Another long weekend has come and gone. While markets enjoyed a sense of calm for most of the season (very strong July and August started off quite decently), the same cannot be said of the past few weeks. Volatility has resurfaced, and along with it, weakness in global equity and fixed income markets.

The Power of the Fed.

The catalyst for the recent softness was a speech delivered by U.S. Federal Reserve Chairman Jerome Powell. In it, he indicated that the U.S. Federal Reserve, the country’s central bank, is drawing on lessons learned in the past as it tries to deal with the current inflationary period. More specifically, he outlined three lessons learned from the high and volatile inflation period experienced during the 1970s and 1980s, and the low and stable inflation witnessed thereafter. The markets sold off on this message.

The first is that while monetary policy can only address demand, as opposed to supply, it is still a key responsibility of the Fed. They remain committed to moderating demand to better align it with supply. The second lesson is that inflation can be self-fulfilling. More specifically, when expectations of high inflation become entrenched in the decisions of households and businesses, it has a tendency to fuel even higher inflation. As a result, it is important to ensure longer-term inflation expectations remain well anchored, which fortunately is the case presently. Its last lesson, which we took away as its most forceful message, was that central banks must maintain a restrictive policy until inflation returns convincingly to a low and stable state. Mr. Powell acknowledged its approach could result in some “pain” for households and businesses, but viewed the risk of long lasting price pressures as being even more painful.

Throughout the summer, markets had started to price in a growing expectation that central banks would potentially reverse course next year with their monetary policy and begin to lower interest rates in response to economic weakness. While that may still be possible, it seems increasingly unlikely in the wake of Mr. Powell’s speech. Predictably, markets have sold off in response to the appreciation that tighter financial conditions are here to stay for some time to come.

The Federal Reserve, and other central banks like the Bank of Canada, seem very willing to tolerate a period of economic weakness in order to bring inflation under control. Investors too will have to be tolerant, patient, and prepared for a period where interest rates are higher for longer. Moreover, investors should prepare for weaker growth as demand from businesses and consumers wanes in the face of higher borrowing costs. That does not mean we, as investors, should just stand pat. To the contrary, bouts of turbulence and broad market weakness often create opportunities to rebalance, reallocate, and unearth higher yielding and higher quality investments. I envision taking some of these actions in the future, just as we’ve done in prior episodes of market volatility. Our models have actually held up quite well year to date and the past 12 months compared to benchmarks.

Shrinking Canadian household size (see chart below from RBC Economics):

“Canada is in the midst of a steep housing correction. And though this cycle has yet to fully play out, it’s unlikely to morph into the type of prolonged spiral observed in the U.S. during the 2008 financial crisis. One of the main reasons: demographic demand for housing in Canada is strong—and it’s getting even stronger. We expect the number of Canadian households to rise by 730,000 by 2024 compared to 2021, adding 240,000 new households annually. Immigration is key to this surge. But another critical factor is the often overlooked, longstanding impact of demographic change, including households that have been getting smaller for decades. Even a relatively small decline in average household size has a big impact on the number of new housing units required to shelter Canadians. For example, over the five years leading up to 2021, the average household size declined by 0.02 people. That was enough to raise the total number of households by 140,000 (or close to 30,000 a year). This trend will be responsible for just under 90,000 of the 730,000 new households created by 2024—and will provide a significant boost in housing demand.”

Bank of Canada hikes to further cool housing market

Elevated Canadian housing prices are expected to decline by at least ~8% next year as the Bank of Canada continues to tighten monetary policy by hiking interest rates, according to a recent poll of 14 property analysts conducted by the Canadian Real Estate Association. Some estimates pin the decline at around 20% as housing activity dampens meaningfully. That being said, affordability is expected to be stretched as the cost of capital continues to rise at a rapidly accelerating pace. So far this year, aggregate housing prices have declined by nearly 6% since the first BoC hike in March, and as Reuters states, “analysts say it will take years for affordability to return, if it ever does.” Robert Hogue, assistant chief economist at RBC has stated that “the pandemic may not be over but the pandemic-era housing market boom certainly is. And the bottom is likely many months away still as our central bank has more work to do.” Overnight index swaps, which act as a proxy for financial market expectations, are currently pricing in at least a 75bps hike from the BoC on its September 7th meeting.

I hope September treats you well,

J. Todd Kennedy, CIM, FCSI

Senior Portfolio Manager

613-566-4582

toddkennedy.ca