The data that came out in April is now in the spotlight in May more than ever. The debate about interest rates, inflation, global production, currencies and more are discussed then wrapped up with a discussion on portfolio positioning.

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Interest Rate Update:

We are seeing Canada diverge from much of the rest of the developed countries. Tiff Macklem, the Bank of Canada governor, has begun to reduce and cease much of its bond buying programs. These programs were designed to keep credit markets flowing and functioning. As this objective seems to have been met, the Bank sees the market as stable enough to remove some of the emergency support. It also signalled that it will likely increase overnight interest rates in the second half of 2022 which is closer than the 2023 previous target.

This is a catch 22. The market wants lower interest rates which are impacted by the bond buying program but it also signals that the Bank sees the economy as strong enough to handle the removal of emergency stimulus.

With Canadian unemployment nearing levels seen prior to the COVID crisis and inflation showing up, it makes sense that the Bank will begin to normalize interest rates and stimulus.

Will the market throw another taper tantrum like it did when the US Central Bank started to increase interest rates in 2013? We will have to wait and see however that was a short term tantrum and not reflective of economic weakness.

Global Production:

Euro zone overall and the UK entered the second technical recession in two years as 2020 Q1 and Q2 were negative growth. A recession is described as two consecutive quarter of negative GDP growth. 2020 Q3 was positive but 2020 Q4 and 2021 Q1 were both negative which means that it was in recession again.

Seeing strength in manufacturing in the US, a rebound in China, Japan and the Euro Area.

UK and Canadian industrial production seems muted even though Canadian employment has almost regained all jobs lost from this time next year. One interesting point to me is the Canadian average hourly wages have been decreasing since January and may be in a bit of a downward trend.

Is Inflation Here to Stay?

There is debate among market participants about whether inflation is here to stay or if it is a temporary factor. There are two measures that I like to compare. The overall inflation rate and the core inflation rate. Looking at US overall inflation, the latest measure was 2.6% in March versus the core inflation rate of 1.6% year over year. The difference between the two measures is that the core inflation rate strips out more volatile items such as food and energy. These items are subject to more volatility.

Given that the central bank in the US and Canada focus on two things, inflation and employment, they will be looking to judge the rate of inflation and understand if a higher inflation rate is here to stay or if it is temporary. 

The tools for controlling inflation are to raise interest rates which will cool demand and therefore slow the demand for these goods and hence slow the rate of price increases.

Given that we’re still dealing with a pandemic and are still not out of the woods they are hesitant to increase rates in the near term. The Bank of Canada feels that inflation is here to stay and given that the employment rate is almost back to pre-pandemic levels then they have some leeway to raise rates. It’s a fine balance to ensure that they don’t slow the economy but don’t let inflation get away from them.

The US Central Bank believes that these inflation rates are temporary and after the initial rebound of spending from a reopening of society that inflation will moderate. The US also hasn’t had the rebound in jobs like Canada has.

My personal opinion is that inflation will be temporary over the course of 6-12 months given a reopening. I believe that after the financial ammunition is spent from decreasing savings account balances, utilization of lines of credit and we sort out the supply chain issues that are causing a shortage of products, that inflation will return naturally to sub 2% growth.

We struggled with generating inflation before the pandemic and I believe that will be the case after we clear the backlog.

I think it is appropriate to remove some of the emergency stimulus however I think that when it comes time to raise interest rates that the Bank of Canada will have limited reason to be on a steady path of increasing rates.

Currencies

For this reason I believe that the Canadian dollar relative to the US dollar may get stronger in the short term however I believe that this will likely have a ceiling and only be able to rise so far.

Further I think that there is opportunity over the medium to long term to have US dollar appreciation relative to the Loonie.

As a result, being a Canadian portfolio manager, I’m okay with holding some US dollar denominated assets however I still look to hedge out most of the currency risk.

Portfolio Positioning

Interest rates driven by economic production will likely control the narrative going forward. This will be dependent on the ability for economies to open back up. 

The risks are that a good economy causes interest rates to rise and the market as a whole throw a taper tantrum with the addiction to low interest rates. Areas to be the hardest hit are tech, real estate and utilities.  Another risk would be a COVID variant that is much worse than the ones currently in circulation. This would cause interest rates to lower and in this case economically sensitive stocks such as materials, industrials and financials to go down.

I think the most likely scenario is for the economies around the world to gradually reopen and get better. I see the United States as being one of the first economies to reopen and as a result their stock market is reflecting this. The spending being passed by the government in the form of fiscal stimulus is massive and will likely ad a meaningful boost to economic growth.

Canada is still dealing with rolling shutdowns and large outbreaks of the virus. Vaccination programs have been much slower relative to the US and the Central bank is looking to remove emergency stimulus and raise rates faster than previously anticipated.

This is causing a preference for economically focused stocks in the US and my preference for currency hedging is neutral at this time.

Until next time,

Trevor Dale

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