January 6, 2023

Financial Letter - December 2022

What does 2023 hold for us: A soft landing, recession or stagflation?

Since the Great Recession of 2008, the financial environment has become one of the most complex ever observed. The year 2022 was marked by a resurgence of inflation and a spectacular rise in interest rates. For 2023, most analysts are forecasting a soft landing for the economy or a weak recession, while a handful of strategists are predicting a more severe recession. A soft landing for the economy would imply the Fed's monetary policy has been successful, despite its poor track record. The central banks need to both increase interest rates without creating a recession and reduce their balance sheets, which have ballooned from bond purchases made at the start of the pandemic, without creating imbalance in the credit market.

Over the past 30 years, central banks have repeatedly shown us their inability to properly forecast the economy and, above all, to react proactively to avoid problems. In 2020-2021, we witnessed an unprecedented response from central banks and governments to address the pandemic. A strong response was clearly necessary to face the shut down of the world economy. Today we might wonder whether a response 5 times greater (in terms of monetary stimuli) than the 2008 financial crisis was necessary. We're currently paying the price for the central banks' slowness to recognize the solid performance of the economy during this period and to finally take adequate action to prevent overheating.

Central banks have used all sorts of reasons to justify keeping interest rates at zero, arguing that inflation was temporary, that the workforce would return as soon as government benefits ceased, that supply chain problems would resolve quickly, and so on. It was when Russia unleashed a war, causing energy prices to skyrocket, that the central banks suddenly changed their tune and in one voice shouted all together: STOP! HOUSTON, WE HAVE A PROBLEM. However, the inflationary evil had been gnawing away for some time. Now the central banks' priority is to focus on the war on inflation, and their 2% target will be take time to achieve. By playing catch-up, they're initiating a very rapid rise in rates in a slowing economy that has never been so deep in government debt.

For these reasons, a recession in 2023 seems inevitable to us. Its extent remains to be determined and depends on the direction of inflation. We should expect volatility in the markets depending on whether the news about inflation and the job market is good or bad.

A large part of the increase in the inflation rate that we've observed since the beginning of the year, and especially during the summer, comes from the higher prices for goods related to commodities. The price of goods represents 27% of the core CPI and goods are the most sensitive to interest rate increases. For this part of the equation, rate hikes are doing their job: the price of lumber dropped, from US$1,700 (per thousand board feet) to US$450 more recently, following the sudden halt in housing starts; the real estate market is cooling; oil went from $120 to $75; and the price of industrial metals is falling. Although we're seeing a drop in inflationary figures, which for the moment is making the markets happy, the game is far from won.

Services represent 73% of the core CPI. The part of inflation that comes from the service sector will be much more difficult to bring down and the rate hikes that we've been subject to so far may not be enough on their own. When we say services, we think of wage increases, increase in mortgage rates and rents, transport, hotels, restaurants, etc. It's this part of inflation that worries central banks. The labour market is currently robust with over a million job openings in Canada and more than 4 million job openings in the United States than there are unemployed people.

The stock market is highly dependent on the direction of interest rates. The recent drop in 10-year rates has triggered a rally since mid-October that could well continue into early 2023. Whether or not the economy enters a recession, the economy is slowing down and corporate profit expectations are currently too high. Analysts are currently expecting profits to grow by 5,3%, while in a recession, profits drop by an average of 20%.

This suggests that we could have a better buying opportunity in the second half of 2023. For this reason, a higher cash level and an overweight position in bonds seems a good strategy for the first half of 2023. This tactical shift will be undertaken according to market trends at the start of the year.

Thank you for your trust in us. Don't hesitate to contact us if we can be of any assistance!

Best regards and happy new year!

Isabelle, Chantal, Xavier, Thomas, Sébastien and Jean-François