Volatility remains relatively subdued as the concerns about the banking sector that arose in early March have subsided. Some of the fundamental issues that had been in the forefront over the past year have, however, come back into focus. Chief among those issues is inflation. Below, we take a closer look at where inflation stands, and what we expect going forward.
Inflation is a normal part of a well-functioning and growing economy. Inflation rates tend to vary over time, despite the goal of the Bank of Canada and U.S. Federal Reserve to maintain long-term inflation rates near 2%. For example, the annual change in the Consumer Price Index (CPI) in both countries ranged between 1% and 3% over the past 25 years, except for a few occasions that occurred immediately before and after recessions, when inflation fell meaningfully, only to bounce back along with a recovery in growth. This consistency changed sharply in 2020 with the reopening of the global economy after the pandemic-induced shutdowns. In 2022, inflation rates in North America surpassed 8%. The spike in inflation led to a revaluation of most asset prices. It also led to one of the most aggressive and synchronized interest rate tightening campaigns undertaken by central banks in history.
Fortunately, inflation has receded notably over the past year. The most recent readings of headline inflation in Canada and the U.S. were 5.2% and 5.0%, respectively. These figures are still elevated by historical standards and remain about 3% away from the mid-point target of 2% maintained by both central banks. Nevertheless, we have transitioned from a “high and rising” period of inflation to one where inflation is “elevated and falling”. That subtle change has translated into more stable returns across asset classes recently. It is the primary reason that 2023 has, so far, been more rewarding for investors than was 2022.
There are some nuances that bear consideration. The most recent U.S. inflation reading revealed that, while broad pricing pressures are abating, some categories are either falling less or still rising. For example, core inflation, which excludes categories like food and energy, posted a modest increase (at 5.6%) from the prior month. Moreover, services inflation, which includes categories like rent, medical services, air fare and car insurance costs, has yet to meaningfully fall from its elevated level of slightly above 7%.
The pressures listed above explain why the U.S. Federal Reserve increased rates by .25% this week and may raise them yet again when it meets on June 12th. The Bank of Canada struck a similar tone over the past week, despite keeping its policy rate on hold. It suggested that while progress has been made, the economy has been stronger than expected, and may require more time and potentially more action on the Bank’s part to get inflation within its target range. Interestingly, markets continue to reflect a belief that rate cuts may occur in the second half of the year. We think that this view is overly optimistic.
The bottom-line is that inflation trends have improved and may remain on a downward trajectory as tighter financial conditions drive goods and services prices lower over time. Falling inflation rates should remain a tailwind for stock and bond prices. We expect this tailwind to be opposed by an impending mild recession and the risk that it poses to growth, corporate earnings, and stock prices. Recession is arguably a more manageable challenge for central banks and investors, and something we continue to prepare for.
If you have any questions, please do not hesitate to contact us.