The Quest to Tame Inflation

This year has been mired by headline risk, specifically the war between Russia and Ukraine, China’s ongoing Zero-COVID policy, and its impact on the global supply chains. However, investors’ main concern has been inflation. From the market’s perspective, that should rightfully be the primary focus, as central banks will continue to tighten monetary policy and withdraw liquidity until there are sure signs that inflation has been tamed.

Inflation, as measured by the Consumer Price Index (CPI), continues to move higher in Canada, the U.S., and other G7 nations (Chart A). In Canada and the U.S., CPI has not been this high since the Great Inflation of the 1970s-1980s (Chart B). Central banks such as the U.S. Federal Reserve (Fed) and the Bank of Canada (BoC) have been aggressively hiking rates, using multiple quarter-point moves, and the overnight index swaps (“OIS”) market shows no signs of the hawkishness abating.

Chart A

As outlined in our Portfolio Strategy podcast last quarter, there is a risk that central banks are using backward-looking measures to manage its interest rate policy going forward. Additionally, what makes the situation more complex is that higher rates will take some time to work their way through the economy. With the majority of the world moving away from lockdowns, supply chain disruptions should be expected to ease over time. However, it’s likely that as the world continues to open up, demand will likely outstrip supply over the near term, making inflation resilient for the coming months. This could mean that inflation may appear stubbornly persistent even as central banks are aggressively tightening.

With no more lockdowns, it is possible that supply will eventually catch up with demand. This would be a significant development in easing inflation. China moving away from its ​“Zero-COVID” policy would also further alleviate supply-side constraints. The next six-to-eight months will likely be very telling as to whether ​“peak-inflation” is on the horizon or whether we head into sustained inflation similar to what we saw in the 1970s and 1980s. An inability to tame inflation would likely lead to interest rates moving much higher.

However, even with the combination of tighter monetary policy and the resolution of supply chain disruptions, it’s likely inflation will be higher than normal in coming years. The NATO-imposed sanctions on Russia will likely remain, regardless of how the Russia/​Ukraine conflict gets resolved. Additionally, energy supply is extremely constrained as companies have been unwilling to commit capital expenditure towards new infrastructure builds with the knowledge that governments have the intention of moving towards renewable energy in the very near future. As a result, elevated energy prices will likely lead to higher transportation costs and a degree of sustained inflation in the best-case scenario.

Given that any change in monetary policy takes months before its impact is felt throughout the economy, we expect both the BoC and Fed to pause with its rate hikes in late summer or early fall. At that point, both central banks will have a number of successive rate moves under their collective belts, which should restore credibility and thus allow them to utilize forward guidance. We believe this would be a more impactful tool as it would not only provide time for the economy to digest the changes related to the key overnight rate, but it would also allow the central banks to tame inflation without further inverting the yield curve or slowing economic growth.

Chart B

Things to Keep an Eye on

One encouraging sign that inflation may slow is the cooling of commodity prices over the last month. Commodities that are used as raw materials or inputs to many everyday items — including buildings, transportation, and food — have come down. Lower input costs would mean that cost savings would be passed back to the end consumer and/​or that profit margins at companies would be able to expand. At this time, it’s unclear whether lower prices are temporary or if central banks’ activities have been successful in tempering demand.

Recommendation: Should commodity prices continue to weaken over the quarter, it’s likely the outperformance in Canadian equities over their U.S. counterparts would begin to reverse course. Canada, with its resource-heavy economy, enjoyed a 10% outperformance over the first half of the year, driven primarily by its higher concentration in the energy and materials sectors. Investors that have been overweight commodities or Canadian equities may want to keep an eye on the relative strength of the BMO S&P 500 Index ETF (ZSP) and the BMO S&P/TSX Capped Composite Index ETF (ZCN).

Outside of ​“peak inflation,” equity market valuations could be the other catalyst that would potentially jumpstart the market. Current price-to-earnings (P/E) ratios for the S&P 500 Composite are 19.2x, which is a valuation level that was last seen in April of 2020, near the market bottom during the onset of the COVID pandemic. At these levels, investors may start dipping their toes back into equities as valuations become more attractive. It can be argued that higher interest rates may lead to higher financing costs, resulting in slower economic growth, lower earnings, and stock prices revising even lower. Over the long term, however, higher rates have acted as somewhat of a cleanse, with lower corporate new issuance in recent months.

Recommendation: While stocks are becoming inexpensive, we don’t know whether valuation levels will remain within the range we’ve typically seen over the last 30 years or if we’ll see persistently lower valuations like in the 1970s and 1980s. There are pockets of the market that have become so cheap on an absolute basis that investors shouldn’t overthink. The BMO Equal Weight Banks Index ETF (ZEB), for example, has a P/E ratio of 9.0x, a near-40% discount to the broader S&P/TSX Composite Index and potentially a bargain for long-term investors.

In the last several months, recession talks have grown louder, bringing down investor confidence. The U.S. yield curve (2−10 year differential) has so far inverted on two separate occasions — a valid reason for investors to take caution. We are starting to see very bearish sentiment being priced into the market, which should be seen as a positive for contrarian investors. Looking at the Citi-Economic Surprise Index for both the large G10 nations and the U.S., negative surprises are reaching levels not seen since the March 2020 pandemic sell-off. While negative surprises may continue, at some point, expectations will be so low that data will only surprise to the upside.

Recommendation: The next several months will be critical in telling us whether central banks can engineer a ​“soft landing” to a normal recession or whether we are headed towards a stagflationary environment similar to the 1970s. If inflation starts to slow, economic data should start surprising to the upside, and this may eventually prove to be a buying opportunity. The BMO Low Volatility Canadian Equity ETF (ZLB) and the BMO Low Volatility U.S. Equity ETF (ZLU) allow investors to stay invested, while also better managing downside risk. 

Changes to Portfolio Strategy

Asset Allocation:

• We are making a slight change in our asset allocation by shifting 2% out of the non-traditional/hybrid section of our portfolio strategy to equities. Should inflation continue to come in higher than expected, the Fed would remain hawkish, which would be a headwind for all assets. However, if signs begin to emerge that inflation is starting to turn over, we believe equities will outperform. We are also allocating to areas of the equity market that are trading at a significant discount and thus have potentially already priced in much of the downside.

Fixed Income:

• Currently, given the flatness of the yield curve, investors are not being compensated for term risk when extending duration in a bond portfolio. With yields moving to attractive levels on the front end of the curve, we are shortening the duration in our fixed income portfolio by moving 5.0% of the allocation in the BMO Mid-Term U.S. IG Corporate Bond Index ETF (ZIC) into the BMO Short-Term U.S. IG Corporate Bond Hedged to CAD Index ETF (ZSU). The mid-part of the curve could remain elevated should inflation prove to be resilient. We are allocating the remaining 1.0% to the BMO Long-Term U.S. Treasury Index ETF (ZTL) to barbell our bond exposure. The front-end exposure to credit allows us to maximize yield while the long end of the curve provides protection should recession concerns heat up further. We prefer U.S. credit as it diversifies the portfolio rather than owning Canadian companies across the capital spectrum.
• We are also increasing our cash position using the BMO Ultra Short-Term Bond ETF (ZST), which currently has a yield to maturity of 3.0%. Having a ​“cash-like” ETF will allow us to have dry powder on hand to take advantage of opportunities as valuations potentially become more attractive.

Equities:

• Our core equity exposure remains fixed on the low volatility and quality factors. As previously noted, low volatility is a good way to stay invested while also better managing downside risk, especially if equity markets further contract. The quality factor, which has served our portfolio strategy well over the years, has been a laggard year-to-date. This has been due to its high exposure to U.S. technology names. However, it should be noted that many of these names are cash-rich large cap companies like Apple Inc. and Alphabet Inc. We believe quality still makes a good long-term holding, particularly if signs begin to emerge that we have seen peak inflation, which would lead the Fed to be less hawkish and would thus provide the technology sector with a significant tailwind.
  
• The valuations on Canadian banks are too attractive to pass up at this point. While it’s certainly possible that banks can get cheaper, historically dividend yields of more than 4.0% have been a good indicator that it’s time to buy. Right now, the average dividend yields of banks are 4.7%. While a looming recession would have a negative impact on loan and mortgage demand, as well as mortgage delinquencies, we believe the wider spread between the overnight rate and the 5-year Government of Canada bond yield may help soften the blow of the lower-growth environment. We are increasing our weight in the BMO Equal Weight Banks Index ETF (ZEB) by 2.0%. While our weighting in this ETF was already near the limit for a non-core ETF, our core Canadian exposure using the BMO Low Volatility Canadian Equity ETF (ZLB) has very little bank exposure compared to the S&P/TSX Composite Index.

Non-Traditional/Hybrids:

• Higher interest rates and wider credit spreads have created opportunities within the bond and preferred share space. Bank-issued instruments in particular offer some opportunities given the quality and high likelihood that the majority of preferred shares will be called within the next five years. The weighted average discount to preferred share portion of the BMO Canadian Bank Income Index ETF (ZBI) is 8.8%. This ETF holds instruments issued exclusively by Canadian banks, with 60% in bonds and the remaining 40% in preferred shares and limited recourse capital notes (LRCNs). The yield to maturity on this ETF is 4.8%, which is very attractive for fixed income, especially given that Canadian banks tend to be extremely conservatively managed. To fund this position, we are eliminating our 6% position in the BMO U.S Preferred Share Hedged to CAD Index ETF (ZHP). The wide credit spreads in U.S. preferred shares represent a significant opportunity for long-term investors, however, we view a higher probability of the assets in ZBI nearing par in shorter time frame. We are also reducing our weight in the BMO Laddered Preferred Share Index ETF (ZPR) by 2%, since some of its holdings are also held within ZBI.

Stats and Portfolio Holdings

Portfolio Characteristics

The Good, the Bad and the Ugly

Conclusion: The next 6-8 months will be critical in determining whether inflation will show any signs of breaking. The move away from lockdowns should mean we will no longer see disruptions in manufacturing, which would alleviate supply shortages, particularly if China moves away from its ​“Zero-COVID” policy. Furthermore, with the central banks throwing everything including the kitchen sink at inflation, demand and supply should eventually find an equilibrium. We are starting to see signs of normalizing prices, but also recognize that with the world opening up, demand will likely outstrip supply in the short run. If inflation breaks, there are plenty of catalysts already in the market that can lead to a start of a bull market, including lower valuations and negative sentiment already being priced in. Should inflation prove to be resilient over the long haul, central banks would have no option but to maintain their hawkish stance and force the economy into a deeper recession.

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