Global financial markets have been under significant pressure in recent days. The trigger was Friday’s U.S. inflation report of slightly higher-than-expected inflation, and the resulting concern that central banks will need to tighten financial conditions more or faster 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. Pricing pressures are not only elevated, but still rising. Economists had been hoping for signs that inflation may have already peaked and is beginning to ease. Core inflation, which excludes food and energy, did show some moderation, but it too was higher than expected.
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 other categories have historically been more persistent and slow to normalize, suggesting that their current pricing pressures may stay uncomfortably high after inflation peaks and begins to moderate (which we expect to occur in the second half of this year).
Following the inflation statistics release, bond yields rose meaningfully. Markets are now pricing in that the U.S. Federal Reserve’s policy rate will reach 3.9% at year-end, versus the 2.4% expected just a few months ago and 3% expected in the first week of June. The Canadian bond market is pricing in a similar story. Financial markets expect central banks to raise rates even more forcefully than what they have telegraphed.
The predominant concern is higher rates and quantitative tightening will lead to a material change in the availability of credit, thereby causing consumers to reduce their spending and businesses to re-evaluate their spending, hiring and capital expenditure plans. Historically, these kinds of conditions have at least 50% of the time resulted in recessions. Not surprisingly, the anticipation of a possible recession in the future has historically 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 during 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 this year given the tightening of financial conditions. Some of the indicators in our U.S. recession scorecard framework are moving in a direction that suggests increasing odds of a recession, but not imminent arrival. There are early signs of a slowing in some sectors of the North American economy, such as housing. 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 may be a positive development and a sign that policy makers are effectively reining in pricing pressures in some parts of the economy.
Our portfolios are structured with a wide range of economic outcomes in mind. Episodes of market volatility are often characterized by indiscriminate 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 address in our portfolios.
If you have any questions, please do not hesitate to contact us.
Drew M. Pallett LL.B. CFP
Senior Portfolio Manager and Investment Advisor
RBC Dominion Securities
Email: drew.pallett@rbc.com
Website: www.pallett.ca