Inflation May Have Peaked, But Other Risks Remain

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Michael Sager

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Michael Sager, I’m vice-president, multi-asset and currency at CIBC Asset Management.

Let’s discuss the outlook for each of growth, inflation and U.S. Federal Reserve policy.

Starting with growth, we at CIBC Asset Management think that the global economy now is broadly slowing. We’ve moved from a period of very strong growth therein this year and at the back end of 2020, to an environment now where growth is slowing, but it’s slowing in a relatively benign way. And benign slowing, I mean that the pace of growth will decline, but will probably end up close to or a little bit above its trend rate of growth throughout the whole of 2022 on average. So that’s a pretty good outlook if we’re right for risk assets. There’s certainly a number of risks out there, when we think about the threats to that benign growth view. Risks include, of course, the Delta Covid variant. They include Chinese regulatory policies and how those have impacted the Chinese real estate sector. And of course, they also reflect risks around Fed policy.

Broadly speaking, the Covid risks appear to be gradually diminishing, at least from an economic perspective. So it’s moving from a mainstream risk to something more akin to a tail risk, and that will continue as we go into 2022. So its threat to our growth outlook is diminishing. Fed policy has become a bit clearer in recent days or weeks. It’s clear I think now that the Fed will taper or reduce its asset purchases over the first half of 2022. But we don’t expect any interest rate increases. So then more certainty around Fed policy presents less of a risk to growth and less of a risk to risk assets.

And then finally, China. China remains probably one of the more important risks. We’ve seen concerns around the real estate sector and risks of spillovers from that sector to the rest of the economy. Those risks are present. They’re probably largely priced, and so again, we would view them as more of a tail risk rather than a central outcome.

On inflation, we’ve clearly seen a significant increase in inflation over the first half of this year. We think we’re close to the peak, particularly in U.S. inflation now. It’s likely to be stickier than we and the market expected over the next several months. So relatively high inflation compared to what we’ve been used to, is likely to stay around for the next several months. We can see bottlenecks in various parts of the global economy, for example. But again, as with growth, we expect inflation to wane progressively, as we move through 2022, and we’ll probably be back close to developed markets, Central Bank inflation targets around 2% year on year inflation by the end of next year.

We think that the U.S. dollar, in the next three to six months, is likely to consolidate around current levels against most currencies. So it’s likely to go sideways. Further out, we think the U.S. dollar, in the very long term, is vulnerable to further weakness. And that really reflects the poor outlook for U.S. economic and financial fundamentals. That includes the size of the current account deficit. It includes the size of the budget deficit and the size of the stock of government debt. These are all fundamentals that weigh on the U.S. dollar in the long term, over the next three to five to 10 years.

So where does that leave other currencies? Let me focus particularly on the Canadian dollar. The Canadian dollar appreciated strongly against the U.S. dollar for much of last year. Over recent months, it’s given back some of those gains. We think that that give back, that Canadian dollar recent weakness, has probably been overstated relative to fundamentals.

Given our benign view on the growth slowdown, that’s likely to be supportive still of commodity prices, and that will likely be supportive of the Canadian dollar. So we think that the Canadian dollar can probably strengthen a little bit in the short term, 3-4% appreciation that the Canadian dollar against the U.S. dollar is probably likely. Longer term, we think that the Canadian dollar will probably hold its ground against the U.S., but no better. Just as we think that U.S. economic and financial fundamentals are quite challenging for the U.S. dollar, the story’s the same for Canada too.