Recovery and inflationary risk

While the end of economic shutdowns will be cause for celebration, the need to position portfolios against increased inflationary risk may be a key investing concern during the recovery.

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“Investors are right to be concerned about inflation,” said Avery Shenfeld, chief economist at CIBC, in an interview last month. “We have the makings of an inflation threat a couple of years out.”

After vaccines are widely distributed, consumers are expected to ramp up their spending after months of stockpiling cash reserves.

“We’re seeing money supply growth in both Canada and the U.S. soar off the charts, in the vicinity of 20% or even higher in the U.S.,” Shenfeld said.

Canada’s money supply hasn’t experienced that kind of growth since the high inflation era of the ’70s and ’80s, he said; in the U.S., these levels were last seen when Teddy Roosevelt was president in the early 1900s. And Congress is on the verge of passing a US$1.9-trillion aid package.

The money supply growth reflects in part the financial support that individuals and businesses received from governments in response to Covid-19, Shenfeld said. It isn’t currently driving inflation because it’s largely sitting idle on deposit.

“If it’s not out there in the economy being spent and recirculating, then it can’t really drive the demand for goods and services in a way that would create inflation,” he said.

As consumers begin spending again, inflation will likely rise gradually.

“There’s a lot of slack in the economy, and there’s a lot of capacity to produce more goods and services,” Shenfeld said, citing empty restaurants and hotels.

As the slack lessens, central banks must act to prevent excess borrowing and spending so inflation stays under control, he said.

“Down the road, we’re going to need to see a combination of interest rate hikes and, well before that, we’re going to need to see central banks stop buying all those government bonds,” Shenfeld said. “We’re really counting on the Bank of Canada and the Federal Reserve to do the right thing when the time comes.”

The Bank of Canada has kept its key interest rate at 0.25% in response to the pandemic and implemented a quantitative easing program.

The central bank stated it expects inflation to achieve its 2% target in 2023, and has already pulled back on bond purchases, with a current purchasing pace of $4 billion per week in government bonds.

“We expect that, over the spring and summer, we’ll see further reductions in the pace of that bond buying to prevent, in effect, an excess of money supply growth driving inflation down the road,” Shenfeld said.

The Federal Reserve has stated it won’t raise interest rates until 2024 and hasn’t yet signalled when bond buying will decrease. However, Shenfeld expects the U.S. central bank may adjust its monetary policy sooner rather than later.

“Our view is that those steps will come earlier than the Federal Reserve is now talking about — likely rate hikes early in 2023, ahead of the bank of Canada, and a beginning of a pullback in bond buying no later than early 2022,” he said.

The Bank of Canada and the Federal Reserve have a track record since 1990 of preventing large increases in inflation, Shenfeld said. As such, the most likely outcome with recovery is “we end up with inflation running in the low 2% range, but a gradual upward drift in interest rates.”

With decreased bond purchases, longer-term rates will drift upward first followed by short-term rates in 2023 when interest rates hikes are expected.

These central bank moves are “designed to prevent the inflation outbreak that might otherwise be harmful to investors,” Shenfeld said.

That gradual drift in longer-term rates spiked last week, with the yield on 10-year U.S. Treasuries rising above 1.5% at one point, affecting equities. The S&P 500 finished last week 2.4% lower, while the S&P/TSX composite fell 1.8%. Markets rebounded on Monday.

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