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The only thing I know, is nobody knows (exactly) …..

Yesterday I sat in on an interesting one hour web presentation by a bank economist for their customers on the economy and inflation. It became evident to me that only one thing is clear. Inflation isn’t at the target 2% yet and volatility in the market will continue (duh!). Don’t get me wrong, the reason I sat through this one hour presentation is because I like this guy, and I respect his outlook and interpretations of the data. Being a data-driven guy myself, I can appreciate anyone who uses data and trends to make sense of the past, present, and the future.

   However, it was clear to me as he went through the slides that many of the things that were happening in the US and Canadian economies right now were not expected nor predicted based on historical data. What happened in the past didn’t totally apply to today’s situation, and what might happen in the future is not certain either. This was no real surprise to me, but I needed to hear it from someone else. Business channels just haven’t been doing it for me lately! They may as well be a shopping channel. The data being used today applied to past and current situations, but this situation was different than the past and current situation for a variety of reasons.

   The other thing that was highlighted, though again not surprising, was the vast differences today between the GDP (gross domestic product) engines in the USA and Canada. These vast differences are not only driven by the differences in the sizes of our populations and economies, but largely driven by the amount of stimulus each country put into their economies through covid and up til now. The way it was put is, if you think Trudeau has been spending like no tomorrow, then you should cut up all Biden’s credit cards and change the account numbers! The USA has put 5x more stimulus than Canada into their ecomony, and has 7x the GDP growth, which has a direct correlation to how interest rates will come off in the future. Canada’s GDP growth is near zero and Canada will have to relax rates more than the USA on this reality. Interest rates have to start to come down in Canada by summer to both relax inflation and to kick-start GDP and keep it out of the basement.

    There are A LOT of moving parts to inflation. One of his slides enforced the point that we should have seen a recession last year. One of the key economic indicators used is the yield curve, and a negative yield curve in any any other scenario in the past would trigger a hard and fast recession. A negative yield curve means it costs more to borrow money than you can ever make over the borrowing term. In this sense, why would anyone ever borrow money? But we haven’t yet seen a massive recession despite a negative yield curve. Why? Well,… I’m going to really boil it down for you,… because covid household savings has artificially and temporarily staved off the effects of rising interest rates and debt. People during covid hoarded savings and are using it now to avoid the impact of high interest rates. But time on this is running out. The adjoining graph explained this. The savings in most Canadian households from covid relative to debt are evaporating, and people are just starting to rediscover the use of debt e.g. credit cards and loans as a means to stay above water. This effect will further curb spending, or increase debt, which both have a negative effect on GDP growth per capita. The GDP is basically what keeps the economy moving forward, keeps your dollar holding its value, and keeps jobs available for everyone. The labor market was tight the last couple years, and we heard that getting workers back to work was tough for employers. Now that job availability is shrinking in combination with the effect of a sputtering Canadian GDP, there still might be more ill effects down the road. If you have a job today, don’t quit unless you have somewhere else to go!

Something else that had a huge impact on reversing the effects of inflation was immigration. Immigration in Canada over the last couple years has added ~1mm new residents into the country. New immigrants, and specifically new, nonpermanent immigrants, are wallpapering over the current economic weakness by shoring up consumer spending. Keep 'em coming I say! 

The supply-demand world is not where it needs to be either. Covid allowed businesses to profit hugely in the absence of supply. You could see this very clearly in the appliance and vehicle markets. Low supply plus high demand in the last couple years drove prices to the moon. Now the opposite is in effect, low demand and high supply. Consumer staples are poised to get a bit cheaper as a result … eventually. To what extent who knows? Once inflation is embedded it's hard to get out, and all you can do is wait for businesses and consumers to catch up.

   There are a lot of things that impact the GDP and inflation, and worker productivity was highlighted as another important factor. Worker productivity can have a huge influence on reducing inflation in the far term. More productivity at the same cost equals more GDP at lower costs equals lower inflation. It has worked before. A.I. could be a catalyst, but that is a long ways out in my opinion.

   The housing market was also hugely impacted through covid. Housing supply versus demand is another covid-driven phenomena. Pre-covid there was a flurry of mortgage activity driving sales and home-building. Young people were creating an urgency to get into the housing market at lower interest rates and parents were helping them. The problem is that in Canada, rate renewals are on 5 year terms, so now all these people that got in pre-covid are now facing mortgage renewals they cannot afford. This is why the government forced banks to increase their loan loss provisions in the last year. Home purchases have dropped off significantly in the last year, and now there is oversupply, and this is expected to grow with potential foreclosures on the horizon.

   I don’t want to go through the whole presentation in this article, but the other piece of information that I found interesting was that while central banks are raising interest rates to fight inflation, the rising rates are also causing equivalent inflationary pressures. This is because the major expense forming the CPI (consumer price index) is housing and shelter, and the associated mortgage interest costs. He described this situation like having a humidifer and dehumidifier in the same room. The data shows that inflation is above the 2% target and exactly equivalent to the amount that mortgage interest has an effect. This fact means the only way to get inflation to target at this point is to cut interest rates. The only question is when and by how much? The market is anticipating rate cuts as early as March, while he feels it will not, or rather, should not, happen until June-July. Who is right? It doesn’t really matter. It’s going to happen at some point, but there is a risk in it happening too early, too much, or happening too late, too little.

   I guess what I gleaned out of the whole presentation is there are a ton of moving parts in the inflationary equation and where we are at today, and the last part of lowering rates to target, that last 2% to get to 2%, are the toughest to get right. The central banks know how to battle inflation (raise interest rates), but they have absolutely no idea how to battle a recession, so they should want to avoid a recession (hard landing) at all costs. This being said central banks are biased. They raised interest rates to reduce inflation, while at the same time causing inflation with the higher interest rates. How they move forward now will dictate whether there is a hard landing or soft landing for the economy. The central banks need to be careful because if monetary policy is too fast or too slow, they put themselves in hard landing territory where their interest rate changes make no difference and people lose the ability to afford the basic necessities that form the CPI. Bad news.

   The good news? Everything that is happening right now is healthly and normal. The economy needs to slow down, and inflation still needs to come down a bit more! Rates will need to get cut,…. eventually. And hopefully, like in the past, the central banks don’t overshoot. It goes without saying, the market will continue its volatile trends over the next 5-10 years as it all irons out. The economy is like a supertanker, it takes a loooooong time to turn around, and any mistakes in monetary policy can be devastating or significantly change the timelines. In the past central banks have made these mistakes,.. let’s hope they learned from them and shake off their biases?

   Should you make drastic changes in light of all the data rolling in? I wouldn’t, but I’m assuming you are already following a logical investment or retirement plan. This basically means you have control of all your expenses and are saving money every year and investing it wisely. You are putting your savings where it can help you make more money, you are reinvesting your dividends, and not taking on any more financial risk than you can afford with the income you are generating. You might even have a rainy-day, emergency fund to help you bridge unexpected gaps? The best person to talk if you think you need to make big changes to your financial plan would be trusted financial advisor. If it was me, I’d look for a paid advisor cuz they are less biased to an institution and their products. But again,… that’s me.

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