August 2022
By Peter Zaltz
Following a historically-weak markets performance over the first six months of 2022, investors have been rewarded with a decidedly upbeat summer: equity markets have jumped sharply from their mid-year lows, bond yields retreated in late June and July, and credit spreads have retraced some of their year-to-date widening.
Coupled with recent data showing the pace of inflation may finally be slowing, it can be tempting to believe financial markets have simply righted themselves faster than expected.
However, this recent strength seems to me more of a bear market rally than a true recovery. The fact is, despite the recent price movement, markets are still dealing with persistently-high inflation, the prospect of several more interest rate hikes, and the potential for significant downward corporate earnings revisions in the fall third-quarter reporting period. As much as it would be nice to call an end to the volatility, we are not there yet.
To begin with, while the July inflation numbers cooled a bit from June, they are still at extreme levels by any measure. U.S. inflation came in at 8.5%, down slightly from 9.1% in June. The result was slightly lower than expected, and markets rallied on the news. Canadian inflation in July also retreated a bit, to 7.6% from 8.1% in June.
While this is a positive sign, getting caught up in fractional percentage-point movements can distract from the fact that inflation is still higher than in any month in the 40 years prior to 2022. It is also still about four times higher than the U.S. Federal Reserve and Bank of Canada’s inflation targets, which are centered around 2%. In other words, while inflation may have peaked, we are still near the top of a very high mountain.
Additionally, the lower July inflation number was helped by a month-on-month decline in gas prices, which followed the price of oil. But there were also several inflationary components that were higher in July, including food prices, which continue to be boosted by the Russian invasion of Ukraine, along with mortgage and rental costs. And while gas prices may be easing, the impact of higher year-over-year commodity prices is still working its way through the economy, pushing other costs higher.
As I’ve noted before, inflation is likely to come down from its current level in the coming months, but to get it down to the 2% range will require a significant deterioration of economic fundamentals, which is unlikely to happen without additional prolonged monetary policy intervention.
Given this, central banks are continuing to push the gas pedal on interest rate increases, markets are currently pricing in at least another 75-100 basis points of tightening this year. Interestingly, markets are also currently expecting central banks to reverse course and begin cutting rates in the latter half of 2023. However, we feel this take is too optimistic.
Monetary policy always works with a lag of about one year, and we expect the Fed is unlikely to cut rates until 2024 at the earliest in order to allow higher rates to take hold and cool inflation expectations for the long term. The market will have to adjust to that reality.
It’s also clear that central bankers are concerned that the market may not be adequately pricing in a prolonged period of higher rates. Following the release of July inflation data, Bank of Canada Governor Tiff Macklem posted an Op-Ed where he predicted inflation “will likely remain too high for some time,” and noted that more than half of the goods and services tracked in monthly CPI data are still rising faster than 5%.
And at the Fed’s annual economic symposium in Jackson Hole, Fed Chair Jerome Powell said restoring price stability “will likely require maintaining a restrictive policy stance for some time,” and said the bank’s overarching focus was restoring inflation to the 2% target.
These statements, and the prospect of additional interest rate hikes to come, suggests to me that markets still have another leg down in them. A trigger for this may be downward earnings revisions, which we have not yet seen in significant volumes, but could emerge as third-quarter earnings season approaches. The long lead-time for corporate results means there is a delay in determining the impact higher prices have on company bottom lines, and those revelations could have a significant impact on market sentiment if and when they come. Currently, our base case is for significant volatility for the balance of the year.
While we do expect additional volatility, we also believe much of the damage has already been done, and we have begun taking on some additional risk in our credit strategies and are cautiously adding names in our equity strategies where we see value. However, I do not expect to fully embrace a more aggressive investment posture until we see a further shift in market conditions, namely a Fed funds rate above 3.5%, substantial inversion of the yield curve, more widespread earnings downgrades, and a few months of lower CPI data. We also need to see sustained evidence that the labour market has loosened, as higher levels of unemployment should cool average hourly earnings gains.
We continue to employ a bottom-up approach to investing, which focuses on individual securities and makes use of our deep relationships with the high-quality companies we invest in. We believe this serves us well in both strong and weak markets and it has done so during this period of volatility. We reduced risk significantly last year in preparation for what we anticipated would be a challenging 2022 on financial markets, and we are optimistic about our current positioning.
There has been considerable debate to this point about the central banks’ approach to dealing with the current inflation situation. Given the delays for rate hikes to take full effect, it will be some time before we know whether or not the banks have been aggressive enough, not aggressive enough, or too aggressive in their actions so far. This will only become clear in the fullness of time. However, with so many dominoes yet to fall, we doubt markets are out of the woods yet. The summer rally was nice, but we are prepared for the return of volatility.