A tale of two countries

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 09/23/2022

Economic Data

This week was interesting on both sides of the border as we got important inflation data from Canada as well as the much anticipated Federal Reserve rate decision in the US.

After a higher than expected inflation number in the US last week, investors were apprehensive about the Canadian consumer price index. The number also surprised the market, but this time on the opposite side; Canadian headline CPI came in at -0.3% for August, lower than the -0.1% that was expected. That took the year over year inflation print from 7.6% to 7%. Average core measures also edged down from 5.4% to 5.2%. Consumers got a reprieve from energy costs, motor vehicles and rents. Unfortunately they still got hit by higher food prices and mortgage costs. Those levels are still far from the Bank of Canada’s comfort zone, but the deceleration might give governor Macklem a bit more confidence that the recent rate hikes are slowing down the economy, as we can see from retail sales which moved down 2.5% in July, with volumes also being down 2.0% on the month and being flat on a year over year basis.

On Wednesday, the Federal Reserve delivered its third 75 basis point increase in the overnight rate this year. While the magnitude of the move was widely expected, the tone of the statement indicated that there was still a long way to go before inflation goes back to target. To quote chairman Powell: “We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2%”. The committee acknowledged that higher rates will probably be damaging to the economy, but its members are willing to accept below trend growth and a weaker labour market to achieve their inflation goal.

Bond Market Reaction

While we normally see a fairly strong correlation between the US and Canadian bond markets, the data we received this week intensified the divide between the two countries. While a hawkish Fed sent 10 year yields in the US to a high of 3.80%, a level not seen in more than a decade, lower than expected inflation in Canada kept yields within the range we have seen in the past five weeks. In Canada, we also saw 30-year bond yields dip below 3%, with the yield curve (representing the difference in yield between the 30 year and 2 year Government of Canada bonds) inverting to new 1-year lows, further conveying that recession risks are increasing. Corporate bond spreads did go wider by a few basis points as the stock market weakened, but the general tone is still constructive, as liquidity and appetite for new issues remain strong.

Stock Market Reaction

Equity markets sank lower this week, led by the persistently hawkish stance of central banks. As rates rise to tackle inflation, equity valuations fall because future cash flows are worth less when discounted back to today. There are still too many outstanding questions needing answers before equity markets settle down. For example, how far central banks will go and how fast, what are equity valuations incorporating if earnings slow, and how long and how deep a contraction could last are just some of these unsettled issues. One silver lining is that expectations are fairly depressed and the relative health of the consumer and corporations could help to exceed a very low bar. At the CIBC Eastern Conference this week, one of the consistent themes we heard from a wide array of company executives was that although they weren’t being blind to all the negativity, their own operations were doing quite well, demand remains solid, and they were starting to see an easing of inflationary pressures in some cases.

What to Watch Next Week

We will be getting important information on how the US economy is faring in those troubled times, with durable goods orders, GDP revisions for the second quarter, personal income data and the Personal Consumption Expenditures (PCE) deflator. Canada will get its economic report card, with the release of GDP for July.

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.

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