Anticipate the blows (costs!)

Ashleay: Welcome to iA Financial Group's “In Your Interest” podcast, where we aim to share with you the essentials of economic news and its impact on your finances. My name is Ashleay, and this week we're taking a look at the latest economic news with, as always, Sébastien McMahon, our Chief Strategist and Senior Economist. The year 2023 is still very young, and it seems to me that the markets are in a state of flux. After a hectic year in 2022, our listeners would certainly have preferred a return to calm. Sébastien, can you try to summarize the major themes at play since the beginning of 2023?

Sébastien: Hello, Ashleay. That's a tall order. It's only been two months and many things are happening. I would say that inflation remains a central theme and I’m sure many people are tired of hearing me and other economists talk about inflation, but it seems to stick around. And markets are now trying to predict how and when central banks will finally win their battle against inflation. So we see inflation being stickier than expected. We see the labour market being on the upswing, which is a surprising; and this is bringing, you know, a wealth effect to households. So, it likely leads to a stronger economy, which is exactly the opposite of what the central banks are trying to achieve. They're trying to achieve, you know, a soft landing to rebalance the economy. And this is not what we're seeing. But so far, so good on the housing market, because it's in retreat. I'm not saying that it's good that housing prices are falling, but this is the plan. This is the consequence of what the central banks are doing, the impacts of monetary policy tightening. Usually there's a sequence which is pretty uncertain based on the timing, but usually you raise interest rates. That means that people are less willing and able to borrow money, so to buy houses, to borrow, to pay for consumption. So, usually housing prices fall, people feel less wealthy, they spend less, businesses have to produce less, they lay off some people. And then you have this cycle, what we call a recession that starts to happen. So we're not there yet. We see the housing part is happening, but the rest is not happening at all. So until we see some clearer signs of inflation cooling off—and we look at the month over month data now, not the year over year data, it's hiding the fact that month over month, the inflation remains strong—until we see some clear signs, sadly, it’s likely central banks will have to hike some more, and markets will have to integrate this new information in price levels. Thus the volatility

Ashleay: I see. And speaking of volatile, markets have been very volatile: up and down in stocks, bonds and currencies. What explains it all?

Sébastien: Well, you know, when prices move, it's because investor positioning is shifting. So, people are buying something, selling something else. And now we see that at the beginning of the year, we were defensive—our team, our balanced funds were positioned defensively—and today, I mean, we're at the end of RRSP season and we’re still positioned in a defensive way. But globally, investors were so defensive at the beginning of the year that some good economic data started to come out and some good surprises—and whoops, the positioning started to shift. So many investors have been buying and buying and buying since the beginning of the year to reposition based on some optimism. So, when optimism comes back into the markets, that pushes prices higher until at some point, you know, the move becomes self-fulfilling, and you have a rally that can last quite a bit. A good example of this is the Nasdaq, which has been up 15% in only a few weeks at the beginning of the year because people were buying the tech stocks. The most speculative themes, you know, I do a lot of marketing, and I start to hear more and more about tech, about crypto, about NFTs. And at some point this snowballs. So we've had that movement at the beginning of the year and now we're starting to see that maybe it is getting tired, this movemen. Maybe. But clearly with the inflation numbers that are coming out, that pretty strongly suggest that the Bank of Canada could come out of its pause maybe in April, that the Federal Reserve will have to hike a few more times than markets were expecting. That could be enough to bring that volatility and maybe, we think, retest the lows from last October. So it's a view, it's not a certainty. We're positioned for something like that. We advise investors to remain, you know, prudent, careful in environments that are as uncertain as this one.

Ashleay: Okay. And for the rest of the year, what does the new information received since the beginning of the year suggest? Will volatility remain or not?

Sébastien: Yeah, volatility could remain a theme for 2023, and it's normal to have volatility, but we could have more volatility than the usual year. So we started the year with volatility to the upside, which is not painful, but we could have some more this year. And again, recent inflation data suggests that further rate hikes are likely, that the bank could come out of its pause. Wages are at the heart of this decision, because wage growth is a bit too strong. And what central banks wanted to avoid was an inflation spiral coming from wages, and we are starting to be in one right now. And just to be clear here, there is absolutely no problem with businesses giving higher wages to their employees to keep them. That's absolutely great. There’re absolutely no issues with employees wanting higher wages to be compensated for inflation. But higher wages lead to more inflation, which leads to higher wages. And we get into that spiral. So the job of central banks—of the Bank of Canada—is to slow down the economy enough to create the kinds of conditions where this snowball effect could end. So the idea is to put the conditions in place to stop this wage-to-inflation spiral and stabilize the economy. So good news is that the recession is—we can probably avoid a recession in 2023. I hear a lot of people in the media say that a recession is inevitable and are pretty downbeat on the economy. Recession in 2023: we went from the odds of 70 to 80%—this is how we evaluated them— and now it's at about 30 to 50%. So still likely, but less likely than before. This is for 2023. But the odds of a recession in 2024 now are likely higher because if the economy is stronger now and central banks need to stomp the brakes heavier than they did before, that means that maybe we'll have a recession that could be even deeper, but later in 2024. So good news, the economy could hold on in 2023. But the bad news is that more rate hikes are coming. And, you know, ideally, we would have seen the economy slow down now, inflation fade and more certainty for the markets. But that’s not what we're seeing.

Ashleay: And we've spoken about stocks and bonds. What about people who invest globally or people who like traveling, for example?

Sébastien: Yeah, sure. So the Canadian dollar is pretty low right now. When you look at the long-term fundamentals—so the long-term fundamentals suggest that the Canadian dollar should be around $0.85 versus the US dollar. This is what we call the purchasing power parity. This is a concept that if you buy the same basket in multiple countries, well, what should the level of exchange rate be? And we're way below that right now. The reason is that we have a volatile environment: when the stock market is lower, when investor sentiment is downbeat, currencies like the Canadian dollar, the Australian dollar, that are considered more linked to the prices of commodities, are considered more speculative from a global market point of view. Not that our Canadian dollar is speculative at all, but it tends to be pulled with the price of speculative assets. So in the short run, if we have a volatile year, we could have some more pressure downwards or some volatility on the Canadian dollar. It's completely something that we can expect. But we still think that at the end of 2023, the Canadian dollar should be stronger than now. So if you invest globally, that could be a headwind for your investment. And if you have travel that's planned—maybe a trip that is planned for later this year or in 2024—you could have the pleasant surprise that the Canadian dollar is stronger. But in the meantime, the Canadian dollar will be volatile, just like the stock market. It comes with the territory.