Good afternoon,

 

Volatility has resurfaced over the past month. It’s been most evident in the bond market, with yields having moved meaningfully higher (and prices lower), reaching levels seen in November of last year. The move on the equity side has been less pronounced, but the weakness still noticeable of late. The culprit? Renewed uncertainty and debate over interest rates. We discuss this and more below.

 

Global economic data through the first few months of the year has been reasonably strong, defying many expectations for a softening in activity. In normal times, this kind of a backdrop would be cheered by most investors. But, recent developments have fueled concern that inflation, while trending lower, may remain stubbornly elevated and force central banks to raise rates further in order to cool demand.

 

Meanwhile, policy makers have started to offer some conflicting signals. The Bank of Canada indicated it was likely to soon pause with its rate tightening, and wait to assess how the economy was faring. More recently, the U.S. Federal Reserve suggested it wasn’t quite ready to take such a break. Instead, it telegraphed the need to continue to raise rates to get inflation convincingly under control. The bottom-line: investors are reassessing rate expectations, which has fueled the recent bout of higher volatility.

 

We don’t have high conviction on precisely where interest rates ultimately land when the hikes end. Nor do we think it matters as much as some pundits would suggest. Through history, most periods of rate tightening have ultimately resulted in slower growth, or outright recessions. We don’t expect this cycle to be any different.

We do believe investors have to be patient though as it may take some time to unfold. There are a few reasons why. First, consumers still have the wherewithal to spend. Cash balances remain elevated, although they are admittedly on a downward trajectory. Moreover, consumers remain very willing to spend and experience the kind of activities – trips, outings, shows, eating at restaurants, etc. - they sorely missed during the pandemic period, regardless of cost.

 

Most importantly, history has shown that it takes time for higher rates to work through the economy. The Canadian housing market is a good example. Canadians with mortgages make up about 35% of the country’s households (another 37% are renters and 28% don’t have mortgages). Only a fraction of households (2%) have variable rate/variable pay mortgages that would see mortgage payments fluctuate with changes in interest rates. A larger share of households either have variable rate/fixed pay mortgages (10%) or fixed rate mortgages (23%), and neither of these see any change to payments over the term of the mortgage. In other words, the number of Canadian households that have been impacted thus far by higher rates over the past year may not be as large as one would think. The bigger challenge will unfold over the next few years as homeowners who either purchased a home or refinanced their home in the past five years may have to potentially refinance at much higher rates. In other words, it’s upon the refinancing that households will have a potential wake-up call and be forced to reassess and reprioritize their spending and saving.

 

The scenario above is not guaranteed to unfold exactly as described, but it’s one we have to be prepared for. The trajectory of inflation and interest rates clearly remain very important to the economic and investment outlook over the next few years. We’ll continue to watch with great interest and recalibrate our own expectations as things evolve.

 

Should you have any questions, please feel free to reach out.

 

Thom & Stefano