2022 so far has seen markets experiencing volatility, something we have only seen a few times in the last 2 years.
The pullback is most prominent in the tech sector. Investors are grappling with what the effects of rising rates and inflation will have on these companies. This is nothing new. We’ve been talking about this since August when supply chain disruption started causing a rise in consumer prices. Interest rate hikes have been a concern for even longer. Both of these factors have the effect of eroding purchasing power. I will go into greater detail below, but for this sector, investors are seeing the incredible growth these companies have shown slow down. Until now, a lot of these companies have been showing momentum. The investor was not worried about valuation- instead just trading on good news. People are at home, more and more turning to online, price keeps going up. They weren’t thinking about a return to work, or what profits they were really showing. Inflation and interest rate hikes have caused investors to take that second look and say “oh”. They are starting to realise that the stock price is not in line with the earnings.
To be clear, we still like these companies. We still recommend remaining invested in them. We started talking about a post-pandemic shift away from tech and into industrials over a year ago. But we still wanted to be invested in them. The way we prepared portfolios for what we are seeing is by:
- Lowering our exposure to tech and increasing weighting in industrials and other post pandemic beneficiaries and
- Rebalancing: trimming our gains in these companies every 3 months.
But, back to the explanation inflation and interest rates and what we are seeing.
For inflation – It’s both the cost of goods that cause inflation (Supply), as well as the amount someone is willing to spend (Demand). For Supply- When the price of a loaf of bread (for some reason the most commonly used example of inflation) rises from say $3.00 to $3.25, that $0.25 is lost money. It’s not 25 cents more profit going back to the maker of the bread- the price was increased because their cost of wheat went up that amount (or more). And the farmer that grew the wheat isn’t making that much more, because their energy cost to harvest the wheat went up. It is simply lost, and the loss is spread through the economy. For Demand, it’s wages. If the economy is expanding and finding employees is more difficult, companies will pay workers more to entice them to come work for them. If people are earning more money, they have more money to spend on goods and are able to purchase goods at higher prices. Stores don’t have to have sales to move inventory, and if there are inventory shortages, consumers may pay a premium for the product.
The Bank of Canada is the entity that combats inflation. Some inflation is good: they want workers’ wages to go up and families to get “richer”. That target is somewhere between 2% and 3 %. Inflation above that is not good because the economy doesn’t have time to react or absorb it. Prices spike too quickly and more wealth is lost. When it’s 2-3 percent, it’s gradual enough that the economy can adjust and absorb.
The Bank of Canada controls inflation by adjusting the overnight lending rate, and thus the interest rate environment. It raises rates when it wants to cool off inflation. The raising of interest rates has a domino effect throughout the lending market as all rates, from bond rates to credit line rates and mortgage rates adjust. Most of us see it with our mortgage rates, but the mortgage rate or housing market is not the main target of the Bank of Canada. It’s more concerned with the rate that companies can borrow at. If they can increase the costs of companies borrowing, then they become less likely to invest in more capital projects (like building plants or expansion), and less likely to employ more people and increase wages.
So interest rate hikes dampen an economy.
The thing is though, this is like tapping the breaks on a freight train. It is not an exact science. There are many external factors out of the control of the bank of Canada (and any other central banks). Also, though inflation is not good, it might be the lesser of two evils. Faced with the pandemic and an economy that could potentially collapse, governments chose to spend- to create social assistance programs and provide access to funds to businesses to keep them afloat. That massive amount of spending possibly saved many businesses, and they did it knowing that all that stimulus would fuel inflation. This isn’t a defense of what political parties have done. We can all be critical of where some of that spending went. It is an explanation of how we are where we are.
Are these dampening factors enough to cause the economy to retract into recession? The simple answer to that is no. On the opposite side of the equation of interest rate rises and inflation, is government spending and the interest rate environment. Government spending is throwing the coal on the fire in the freight train, and the interest rate environment is the temperature of the furnace.
At this time, the amount of government spending far outweighs what inflation and rate hikes could do to cool the economy to recession. And even though rates are going up, they are still incredibly low and not at all prohibitive for businesses to get access to capital.
In conclusion, there are no signs of a pending recession. The economy is expected to continue to expand and our outlook for equity markets continues to be positive, what we are seeing is a tapping of the breaks.