Lester Asset Management...MacroEconmic Outlook

Lester Asset Management...MacroEconmic Outlook

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Our view has been that inflationary pressures would show clear signs of easing before year-end as a result of monetary restraint imposed by both the Bank of Canada and the Federal Reserve. Fiscal deficits in Canada and the U.S. have been shrinking dramatically, and as a result the major causes of high current inflation, excessive monetary stimulus and massive fiscal deficits, have been removed. Published inflation numbers in both countries, because of time lags, are still extremely high, and policy will remain focused on getting price inflation on a sustainable trend back to a target level of 2%. Both central banks are focused on labor markets which are still very tight. Historically, inflation falls only when slack develops in the labor market. Unfortunately, unemployment and published inflation data are lagging indicators, which raises the risk of a weaker economy. But this is a necessary condition to get inflation down. There will, therefore, likely be a short-term decline in corporate profits and possible job losses. However, the impact on stock prices would likely be muted because the prospect of falling inflation is a bullish offset, and equities have already had a significant correction.

The important focus for investors should be on the future, not on today’s news. Markets are forward looking by roughly six months and in recent weeks there have been some positive developments. Market-based measures of inflation expectations for two to five years out have begun to fall sharply. The five-year indicator, for example, has recently dropped from about 2.6% to about 1.8%, which is below the Fed’s target. The two-year measure has dropped from 5% to about 3.3%. This is a significant development since it suggests that we are moving fairly quickly to the point where we can expect published inflation (and yields) to start falling back to more normal levels. Already, the 10-year Government bond yield in both countries appears to have made a cyclical top and is now on a downward slope. Developing economic weakness will, if extended, reinforce this downtrend which would also be good news for bond investors.

In summary, economic developments are pointing to the likelihood of a continued decline in longer-term interest rates as inflation expectations have dropped significantly. This bodes well for an end to monetary restraint and a peak in short-term interest rates before year-end which would tip the scales in favor of a “soft landing” and improving stock prices. Even though commodity prices, including energy, have fallen sharply from recent peaks, they are still far above the average of recent years. High commodity prices are a net positive for the Canadian economy. In addition, the Canadian dollar is cheap, which is playing a major role in the massive increase in Canada’s trade surplus with the US.

Stephen Takacsy, 

Olivier Tardif-Loiselle, 

Matthew Kaszel, 

Tony Boeckh,

July 15, 2022

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Source

https://www.lesterasset.com/investment-reports/Quarterly-Comments-2022/2022-Second-Quarter-Letter