The surge in inflation seems to be cooling off a bit in most places. After the pent-up demand following the pandemic and interest rate increases by central banks, economies have cooled off, resulting in lower inflation. Labor markets remain tighter than usual as many people of retirement age chose the pandemic as a time to retire. However, the demographics of many western countries means that there are still many more are at or near retirement age, so this issue will be with us for some time and will likely continue to put upward pressure on wages. As well, many businesses are re-shoring (opposite of offshoring) despite higher costs due to the reliability of production. Further, many western governments are hiring public sector employees at a fast pace, which is counteracting the intended weaking effects of higher interest rates on the broader labour market. This is working against central banker’s efforts to tame inflation. I believe that these factors will ultimately cause a higher rate of inflation than the base line of 2%.
Central banks have been fighting economic disasters for decades by lowering interest rates only to find out that that these policies are leading to different problems. In many cases they printed money and injected it into the financial system leading to excess money sloshing around the economy. This excess money was then left looking for a place to be deployed, and with bonds offering little to no yield investors turned to risker assets (stocks, real estate, private equity etc.). This in turn pushed up the valuation of these asset classes. This has gone so long that many believed it was unlikely to change even when inflation reared its head and interest rates rose. It is not a surprise that there have been some financial casualties and there will likely be more to come.
The US consumer accounts for about 16% of the world’s entire GDP or economy. As such an important component of the world we need to focus our attention on their job prospects, financial health and whether they are optimistic or pessimistic.
Looking at consumer’s health in the US, overall, it looks good, despite rising costs associated with inflation. Jobs are available, unemployment is low, optimism is ticking up, and consumer balance sheets are okay. As well and as noted above, the outlook for wage growth looks good too.
Russia’s aggressive attacks to annex Ukraine are unsettling and reinforce the brutish lengths that some nations will go to in order to achieve their own agenda. However, it also has had the effect of redrawing world alliances between those who sympathize with Russia and those that sympathize with Ukraine and much of the west. China and Russian leaders recently met, and it is believed that Russia asked China for military arms to help conquer Ukraine. Given their desire to repatriate Taiwan, China is sympathetic to Russia’s Ukraine ambitions, however it is doubtful they would risk losing the almighty US consumer as a customer for its exports. The new alliances that are forming will ultimately affect trade and commerce. As western businesses look to re-shore or bring their production closer to home, they will look to locate production to friendly locales. The pandemic taught us when times are tough you can’t rely on delivery of critical components from far away and opaque places.
Inflation is easing and is definitely “off the boil”. Markets have rejoiced with most stocks and bonds rallying, presumably celebrating the conquering of inflation. We think this is premature. Core inflation remains sticky and structural issues noted above will likely keep it that way for longer than many expect. So far, we have seen a handful of banks require government help, but after 20 years of easy money and very low interest rates surely more marginal businesses should fail. Historically business cycles every four years or so purged weak or imprudent businesses. This was healthy, as quality businesses survived and the economy rebounded without requiring government assistance.
Whether western economies will see a recession rather than an economic slowdown ahead is unclear as much depends on how things evolve from here. If central banks stay true to their word, we should see interest rates remain higher for longer than the markets expect. It’s also possible that future incremental interest rate increases may be required, upsetting some investors.
It is better to have a bit of inflation rather than flirting with deflation as we have been for the past decade. It rewards savers, while making it costlier for borrowers which will likely diminish foolish investments and speculation. It will result in higher wages for workers, which is sorely needed. It will probably mean that central bankers will be less likely to lower interest rates to near zero and print money to stave off deflation anytime problems arise. Moderate and controlled inflation is healthier and more familiar than the unknown quagmire that deflation likely entails.
Many major issues are fluid, or a work in progress at this juncture but if our perceptions are somewhat correct, they will ultimately change the investment landscape. Good, quality companies with good businesses, good cultures and management will differentiate themselves from others that were buoyed by zero interest rates and speculation. As always, we at the Pringle Group at RBC Dominion Securities, will do our best to protect your interests.
Tony Pringle, CFA
March 31, 2023
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