The price is right

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 12/09/2022

Economic data

This week the Bank of Canada decided to deliver its second straight 50 basis points (bps) hike to the overnight rate, in their on-going efforts to beat down inflation. While the market was somewhat split on whether we’d see a 25 bps or a 50 bps move, ultimately consensus expectations were for the bank to reach 4.25% over the next 3 months, so the magnitude of the move was less important. What really stood out was the change in language in the accompanying statement, which explicitly implied that any further rate hikes would be data dependent. The Bank recognizes that its previous 400 bps of cumulative rate hikes will take time to fully impact the economy, and as in the game show The Price is Right, it doesn’t want to overshoot only to be forced to reverse course next year. Currently, consensus expectations see the Bank potentially hiking by 0.25% over the next six months, and subsequently see the overnight night rate being modestly lower by the end of 2023.

On the economic front, we continued to see signals of further weakness in the Canadian real estate sector, with building permits falling by 1.4% month over month in October, far below expectations of a 7.9% gain, and after declining by more than 18% in September. Year over year, permits are down more than 6%, being negatively impacted by a slowdown in both the residential and non-residential sectors. U.S. data was stronger however, with both factory orders and the Institute for Supply Management’s (ISM) service Purchasing Managers Index (PMI) coming in better than expected. ISM survey participants noted a material improvement in business activity, coupled with improving hiring conditions, and pricing pressures. We also saw the first revision to Q3 productivity, which came in stronger than expected, partially enabling unit labor costs to fall to 2.4% representing its lowest level since Q1 2021 and consistent with the 10 year average. Changes in unit labour costs are generally used as a medium term gauge for inflationary pressures, as higher wage costs are generally passed on to consumers in order for companies to maintain their profit margins. So, a deceleration in wage growth supports the view that inflationary pressures are easing. Another supporting argument for easing inflation was the Manheim U.S. used vehicle index, which in November was down 14.2% year over year, representing the third consecutive monthly drop and bringing the index back to its lowest level since August?2021. Lastly, November’s Producer Price Index (PPI) reading was modestly higher than expectations, attributed to pressures from food and services, but year-over-year pressures continue to be easing.

Bond market reaction

Despite the move higher by the Bank of Canada and some intraday volatility, bond yields were only modestly higher on the week, as investors continued to see evidence of slowing inflation and further weakness in the economy. The yield curve, defined as the difference in 30-year and 2-year government bond yields, also continued to invert, now by more than -1.0%, further signaling increased recession risks over the next 12?months. While less pronounced than in the past few weeks, credit spreads saw modest improvement, as investor demand remained strong especially against new bank supply. As expected, we also saw National Bank call one of its tier-2 debt securities, which was supportive of bank spreads. ?

Stock market reaction

Global equity markets were slightly volatile this week after renewed fears over slowing US consumer spending and continued speculation around interest rate hikes. A company most of us can relate to, Costco, reported slowing monthly revenues despite Black Friday shopping sales. E-commerce saw the biggest slowdown as customers resumed their pre-pandemic shopping habits and visited stores in-person. There is chatter about a membership price increase but management is trying to put this off for as long as possible. Given recession fears and continued inflation, Costco doesn’t want to put further pressure on the consumer. However, this price increase is most likely coming as Costco’s value proposition continues to resonate with customers and membership numbers rise. On the Canadian retail front, Dollarama’s sales were up over 10%. However, higher sales of consumables and continued pressure on logistics resulted in lower margins. Lastly, we saw new regulations from the Office of the Superintendent of Financial Institutions (OSFI), which will increase minimum capital ratios for domestic banks in early 2023. While all the Canadian banks are onside with the new requirements, which limit the need for further equity to be raised now, they do raise concerns that the regulator may increase these capital requirements further.

What to watch next week

Next week will be busy with the Fed’s last rate decision for 2022. We’ll also get the U.S. monthly budget statement, Consumer Price Index (CPI), import/export prices, industrial production, business inventories and retail sales. In Canada, we’ll see manufacturing sales, housing starts, existing home sales and wholesale trade sales.?

Disclaimer

Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

The views expressed in this document are the views of CIBC Asset Management Inc. and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. Certain information that we have provided to you may constitute “forward-looking” statements. These statements involve known and unknown risks, uncertainties and other factors that may cause the actual results or achievements to be materially different than the results, performance or achievements expressed or implied in the forward-looking statements. This document is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this article should consult with his or her advisor. All opinions and estimates expressed in this document are as of the date of publication unless otherwise indicated, and are subject to change with the exception of bond data, which is as of end of day the previous Wednesday, and equity data, which is as of mid-day Thursday. CIBC Asset Management and the CIBC logo are trademarks of Canadian Imperial Bank of Commerce, used under license. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc.