Higher Rates But Less Inflation Panic

Mounting fears of a recession have gripped equity markets, with the S&P/TSX Composite Index now firmly in correction territory. The S&P/TSX is down 13 per cent from its record closing high of 22,087, reached on March 29.

The Globe and Mail recently spoke with Benjamin Tal, deputy chief economist at CIBC Capital Markets, who shared his perspectives on the risk of an economic contraction, monetary policy and implications for the housing market. Mr. Tal also provided some suggestions on which stocks may do well in this challenging environment.

Inflation is at a multidecade high, negatively affecting corporate profitability and consumers. Yet, inflation is a lagging indicator so I wonder if there’s the risk that the Bank of Canada keeps raising rates while economic growth is contracting, putting the economy at risk of a recession. Has there ever been a time when the Bank of Canada combatted inflation that was more than 5 per cent and there hasn’t been a recession?

Nope, that’s the point.

I look at four sources of inflation, but before you start analyzing any of that, you have to have a working assumption about COVID: We are in the process of transitioning from a pandemic to an endemic.

Now we can analyze those four sources of inflation.

We’ll start with energy. If you look back in history, almost every time we had an oil shock, we had a recession immediately after. So the question is, to what extent is oil as inflationary as it used to be? So here we have three things. One, the shock that we are experiencing now is not as bad as in previous years in real terms. Second, the economy’s sensitivity to high energy prices has been reduced. If you look at the last 10, 15 years, energy consumption per unit of GDP is going down so we are more efficient. The other thing is the response from Alberta. In the past, the minute oil prices went up, oil executives in Alberta were very busy investing. That’s not the case now because everybody knows that green is replacing black.

Given that underinvestment are we now in an energy supercycle?

I am not sure about a supercycle but I think it’s fair to say that oil prices will remain elevated. But remember we’re talking about inflation. Inflation is the rate of change. It is reasonable that at this level energy is flat, or steady, which means that on a year-over-year basis, energy will not be a major inflationary force.

And the other sources of inflation?


The second source of inflation is the supply chain, and that’s a big one. If we are able to ease the restrictions on the economy vis-à-vis COVID then I think you remove a huge portion, maybe 60 per cent, of the inflation we’re seeing.

The third is rent inflation. If you look at the home price-to-rent ratio, it went to the sky. The combination of higher rents and lower home prices will help this ratio to go back to semi-normal. Higher interest rates will increase rental demand because people cannot afford to buy houses. We still have new immigrants coming. We have a lot of foreign students coming. We’re underestimating the number of people looking for units so the demand will be there. The supply is very limited, and more and more what we’re seeing is builders are not building because of the increase in construction costs. I had conversations with at least six big builders and I can tell you that big projects, especially rental projects, are being delayed or cancelled altogether because they simply cannot make money, the margins are squeezed.

The fourth source is the labour market – the wages. Wages are rising, especially among low wage individuals because that’s where the shortage is.

So you have the Bank of Canada able to control two things: one is wages, the other is rent, and the rest they cannot control, those being energy and the supply chain.

What you need to remember is the supply chain story. If the supply chain over the next six months starts easing then I think the Bank of Canada will be less concerned because they know that a significant portion of inflation is going to disappear. Therefore, I look at supply chain inflation, not now, not next month, but in September, October, November. I need to see some softening. The risk we are facing, and it’s a big risk, is that while the supply chain eventually will ease, it may not ease soon enough for the Bank of Canada to stop hiking.

At the end of the day, this is not about inflation. It’s about the cost of bringing inflation down to 2 per cent. The Bank of Canada and the Fed are telling you that they will do whatever it takes, even if it means taking an economy into recession, because they believe that’s the only way to keep the economy going, from a longer perspective.

So where do you see rates headed?

The market is forecasting an overnight rate of 3.5 per cent by the end of this year. Our official call is that they will stop at 2.75 to 3 per cent. Now, in my opinion, the difference between 2.75 to 3 per cent and 3.5 per cent might be the difference between no recession and a recession. The enemy of the economy is not only higher interest rates but also rapidly rising rates.

The effectiveness of monetary policy in Canada is actually stronger than in the U.S. Per capita, we have more debt, which means that we are more sensitive to higher interest rates. Second, their mortgage terms are for 30 years, our typical terms are for five years or less so we are more sensitive, which means that the tiny Bank of Canada is more powerful than the mighty Fed when it comes to impacting the consumer. In those terms, we estimate that a 1-per-cent increase by the Bank of Canada is equivalent to a 2-per-cent increase by the Fed, theoretically speaking. So the Bank of Canada is more effective in its ability to slow down the economy and this higher sensitivity to interest rates might slow down the economy enough for the bank to stop raising rates at 2.75 to 3 per cent, assuming that the supply chain is behaving. There is a probability of 30 per cent or so that that will not happen and we might overshoot.

So you believe there is just a 30-per-cent probability of a policy error that leads to a recession?

That’s fair. Usually you have a 10-per-cent probability of a recession at any point in time. The probability of recession is much higher now, three times higher than usual, so it’s not a rosy scenario.

With rapidly rising rates are you expecting to see a steep correction in home prices?

The housing market is very vulnerable to higher interest rates. If you look at some areas in the GTA and Vancouver, in the low-rise segment of the market, detached houses, prices are already down by 15 to 20 per cent. Prices will continue to go down, I believe. But remember, prices went up by 50 per cent in two years, so this is just an adjustment because we borrowed the activity from the future.

The lack of supply will work as a protection from a significant decline in prices.

My fear is that the economy will slow down. The housing market will slow down and over the next two years that will remove the sense of urgency about supply. But when we go back to semi-normal, the supply will not be there and there will be another wave of upward pressure on prices.

The S&P/TSX Composite Index recently dropped to its lowest level in the past year. Is the market sell-off a buying opportunity? Are we near a bottom?

I’m not sure where the bottom is. Timing the market is impossible. But if your time horizon is two or three years, I think that there are some good bargains at this point.

Our research suggests that dividend-paying stocks actually do okay during a period of higher interest rates. Telecommunications and utilities actually do okay, historically speaking.

Also, financials might be oversold at this point. The market is pricing in a lot of bad news. I think that from a long-term perspective, there are some opportunities there.

Are there country exposures that you favour?

I like Canada more than the U.S. in this environment for two reasons. If you look at the dividend yield in Canada, it’s double the dividend yield in the U.S. Also in Canada, we are benefiting from commodities.

When I interviewed you back in January, I asked you for your stock market prediction for 2022. You said you would assign the highest probability to a single-digit gain for the S&P/TSX Composite Index. Are you standing by this prediction?

Yes, I think it’s still reasonable to reach a flat to low-digit gain, at least we hope. With so much bad news already priced in, the market might have enough time to get there.

Credit to:  Jennifer Dowty, July 2022 (Globe & Mail)