Views from the Desk

Q&A on Central Banks and Interest Rates

Sep. 26, 2022

The U.S. Federal Reserve (the Fed) has just raised their overnight lending rate by 75bps. Can you comment on what this means for consumers and investors going forward? 

AL: The Fed and the Bank of Canada (BoC) are clearly prioritizing taming inflation at all costs at this point. Several months ago, it can be argued that they were looking to balance economic growth and inflation control. Although the U.S. Consumer Price Index (CPI) year-over-year reading for August came in ahead of expectations (8.3% vs. 8.1%), the silver lining is that it still trended down. 

Admittedly, core CPI, which is the more relevant number, went up in August after 4-months of steady decreases. It is unrealistic to expect inflation to come down in a straight line, however, particularly given that CPI can be a flawed measure. 

The more important piece of information from the Federal Open Market Committee (FOMC) on September 21 was the adjustment of the Dot-Plots,” which provides a look at how the Fed members are voting in terms of their interest rate expectations, particularly for the terminal value at the end of 2023, which went up from 3.8% to 4.6%.

The likelihood is that we will see some repricing in the markets over the short term. It’s interesting, however, that when looking at where we are, compared to pre-COVID-19 highs, we’re not that far off, whether this would provide a psychological floor for technicians, and if that support level would lead to buying activity. Although volatility is expected in the near term, I think if you’re a longer-term investor, looking 3-5 years out at least, you have to start looking at the market and seeing where there are bargains. From a fundamental perspective, there are some attractive opportunities out there, both in the equity and fixed income markets. 

Investors have heard a lot about consistent inflation, rising rates and recession. At what point do we believe that the central banks will slow down or pause their rate hikes? What is the likelihood of a long-lasting recession around the world?

Central banks are taking the view that inflation needs to be put out,” and they want to take no chances of having any embers” remain. The danger they see right now is that if they pause, inflation can reignite and gain momentum, especially with the strength of the job market right now. The flip side to is it takes many months for higher rates to trickle into the economy, which means they’ll have no way of knowing they would have overshot until its too late.

The likelihood of a long-lasting recession, in my opinion, really has more to do with the supply side than the demand side. 

To breathe a little bit of optimism, I think a big part that a lot of people are discounting is the supply side healing that we may potentially see in the coming months. With the world moving away from lockdowns, we’re no longer going to see any manufacturing disruptions and any shortages. The Fed Chair, Mr. Powell, mentioned that there aren’t signs of supply chain healing; however:

  • Used car prices are starting to come down.
  • Shipping container costs have also come down, as well.

On top of that, we have a big portion of the boomer generation expected to retire over the next 5 years, which could keep the labour force relatively strong and offset some of the recessionary forces.

Central banks have been consistent with their messaging about increasing interest rates for the foreseeable feature. What are the impacts on fixed income and equities, and how should investors position themselves for this environment?

In the short run, I don’t think either the tone of the BoC or the Fed is going to be positive for assets. While the focus has been on rate hikes, the Fed and the BoC also have quantitative tightening (QT) occurring in the background to further fight inflation. 

I think investors have to look at their portfolio in two ways:

  • Buy assets that will perform well in the short term (as inflation persists).
  • Buy assets for the long-term that are attractive bargains.

Short-Term/Inflation Portfolio

Long-Term/Bargain Portfolio

  • BMO MSCI USA High Quality Index ETF (Ticker: ZUQ): Price to earnings (P/E) inline with broader S&P 500; usually trades at a premium (good opportunity to pick up long-term, blue-chip holdings in a portfolio).
  • BMO Equal Weight Banks Index ETF (Ticker: ZEB): Bank shares are trading at a 30% discount to the S&P/TSX, in terms of current P/E ratios. The sector has underperformed, as banks have increased their loan loss provisions; however, Canadian banks are well capitalized.
  • BMO Canadian Bank Income Index ETF (Ticker: ZBI): Both bonds and preferred shares are trading at a discount.
    • Bonds are trading at discount > but will be held until maturity (par).
    • Preferred shares are also trading at discount. (Banks will likely be called by the issuers.)
    • Year-to-month 5.6% (short-duration; protection against rising rates).
    • IG portfolio: This ETF comprises all Canadian banks (i.e., is well capitalized); Tier 1 above OSFI minimum requirements (more conservative than Basel 3)
  • BMO Equal Weight REITs Index ETF (Ticker: ZRE): REITs are also looking super cheap at this point.
    • Price/​funds from operation (FFO) looking attractive.
    • Even some of the areas that were overvalued (industrial and residential) are becoming more attractive at this point.

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