Asset Allocation Quarterly: It’s All about Inflation
Quarterly Outlook: It’s All about Inflation
Key concerns in the first half of 2023 focused mostly on central banks raising interest rates to tackle inflation brought on by stimulus from fiscal and monetary policy pandemic relief efforts, supply chain disruptions and commodity volatility. Recession concerns have also been a persistent theme for over a year, and a few notable bank failures and U.S. debt ceiling uncertainty raised anxieties further. Despite this backdrop, some equity markets have surprised many by surging, most notably the NASDAQ and S&P 500, with the caveat that seven notable technology stocks were responsible for the majority of those gains.
As we enter the second half of the year, we are primarily focused on the fight against inflation as central bankers try to drive that measure down to their two per cent targets. Although we have seen relatively rapid retrenchment from the peak inflation numbers in mid-2022, employment and wage growth have remained strong, making further progress slow, with the Bank of Canada (BoC) expecting to achieve its target now only in mid-2025. This could lead to interest rates that stay higher for longer as the risks of easing up too soon are seen as greater than the potential benefits.
As the global economy slows and previous rate hikes continue to be absorbed by the economy through 2024, we remain generally conservative regarding equity markets in the short term and recognize certain opportunities in fixed income.
- Growth is slowing. Most developed countries are expected to enter recessions as interest rates have risen to slow spending and tackle inflation. Most recessions are forecast to be mild and short lived, with some economies (Canada’s included) expected to navigate a soft landing, getting inflation down to two per cent target levels without having real GDP growth slip into negative territory.
- Equity markets have generally done well so far in 2023. For the most part, equities have done well, especially companies that focus on technology and specifically Artificial Intelligence (AI). Broader indexes have been more modestly positive, but have recently shown signs of picking up.
- Expect volatility. As economies slow, we could still expect to see negative surprises in quarterly results or forward-looking guidance. We are cautious short term but positive about opportunities as we look past this recessionary environment, recognizing that the path may be rocky.
- We favour a defensive posture. Within the context of staying invested, we favour sectors that have generally fared better during downturns. In Canada, we would consider consumer staples, communication services and utilities. In the U.S., we would look at healthcare, utilities, consumer staples and real estate.
- Inflation is going to persist. In Canada, the battle to get from ~3 per cent to the 2 per cent target will likely drag well into 2025. That leaves the BoC with both the latitude and impetus to keep interest rates higher for longer and/or further raise rates. The risks of lowering rates too soon outweigh the risks of not doing enough.
- Higher rates provide opportunities in fixed income. If we accept that yields, especially those of longer maturities, have peaked, adding duration or extending maturity to fixed income portfolios could provide attractive yields and lower re-investment risks as well as capital gains potential when rates decline in the future.