Global markets have experienced a period of relative tranquility in recent weeks, which stands in contrast with much of the earlier portion of the year. Broad levels of volatility have declined, bond yields have been stable and equity markets have pared some of their losses. While there are a host of factors that may be responsible for the renewed stability, the overarching driver is the signs that inflation may have peaked, at least for now. We explore this more below.

 

The Canadian Consumer Price Index results for the month of July were released last week. They came in at 7.6% on a year-over-year basis, below the 8.1% level reported in June. The U.S. CPI reading for July was released a few weeks ago. It reflected a similar decline from 9.1% to 8.5%. These figures are still very high in absolute terms. Households and businesses continue to grapple with elevated pricing pressures. Nevertheless, the results mark an important shift in trend that may continue within North America as tighter financial conditions work their way through the economy into 2023.

 

There is a growing expectation that the Bank of Canada and the U.S. Federal Reserve may be able to moderate the pace at which they have been raising interest rates in the not too distant future. While both are expected to raise rates meaningfully once again in September, any further increases may be tame in comparison. Fixed income markets are reflecting an increasing probability that both central banks will begin to lower interest rates by the second half of next year in response to slowing economic growth.

 

We are skeptical regarding the prospects for a reduction in interest rates next year. We forecast an ongoing moderation in inflation as we move through the balance of this and into 2023. We estimate that inflation will finish 2022 above 5% in both Canada and the U.S. While this rate is lower than the levels seen earlier in the year, it is still well above the target range of 2% to 3% experienced over the past decade. As a result, inflation may remain the primary focus of central banks as we move into 2023. Just as central banks were patient when inflationary pressures were beginning to rise last year, they may wait for signs of a durable and sustainable decline in pricing pressures before shifting their policy direction.

 

In our view, we are in the process of transitioning from a period of high and accelerating inflation to a period where pricing pressures are elevated but decelerating. Historically, the latter environment has proven to be a more welcome backdrop for investors. This has us feeling more comfortable with respect to the near-term outlook. Nevertheless, we are mindful that inflation could remain uncomfortably high for longer than some economists may expect. In addition, we see vulnerabilities to the corporate earnings outlook as we begin to focus on 2023. For these reasons, we continue to proceed cautiously to ensure we manage our client portfolios with a range of potential outcomes in mind.

 

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