Less than three months into the new year, the prevailing narrative has changed substantially for the economy. In the fourth quarter of 2022, the consensus view was that peak inflation was behind us and that the economy was decelerating at an alarming rate, both in North America and globally. In fact, by some measures, expectations for an imminent recession were at record levels going back through decades of history. However, history has also shown how difficult it is to forecast a recession. Indeed, whether they be central bankers, economists or investors, observers have struggled to identify recessionary conditions in real time even when they’re in the midst of one.
The first aspect of the consensus outlook – disinflation – has directionally been playing out as expected. Various measures of price changes, including producer inflation, consumer price indexes and personal consumption expenditures, have been decelerating in most Organization for Economic Co-Operation and Development [OECD] countries from their 2022 peaks, although the pace of moderation has been frustratingly slow based on the surprising strength of the most recent data. The trend has also been evident in commodity prices, headlined by energy and food, and core goods prices, which have benefited from an improvement in supply chains and a shift in demand from goods to services. Even some of the more stubborn core service prices have begun to recede from peak levels. This trend, along with concerns about an economic slowdown, drove a bond market rally to start the year as yields declined from last fall’s high-water marks.
Yet recession fears have proven to be misguided. Several factors have contributed to economic resilience. Businesses and consumers have enjoyed an energy dividend in the form of substantially lower prices, as oil and gasoline have fallen some 40% from early 2022 levels, while natural gas in North America and Europe is down in the range of 80%. Capital spending picked up as companies adapted to supply chain issues and strove to replenish sources of raw and intermediate goods in the face of rising geopolitical uncertainty. Finally, consumers still have a stockpile of excess savings from the pandemic response, which in the U.S. could last until at least the summer. As a result, economic data have surprised to the upside. This Goldilocks environment of disinflation and economic growth has changed the narrative to that of a soft landing, or possibly even no landing. In a reflection of the improving outlook, bond yields rebounded in February.
Nevertheless, market participants may once again be latching on to the wrong perspective. First, while the disinflation story may continue for some months to come, we may not be out of the woods yet. In our view, the potential for inflation to reaccelerate later this year may be underappreciated. Here are six reasons why:
The tailwind of declining energy prices may be subsiding as supply becomes more constrained, with prices approaching production cost bases and potential geopolitical issues in areas such as Russia/Ukraine and Iran/the Middle East remaining elevated.
China’s economy is reaccelerating as it reopens this year.
A combination of mid- to upper-single digit cost-of-living adjustments and multi-year contract negotiations at mid-single digit percentages (or higher) levels may keep pressure on wages and services inflation.
The economic resilience discussed above, coupled with financial conditions that are actually looser than when the hiking cycle started, is unlikely to allow inflation pressures to moderate as much as officials are hoping.
The substantial weakening in the U.S. dollar, which remains close to 10% below its September peak in broad index terms even after a February rally, may generate higher import inflation down the road.
Finally, the easy year-over-year inflation comparisons we are currently experiencing become tougher in the second half of 2023, as the economy laps the more benign monthly inflation prints in the latter part of 2022.
For those reasons, we believe the market has been too sanguine about disinflation, as reflected in inflation breakeven levels, which declined through most of 2022 even as investor worries about inflation were top-of-mind. Breakevens have finally started to move higher in recent weeks as markets begin to reassess medium-term inflation prospects – a key factor in the recent rise in bond yields.
The other area the market may not be fully appreciating is the economic outlook. The fabled “pivot” has ended up not being in central bank policy, but rather in recession fears, which have faded from the highest levels ever through “soft landing” to “no landing” in a remarkably quick two months. The outcome, though, is that central bank terminal policy rates have shifted higher and later, another reason for the recent backup in bond yields. Ironically, this reset of overnight rate expectations is resulting in tighter monetary policy. While rate hikes have not derailed the economy so far, the second half trajectory is looking increasingly fragile as the lagged impact of the largest and fastest hiking cycle in a generation takes effect. Add to that a deceleration in capital expenditures from elevated 2022 levels, along with consumers using up the remainder of their excess pandemic savings, and the prospects of recession merely look to have been deferred, not eliminated. Far from “no landing,” we believe the probability of a recession next winter continues to rise.
What does this mean for bond yields?
A potential resurgence in inflation (albeit not nearly as high or intense as in 2022) and near-term economic resilience portend a risk that bond yields may not yet have peaked. However, if a recession does transpire toward the end of 2023 or early in 2024, yields may start to fall later this year in expectation of this outcome. Overall, we expect bond yields to be rangebound in 2023 after the substantial backup in 2022.
For the moment, we continue to hold short-duration positions, although the recent rise in yields is presenting an opportunity to start nibbling again, and we anticipate taking advantage of higher yields to lengthen duration as the year progresses. In addition, inflation-linked bonds are looking more appealing, and we have begun adding exposure again. Our third area of focus has been on corporate bonds with attractive yields. These opportunities include investment-grade bonds with yields well north of 5%, high-yield bonds with yields of 8-10% or more and solid business prospects in our view, and idiosyncratic opportunities in other parts of the fixed income market such as convertible debentures, leveraged loans and Emerging Market debt. In combination, these securities can result in portfolios with mid- to upper-single digit yields.
Since yields should comprise the majority of returns for bond investors (as has historically been the case over time), fixed income returns should not only be much better in 2023 than in 2022, but should also offer a more viable alternative to equities than has been the case through most of the post-Great Financial Crisis period. Bonds now provide a more competitive yield, better potential for downside protection in the event of a recession, and lower volatility than equities despite last year’s elevated risk.
The views expressed in this blog are those of the authors and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds, or investment strategies.
Commentary and data sourced Bloomberg, Reuters and company reports unless otherwise noted. The commentaries contained herein are provided as a general source of information based on information available as of March 1, 2023 and are not intended to be comprehensive investment advice applicable to the circumstances of the individual. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Market conditions may change and AGF Investments accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained here.
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VICTORIA – British Columbia is forecasting a record budget deficit and a rising debt of almost $129 billion less than two weeks before the start of a provincial election campaign where economic stability and future progress are expected to be major issues.
Finance Minister Katrine Conroy, who has announced her retirement and will not seek re-election in the Oct. 19 vote, said Tuesday her final budget update as minister predicts a deficit of $8.9 billion, up $1.1 billion from a forecast she made earlier this year.
Conroy said she acknowledges “challenges” facing B.C., including three consecutive deficit budgets, but expected improved economic growth where the province will start to “turn a corner.”
The $8.9 billion deficit forecast for 2024-2025 is followed by annual deficit projections of $6.7 billion and $6.1 billion in 2026-2027, Conroy said at a news conference outlining the government’s first quarterly financial update.
Conroy said lower corporate income tax and natural resource revenues and the increased cost of fighting wildfires have had some of the largest impacts on the budget.
“I want to acknowledge the economic uncertainties,” she said. “While global inflation is showing signs of easing and we’ve seen cuts to the Bank of Canada interest rates, we know that the challenges are not over.”
Conroy said wildfire response costs are expected to total $886 million this year, more than $650 million higher than originally forecast.
Corporate income tax revenue is forecast to be $638 million lower as a result of federal government updates and natural resource revenues are down $299 million due to lower prices for natural gas, lumber and electricity, she said.
Debt-servicing costs are also forecast to be $344 million higher due to the larger debt balance, the current interest rate and accelerated borrowing to ensure services and capital projects are maintained through the province’s election period, said Conroy.
B.C.’s economic growth is expected to strengthen over the next three years, but the timing of a return to a balanced budget will fall to another minister, said Conroy, who was addressing what likely would be her last news conference as Minister of Finance.
The election is expected to be called on Sept. 21, with the vote set for Oct. 19.
“While we are a strong province, people are facing challenges,” she said. “We have never shied away from taking those challenges head on, because we want to keep British Columbians secure and help them build good lives now and for the long term. With the investments we’re making and the actions we’re taking to support people and build a stronger economy, we’ve started to turn a corner.”
Premier David Eby said before the fiscal forecast was released Tuesday that the New Democrat government remains committed to providing services and supports for people in British Columbia and cuts are not on his agenda.
Eby said people have been hurt by high interest costs and the province is facing budget pressures connected to low resource prices, high wildfire costs and struggling global economies.
The premier said that now is not the time to reduce supports and services for people.
Last month’s year-end report for the 2023-2024 budget saw the province post a budget deficit of $5.035 billion, down from the previous forecast of $5.9 billion.
Eby said he expects government financial priorities to become a major issue during the upcoming election, with the NDP pledging to continue to fund services and the B.C. Conservatives looking to make cuts.
This report by The Canadian Press was first published Sept. 10, 2024.
Note to readers: This is a corrected story. A previous version said the debt would be going up to more than $129 billion. In fact, it will be almost $129 billion.
NANAIMO, B.C. – Former Bank of Canada governor Mark Carney says he’ll be advising the Liberal party to flip some the challenges posed by an increasingly divided and dangerous world into an economic opportunity for Canada.
But he won’t say what his specific advice will be on economic issues that are politically divisive in Canada, like the carbon tax.
He presented his vision for the Liberals’ economic policy at the party’s caucus retreat in Nanaimo, B.C. today, after he agreed to help the party prepare for the next election as chair of a Liberal task force on economic growth.
Carney has been touted as a possible leadership contender to replace Justin Trudeau, who has said he has tried to coax Carney into politics for years.
Carney says if the prime minister asks him to do something he will do it to the best of his ability, but won’t elaborate on whether the new adviser role could lead to him adding his name to a ballot in the next election.
Finance Minister Chrystia Freeland says she has been taking advice from Carney for years, and that his new position won’t infringe on her role.
This report by The Canadian Press was first published Sept. 10, 2024.
HALIFAX – The Nova Scotia government has introduced a bill that would kick-start the province’s offshore wind industry without federal approval.
Natural Resources Minister Tory Rushton says amendments within a new omnibus bill introduced today will help ensure Nova Scotia meets its goal of launching a first call for offshore wind bids next year.
The province wants to offer project licences by 2030 to develop a total of five gigawatts of power from offshore wind.
Rushton says normally the province would wait for the federal government to adopt legislation establishing a wind industry off Canada’s East Coast, but that process has been “progressing slowly.”
Federal legislation that would enable the development of offshore wind farms in Nova Scotia and Newfoundland and Labrador has passed through the first and second reading in the Senate, and is currently under consideration in committee.
Rushton says the Nova Scotia bill mirrors the federal legislation and would prevent the province’s offshore wind industry from being held up in Ottawa.
This report by The Canadian Press was first published Sept. 10, 2024.
