Terry Soluk CIM, PFP
Senior Portfolio Manager and Wealth Advisor
250-770-1207
terry.soluk@rbc.com
Franz Wagner CIM, DMS
Portfolio Manager and Investment Advisor
250-276-1081
franz.wagner@rbc.com
Corey Bollman
Associate
250-770-1207
corey.bollman@rbc.com
Diane Kello
Associate
250-276-1080
diane.kello@rbc.com
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Dear Client
Global markets have been under notable pressure in recent days. The trigger
was a recent inflation report that has investors believing central banks
will have to tighten financial conditions more than planned, thereby
increasing the odds of a future recession. We share our perspectives below.
The most recent U.S. inflation reading for the month of May came in at
8.6%, representing the highest inflation rate in over 40 years. It
indicates pricing pressures are not only elevated, but still rising. That
stands in contrast to what some investors were hoping for: signs that inflation
may have already peaked and was on the verge of easing. Core inflation,
which excludes food and energy, did show some moderation, but it too was
higher than expected. Moreover, the inflationary pressures that began well
over a year ago in areas like vehicles and household goods have broadened
to other categories such as public transportation and rent. Some of these
areas have historically proven to be more persistent and slow to normalize,
suggesting pricing pressures are at risk of being uncomfortably high even
after inflation peaks and begins to moderate, which remains a possibility
for the second half of the year.
Following the inflation release, bond yields rose meaningfully and markets
now believe the U.S. Federal Reserve’s “Federal Funds Rate” will reach 3.4%
at year-end, versus the 2.4% it was expecting just a few months ago. It’s
not necessarily that much different in Canada. In other words, markets
expect central banks to raise rates even more forcefully than what they
have telegraphed thus far.
The predominant concern is higher rates will lead to tight financial
conditions. This is often characterized by a material change in the
availability and access to credit that causes consumers and businesses to
re-evaluate their spending, hiring, and capital expenditure plans.
Historically, these kinds of conditions have resulted in recessions. Not
surprisingly, recessions, or even the anticipation of them, have driven
some of the weaker periods of stock market performance. On the other hand,
some of the strongest periods of market performance have traditionally
begun amidst periods of economic hardship, as markets begin to anticipate
the potential for an economic and earnings recovery well ahead of one
actually occurring.
The odds of a recession over the next few years have undoubtedly risen, and
may continue to increase through the second half of the year given the
tightening of financial conditions. There are early signs of a slowing in
some of the more interest rate sensitive sectors of the North American
economy, such as housing for example. In some ways, this comes as a relief
to many who have been concerned, particularly in Canada, about the
seemingly endless rise of house prices and the significant decline in
affordability. A slowing in the domestic housing market, should it occur,
may ironically be a positive development and a sign that policy makers are
effectively reining in pricing pressures in some parts of the economy.
Elsewhere, some of the indicators in our U.S. recession scorecard framework
are also moving in a direction that suggest the odds of a recession are
rising, but not necessarily imminent.
We have been preparing our portfolios for a wide range of economic outcomes
by undertaking regular portfolio reviews, re-evaluating positions across
all asset classes, and considering rebalancing to the targets in our
investment plans. Moreover, episodes of volatility can typically be
characterized by an indiscriminate amount of selling across all assets,
regardless of quality. This can present investors with opportunities to add
to existing holdings or build new ones. These are some of the actions we
continue to explore in our portfolios.
Should you have any questions or concerns, please feel free to reach out.
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