sharp moves up earlier in the year. It is likely going to take some time to show up in the data, but there are some so-called “green shoots” as it relates to inflation. Further, with the rise in interest rates, we have already begun to see the Canadian housing market lose some of its steam:

House prices nationally have now been down for two consecutive months with June almost certain to bring a third straight decline. This should help to stem housing’s push on the inflation string.

Okay, changing gears slightly, high inflation has caused central banks, including the Bank of Canada, to get aggressive on raising interest rates as this is seen as the best tool for cooling inflation. Let’s break this down into some bullets:

• Inflation occurs either because there is too much demand for something relative to supply, not enough supply because of some production issue, or some combination of the two.
• This time around, it was clearly a lack of supply in the wake of Covid that first stoked the inflation problem, which was then exacerbated by massive government stimulus, which increased demand for a lot of goods that simply were not available because of the aforementioned supply problems.
• Meanwhile, central bankers slashed interest rates to near zero (again because of Covid), which drove a frenzy in housing markets as mortgage rates hit all-time low levels.
• Then the economy reopened, but many people, either because their bank accounts were still full of stimulus money or for other reasons, did not want to return to the workforce, which pushed inflation higher still as demand for labor soared and with it – wages.
• At the same time, China, because of its zero Covid policy, locked down much of its economy, which reignited the problems with the global supply chain.
• And then Russia invaded Ukraine, which drove up oil prices and many food related commodities (Ukraine and Russia are big producers of food and fertilizer), giving us our latest (and hopefully last) leg up on inflation.

Now, the challenge with the above is that we are fighting inflation with interest rates and this will deal mainly with the demand side. So, while we have already begun to see demand come down, inflation is likely to persist in some form until we see the supply side recover.

Okay, so what does this mean for the economy? There has been a lot of talk of recession and the risks have certainly risen significantly:

While there are lots of ways to measure recession risks – jobs, manufacturing activity, et al – the availability of credit tends to be a very good gauge. Conditions have tightened significantly over the past 6-months and are now globally firmly in the “tight conditions” zone. The U.S. is closer to neutral, but with the Federal Reserve hiking rates 75 basis points at its last meeting and likely to do so again at its next meeting, the U.S. may push into the tight conditions zone soon.

Here is an update on our recession table. While we would not proclaim a U.S. recession a done deal, the risks are now pointing to one occurring:

While there are few holdouts, the preponderance of indicators are in the red. We would note that the jobs market remains robust and that tends to be a good indicator of a growing economy, so while we would lean into the recession narrative, the jobs market continues to give us some hope that it will be avoided.

Okay, so what does this mean for markets? The damage that has been done so far in 2022 has been significant. The median stock in Canada is down ~13% for the year, while the median stock in the U.S. is down 17%. Further, there are many stocks that are down 30% or more thus far in 2022 (1/5^th of the S&P 500), which is usually where we get to toward the end of the recession as opposed to before it has even begun. Thus, while we are concerned about recession risks, a good chunk of the bad news has likely been priced in already. Many high quality businesses are now trading at distressed valuations and while we think it will take some time for the damage to repair itself, we think that 1) the worst is likely behind us and 2) the returns over the intermediate term from today’s levels are likely to be significant.

We would add that the bond market, which had also been a source of weakness in the first half of the year, has settled down and we think this will provide a nice layer of defense over the next 6-12 months, which will be more in-line with historic norms. Thus, while we are likely not out of the woods yet, we see some reason to be optimistic about the 6-18 month timeframe as: 1) we are likely to be through the rate hiking cycle; 2) valuations are likely to be at or below historic norms; 3) we should have some relief on inflation; although, we acknowledge there are some wildcards related to this.