ECONOMIC & FIXED INCOME COMMENT: THE PERFECT STORM
Thus far, 2022 has been one of the most challenging times for investors due to unprecedented volatility leaving few safe havens in both equity and fixed income markets. The main culprits driving market volatility include: inflation, monetary policy, the war in Ukraine and the pandemic. Any one of these factors alone would test investor sentiment, however the combination of all four has led to major declines in risk assets (i.e., cryptocurrencies, equities, high yield debt), as well as normally less-volatile securities such as sovereign debt. As a result, investor and consumer sentiment has declined to the lowest levels since the global financial crisis, despite low unemployment and strong business activity.
At the start of the year, markets expected supply chain bottlenecks to ease in the second half of the year. This, along with a shift from goods to services spending and favourable year-over-year comparisons, many central banks believed inflation would trend lower. However, geopolitical factors (war in Ukraine and COVID-19 lockdowns in China) are keeping headline inflation higher for longer and continue to weigh on the global economic outlook. At the time of this writing, global GDP has been revised down and is forecast to expand by 2.9% in 2022. Looking at North America, U.S. GDP is forecast to expand 2.6% in 2022 while the Canadian economy is expected to grow by 3.5% (see chart 1).
The recent economic growth downgrade can be attributed by the inability of advanced economies to dampen surging inflation. Specifically, headline inflation (including food & energy) has continued to move considerably higher over the past few months with no sign of easing. Economists now view inflation as the main threat to economic growth (see chart 2). Specifically, inflation is expected to remain above the Federal Reserve’s (Fed) and Bank of Canada’s (BoC) 2% target for the remainder of 2022 and 2023. In the U.S., May CPI reading was 8.6% while Canada was 7.7%. In both countries, price pressures remain broad with 60% of the CPI baskets increasing more than 4% y/y.
The latest U.S. and Canadian CPI readings released in June have created a distinct change in the market’s tenor. Specifically, it has highlighted a more challenging economic path with “stickier” inflation requiring more aggressive central bank action to tame overheating consumer demand and ease inflation momentum. Consequently, the Fed raised the Fed Funds Rate 75 basis points to 1.75% on June 15th; the largest rate increase since 1994. The market welcomed this rate hike as a signal of creditability in the Fed’s inflation fighting mandate and a step in the right direction towards bringing interest rates back to a more neutral territory. In addition, the Fed has revised upwards the yearend Fed Funds Rate forecast to 3.5%.
Within Canada, the BoC raised the overnight rate 50 basis points on June 1st, taking the overnight Bank Rate to 1.5%. The next meeting is on July 13th, and is anticipated the BoC will raise the overnight rate 75 basis points following in the footsteps of the Fed. This will bring the overnight rate to 2.25%; close to the lower bound of the neutral rate 2.5%-3.25% (See Chart). The neutral rate is the level that neither stimulates nor decreases economic activity. With the economy rebounding and inflation above target, the BoC is expected to continue raising the overnight bank rate at an aggressive pace with the year end target projected to reach 3.25%.
Central banks in most advanced economies have shifted to more restrictive monetary policy than originally anticipated in order to preserve long term inflation expectations. Our view is that policymakers will be successful, however it will be at the expense of economic activity. There is a growing concern that central banks will not be able to engineer a soft landing and a recession is inevitable in the second half of 2023. Even with the rising risk of recession, its worth noting the economy is relatively healthy, with a solid banking system, low unemployment and consumers who aren’t overly extended.
During the second quarter, the bond market continued its selloff. Growth implications due to aggressive central bank tightening and inflation fears have led to a rapid adjustment in interest rates and valuations. Year to date, the FTSE Midterm Bond Index (5-10 years) declined 11.34%. The 10-year Government of Canada yield has more than doubled since the start of the year and hit a new cycle high at 3.6%. Presently, the bond market has priced in the fastest tightening cycle since the 1990’s with the overnight rate settling in the range of 3.5%-3.75% by yearend. With interest rate expectations having reset higher, we expect better returns in the second half of the year. Specifically, we believe the bulk of the increase in yields have already been priced into the bond market.