Inflation, taux d’intérêt et économie : que nous réserve l’avenir?

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Speaker 1:

Welcome to Markets Plus where leading experts from across BMO discuss factors shaping the markets, economy, industry sectors, and much more. Visit bmocm.com/marketsplus for more episodes. The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries.

Speaker 2:

In this episode, Chief Executive Officer and group head of BMO Capital Markets, Dan Barclay, hosted BMO experts, Michael Gregory, Margaret Kerins and Brian Belski to explore what may lie ahead for households, businesses, markets, and the economy, and whether a recession is in the cards.

Dan Barclay:

Welcome, BMO is excited to host our economic update and discussion around interest rates, inflation, the economy, and what lies ahead. It's great to see you all joining us today and great that we could have this opportunity to share our current thinking. Since we last had one of these sessions, which feels a little while ago, lots has changed. If we think about the war in Ukraine, the evolution of COVID and where we've gotten to some of the outputs around supply chains, commodities, and now a real transition as inflation goes up, change in Fed policy, around the world, looking at interest rates and where we can go, and now headed into potentially a recession. So this is a great chance for us to get together today, talk about these issues. We look forward to an engaging discussion today. Joining me, Michael Gregory, our Deputy Chief Economist, Margaret Kerins, head of Fixed Income Strategy, and Brian Belski, our chief investment strategist. With that, why don't we get to the engaging discussion we expect to have today. And Michael, why don't you give us our current thoughts around the global economies and the issues that you're focused on.

Michael Gregory:

Sure thing. Well, good morning everyone. All right, so to answer the question, Dan, what lies ahead, there's one overarching theme. It is the fact that core inflation, inflation broadly, is proving to be more stubborn than expected. Now, headline inflation has been going down over the past couple of months, helped by lower oil prices and that should continue in the months ahead, but it's really the fact that the food costs continued to escalate amid persistently high core inflation and wage growth.

Michael Gregory:

Now the genesis, as we all know, to this problem was the combination of constrained supply and strong demand. Supply was constrained first by the pandemic and as you mentioned then by the war in Ukraine. And then demand has been charged up, first by pent up spending, but more importantly from massive amounts of fiscal and monetary policy stimulus. And it's quite frankly, both the Bank of Canada and the Fed and other central banks around the world are now attempting to remove that monetary stimulus by raising policy rates in some cases, shrinking their balance sheets to try to dampen demand, bring demand and supply back in better balance, and hopefully dampen inflation.

Michael Gregory:

We've seen both the Bank of Canada and the Fed so far have raised rates quite aggressively, both by 300 basis points. And because core inflation and wage growth continue to remain quite stubborn, we expect that tightening to continue. In fact, in the wake of recent inflation readings and last week's sort of hawkish Fed hike, we've actually adjusted our own projections for policy rates. We raised the Fed funds projection by 75 basis points to four and a half to four and three quarters, and the Bank of Canada policy rate by 25 basis points to 4%. Now, kind of an interesting development there. Up until now, the Bank of Canada has been as aggressive or even more aggressive than the Fed in terms of tightening policy. But now we think going forward the Bank of Canada has to be a little bit more cautious, with Canadian households flirting with record high debt burdens and a looming surge of higher mortgage payments as a lot of these variable rate mortgages that were done months ago get reset.

Michael Gregory:

Now when you start talking about four handles on policy rates, we think that that becomes the proverbial straw that breaks the camels back. We've made adjustments to our economic forecast. We now expect on both sides of the border, growth will grind to a halt next year. We're looking for zero growth on average for both the Canadian and US economies. And in fact in the early part of next year, we're looking for a couple consecutive quarters of negative growth. This time though, we think it will be broad enough so that it will probably be considered a recession. Obviously on both sides of the border, the arbiters of recessions, it's the National Bureau of Economic Research in the US, it is the C.D. Howe Institute in Canada. And we do think with time they will take those negative quarters we are expecting in the first half of next year and will end up calling it a mild, but nevertheless a recession.

Michael Gregory:

Keep in mind though, two consecutive quarters by definition is not necessarily a recession. The first half of this year we had that in the US, that wasn't a recession, and we had it in fact in the first half of 2015 owing to the collapse in oil prizes, that was not a recession. So again, we think it'll be broad. We'll see it across many sectors and both the spending and income. All right, so there are some silver linings here though and the fact that Canadian and US households still have a lot of accumulated excess savings and there still is some pent-up demand, particularly for services. So I think those supports will keep the recession short and shallow and lay the groundwork for recovery in the second half of this year. Now we've also raised our forecast for the unemployment rates, as expected, we look for the jobless rate to peak at 5% in the US, around six and a half percent in Canada.

Michael Gregory:

But what we really didn't make any changes lately to our forecast is on the inflation side. We still have the key metrics running slightly above 3% by the end of next year. Basically the additional inflation damper provided by the recession, the mild recession, is offset by the fact on the ground now we have a lot more inflation momentum because of stubborn core inflation and wage growth. Then this is basically a wash, and in fact with inflation not expected, at least in our own view, to get below 3% by the end of next year, that also suggests to us that once peaking policy rates will not start falling, or being cut, until 2024. But that also emphasizes where the net risk lies. That lies in the fact that we could get even higher policy rates, a deeper recession, and faster disinflation where we actually get inflation falling to 2% next year.

Michael Gregory:

Now one more thing I wanted to just mention just before we turn it back to you, Dan, is so far, the catalyst for more central bank tightening, potentially more aggressive central bank tightening, is the stubbornness of inflation. Well, there's another reason why central banks may continue tightening if not tighten aggressively. It is what happens on the fiscal policy front. And we've seen what's been unfolding over the past several days in the UK where fiscal policy there has taken a very stimulative tack and with the freezing of energy prices, energy bills, quite frankly, avoiding that 80% hike as well as the largest tax cut the UK has seen in some 50 years. Now, governments, of course, politicians, they do want to do something to try to offset the ravages of inflation and try to offset the risk of recession, but there's only a limited scope you can do that within, until you start moving against what monetary policy's trying to do.

Michael Gregory:

The Bank of England has been raising policy rates to try to tamp down inflation, yet this kind of fiscal stimulus is going to work against that and it's this kind of fiscal policy moving in one direction, monetary policy moving in another, that of course has contributed to the weakness we've seen in the British pound hitting record lows against the dollar. And of course the spike we've seen in long term interest rates in the UK, spiking more than a hundred basis points, although with the Bank of England now coming in to provide some stability to that market, it's as if we've seen it, some commentators refer to it as the return of the bond vigilantes, in which case fiscal profligacy is punished by higher bond yields.

Michael Gregory:

And quite frankly, in an environment where inflation is the number one issue, central banks are raising policy rates to try to mitigate that, I do think in fact we will see that, and I think it's probably a warning for governments around the world. There's a limited scope for trying to mitigate inflation, try to mitigate the risk of inflation, before you too suffer the wrath of the bond vigilantes. I'll turn things back to you, Dan.

Dan Barclay:

That's great, Michael. One of the things that I was struck, obviously there's a balance between this monetary and fiscal policy, the balance between curbing inflation and introducing a recession. You're the economist. Take us through the thesis as to why we need to keep inflation low. I think we all understand near term pocketbook issues, but I think fundamentally there's a much deeper discussion for the economy.

Michael Gregory:

Oh absolutely. I mean when you look at, firstly, it is an empirical fact that countries with high rates of inflation tend to have poor economic outcomes and those with relatively stable inflation, low inflation, have higher economic outcomes over time. So from a long term perspective, it promotes growth, but you can see why, high inflation over time it erodes wealth, it erodes incomes as you mentioned even in the short term, but it also creates distortions in the way in which businesses invest, the way individuals purchase assets, where trying to mitigate inflation or accounting for it or planning for it becomes a paramount part of an investment decision. And that is why central banks believe that we cannot let inflation get out of hand. We can't let high inflation factor into higher inflation expectations because that gets very hard to try to remedy. Just go back to what Paul Volcker had to do and other central banks had to do to try to arrest the kind of inflation that came out of the 1960s and the 1970s.

Michael Gregory:

So the idea is now we're going to take some pain now and in fact they call it pain. Powell uses that P word and it's not normal where you see central bankers actually talk about "this is going to hurt," but you know what? If we have to do more down the road, that pain will even be greater. So it's either a little bit of pain now or a lot of pain later and they're taking the tack we can try to minimize the pain now, but it will be pain, and I think that is what we'll be seeing now as we move forward into next year.

Dan Barclay:

Speaking of volatility and pain and excesses in the economy, let's talk about housing for a minute. When we think, particularly in Canada, I think various places across the world, we've had enormous price increases in the last couple of years through COVID. Some real change in buying behavior, et cetera. What do we think's going to happen to housing in the near to medium term around prices and some of the valuation issues that we've seen in recent memory?

Michael Gregory:

Good question. And in fact I kind of think housing is a little bit of that canary in the coal mine of what could be in store if inflation really got out of hand in the broader economy. Obviously we've seen mortgage rates go up around the world, but particularly both in Canada and the United States and we've seen the impact that's had on demand. Demand has fallen off, we were seeing the kind of, at least in Canada, the way in which demand has fallen off is a kind of decline you would normally expect to see in recessions. And in fact I think it's fair to say that the housing market is in fact in a recession and we're beginning to see a lack of demand now beginning to be reflected in lower prices in Canada, since prices had their last peak in February, we're down about 7%.

Michael Gregory:

We think that peak to trough we will get about a 20% decline in prices on a nationwide basis, probably 10 to 15% peak to trough in the US. And the good news is that that sets up better affordability, particularly once interest rates start falling, and they will fall, once markets get a whiff that the worst is over from the inflation perspective and then rate cuts start to be priced in. We're going to have a situation with lower priced homes with declining borrowing costs and I think housing will bounce back, particularly given at least in Canada, fundamentally supported by immigration inflows and on both sides of the borders by millennial demand.

Dan Barclay:

That's great. Well why don't we transition to Margaret. Margaret, overall, when you think about what you're telling your clients today about fixed strategy, take us through your thoughts and the issues you're looking at please.

Margaret Kerins:

Sure. I think, Dan, as Michael mentioned, the risk here is toward more tightening rather than less tightening. And the US rate market has swiftly repriced to higher yields overnight. We did see tens cross 4% as the Fed is solidly hawkish. The market narrative now continues to remain focused on just how high two year yields will go in this type of environment. And we do think that there's room for twos to run all the way up to what the Fed is telling us they expect for the Fed fund's effective rate for next year, which is 4.60. And this is really based on their intention to hold rates in restrictive territory and not just restrictive but meaningfully restrictive for as long as it takes to contain inflation and get it back to the 2% level.

Margaret Kerins:

So there are really three main implications for us, for US treasuries, and the first is that the Fed's higher for longer narrative should put a floor under two year yields, which they can't rally through even if the economy or when the economy continues to slow, or I should say, as the economy continues to slow, so we remain bearish on the front end.

Margaret Kerins:

I think that the Fed's huge change in their dot plot from June to December where of course they revised the year end Fed funds projection up by a hundred basis points and the terminal rate up by 80 basis points, also puts a level of risk premium into the front end because people, investors, are questioning whether or not we might see another revision next year if they remain behind the inflation curve. So that's really the first implication, a floor under two year yields. Secondly, 10 year yields will react to the slowing economy and what that means for us is that while we're hovering around 4% right now, they will rally back down to closer to 3% as the economy slows. And this really keeps our choose tens deep inversion trade intact. The idea that the Fed continues to push really hard on this higher for longer narrative and that they'll fight inflation at any cost really implies also that they might keep rates high for too long.

Margaret Kerins:

Just as they stayed at the party on the other side for too long, we think that that's really the risk on this front and that the economy could slow down much more than they clearly want. And that's really based on them, their message of waiting to see the reverse of the whites of the eyes of inflation. Now they want to see the whites of the eyes of contained inflation. So those are the three risks that we see based on the Fed's messaging. But in the very near term, we wouldn't stand in front of the bearish momentum that's going on in the market. We've got a lot going on globally that is pushing yields across the curve, out through tens I should say, well through the 4% level in the front end. Liquidity is very thin, uncertainty is high, much higher than in the past, and I think the market will begin to price a reversal in the Fed's meaningly restrictive stance at some point next year.

Margaret Kerins:

And at that point the trade will switch from being this deep inversion trade where we expect to test the negative 57, 58 levels of just a few weeks ago, and go all the way to negative 75. But the next year will be the opposite. It will be the bull steepening trade and that's a very, very different trade where twos will rally down at some point reflecting, as Michael said, the Fed could be reversing course in 2024, the maturity of the two year is well within the 2024 timeframe. And so we should get a little bit of pricing of that sometime next year. It's not today's story, but that will be the next big narrative driving the market and the trade that we are watching for. I think we won't see it until we get Fed messaging changing off of this very, very high for long type of message.

Margaret Kerins:

In credit, we did see credit start to move a little bit this week. We remain negative on credit spreads. We do think they have the potential to widen out 15 basis points in the near term and it could be, I would put the risk on that to being wider than we currently expect right now. Credit has been lagging the sell-off in equities and of course the sell-off in treasuries as well. So we think they have some catching up to do as we enter into a weakening economy, a recessionary environment. And of course along with that you have a credit downgrade cycle. So I can pass it back to Dan if you have any questions.

Dan Barclay:

Well why don't we, Margaret, why don't we jump into the obvious one. When we say higher for longer, and I'm sure that that's got a wide band of what longer means, but why don't you share with them and what we think that that feels like for when the Fed will rise, the signals we'll see in the economy, but how long is longer in your mind?

Margaret Kerins:

So in the past the Fed typically reacted to forward expectations for inflation based on the monetary policy that they had implemented. So if they raise rates by 300 basis points or 400 basis points, they would look forward a year or 18 months, expecting inflation to come down and the economy to slow. This time, I think they're a little bit more worried and they won't be reacting as much to their forward expectations, but rather waiting to see inflation actually printing down closer and closer to their 2% level. So we're expecting them to hold at least through next year, whether or not they'll be able to do that, of course, is questionable as we of course wait to see what the employment situation looks like and how the economic data comes in. But I think that they are going to try to hold as long as they possibly can because they want to avoid the mistakes that were made in the seventies where they paused and then had to restart again.

Margaret Kerins:

So the risk is I think that they would rather overshoot on fighting inflation here rather than undershoot. So we would expect higher for longer to last at least through next year. Again, there will be periods where the market questions that and their resolve, even I think in the backdrop of what's going on overseas overnight, we are seeing people question whether or not the Fed will take a little breather here. We do not think so. I think that would be a mistake. So they are going to stick to their narrative and for us, it's really until something big breaks, we're already seeing certain things break, but their tolerance for what breaks is much higher, much, much higher. In fact, according to them, they will basically be able to or are willing to accept any level of pain in order to get inflation under control because you cannot have a healthy economy without price stability.

Dan Barclay:

Margaret, what about on currencies? The US dollar is very strong on a global basis. We have seen preemptive rate rises or leadership out of the US and Canada. Is that a sustainable outperformance the US dollar or is it temporary?

Margaret Kerins:

So we think that, we're about 50-50, which isn't really helpful, on whether we're near the or at the kind of blow off top in the US dollar. When the US dollar top is in and the cycle turns, I think CAD will be viewed as quality and we'll start to perform. Obviously oil has an impact on CAD, it's asymmetric, so we're watching that. But we do think that money markets do have the Fed going in, as Michael said, expectations are the pretty consensus across the board that 4.50, 4.75 range. And so I think the BOC, like Michael said, stopping at around 4% is right. We don't think that if the Fed continues to go, the BOC will continue to move along with them. Our call for I think three month US dollar CAD is 1.33, but probably push it to 1.35 when our FX team revises that.

Margaret Kerins:

In Europe, we have been very negative on European currencies, negative on Sterling for some time, and continue to remain negative even despite the massive moves. And that's really because we've got winter coming in Europe and of course the energy crisis and whatnot. The target for Great British pound US dollar is 1.04, pretty close to that overnight, but we wouldn't rule out a test of parity, given what's going on.

Dan Barclay:

Wow. That is a very big change in a relatively short amount of time. Well Margaret, thank you for that. Let's move over to Brian. Brian, you have been in on the record quite boldly for a while. You continue to be bold and yet the market has had enormous gyrations this year. So why don't you take us through your current thinking, what you're hearing from investors in the marketplace, and in particular, what do you think are the places you should be investing on the equity side right now?

Brian Belski:

Thanks Dan. And with much humility, it has been tough to be a bull and the reason why we've remained bullish, I want to talk about that. I also want to talk about where you should be invested now and then kind of give you a three to five year view on this return to normalcy. Something that we actually stole from you, Dan, in terms of this transition and the return to normalcy as we kind of transition I think, and how the US and Canada, we actually believe will lead that. So let's start off with number one. Here's why we were wrong. I've had the very good fortune of doing this job for a long time and this is my 33rd year on Wall Street and I learned the job as an analyst. I learned the job coming out of undergrad with an accounting and finance degree and I learned how to dive into financial statements at a very young age.

Brian Belski:

Started in the business in the late eighties, early nineties, with you got out of the eighties where it was all about restructuring charges and continuing operations and where are you going to charge? You're going to charge off the balance sheet, you're going to charge off the income statement. And so why I'm starting with that notion, Dan, is that never in my 33 years in business have I seen the type of balance sheet strength, cash flow consistency and earning stability ever from small, medium and large cap publicly traded companies than I'm seeing right now. Further to that, we have the very good fortune to travel around the country, both the US and Canada, and especially the US to different regions and speak with small and medium private companies and they remain quite positive even through this storm that really intensified in the February, March, April timeframe. We met with several clients in summer and we just did another swing here in September and our clients remain bullish.

Brian Belski:

What does that tell you? It tells you and tells me that the fundamental construct of both the US and Canadian markets from a bottoms-up basis remains very strong. Now obviously we've had a massive shift with respect to what's happening in terms of how we're valuing companies, what the discount rates are, what we're using for cash flow, all of this. But there's a means to an end with respect to this, and it's really the return to normalcy over the next three to five years. 2022 will obviously be this shakeout period, this control-alt-delete where we're shocking the system, and I'm going to use the word unprecedented. What we've incurred on a societal basis and on a business basis has been unprecedented the last couple of years. We've basically went to zero interest rates. We kept the world alive, we kept business alive. We had unbelievable returns in both the bond market and the stock market the last couple years.

Brian Belski:

Now it's on to shock and awe to kind of force us to get back into normalcy, which I thought 2022 was going to be. And then along came the war and then along came the word stubborn, Michael Gregory used it, in terms of inflation and the inflation piece of it has been more sticky and has been more stubborn than what we thought. Now I'm not an economist, but we're starting to see the 12 month forward inflation expectations drop pretty quickly. Now remember, the formula for investing is stocks lead earnings, which lead the economy. Stocks lead earnings which lead the economy. Stock market's already gone down 25%, which has already told you that we're going to have a recession. The bond yields inverted, so we're going to have a recession the first half of the year. Our great economics department is now on track with that. So we've already kind of discounted that.

Brian Belski:

We believe on a near term basis, the stock market actually has been an amazing discounting function and has done its job, believe it or not. Now what does that mean? Well, it took out the froth. What's the froth? I like to call it the four horsemen of the apocalypse. It's both Old Testament and New Testament, if you follow me. Who's the four horseman in the apocalypse? Cathie Wood stocks. No disrespect there. Number two, the meme stocks, not real investments. Number three, SPACs. And number four, my favorite, starts in a bit and ends in a coin. So we took that out. Then we went to the high multiple names, then we went to the high growth names, then we went to the fangs and then we went to the leaders, Dan, we went to the leaders, which was energy. When they took energy out in May, I felt with Accords that was the bottom.

Brian Belski:

Markets rallied. We've had a bit of a bounce. Then recently they took out energy again, the leader. So when you start to see the leaders and the generals get taken out, that I believe is starting to see the bottom. Now, we've seen this exacerbated moves the last couple of weeks, and not to pick on the currency people, but it always tends to be the bonds and the currency people that mess this up. I remember 1997, 1998, somehow this is the shakeout. This is the shakeout in every single thing that we see from a sentiment perspective, as you mentioned in your beginning comments, Dan, I've been on the road basically every day since Labor Day. I've been around the world and clients are more bearish right now than they were in 2008. Some of them are more bearish than they were in 2000 toward the top of the tech market.

Brian Belski:

That to me, from a sentiment basis, especially the cash on hand that we've seen from the majority of our institutional clients, means that a bounce is coming because the majority of our clients are not positioned for any change on the upside. So we think a bounce is going to happen and the fourth quarter is going to be very strong. And I'll use the unprecedented coin. We have so much pent up, pent up demand for stocks and pent up demand for positive performance, per Margaret's comments, if rates are going to be going down next year, markets looking at that, remember stocks lead earnings which lead the economy. I think that's why we could see a very big bounce based on the strong bottom fundamentals. But looking forward, with respect to lower rates and the impending fallback of inflation, that's why we're going to get a bounce in the fourth quarter.

Brian Belski:

What do you invest in now? I like to call it the cross section of growth and value. So opportunistic growth stocks in the value index and attractively valued value growth stocks in the growth index. So again, where does that take us in America? It takes us in stocks like communication services, financials, in healthcare. In Canada, it's still consumer discretionary, it's still parts of energy, and its financials. I think Canada actually has a very good chance to outperform the US in the fourth quarter because of the value proposition that it takes. So where do we go from here? I call it Consistency Canada and Fortress America. For my 10 years at BMO, we've been explicitly negative in emerging markets. We've been very negative on Europe and now we're starting to see that come to obviously at the end of this, the fruition.

Brian Belski:

I believe that non-Canadian and non-US assets are coming back to the US, coming back to Canada, meaning global investors are going to invest in North America, which they'll be paying for stability. Now, again, I'm going to, I'll end where I started, in terms of cash flow, earning stability and balance sheet strength, which also means debt to equity, I've never seen this in my 30 plus years on the business, Dan. That's what keeps us bullish and that's why I think it's going to lead the transition over the next few years as we transition to normalized interest rates, normalized stock market performance, and normalized GDP. And with that, I'll hand it back to you.

Dan Barclay:

Well always enlightening thought process and interesting, a little contrition at the beginning. That's good on you. You've been very vocal and very bold. When you think about if someone was going to invest in a particular sector right now, what sector would you prefer? Right? Of all of the 12 majors or 13 major sectors, which one is your favorite at this moment?

Brian Belski:

We love financials, Dan. We love it. And not just because we work for one, but because we love financials. Now, financials should be doing better in a rising rate environment. And we think especially the banks in Canada that are centered more on US because that's where the growth is going to be coming from. And then also the money center banks in the US because the multi-divisional assets, it's going to be a tough kind of period for your near term on the investment bank slash capital market side of things. But the commercial bank and the wealth management side of businesses look very good, and I think a lot of analysts out there are going to miss the fact that we've had higher interest rates in the brokerage businesses. Very good, because believe it or not, people still buy on margin and that's going to be a bit of an uptick with respect to earnings on the wealth management side.

Brian Belski:

I would also say secondarily, Dan, that there seems to be a lot of underinvested capital with respect to healthcare, which is amazing to me given the fact of what the vaccine was able to do. But healthcare from a valuation perspective and where cash is, especially in biotechs and some of the drugs and some of the devices, looks very interesting to us. And from the growth proposal, kind of reminds me back to when healthcare coming out of the '94 valuation lows, very similar in terms of the makeup, in terms of the sector. So I think there's a lot of opportunity there.

Dan Barclay:

We've had an exceptional call today. I want to thank Michael, Brian, and Margaret for your insights and the rest of our research and investing teams. We're obviously in a period of high uncertainty, I would say one of the highest in my career, where the predictability of the future seems low, but I think Brian gave some very good insights, as did Margaret, around the return of normalcy will come. And cycles and change while difficult, one of the things for our clients, BMO's here to help. We're here to stand by you and support you in your needs. If there's things where you'd like deeper insights or more information, please reach out to your BMO relationship manager, your BMO connection, and a reminder that we have extensive research and topics out through our various research portals, whether that's our podcasts, our market access, or our research. Please access that to help you in this time of uncertainty as you look forward.

Dan Barclay:

We thank you for spending the time with us. I thank my colleagues for their great insights as we go forward and we look forward to continuing to support our clients and their business. And thank you for spending your time with us today. That's all, and thank you.

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