At the start of the year, our inflation views reflected the existing supply chain disruptions and strong consumer demand. We expected to see inflation peak in the first quarter and move lower throughout the rest of this year, resetting to a new range above 2%.
Like most investors, we did not foresee the invasion of Ukraine by Russia, which has constricted the global supply of many raw materials, including grains, energy and minerals.
Meanwhile the Omicron COVID wave and resulting temporary lockdowns in manufacturing centres such as China also have the potential to further crimp the supply of some finished goods.
Inflation that began as a complex logistics issue has become an outright supply problem.
The result was inflation hitting highs not seen since the 1980s, which has subsided slightly, but remains with us into the middle of the year. North American and European central banks have acted aggressively to tamp down inflation, with higher policy rates.
We are watching economies recalibrate in real time.
Many central banks are now focused squarely on reducing inflation. Among these are the Fed and the Bank of Canada, which can only achieve this by tightening monetary policies to reduce aggregate demand.
Although we expect inflation rates to gradually fall this year, the pace of decline is going to be an important variable in how much and how fast central banks tighten.
Combined with global supply issues that are keeping inflation uncomfortably high, a policy-led slowing of economic growth has raised the possibility of a stagflation scenario in the quarters ahead.
Longer-term market-based measures of inflation expectations have moved higher this year but are not yet considered to be unanchored from the Fed’s 2% inflation target. We expect inflation will come down but linger in a range above target by the end of the year.
There’s no quick fix for many commodities. Supply disruptions can be expected to persist for as long as the war in Ukraine continues. Continued sanctions against Russia will restrict its energy exports, while a disruption in Ukrainian agriculture will have a dramatic impact on global grain supplies. Both imply elevated pricing at recent levels of demand.
Passing costs on to consumers is no sure thing. Last year’s high consumer demand was partly fuelled by low interest rates and large-scale pandemic fiscal spending. But this free spending is already in decline. Interest rates on consumer credit have climbed this year in anticipation of continued rate hikes. Wage gains, while robust, have failed to keep pace with inflation.
A silver lining
From energy to agriculture, commodities have served as an effective hedge in the wake of soaring inflation expectations. The commodity complex has been fueled by strong demand as the global economy emerged from the pandemic.
This occurred at the same time as tight supply conditions from a decade of under-investment for future production, pandemic lockdowns and a redirection of capital in favour of higher dividends and share buybacks.
In our view, inflation’s impact on investments has been double-edged. On the one side, it has hit growth-oriented markets hard, particularly in the technology sector. But rising commodity prices should provide a relative boost to the economies where they are produced. These include Canada and much of the emerging markets, which have lagged in recent years.
It’s certainly a difficult time to navigate markets when there are competing forces that can have an impact on different asset classes. We were bullish on Canada at the end of 2021, and remain so today, as the cyclical nature of the domestic market should be supportive.
This environment presents short-term tactical opportunities, but the best approach is, as always, diversification across asset classes and a long-term time horizon to ride out any short-term turbulence.
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