The summer has come and has nearly gone. While markets enjoyed a sense of calm for most of the summer, the same cannot be said of the past few weeks. Volatility has resurfaced and, along with it, weakness in global equity and fixed income markets. We share some brief thoughts below.
The catalyst for the recent volatility was a speech delivered by U.S. Federal Reserve Chairman Jerome Powell on August 26th. Chairman Powell stated that the U.S. Federal Reserve is drawing on lessons learned in the past as it addresses inflation. He referenced the high inflation periods experienced during the 1970s and 1980s, and the low and stable inflation witnessed thereafter.
The first lesson is that while monetary policy can only address demand, as opposed to supply, it is still a key responsibility of the U.S. Federal Reserve to reduce demand to better align it with supply.
The second lesson is that inflation can be self-fulfilling. When expectations of high inflation become entrenched in the decisions of households and businesses, these expectations themselves can fuel even higher inflation. As a result, it is important to ensure that longer-term inflation expectations remain well anchored. Fortunately, this is the case presently.
The third lesson, which was Chairman Powell’s most forceful message, was that central banks must maintain a restrictive policy until inflation returns convincingly to a low and stable state. Mr. Powell acknowledged that the Fed’s approach could result in some “pain” for households and businesses, but viewed the impact of long-lasting price pressures as being even more painful.
Throughout the summer, stock and bond markets had begun to reflect a growing expectation that central banks may reverse their monetary tightening course next year and lower interest rates in response to economic weakness. While this may still be a possible outcome, in our view it is increasingly unlikely. Predictably, markets have sold off in response to investors’ appreciation that tighter financial conditions are here to stay for some time to come.
The U.S. Federal Reserve, and other central banks like the Bank of Canada, appear to be willing to tolerate a period of economic weakness in order to bring inflation under control. Investors will have to be tolerant and prepared for a period in which interest rates are higher for longer. In addition, we expect a period of weaker growth, as demand from businesses and consumers wanes in the face of higher borrowing costs and tighter financial conditions.
Periods of turbulence and broad market weakness often create opportunities to rebalance, reallocate and unearth higher yielding and higher quality investments. We envision taking some of these actions in the future, just as we have done in prior episodes of market volatility.
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