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Categories
Interest Rates
BoC going where no central bankers have gone before
Tom Reithinger
Portfolio Manager/Analyst

Will the Bank of Canada (BoC) succeed or fail?


That’s the question being asked by economists, analysts and investors as the BoC prepares to break from its G7 peers and embark on a real-time economic experiment to engineer a smooth exit from emergency levels of pandemic monetary stimulus.


“All eyes are on the BoC,” says Tom Reithinger, fixed income portfolio manager on Capital Group Canadian Core Plus Fixed Income FundTM (Canada).


Canada was the first G7 nation to start scaling back government weekly debt purchases — tapering — in April 2021. The BoC then announced at its October meeting that starting November 1 it will only purchase government bonds to replace maturing ones. The bank also jumped forward the timing of an interest rate increase, as it expects a full economic recovery sooner than previously expected. The bank had forecast a full recovery for the second half of 2022 and said it would keep rates at current levels until then. Now, the bank expects a full recovery and excess economic slack to be absorbed by mid-year.


“The Bank of Canada was undoubtably hawkish in their October statement,” says Reithinger, adding that he expects the bank to lift its benchmark interest rate from 0.25% in the first quarter of 2022, just ahead of hitting a full mid-year recovery. If the rate hike comes to pass in advance of another G7 country doing so, Canada would set an example for other central bankers who will have to journey down this path sooner or later.


Inflation upside risk


According to Reithinger, the bank is now worried about inflation upside risk as the Canadian Consumer Price Index (CPI) hit a near-20-year high in October. This explains their willingness to be more aggressive in this rate-hiking cycle than through years 2017 to 2018.


Consumer Price Index: Up, up and away?

The chart shows the percentage change in the Consumer Price Index (CPI) over the past 12 months from 1995 through October 2021. That’s when the CPI reached 4.7%, the highest since February 1, 2003. CPI is an indicator of changes in consumer prices experienced by Canadians. It is obtained by comparing, over time, the cost of a fixed basket of goods and services purchased by consumers. Source: Bank of Canada.

Source: Bank of Canada. The chart shows the percentage change in the Consumer Price Index (CPI) over the past 12 months from 1995 through October 2021. That’s when the CPI reached 4.7%, the highest since February 2003.

“There’s no doubt in my mind the bank will be nimble and respond to the next few months of inflation outcomes, which the Governor reinforced in the press conference,” he says.


Among the data outcomes the bank will be watching will be CPI core measures, which strip out the most volatile components in the index, and not just the headline all-in total CPI number. 


Running hot: CPI-trim, CPI-median, CPI-common

The chart shows three “core” inflation measures — CPI-trim, median and common — the bank uses to look through transitory movements in total CPI inflation which better reflect underlying inflation trends. As shown, two of the three inflation measures have reached 20-plus year highs. The 10/21 value for the CPI trim is 3.3%; the 10/21 value for the CPI median is 2.9%; the 10/21 value for the CPI common is 1.8%. Source: Bank of Canada.

Source: Bank of Canada. The chart shows three “core” inflation measures — CPI-trim, median and common — the bank uses to look through transitory movements in total CPI inflation which better reflect underlying inflation trends. As shown, two of the three inflation measures have reached 20-plus year highs.

Core measures have spiked with CPI-trim at 3.3%, CPI-median at 2.9% and CPI-common at 1.8% year-over-year. The last time total CPI inflation rose above the bank’s 1%-3% target range — May 2011 — all three core measures were at or below 2%. Within 10 months, total CPI, or so-called headline inflation, retreated and fell below target. But unlike 10 years ago, core inflation indicators are now telegraphing inflation.  


Inflationary signals


Core inflation measures aside, Reithinger is studying data points in the bank’s quarterly Business Outlook Survey, released the same day as the October monetary policy meeting. The survey polls a cross-section of business leaders across Canada, from about 100 firms.


One of the key dimensions Reithinger is watching is a gauge of investment spending plans among firms on machinery and equipment and whether companies anticipate spending more, less or about the same as they did over the last 12 months.


Open wallets


In response to this question, business leaders overwhelmingly said they plan to invest more. What’s eye-catching is the number of companies with higher spending plans —an all-time high over the past 20-plus years.


“The third-quarter BoC Business Outlook Survey showed the highest capital expenditure plans since the beginning of the survey,” says Reithinger, who continues, “Higher capital expenditure signals that businesses are confident in future growth, which tends to be inflationary.”


Long shopping lists: Plans to invest to meet demand are widespread

The chart shows the percentage balance of opinion among firms expecting to spend more on machinery and equipment minus the percentage expecting to spend less compared to the prior 12 months. As shown, the balance of opinion for higher expenditure plans is at an all-time high among Q3 Business Outlook Survey respondents, at 46%. The bank says this is especially true among large firms who say intentions to increase capital expenditures are due to strengthening demand — both domestic and foreign — and the need to alleviate capacity pressures, including labour shortages. Source: Bank of Canada, Business Outlook Survey Q3, 2021, chart 8.

Source: Bank of Canada, Business Outlook Survey Q3, 2021, chart 8. The chart shows the percentage balance of opinion among firms expecting to spend more on machinery and equipment minus the percentage expecting to spend less compared to the prior 12 months. 

Another key survey gauge for Reithinger is expectations for wage growth. Again, firms anticipate the biggest jump in wage growth since the survey began more than two decades ago. 


More per hour: Expectations of faster wage growth are widespread 

The chart shows the percentage of firms expecting higher labour cost increases minus the percentage expecting lower labour cost increases. At an all-time high of 50%, firms reported their compensation plans are fuelled by the need to attract and retain workers amid strong labour demand. Source: Bank of Canada, Business Outlook Survey Q3, 2021, chart 10.

Source: Bank of Canada, Business Outlook Survey Q3, 2021, chart 10. The chart shows the percentage of firms expecting higher labour cost increases minus the percentage expecting lower labour cost increases. At an all-time high, firms reported their compensation plans are fuelled by the need to attract and retain workers amid strong labour demand. 

“Faster wage growth tends to feed into overall inflation with a lag during steady periods of economic growth. Hence, I expect the wage effects to be felt in Canadian inflation during 2022 and 2023. Again, this signals that higher inflation is more persistent rather than transitory in the next few years,” he says.


Investment implications


Before making portfolio adjustments, investors should remember that sustained periods of elevated inflation are rare in Canadian history. People of a certain age will remember the ultra-high inflation of the 1970s and early 1980s. But in hindsight, it’s clear that was a unique period. In fact, deflationary pressures have often been more difficult to tame, as students of the Great Depression will attest.


More recently, in the aftermath of the 2007–2009 global financial crisis, inflation has struggled to hit 2% on a sustained basis. And that’s despite unprecedented stimulus measures engineered by a wide range of central bankers in North America, the eurozone and Japan.


Inflation extremes


Another important point: It’s mostly at the extremes — when inflation is 6% or above — that financial assets tend to struggle. Stocks have also come under pressure when inflation goes negative, as one would expect.


For investors, some inflation can be a good thing as evidenced by the performance of U.S. stocks and bonds. Even during times of higher inflation, both asset classes have generally provided solid returns as shown in the chart below.


Stocks and bonds have done well in various inflation environments 

The image shows the average annual returns at different inflation levels in the U.S. from 1970 to 2020. All returns are inflation-adjusted real returns and are in USD. U.S. equity returns represented by the Standard & Poor’s 500 Composite Index. U.S. fixed income represented by Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index from January 1, 1970 to December 12, 1975 and Bloomberg U.S. Aggregate Bond Index from January 1, 1976 to December 31, 2020. Inflation rates are defined by the rolling 12-month returns of the Ibbotson Associates SBBI U.S. Inflation Index. Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor's.

Sources: Capital Group, Bloomberg Index Services Ltd., Morningstar, Standard & Poor's. All returns are inflation-adjusted real returns. U.S. equity returns represented by the Standard & Poor’s 500 Composite Index. U.S. fixed income represented by Ibbotson Associates SBBI U.S. Intermediate-Term Government Bond Index from 1/1/1970–12/12/1975 and Bloomberg U.S. Aggregate Bond Index from 1/1/1976–12/31/2020. Inflation rates are defined by the rolling 12-month returns of the Ibbotson Associates SBBI U.S. Inflation Index. Returns are in USD.

An active approach


An active approach to fixed income investing is key, says Reithinger, as is the flexibility of the mandate to invest in a range of debt in Canada and around the world. Most recently, the Canadian Core Plus Fixed Income mandate reduced exposure to developed-market bonds while increasing exposure to emerging markets and inflation-linked debt. Portfolio duration stood at 7.5 years as of September 30, 2021 — lower than the mandate’s FTSE Canada Universe Bond Index benchmark of 8.1 years. Higher duration is typically associated with higher interest rate risk.   


All of which brings us back to the question at hand: will the BoC succeed or fail to engineer a smooth exit out of pandemic emergency monetary stimulus?


“The BoC is treading a thin line between reigning in higher inflation and stopping the economic recovery, the outcome of which is still very much uncertain,” says Reithinger.


And after a potential first-half 2022 rate hike?


“My view is that the bank will be cautious over the next two years to allow the economic recovery to continue but it all depends on how successful the BoC was at engineering a smooth exit in the first place.”



Thomas Reithinger is a fixed income portfolio manager with 11 years of experience (as of 12/31/2021). He holds an MBA from Harvard Business School and double bachelor’s degrees in business & management and computer engineering from Rensselaer Polytechnic Institute.


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