Diego Thomazini
Stock markets mounted their biggest rally since 2020 after a recent U.S. inflation report buoyed investor hopes that red-hot inflation may have peaked. Michael O’Brien, Portfolio Manager at TD Asset Management, speaks with Greg Bonnell about his outlook for interest rates, the economy and the next big test for markets in early 2023.
Transcript
Greg Bonnell: So we have seen some of that positive momentum in the markets in recent sessions. Of course, after a pretty tough year for many investors, many of us may be wondering whether stocks have more room to run from here. Joining us now for more on that, Michael O’Brien, portfolio manager at TD Asset Management. Michael, let’s dig in. Obviously, green on the screen. You like to see it if we’re long in the market. It’s been a tough year. What should we make of the rally?
Michael O’Brien: I think it’s very evident that investors are cueing off of the inflation trends. As you were mentioning just a second ago, when we get a few of these indications that maybe inflation is peaking, maybe inflation is starting to roll over, it gives people encouragement that the Federal Reserve in the States and the Bank of Canada here might be close to being finished with their work. And obviously, that’s been a huge concern for markets this year because the magnitude of rate hikes both north and south of the border has really caught investors by surprise.
One of the things that’s really weighed on valuations year to date has been this constant resetting of investor expectations. Oh, they’re going to have to go higher. They’re going to have to stay there longer. So last week’s inflation print in the US, and hopefully, we’ll get something similar tomorrow here in Canada, that’s one of the first signs we’ve had that inflation really might be peaking here. We might start to get a bit of deflation or get a little bit of an easing in those pressures. And that will hopefully allow the central banks to sort of recede to the sidelines, like you were saying.
I think a lot of investors are very worried about the cumulative effect of all those rate hikes we’ve seen year to date. What’s that going to do to growth next year? What’s that going to do to earnings next year? So the faster we see inflation starting to break, the sooner, hopefully, the central banks can retreat to the sidelines. And that just reduces the risk of a really bad, really negative growth year next year. So to the extent that these signs of inflation might be peaking, take some of the pressure off central bankers, hopefully, what that means is there’s a little less risk of a deep recession next year and more hope that we get a soft landing. So that’s, I think, what’s moving the rally here. That’s what sparked the rally. I think it’s got a bit of staying power.
I think the next big challenge for the markets really is probably a Q1 event. When we get into the next round of corporate earnings in late January or early February, I think that’ll be the next big test for the markets. But hopefully, we enjoy some of those seasonal tailwinds here. And hopefully, this has a bit of legs to it.
Greg Bonnell: Is part of that first quarter test going into the New Year going to be, after the US Federal Reserve, the Bank of Canada, the central banks feel, OK, the job is done. We’re pretty close to the end. And they get to the end. But of course, the whole point of raising rates, it was the tough medicine, right, to try to tame inflation and try to cool the labor market, to try to slow down the economy. Does that start to play its way through corporate earnings? I mean, a slower economy usually isn’t great for earnings.
Michael O’Brien: No, you’re exactly right. That is the whole point. And until the economy slows, until the overheating that we saw both north and south of the border begins to ease up, and what that translates to is until we start to see labor markets loosen up a bit, the Fed’s job won’t be done, the Bank of Canada’s job won’t be done. So that’s what I think we’re going to be watching for as we get into late January, early February. Like I said, when Q4 earnings are reported, these companies are going to have to give us their best guess as to what 2023 holds. And clearly, if the cumulative impact of all these rate hikes means a tougher growth year next year, it’s going to be hard for companies to avoid that discussion.
So that’s why I say that’s going to be a real test, because I don’t think we can realistically expect inflation to stay down if we have full employment, if the economy is growing gangbusters. Like, the two don’t go together. We need to have both. And so we’re sort of seeing maybe inflation is easing. But to your point, the reason it’s easing is because, presumably, we’re going to see some lessening of demand, some loosening up in the labor market. And that’s the next shoe to drop, effectively.
Greg Bonnell: Last time we heard from Fed Chair Powell, he seemed to be laying the groundwork to say we might end up at an endpoint, that terminal rate where we’re going to stop may be a little bit higher. So the market has been focused on, will they slow the pace – stop with the 75s or the 50s. Eventually, maybe get back down to – 25 seems so quaint, doesn’t it, in either direction. That’s what we used to be used to. But then we’ve had a few other Fed speakers in recent days. And they seem to be trying to drive that point home. They’re saying don’t get hung up on the size of the next increase, whether it’s as big or whether we’re sealing off a [INAUDIBLE]. But getting to that end game, is that the new nuance now, where do we end up?
Michael O’Brien: Yeah, exactly. The central bankers are trying to message that – I think what they’re trying to do is say to investors, don’t get so fixated on the cadence. In other words, whether it’s 25, 50, 75, focus more on the destination, which is, is it the terminal rate, as you say? Is it 4%, 4.5%, 5%? They don’t want investors to get ahead of themselves and misread a slowdown in the pace of rates for any sort of lack of determination to get where they need to be. And at the end of the day, where they need to be is in a position that will slow the economy. That is what they’re attempting to do. And that is what they will do. So they’re trying to warn investors.
I think we’d be well to listen to them. Don’t fight the Fed. It hasn’t gone out of style, you know, that old moniker. So I think we should take them at their word. There will be some slowdown next year. It’s a question of how deft a touch the central bankers have and how quickly inflation does wane.
Greg Bonnell: Now, they warned us about pain, right, that there will be pain to come. But the labor market is still strong. The economy is hanging in. I mean, we’ve seen the pain in our portfolios. But the pain is sort of like the real world – your job, your finances, and other areas. Once the recession comes, you’d expect that pain to be a little more widespread. Do the banks have to live through a period of pain? I mean, traditionally, a central bank would then say, wow, the economy’s slowing down. Let’s lower borrowing costs and get the economy moving. And this feels like a different kind of situation.
Michael O’Brien: Well, I think you’ve hit on an important point, Greg, which is I think a lot of investors earlier in the year had thought the central banks would raise rates to a restrictive level. But then they backtracked pretty quickly and started actually reducing rates. The moment any sort of weakness appeared in the economy, the central banks were going to ride in and save us and alleviate it with some rate cuts. I think the central bankers have made it very clear that’s not their playbook.
I think what we should expect is once they get to this terminal rate sometime in early 2023, that’s likely to be there for a while. And the reason it’s going to be there for a while is they need to be good and sure that inflation not just goes down but stays down. And so this is the tricky part. I think we’ve forgotten a little bit about this. I think we all knew that there were elements of this inflationary burst we’ve had that were transitory. And that was a very overused word last year: transitory inflation. But there are elements that clearly were distorted by supply chain disruptions.
Greg Bonnell: And you can build a deck again now at the back of your house without taking an extra mortgage.
Michael O’Brien: Yeah, exactly, or used car prices went through the roof because you couldn’t get them. Like, clearly, those are going to normalize. So I think what we might be in for here in the next couple months is what I would call the easy disinflation stage where a lot of these more temporary or artificial or transitory drivers of inflation start to finally roll off. And that’s going to feel good as investors. And that’s why I say maybe this rally has some legs here.
But I think at some point as we get into 2023, the low-hanging fruit will have been grabbed. And we’re going to get into a stickier situation where, OK, inflation has come off. It’s no longer 6%, 7%, 8%. Maybe it’s 3%, 4% or 5%. But that next 1% or 2% lower to get to the 2% target is going to be really tough. And that’s where the grind sets in. And that’s why I think we should expect wherever the central bankers land here, whether it’s 4 or 4.5, 5, we’re going to be there for a while. And so that’s going to be the grinding phase in 2023 where it just gradually takes a bit of the oomph out of the economy.
And so, the faster that those more lasting elements of inflation – like I say, the labor market’s such an important focus – the trajectory of wage gains as we get into 2023, that’s really going to determine when the central bankers feel it’s safe to finally take – to finally go to the sidelines and stay there or to think about rate cuts. If we see inflation remaining sticky in that sort of 3% to 4%, which is uncomfortably above their targets, they’re not going to relent. So that’s the key to 2023 is some of these more lasting elements, and particularly the labor market, particularly wages, how do they respond to the constraints or the restraint that’s already been put in place by these rate hikes we’ve seen this year.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
Be the first to comment