Investors who had been hoping for a quiet start to the summer have been disappointed. Concerns have included an oversized interest rate hike from the Bank of Canada, closely scrutinized inflation data in the U.S. and Canada, and the potential for Russia to cut off its supply of natural gas to Europe. The second quarter earnings season, now underway, will provide feedback regarding the resiliency or difficulties companies are experiencing in the current economic environment. Below, we share some thoughts on central bank actions and inflation.
The Bank of Canada surprised investors by raising its policy rate by a full percentage point, instead of the 0.75% that had been expected. The decision reflected the unexpected persistence and breadth of inflationary pressures. The Bank of Canada now expects inflation to end the year at an annual rate of 7.5%, compared to its prior forecast of 4.5%. Officials stated that they would prefer to “front load” the interest rate hikes, with a view to getting the policy rate back to neutral as quickly as possible. The Bank is hoping that by raising rates forcefully at an early point in its tightening cycle, it will reduce the odds of having to raise rates by an even larger amount in the future. We expect a further 1.0% in combined rate increases by the end of this year.
In the U.S., the Consumer Price Index (CPI) for the month of June was released. It rose more than 9% year-over-year, representing the highest increase in more than 40 years. More importantly, CPI numbers revealed that pressures are relatively broad and continue to rise in areas such as rent, where inflation has historically been more persistent and taken time to unwind. Not surprisingly, this report paves the way for the U.S. Federal Reserve to take action. The Fed is expected to raise rates by either 0.75% or 1% when it makes its decision on July 27th.
Markets have been surprisingly resilient, despite the above-noted developments. Recent market reactions have been in contrast to the behaviour earlier in the year, when there appeared to be a greater degree of trepidation. We attribute this to a few things. First, central banks are already aggressively tackling inflation, with a series of forceful rate hikes in recent months. Second, there are signs which suggest that inflationary pressures are beginning to decline. For example, commodity prices have fallen substantially. These declines will eventually make their way into future inflation readings. Some leading economic indicators, such as the yield curve, are pointing to activity that is likely to slow further in the months to come, with growing risks of a potential recession. Financial conditions have tightened meaningfully in a short period of time and are starting to deliver some of the intended impact, namely a deceleration in demand. Last, and perhaps most importantly, measures of longer-term inflation expectations have fallen significantly. All of this suggests that, while inflation remains a serious issue at the present time, it may pose less of a challenge in the future.
The risks facing investors remain elevated. The risks may, however, be transitioning from being strictly inflation-oriented toward economic and earnings growth. Some vulnerabilities may emerge in guidance provided during the current earnings season, as often occurs when the growth outlook is deteriorating.
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