By Peter Zaltz
Through much of early 2022, many in the market had held out hope that the generational inflationary pressures that have roiled markets this year might soon begin to recede on their own, allowing the U.S. Federal Reserve (Fed) to ease off on its hawkish approach and avoid pushing the U.S. into recession. But that outcome seems much less likely following data showing still-rising inflation and the Fed’s subsequent 75 basis point interest rate hike.
The U.S. May inflation reading of 8.6% was ahead of expectations and prompted markets to sell off as investors priced in more aggressive central bank tightening. Most notable was the S&P 500 index falling into bear market territory, defined as a 20% drop from its most recent peak. The Fed rate decision led to additional selling, resulting in the S&P/TSX composite index—which has outperformed the S&P 500 this year—falling further into correction, or a 10% decline from its all-time high in April, as investors anticipated the Bank of Canada (BoC) would follow the Fed’s aggressive lead. Indeed, following the release of Canadian data showing higher-than-expected 7.7% inflation in May—the highest in nearly 40 years—markets are now pricing in a 75 bps rate hike at the BoC’s next meeting in July.
In addition to the Fed’s 75 bps hike, which was its first rate move of that size since the 1990s, Fed Chairman Jerome Powell indicated in his commentary the next rate decision in July would likely be an increase in the 50-75 bps range. He also made specific mention of the toll that price increases are having on U.S. consumers struggling with a rapidly rising cost of living. The message I take from this is that Powell has calculated that stopping inflation in its tracks is crucial, even if it means pushing the world’s largest economy into recession.
It may seem strange to imagine a recession as a preferred outcome, but the Fed has decided the potential for current inflationary pressures to become embedded in the consumer psyche represents a greater threat. In that situation, consumers might decide to bring forward purchases out of fear that products will soon become even more expensive, thus feeding into more inflation. The other challenge is that the price pressures brought on by the war in Ukraine and by COVID-related supply chain issues are not within the Fed’s sphere of influence, which means it can’t afford to let up on factors that are primarily consumer driven.
The Fed also must be wary of the lessons learned from the inflation crisis of the 1970s, which was only ended by aggressive rate hikes that ultimately put the U.S. economy into a severe recession in the early 1980s. We don’t anticipate such a severe outcome in the current situation, but Powell—as well as BoC Governor Tiff Macklem—understandably want to contain the current situation as quickly as possible.
What this means is that borrowing costs are set to rise faster and higher than the market had previously thought, which will likely result in additional volatility in certain asset classes than had been previously anticipated. However, we believe we are well positioned to handle this uncertainty.
On credit markets, we think a considerable amount of the damage has already been done, although corporate credit will likely continue to see volatility until inflation stabilizes. In Canada, we don’t anticipate much additional spread-widening given the high level of absolute yields and the significant widening we have already experienced year-to-date. In the U.S. high yield space—which enjoyed its first positive month in May following sharp declines early in the year—credit quality has improved in recent years, which positions the space better for a potential recession. Overall, the sub-investment-grade space already has very attractive yields.
However, our credit outlook is highly contingent on central banks’ ability to wrestle down inflation over the next 12 months. If they are unable to do so, we would anticipate much higher rates and additional negative fund flows.
Canadian equities have seen a sharp drop since mid-April and continue to deal with sustained volatility. However, the selling so far has mostly been on a sectoral basis, which suggests it has been a reaction to negative news, rather than due to concerns about individual names. Indeed, on a price-to-earnings basis, the space remains attractive with valuations below 14 times forward earnings. In the key financial services sector, earnings have been strong, and we continue to see strong capital reserves and low loan delinquencies going forward.
The U.S. has been hit harder than the Canadian market and we have seen valuations come down quite a bit this year, particularly in growth and cyclical stocks. While this might normally make us more constructive on the space, we also have not seen earnings expectations revised lower, which seems likely given the growth concerns, and that could result in further weakness.
In terms of our investment strategies, Gluskin Sheff has been well positioned for higher inflation since last year, when we were preparing for what we expected to be a volatile 2022. With the additional price pressure brought on by the Russian invasion of Ukraine and pandemic-related shutdowns, we have further reduced our risk profile.
In our U.S. equity strategy, we have reduced our holdings of cyclically-sensitive stocks and added in defensive areas such as healthcare, while our Canadian equity strategy has focused on companies with pricing power that can benefit from inflation. In our international strategy, earlier this year we added exposure to energy and basic materials and we have reduced exposure to consumer cyclicals.
In our Blair Franklin Global Credit Fund—our investment-grade credit strategy—we have added shorter-tenor securities that can benefit from the rate hike cycle and have also been active in our positioning to capitalize on the recent turmoil. In our sub investment-grade credit strategies, we have been adding higher-rated securities to improve overall quality and of late we have been adding to our high-yield bond holdings, which are very attractively priced following recent declines.
Longer-term, we are very optimistic about our positioning, and we believe that equity markets will eventually benefit from a rate hike environment once there is more visibility on inflation. Credit markets are also appealing over the longer term as rates will eventually rally from their current levels, although there may be considerable volatility until that happens.
As we work our way through a very uncertain period, we will rely on our disciplined, bottom-up approach and will remain nimble in the face of rapidly-changing market conditions. If the U.S. and Canadian economies do tip into recession, we do not think it will be a deep one, but it could last for some time. However, while we anticipate additional market volatility, we also believe this will bring additional opportunities, and we be on the lookout for them as we continue actively and carefully manage our clients’ investments.