- The financial media is squarely focused on three things these days – Artificial Intelligence, inflation and the Federal Reserve.
- For as long as we can remember, the Fed has always been front and centre for investors, and there is always a new trend that is capturing the public’s imagination – today it is AI, tomorrow who knows?
- While inflation has been a durable theme for the past few years, that wasn’t the case for most of the previous two decades.
- Bond market investors and central bank watchers still need to keep a keen eye on inflation, but equity investors can play by a simpler set of rules.
- The rules differ slightly whether we are looking at Canadian or U.S. stock returns, but both benefit most from levels of inflation that are not too hot and not too cold.
2024 has been the year of Artificial Intelligence…
When the market historians look back at 2024, it is fair to say that it will be seen as the year of Artificial Intelligence (“AI”). The media loves a durable theme to grab hold of, especially if it has to do with technology and there is no doubt AI has delivered. This year has also seen a lot of speculation of “will they/won’t they” with regards to the Federal Reserve and interest rate cuts. We have swung from six rate cuts expected at the beginning of the year, to maybe one earlier this summer, to an increasing chance we see a cut as early as September.
… but inflation continues to play a significant role…
As important as the Fed is, far and away the most important economic indicator every month this year has been the consumer price index inflation report. It is almost guaranteed to move markets, and will often make front page news in the A-section of the newspaper. It wasn’t always this way. For the first 20 years of this century, the monthly employment report was the one everyone watched and was the subject of office betting pools. While the employment readings still garner a lot of attention, they have taken a clear backseat to inflation. A historic spike in prices after a fairly quiet 20-year period will do that, especially when it is accompanied by an eye-watering jump in interest rates.
…for both bond and equity investors
Every nuance of inflation is of particular importance to bond investors, as their returns are heavily dependent on the trend in bond yields, of which inflation is a large driver. Stock investors have it a bit easier, however. The value of a company is driven by many different variables, and inflation is just one of many. When we look at broad trends in inflation, an interesting pattern emerges when it comes to stock performance. Like we see in many aspects of our respective societies, the trends for the U.S. and Canada are similar, but with some notable differences as well.
The S&P 500 and TSX both do well with moderate inflation; performance diverges at the extremes
As seen above, different levels of inflation can have a meaningful impact on stock returns, but at the extremes it depends on which country we are in. When inflation is high, above 5%, the TSX puts up a respectable performance, but the U.S. badly lags inflation, resulting in a negative “real” return after inflation. This is likely due to the heavy resources concentration in the TSX, which tends to do well during inflationary periods. In the more moderate inflation scenarios, between 2% and 5%, both markets have up healthy returns. At the other extreme with inflation below 2%, the tables turn and the U.S. handily outperforms. Index composition strikes again!. Resources don’t tend to do well in low inflation/deflationary scenarios, but this is often a ripe environment for growth stocks, which are plentiful south of the border. We think the rules of inflation for equity investors are pretty simple – overweight Canada if the concern is high inflation, tack to the U.S. if deflation is a risk, and everyone wins with moderate inflation, even at levels above central bankers’ 2% target.
The Harbour Group
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