If this is the case, central bankers’ efforts to bring inflation back down to their 2% target may prove to be a vexing exercise.
While there are transitory causes of current inflation such as post-pandemic supply chain issues and the Russian aggression against Ukraine, there are more permanent causes too. These include ageing populations in much of the world, and more specifically the ‘baby-boomer’ bulge in populations that are at or near retirement age. When the pandemic hit, many baby boomers decided to take the lock downs as a reason to put their careers to bed. Those choosing to retire earlier than they would have otherwise have left a large hole in the skilled job market. This issue cannot be fixed quickly by immigration or quick training and is likely with us for some time.
Another cause of inflation is likely due to globalization retreating. The world benefitted from globalization and the disinflationary advantages of it. Sourcing cheap commodities or goods from afar helped keep costs down in developed countries resulting in lower inflation and interest rates. Low interest rates helped asset prices like stocks, bonds and real estate rise in values. The western developed countries have decided that there are bad actors in the world that they no longer want to support and do business with. The obvious ones are Iran, Russia, North Korea, and increasingly China. Many of these emerging countries have aspirations of being more important: Russia regaining its Soviet Union sphere of influence, China regaining control of Taiwan and the South China Sea, North Korea regaining control of South Korea, etc. The ironic part of this is that many of these actors benefitted from trading with the developed west, and used the money and benefits to build military capabilities that one day they would use against the West’s interests. That day appears to have come.
The supply chain issues related to pandemic lockdowns laid bare the folly of free trade going too far in that sourcing critical components from distant places just because of price is foolish. This experience as well as the geopolitical re-shuffling of alliances means that supply chains are being redrawn. ‘Reshoring’, or bringing production back to home markets rather than ‘offshoring’ is likely, as is sourcing production from friendly countries.
It was a miserable year for markets as bonds and stocks declined as central banks implemented a series of interest rate increases to battle the surge in inflation (see chart below). At this stage, inflation in most places has come off a bit from high levels of last fall. Regardless, central bankers are signaling that rates may need to be raised a bit more and remain elevated through 2023. Further, they are talking tough vigilance to kill any speculative mindset that remains. This is good, and in fact is beginning to work. Crypto exchanges have collapsed and others are teetering. Real estate is rolling over and some real estate investments cannot fulfill redemptions.
It seems that there are too many people in financial and real estate markets still out there that incorrectly think this is a brief bad dream. It isn’t. The US Federal Reserve over stimulated during the pandemic by printing money, buying public market bonds, and doubling their balance sheet in 2021-2022. This contributed to inflation, speculation and the development of ‘animal spirits’. They are not only raising short term interest rates, but are letting the short term bonds they bought mature. Tighter monetary conditions will continue to be required to reverse the dramatic ease following COVID-19 crisis.
The US political situation is fractured. The Democrats are being driven by their left leaning and green constituents, while the Republicans are being influenced by their right wing flank.
In summary, I think that inflation fighting will take some time. My guess is that central bankers will ultimately settle upon a neutral rate of inflation above their current 2% target. If inflation remains higher than the central banker’s target of 2% in the years ahead, we will be facing a very different investment landscape than we have experienced over the last decade. High quality dividend paying companies trading at reasonable valuations will continue to be a good store of value and income. The low interest rate environment is behind us and true stock picking will return. ‘A rising tide lifts all boats’ and index investing was yesterday’s story.
Tough markets remind us that good quality income paying stocks are worthwhile investments. For long term investors patience will be required, but it will be rewarding when the speculators are washed out and create opportunities. As always, we will do our best to protect your interests.
Tony Pringle, CFA
December 31, 2022
This information is not investment advice and should be used only in conjunction with a discussion with your RBC Dominion Securities Inc. Investment Advisor. This will ensure that your own circumstances have been considered properly and that action is taken on the latest available information. The strategies and advice in this report are provided for general guidance. Readers should consult their own Investment Advisor when planning to implement a strategy. Interest rates, market conditions, special offers, tax rulings, and other investment factors are subject to change. The information contained herein has been obtained from sources believed to be reliable at the time obtained but neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers can guarantee its accuracy or completeness. This report is not and under no circumstances is to be construed as an offer to sell or the solicitation of an offer to buy any securities. This report is furnished on the basis and understanding that neither RBC Dominion Securities Inc. nor its employees, agents, or information suppliers is to be under any responsibility or liability whatsoever in respect thereof. The inventories of RBC Dominion Securities Inc. may from time to time include securities mentioned herein. RBC Dominion Securities Inc.* and Royal Bank of Canada are separate corporate entities which are affiliated. *Member-Canadian Investor Protection Fund. RBC Dominion Securities Inc. is a member company of RBC Wealth Management, a business segment of Royal Bank of Canada. ® / TM Trademark(s) of Royal Bank of Canada. Used under licence. © 2022 RBC Dominion Securities Inc. All rights reserved. 22_90421_JTE_002 (06/22)