Inflation……..It’s Back

After a forty-year nap, inflation has once again made its presence known, creating uncertainty throughout financial markets. With this statement comes a mea culpa as our bias had been that inflation pressures would ease as 2022 progressed. Unfortunately, the same factors that we believed would help relieve the strain have shifted in the opposite direction and are now magnifying the inflation pressures. Instead of stabilizing, oil prices shifted higher following Russia’s invasion of Ukraine. Similarly, food prices are also on the rise as both Russia and Ukraine are key providers of various grains, fertilizers and other agricultural products. Add to this that China is struggling with a new wave of Covid-19, leading it to shut down not just manufacturing facilities, but entire cities. With this latest disruption, muddled supply chains are not likely to improve soon. So, inflation looks like it is here, at least for a little while.

In response, financial markets have pushed interest rates higher over the past three months, even though the Bank of Canada has only raised interest rates by 0.25%. The market is forward looking and will adjust to expected interest rate hikes well in advance of them occurring. For example, at the beginning of 2021 a Government of Canada two-year bond earned investors a 0.19% annualized return. By the end of 2021, a two-year bond was paying investors 0.97%. The market had already adjusted to the expectation that interest rates would move 0.78% higher without too much fuss or any actual action by central banks. By the end of March, that same two-year bond was now paying investors 2.3% – and there was a lot more fuss.

Data: Refinitiv

Some short-term pain for bondholders

What does that mean for bond investors? It depends. First, let us try to explain how and why bond prices move. If numbers are not your thing, we give you permission to skip the next three paragraphs, but for those that are prepared to stick with it, we will take you through an example.

Let’s say Jack decided on January 1, 2022, to buy the bond discussed above. He spent $100 and over each of the next two years he will be entitled to receive annual interest payments of $0.97. At the end of the two-year period, he will receive his $100 back.

For the sake of simplicity in our example, we will condense the time frames, so let’s say on January 3^rd, 2022, Ilsa wants to buy a two-year government bond and the return is now 2.3%. Jack is feeling disillusioned by his investment choice and tries to convince Ilsa to buy his bond. But of course, Ilsa has no use for a bond earning 0.97% when she can buy one earning 2.3%. So, Jack, makes her an offer. He will sell her his bond for $97.34 (you’ll see why in a minute).

If Ilsa buys Jack’s bond, at the end of two years she will have received two interest payments of $0.97 plus $100 on the bond’s maturity ($2.66 more than what she paid Jack). Therefore, at the end of two years, Ilsa has earned $4.60 ($0.97 + $0.97 + $2.66) on her investment or the equivalent of 2.3% per year.

When interest rates rise, bond prices fall. And bond prices have fallen notably in the first quarter, with the main Canadian bond index down 7.1%. This leads us back to the original question as to what this means for bond investors, or asked another way, does it matter? That question may seem crazy – of course it matters, or at least it kind of matters. Let’s go back to Jack for a second. If Jack was satisfied with his bond on January 1^st, should he be any less pleased on January 3^rd? Unless Jack has to sell his bond, he is still going to earn the exact same return as what he expected on the day he purchased it. He will still receive the same interest payments and the same amount on maturity. Nothing has changed for Jack – except the current value showing on his investment statement, which will reflect the price at which Ilsa was willing to buy the bond from him.

The point being that the total return Jack is going to earn on his bond was set on the day that he purchased it, and that amount is not going to change. Even if the price he could sell it at drops now, it will still revert to $100 by its maturity date. Therefore, the decline in price matters mostly if you need to sell the bond prior to its maturity.

There is no doubt that the speed and scale of the downturn in bond prices is unusual – likely the worst in the last 20 years. And that leads to the next natural question – when will it stop? As stated above, bond markets tend to move in anticipation of central banks raising interest rates and historically bond markets have tended to stabilize shortly after the first interest rate increase. That stability may be delayed this time as fresh inflation concerns, due to the war the in Ukraine, arose at almost the same time as the Bank of Canada raised interest rates the first time. It may take a little bit of time to fully adjust to this new factor.

The period to reach stabilization could also be impacted by how aggressively central banks raise interest rates. If the Bank of Canada or the Federal Reserve in the United States choose to drip out the planned interest rate hikes steadily over the year, we would expect to see the majority of the adjustment in prices completed in the next few months. If a more aggressive approach is taken, with a series of 0.5% increases between now and June, there may be a sharper reaction in the near term, but it also likely shortens the time frame until the market stabilizes.

Equities – the new safe haven?

Equity markets have been reasonably resilient throughout this period. Led by strong gains in commodity prices, the S&P/TSX Composite Index (on a total return basis) finished the quarter up 3.8%, while the S&P500 recovered from its January lows to end the quarter down only 5.7%. Why have equity markets held up so well, ending the quarter well above the January lows? We have some thoughts on that. First, there remains a lot of liquidity in the financial system. After two years of pushing cash into financial markets, the central banks made the last contribution to financial liquidity in March. So, the market remained flush with cash through to the end of the quarter. The impacts of that will also likely trickle over into the next few months. Second, as investors have moved away from owning bonds, some of that money is likely finding its way into equities. Stable, dividend paying companies seem to be some of the main beneficiaries of these money flows, which suggests investors are seeking them out as bond substitutes.

The path for equity markets from here is probably even more unclear than it is for bonds. Let us paint both the bear case (negative) and the bull case (positive) for stock prices.

The bear case looks something like this.

1. The combination of higher interest rates, food and fuel prices leads to a decline in consumer spending. In the chart below, you can see that the expected impact of increased food and fuel prices is the same on Canadian households as raising interest rates 0.78%. Add that to the 0.25% interest rate increase that has occurred, and it is already the equivalent of having raised interest rates 1.0%, costing Canadians an estimated $14 billion over the next year. That is $14 billion that can’t be spent on dining out, vacations, a new cell phone or new shoes for that matter. This leads to an inevitable slowing of economic growth.

2. For years, low interest rates were used as the justification for the U.S. equity market trading at valuation levels above its long-term average. If this is the case, then as interest rates move higher, valuations should move lower. The S&P500 is currently trading at approximately 20 times the earnings of the companies that make up that index. If that were to slide towards 18 times earnings, a 10% decline in share prices would be expected. A combined slowdown in growth and shift to a lower valuation level, would suggest a decline in the 15% to 20% range.
3. The Yield Curve has inverted, which means that short term bonds are yielding more than longer term bonds. This often is a precursor to a recession.
4. After years of adding liquidity to the financial system, the central banks may begin to withdraw that money in a process referred to as Quantitative Tightening. At this point, central banks have not provided details of that plan or the timing for when they may begin removing the liquidity.

Before you start to panic, let’s move onto the bull case. It looks like this:

1. Consumers have built up significant savings over the past two years and we are seeing a notable increase in wages. The combination of those will prevent any significant decline in consumer spending.

https://www.atlantafed.org/chcs/wage-growth-tracke

2. Due to labour shortages and higher wages, planned capital investment has increased. That capital investment is a source of growth to the economy.
3. Corporate profitability tends to improve during periods of inflation as companies pass on higher costs and protect profit margins.
4. If financial markets start to decline and liquidity to credit markets becomes challenging, the central banks will be forced to reverse their stance and provide a fresh wave of liquidity, essentially backstopping equity markets.

Neither side has it all right

Which side of this debate are we on? To be honest, neither. You may recall that coming into 2022 we anticipated a volatile year, and we expect to see sentiment swing between these two positions throughout the year. The outcome will likely be far less dramatic than the path to get there. Each camp in this debate has some valid arguments.

It is hard to imagine that the combination of higher interest rates and higher cost of core non-discretionary spending items such as food and fuel, will not impact households’ ability to consume other goods. That may be moderated by the increase in wages and savings. Corporate investment may also ease some of the damage to growth, but we do expect to see economic growth slowing as the year progresses.

Valuations for the U.S. equity market remain high, while the Canadian index trades at levels close to its long-term average. Higher interest rates should lead to a decline in that valuation level, but solid gains in corporate earnings can offset that. If valuations retraced to 18 times earnings from the current level of 20 times, but earnings grow by 10% (approximately the current estimate for earnings growth), the markets would stay virtually unchanged.

Will central banks reverse course if economic growth begins to slow more than anticipated or if financial markets show signs of stress? That is a more difficult question. Currently, central bankers want to be perceived as aggressively tackling inflation. As the inflation issues are primarily triggered by supply constraints not excessive demand, the central bank’s ability to use interest rates to stem inflation is not a given. Therefore, if central banks must choose between fighting inflation and preventing the economy from going into recession, which will they choose? In the past, when confronted with supply disruptions central bankers have generally protected the economy. But in those instances, inflation was not as high nor at as high of a risk of becoming embedded in the economy as it is today.

The one instance where we believe it is possible to have more confidence that central banks would intervene (again), is if credit markets were to show signs of strain. If the situation were to arise where it becomes difficult for companies to issue new debt or rollover maturing debt, central banks would likely be forced to return to the role of liquidity provider or risk a more serious seizing of the economy.

So, where does all of this leave you as investors? First, at some point there should be the opportunity to purchase bonds at attractive returns. Second, we believe the three main themes to watch as this year unfolds will be the messaging set by both the Canadian and U.S. central banks, the trends in corporate earnings growth and lastly, inflation indicators, including energy prices.

In contrast to 2021, this year is not likely to be an easy ride for investors. But as we have said before, it is only when there is some volatility that there are opportunities. With that in mind, most clients have above normal cash balances available to take advantage of those opportunities and, we remain focused on quality holdings as those tend to prove more resilient during periods of uncertainty.

Disclaimer:  Please note that the publication is designed to provide general information only. It reflects the thoughts and opinions of Logan Wealth Management and should not be construed as financial advice, nor should the information be considered a substitute for personal advice. Information used in this publication has been gathered from sources believed to be reliable. Logan Wealth Management is not responsible for and assumes no liabilities or responsibility for any loss or damages suffered as a result of the use or misuse of, or reliance on the information or content of this publication. Please consult your financial adviser to determine whether the information is applicable to your personal situation.