Inflation, Interest Rates & the Economy: What Lies Ahead?

As central banks weigh further interest rate hikes to tame inflation raging at four-decade highs, BMO hosted its inaugural Markets Plus digital event to explore the unfolding panorama. Our experts discussed what may lie ahead for households, businesses, markets and the economy, and whether a recession is in the cards.

Listen to full discussion.

Markets Plus is live on all major channels, including Apple and Spotify.

Podcast Disclaimer

Start listening to our library of award-winning podcasts.

Participants:

• 

  Dan Barclay, Chief Executive Officer & Group Head, BMO Capital Markets

• 

  Michael Gregory, CFA, Deputy Chief Economist & Head of U.S. Economics

• 

  Margaret Kerins, CFA, Head of FICC Macro Strategy

• 

  Brian Belski, Chief Investment Strategist

Following is a summary of the event.

The highest inflation in over four decades has seen central banks aggressively reverse years of fiscal stimulus over the past six months, and Chairman of the U.S. Federal Reserve Jerome Powell has openly predicted economic pain to come as the U.S. economy gets back on track.

Amid some of the greatest economic uncertainty in decades, BMO hosted its inaugural Markets Plus digital client event to explore the unfolding panorama. As the COVID pandemic lingers and the war in Ukraine underscores regional disparities in energy security, our leading capital markets experts tackled headline questions, like, will North America enter a recession next year? How far will central banks go to fight the highest inflation recorded in decades? And when might battered equity markets turn around?

“We’re obviously in a period of high uncertainty, I would say one of the highest in my career,” BMO Capital Markets Chief Executive Officer Dan Barclay said to open the digital event with clients. Moderated by Mr. Barclay, the call also featured BMO Deputy Chief Economist Michael Gregory, Margaret Kerins, BMO Head of FICC Macro Strategy and BMO Capital Markets Chief Investment Strategist Brian Belski.

BMO Deputy Chief Economist Michael Gregory stated on the call that he expects a mild recession in North America in 2023 as both the U.S. Federal Reserve (the “Fed”) and the Bank of Canada aggressively raise interest rates to combat inflation that arose out of pandemic-related supply constraints, pent-up demand and central banks’ and governments’ stimulus measures since 2020.

“Core inflation broadly is proving to be more stubborn than expected,” Gregory said. “Central banks around the world are attempting to remove that monetary stimulus,” he added. Headline inflation has begun to trend downward, he noted, but it is still a long way from what central banks consider desirable.

The Fed and the Bank of Canada have each raised overnight lending rates by 300 basis points since March, and they are likely not done. BMO Economics has adjusted its Fed funds projection to top out at 4.50-4.75 percent, and the Bank of Canada’s to 4 percent. North of the border, the Central Bank will be more sensitive to rate hike impacts on highly indebted households, Gregory said.

But the impact on the economy will be broad and far-reaching.

“We now expect on both sides of the border that growth will grind to a halt next year,” Gregory said, forecasting a recession with negative GDP growth in the first half of next year. Strong household savings from the pandemic along with lingering pent-up demand will keep it short and shallow, however, and lay the groundwork for a recovery in the second half of 2023.

Gregory expects unemployment to rise to 5 percent in the U.S. and around 6.5 percent in Canada. Meanwhile, inflation will only come down to 3 percent or so. As central bankers learned in the 1970s and 1980s, rising prices become hard to remedy once high inflation expectations get baked into the economy through wage settlements and corporate planning.

Some governments may attempt novel solutions to address the impact of high inflation and rising recession risks, but as we’ve already seen with the United Kingdom’s tax cut plan, “bond vigilantes” will limit their wiggle room. With inflation and central bank tightening on the market’s mind, “Fiscal profligacy is punished by higher bond yields,” Gregory said.

Gregory noted further that the housing market has been the “canary in a coal mine” for the worsening economy on this side of the Atlantic, with mortgage rates soaring and demand falling off.

“It’s fair to say the housing market is in fact in a recession,” he said. So far this year, housing prices nationally have declined about 7 percent in Canada. “Peak to trough, we will get about a 20 percent decline in prices on a nationwide basis,” Gregory predicted, along with a 10- to 15 percent home price drop in the U.S.

The good news is that once policy rates start to fall — not until 2024, he forecasts — we could see housing finally become more affordable across Canada.

For Margaret Kerins, BMO Head of FICC Macro Strategy, the Fed has made it clear that it is prepared to do whatever it takes to bring inflation under control, implying that it runs the risk of keeping rates higher for too long.

“Just as they stayed at the party on the other side for too long, we think that that’s really the risk on this front, that the economy slows down much more than they clearly want,” Kerins said, noting that the Fed wants to see the “whites of the eyes” of contained inflation. “The Fed has been clear with its intention to hold rates in restrictive territory, and not just restrictive, but meaningfully restrictive, for as long as it takes to contain inflation and get back to the 2 percent level.”

Once the Fed reaches what it expects to be the terminal rate early next year, it will wait for the rate hikes to transmit into the economy before deciding if they were enough to drive inflation down to their 2 percent objective.

“They will need time to see how these front-loaded, jumbo hikes impact inflation,” she said. “Said differently, today’s rate hikes fight tomorrow’s inflation, so we need to wait for tomorrow’s economic data to determine if the Fed funds rate is sufficiently high to contain inflation.”

Kerins said the U.S. rates market has swiftly repriced to higher yields as the Fed stance became solidly hawkish, with the market narrative now firmly focused on just how high 2-year yields might go in the prevailing environment. As the economy continues to slow, she said, the Fed’s higher-for-longer narrative will put a high-risk premium and a floor on two-year yields that they cannot rally through.

She said 10-year yields would also react, driving them from a current 4 percent rate to closer to 3 percent as the economy slows.

“The market won’t start to price a reversal in the Fed’s meaningfully restrictive stance until at some point next year,” said Kerins.

BMO Capital Markets Chief Investment Strategist Brian Belski said that despite the economic backdrop, North American stock markets are set to rebound, reflecting some of the healthiest corporate balance sheets he has seen in his career. Most businesses, he said, are doing exceptionally well right now.

“In my 33 years in business. I have never seen the type of balance sheet stream cashflow, consistency and earnings stability – never from small-, medium- and large cap publicly traded companies – that I'm seeing today,” he said.

At the same time, BMO’s Chief Investment Strategist has been talking to small- and medium-sized private companies across the country and most are positive about their futures.

“What does that tell me? It tells me that the fundamental construct of both the U.S. and Canadian markets, from a bottom-up basis, remains very strong,” he explained.

While valuations have come down quite a bit over the past year, Belski expects a return to normalcy within the next three to five years. After this year, which he described as a “shocking of the system,” the markets will start to settle down. He said he’s already seeing 12-month forward inflation expectations drop quickly and since the stock market typically leads earnings, which lead GDP growth, the economic downturn may be nearing its end.

“The stock market’s already gone down 25 percent and bond yields have inverted, so we're going to have a recession the first half of the year,” he said. “But we've already kind of discounted that. We believe, on a near-term basis, the stock market has been an amazing discounting function and has done its job.”

If the market is indeed bottoming, that means a rebound could soon come. And when it does – likely in the fourth quarter, said Belski – it will be strong. He noted that clients are more bearish now than they were in 2008, and many are even more bearish than they were in 2000, at the top of the tech market. Yet, many have a lot of cash on hand, while there’s a growing expectation that rates and inflation will fall due to recession.

“That bounce is coming because a majority of our clients are not positioned for any change on the upside,” he said. “So, we think a bounce is going to happen in the fourth quarter and it’s going to be very strong – I'll use the word unprecedented. We have so much pent-up demand for stocks and pent-up demand for positive performance, especially if rates are going to go down next year.”

All that said, now’s a good time to be in the market, says Belski – and especially in North American stocks. Belski, who has, for a decade, been negative on emerging markets and European equities, expects stability-seeking investors to jump back into Canadian and U.S. stocks, and especially in communication services, healthcare, financials and parts of the energy sector. “I call it ‘Consistency Canada’ and ‘Fortress America,’” he said.

In terms of investment strategy, Belski believes that companies with a cross-section of growth and value should do well. “[Look for] opportunities in growth stocks in the value index and attractively valued growth stocks in the growth index,” he explained.

In addition to strong earnings and cashflow, many companies have low debt-to-equity ratios – “I’ve never seen this in my 30-plus years in the business,” said Belski – which is another reason why he’s bullish on the future. “Over the next few years, we’re going to transition to normalized rates, normalized stock market performance, and normalized GDP.”