Forks in the road

 

We have had one of the worst year to date performances in the markets since the great financial crisis. Coming into the year, major financial institutions forecasted a lower but positive growth in the economy, however, the Russia/Ukraine war sparked unexpected spikes in energy and food prices. Additionally, supply chain disruptions due to China lock downs and a tight labour market coming out of the pandemic further exacerbated inflationary pressures. As a result, central banks in US and Canada felt compelled to raise benchmark interest rates to combat inflation. The rapid pace of higher interest rates lead to a systematic repricing of financial assets.

 

That is the story for the first half of the year, what can we expect for the second half? There are two possible scenarios and let’s explore each.

 

Scenario 1: Fed is able to engineering a soft landing     

 

The Fed and central bank of Canada have been raising rates at a rapid pace to achieve two objectives, one is to dampen domestic demand, this could mean they will intentionally engineer a recession and the second objective is to send a strong signal to the market that they are serious in their commitment to keep inflation in check. As some of the headline inflations start to tease however, the Fed would ideally stop raising and potentially cutting interest rates again to stimulate the economy. This is the scenario that we are hoping for and what we think is more likely. The central bankers have gotten very good at moderating the economy in recent history through setting expectations for interest rates and targeting monetary growth with the growth of the economy. There are signs that headline inflation which include energy and agriculture prices have peaked and if that is the case, there will be less of a need for further tightening. In this scenario, we may only experience a shallow recession and this is great news for the financial markets.

 

Inflation peaking?

US inflation peaking scorecard suggests a change is on the way

As at 07/20/22. “Turning” identified using mix of M/M and Y/Y methodologies. “Pandemic boom goods” is used vehicles + sports vehicles. Source: RBC GAM

 

Market expectations of Fed hikes have shifted and risen significantly. The path for future interest rate hikes is still subdued as the expectations are for the Fed to front load interest rate hikes and ease later.

Source: Bloomberg, RBC GAM, as of 06/13/2022

 

Scenario 2: growth in inflation persists and economies enter a deeper more prolonged recession

 

In this scenario, we continue to see strong headline inflation as well as persistent core inflation growth. The central banks will not have a choice but to tighten financial conditions even further and slow down the economy even more. What they would like to avoid is a repeat of the inflationary environment in the 1970s where interest rates were high and impossible to slow down until brakes were applied sharply at the cost of high unemployment rates and a deeper recession.  The great inflationary time period was finally brought to a stop by Fed chairman Paul Volker by raising rates from 5% to 15%.

 

Once higher inflation expectations set in, the wage and inflation spiral is difficult to break. Consumers continue to make big purchases once they know money is losing its purchasing power and it took significant effort in raising interest rates to encourage less spending and more savings.

 

Inflation and Fed Fund rates during the great inflation era

Source: Barclays, Bloomberg, RBC PAG

 

It is worth noting corporate earnings growth were health in periods of rising inflation as companies pass higher inflation costs to consumers. Between 1973 and 1975, earnings grew 15.8%, but valuation compressed by 22.4% which resulted in an overall negative return.

 

SPX return decomposition for different inflation environments from 1966-1983

Source: Barclays Research, Refinitiv, Shiller Data

 

We live in a period of increasing uncertainty despite the fact that market returns have been strong.  Until there is confirmation that economies are on strong footings again, it is better to focus on companies with strong balance sheet that pays a stable dividend and are able to pass on higher costs to their end consumers.

 

Since 1920, there have been 17 recessions, one Great Depression, a World War and several smaller scale wars. Despite the turbulence and uncertainties, S&P500 were able to deliver strong annualized turns throughout the century. We have heard this many time before; it is “time in the markets, not timing the markets” that lead to real wealth accumulation.

 

As always, please reach out with any questions, comments or concerns. I would love to discuss with you and I am here to support you.

 

 

Rita Li works with individuals and business owners and healthcare professionals to provide tailored investment advice, risk management and financial planning. Her team comprises of professionals with in-depth taxation, insurance and legal expertise, together, they deliver a high standard of service to clients. Rita is a Chartered Financial Analyst CFA® and holds her MBA from Richard Ivey School of Business.