The Week in Review

A Change is Gonna Come

Keeping up with the theme of 2022, this week brought investors volatility, rising yields and higher recession probabilities. The high reading from last Friday changed the narrative from peak inflation to a hard to contain inflation. Wage inflation is slowing down, shipping lead times have come down (although still above normal) but energy?costs are still elevated and have the possibility to go higher before they begin to normalize.

Certain questions arise from this situation: What are central bankers doing? What are governments doing and what can we do?

The US Fed raised rates by 75 bps this week, the highest increase since 1994, a reaction to last Friday’s strong inflation reading. Jerome Powell is trying to make it clear that fighting inflation is priority #1 at the Fed. This approach will increase the risk of recession though Mr. Powell did articulate that “we’re not trying to induce a recession now…we’re trying to achieve 2% inflation with a strong labour market”. This is easier said than done which is why markets are now pricing in a recession with an 85% probability of occurring. Importantly, a strong labour market could reduce the severity of a hypothetical recession and consumption could prove more resilient. Mr. Powell mentioned a 4.1% unemployment rate, The Economist gave the argument for 6%; these are both much lower than what we experienced in previous down cycles. As I wrote last week, those small percentage increases do represent a few million jobs and lives that could be impacted.

The Fed is not the only central bank to raise rates. The Swiss central bank raised its policy rate for the first time in 15 years; the ECB has hinted that a 25 bps increase was coming and the Bank of Canada has been raising rates at a similar pace as the Fed (until this week’s 75 bps increase). Only the Bank of Japan is continuing to ease financial conditions at this time, making the Yen the second worst performing G20 currency this year. While it is cheaper to travel to Japan this year, it will make their imports more expensive. Back in Canada, we already see the impacts of higher rates in real estate markets. Existing home sales were down 8.6% in May and the average home price is now up 3.4% year over year (after hitting a high of 11% in February). A cooling in real estate prices is welcomed and will help with future inflation readings. We just have to watch out for vulnerabilities in the real estate market as leverage is still very high and debt servicing is rising rapidly. 23% of households now expect lower prices over the next 12 months versus 44% who expect higher prices (down from 64% earlier this year).

While the central banks have to balance containing costs and maximizing labor, governments have their own work to do. In the US, the government is releasing 1 million barrels of oil per day from the strategic reserves, it is addressing bottlenecks at ports and working with partners at both international and local levels to keep food supply chains humming and prices low. The White House has also engaged in a war of words with petroleum refiners, singling out their increased margins and disinterest in reinvestment. The refiners responded by stating that they are doing everything they can and that the regulatory burden could be lightened to help expedite their efforts. The truth is, as explained to me by an energy money manager, oil and gas firms are being asked to return their cash to shareholders as opposed to focusing on bringing prices down. They were challenged for the last decade, their concerns about underinvestment ignored and now they’re being villainized for being profitable. The thought process here goes along the lines of why is it their responsibility to bring prices down? Does Apple feel the same pressure to bring its iPhone prices down? Are we asking telecommunication companies to lower their prices and dividend payout ratios because of inflation??

It’s not entirely so straightforward in my opinion. On one hand, housing inflation is also problematic but we are not really doing anything to stop large property managers from driving up rents or pricing people out of neighborhoods nor are we paying attention to some of the price gouging we’ve seen in the homebuilding space (anyone who has done renovations can empathize). So it is a fair question to ask, why are we villainizing oil firms for seeking profits like all other industries? That being said, these are the same firms that placed significant efforts in misinforming the public over the effects of climate change and we are now scrambling to catch up. Clearly, some of the actions of the previous decade were short-sighted but the situation may not have been as urgent had these companies not used their vast resources to stop progress on the climate front. I believe that a reset in relations between oil and gas firms and government is necessary; we need to work together at this, we also need to acknowledge that the private market is for profit but that the pursuit of profit should not come at any cost.

As investors, we must continue to remain patient. Our worst case scenario as market participants is currently playing out. This is not the first time, however, nor will it be the last time. We have already made adjustments to increase energy and reduce risk; although losing less than we were before might not seem like a great consolation prize at the moment, it is the most prudent action we can take.

Healthy Distraction

US Equity markets will be closed on Monday to celebrate Juneteenth National Independence Day. It is a day reserved to commemorate the emancipation of enslaved African Americans. June 19, 1865 marked a turning point in the battle for equality, however, it is evident today that there is still more work to be done. This day is both a celebration of progress as much as it is a reminder of the struggle we faced then and the challenges we continue to deal with today.

Since the beginning of civilization, our differences have been used to divide us. This trend must stop if we are to get the best of our society and economy. This weekend, as you appreciate the liberties that you do have, be aware that there are many who do not share such privileges. As individuals, we cannot undo all the wrongs in the world at the snap of our fingers, yet we can change the trajectory of another’s life with a simple act of kindness and respect. That’s a superpower worth having.?

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