Martin Lefebvre (ML) and Warren Lovely (WL)
(ML)
Hi everyone, I’m Martin Lefebvre, Chief Investment Officer at National Bank. Welcome everyone and thank you for tuning in this National Bank Investment podcast series on the state of the market. Today I have the pleasure of introducing Warren Lovely, Managing Director with National Bank Financial who serves as a Chief Rates and Public Sector Strategist within the economics and strategy group. Warren, welcome and thank you for being with us.
(WL)
Yeah, it’s my pleasure. Thanks for having me.
(ML)
OK, so let’s jump right in and start with the state of the economy. So Warren, after we saw a COVID induced complete shutdown in 2020 of the global economy, which, as you know, resulted in the most severe correction ever recorded in a single quarter, market players have been surprised by the magnitude of the recent recovery. So my question for you is, is this sustainable and what type of growth do you foresee over the next 12 months?
(WL)
Well, let’s just say this is a tricky question in the current environment because we still have, I think it’s fair to say, a tremendous amount of uncertainty as it relates to the ongoing virus situation. But you’re right. The magnitude of the recovery was particularly striking earlier this year. Really got the attention of markets we saw a significant repricing of some asset classes. Interest rates started to move up aggressively. We’ve, of course, had a setback.
In the summer with the Delta variant and resurgence of case counts that’s led markets to step back a little bit from this voracious recovery narrative, we still see healthy recoveries. Continuing in the tail end of this year throughout 2022, when we get there but safe to say that Canada had a bit of a setback in our latest quarter. The second quarter results that we saw just recently. The third quarter started with a bit of a hiccup as well, in terms of a July decline in GDP. So, we’re getting through this latest wave, data are still massively distorted, but the recovery narrative is something we still believe in.
(ML)
OK, that’s good. How do you link all of that towards inflation which has really been top of mind lately? In what we see on our side are two really distant camps where on one side, you got those that find the recent rise in prices to be COVID-sensitive, base effects related, and as such, transitory in nature, while on the other side you got others seen a shift in regime with deglobalization, polarization, labour shortages, which inevitably are going to be exerting upward pressures on inflation. So what’s your take on the matter?
(WL)
OK, well there’s a lot to unpack there, and inflation I think, is it’s fair to say we’ll be the big issue. The big question that we’ll be dealing with how transitory is this inflation surge that we’re seeing in the United States, here in Canada? Or how systemic and long-lasting or some of these pressure points?
So let me take it back a little bit. We talked about at the beginning. You know, the GDP recovery that we’re having? So, the first point I’d want to make is that look, GDP recoveries, by their definition, close up slack in the economy. So, this is a little bit of a messy calculation, but economists will like to try to pinpoint when the output gap might be closed and what it appears to be the case. In our view of the world is that we’re moving towards output gap closure quickly in the U.S. We had a, as I say, a bit of a setback, a temporary delay in Canada, but we’re still moving towards closure of output gaps in the North American context, if not by the end of this year, then, you know, probably by latest mid of next year.
So, slacks closing up. The labour market still has some slack and I think this is something that central bankers: Jay Powell and the U.S., Tiff Macklem here at the Bank of Canada are quick to point out. And there’s some merit to that argument. We haven’t got employment levels back to pre-COVID levels. There’s, of course, been population growth, so we’re maybe even farther away in terms of full employment utilization. So yes, there are still some slack in the economy. And you know, I guess if you were in inflation dove, maybe you’d take some comfort in that. The reality is, though, we’re seeing yes, some temporary factors, some year-over-year comparisons that are clearly contributing to inflation prints. But those labour shortages you spoke about, those could become quite pressing. Some of the supply chain disruptions maybe aren’t permanent, but they’re certainly contributing to the short term we have as well. Something that appears to be the making of a regime shift, as it relates to ESG and putting a price on carbon and environmental reforms, all of this adds up to us, to a less temporary, less transitory inflation phenomenon than what some central bankers maybe currently believe or would have us believe so.
Inflation looks like a legitimate worry from markets, not just right now with these elevated prints, but probably an issue we’re going to be contending with all through next year and beyond, and it’s going to eventually, kicking and screaming, you might say, drag central bankers off the sidelines and get them back in the game in terms of having to normalize interest rates.
(ML)
Yeah, that was pretty much my next question. You’ve alluded to a lot of topics that are top of mind for our central bankers. Uhm, the potential gap? You know. Perhaps getting close towards the end of the year, so exerting upward pressure on the economy and inflation. So what does it all mean for monetary policy?
We know the forward guidance by the Bank of Canada has been pretty clear over the past couple of meetings where they’re thinking about being able to raise rates, and the second half of 2022, the Fed has just announced that they were standing ready to start tapering those monetary purchases somewhere towards the end of this year, and eventually that will lead the way to perhaps raising rates? Raising rate environment also in the U.S. So where, where do you see them really started raising interest rates and what type of impact do you see that having on that the global economy?
(WL)
Well, when it comes to monetary policy, you know you must walk before you can run. So, before we can talk about interest rate hikes, and it’s a great question and something we will chat about here. But the first thing we need to do is a step down and wind down taper. You know, much used word in the current environment. The purchases of bonds that both central banks are doing right now. And I mean, look, let’s be clear, it’s not just the Bank of Canada and the Fed that are buying securities. This is happening across the world as central banks continue to inject extreme extraordinary support into financial systems.
But closer to home. You know the Bank of Canada is still buying bonds. I think importantly, and I’ll give them some credit. You know the Bank of Canada has at least initiated the first few rounds of a taper. In fact, we got this underway almost a year ago. In October of last year, with the first taper from what was to be frank an extremely outsized level of bond buying. So we’ve been buying and then last year buying way too many bonds, far too many for the size of our market, and I think that was recognized last year. We started to moderate those purchases. We’ve had a few more tapers this year. We think we’ll get another taper by the Bank of Canada in a month’s time in October, and that’s going to bring us, Martin, close to a level that economist and strategist and market participants are labelling the reinvestment phase.
You know that stage of the monetary policy cycle where central bankers are no longer adding to their portfolio of bonds. It’s kind of a net neutral run rate, and we should be there in Canada, that reinvestment phase, towards the end of this year. And then I guess the question is, how long we should be in this reinvestment phase before we start to do the blunt instrument of interest rate hikes and to us the answers in the neighbourhood of six months, there’s no precision here. We don’t have an empirical playbook in Canada to go by. We’ve never done quantitative easing in Canada before, so we’re flying blind in a sense. But assuming the recovery we talked about at the very beginning plays out, if slack in the labour market that still exists continues to get absorbed, there’s going to be every reason for central bankers to respond via interest rate hikes in Canada. That first hike probably comes by the summer of next year.
What we would be looking for and what we officially forecast is a couple of hikes in the second half of next year, giving way to some continued normalization in 2023. I guess the question to some extent is going to be how sensitive is today’s Canadian economy to interest rate hikes? We know how much activity is happening in the housing market. So there’s a sense, I think, appropriately, that we might not need too many interest rate hikes to start to alter behaviour and slow things down. So you know, there’s a discussion, I guess maybe a separate discussion, Martin, we could have about, you know where’s the terminal rate? The neutral rate of interest in Canada versus the U.S.?
(ML)
OK, so if you’re writing your assessment, where do you see benchmark bond yields and in 12 months’ time? We know markets are a precursor to monetary policy. So where does that leave us?
(WL)
So where were short-fixed income in our recommended asset allocation. I wouldn’t say that it would be impossible to get lower yields here, but the balancer risk to us is higher a higher rate complex. Call it a bear flattener as we get closer to those first interest rate hikes. You know again, we must get through the Delta variant. I don’t want to suggest that yields are going to start to leap, starting next week. We do have a FOMC decision, mind you, next week to be watching. I think you’re going to be seeing 10-year yields, 50, 60, maybe 70 basis points higher in a year from now. So a 10-Year Treasury pretty closely watched instrument in the marketplace might have a handle around 185, maybe 190 this time next year. I would not be expecting that Canadian rates need to sell off more than in the U.S., even though the Bank of Canada is ahead of the game on taper. And the Bank of Canada will be ahead of the Fed, most likely when it comes to policy normalization, I think again coming back to this point about terminal rates and so on: I’m not sure the bank’s gonna be in a rush to be so far ahead of the Fed and to be outgunning the Fed. And moreover, I don’t think that the neutral rate of interest in Canada is higher than it is in the U.S. It’s probably lower.
(ML)
Yeah, but nevertheless in an environment of rising rates, where working bond holders find value in all of this?
(WL)
Well, so you’d be short duration in an overall bond portfolio. I think there’s still an argument, at least in the near term for still being comfortable with credit. Look, I’m aware of the fact that credit spreads are tight. Any type of chartist is going to tell you and point to a credit spreads as being near cyclical tights. I guess the same argument could be held up for equities to be frank.
In the short term, I’m still pretty comfortable with credit here. I think there will be some survivability as it relates to reasonably typed credit spreads through the balance of this year. Again, the tougher test is going to be when we start normalizing interest rates in more meaningful and sustained fashion and, therefore, start draining liquidity from the system, you know how credits hold up in that environment. And there it might require a little bit more of a value proposition. You might be looking for lower beta plays and so on, but in the short term, I think there’s still good carry to be had in credit, so some areas of the fixed income universe where you’re probably still enjoy some excess return.
(ML)
Yeah, I tend to agree with you, and since we’re early in the cycle, I think there’s more room to grow, especially in a good quality investment grade environment. Well, Warren, thank you very much for this very spontaneous value-added discussion that we had today. Thank you everyone for tuning in and we’ll talk again next month.
Warren Lovely