State of the Union: What Lies Ahead

Brian Belski: Morning, everyone.  This is Brian Belski, Chief Investment Strategist at BMO Capital Markets, on behalf of BMO Financial Group.  Thank you so much for joining us this morning.  Last night was the 98th in-person address from the President of the United States since George Washington.  In 1913, the format changed to a joint session of Congress with Woodrow Wilson, President Woodrow Wilson.  And what we have now today is the State of the Union address. 

President Biden had a lot on his plate last night with respect to COVID, inflation, interest rates, and of course what's happening from the geopolitical perspective in terms of Ukraine in Russia.  We're going to discuss all of those things tonight -- or today, I'm sorry. 

And a quick reminder, all of our discussion points in the podcast will be available to you on our BMO COVID-19 Insights podcast and on BMOCM.com/COVID19.  In fact, you're going to hear and witness a lot of great content today, all available to you, so please reach out to your relationship manager or you can quickly go to BMOCM.com or BMOHarris.com/commercial. 

On the call today joining me will be David Jacobson, Vice Chair of BMO Financial Group, and also former US Ambassador to Canada during President Obama's administration; then we're going to follow up with Deputy Chief Economist and Chief Economist for the US with respect to BMO Financial Group, Michael Gregory; and then Earl Davis, from BMO Asset Management, who is our Head of Fixed Income and Money Markets. 

With that, we're going to start the discussion with Mr. Jacobson.  David, the floor is yours. 

David Jacobson: Thank you very much, Brian.  You know, last night as I was listening to the State of the Union, I was reminded of something that I realized back when I worked in the government, and when I worked in the White House.  And that is that no matter how hard you work, no matter how carefully you prepare, no matter how smart the people are who surround you, you simply can't control events.  And events, I think pretty clearly took over the speech last night. 

The most obvious event was the Ukraine, but what's going on with inflation, the recent changes in the COVID situation, the first African-American woman nominated to the Supreme Court.  And the speech is called the State of the Union.  That language comes from the Constitution.  And the Constitution says -- and I think this is important in understanding what goes into the thing -- it says that the President shall, from time to time, give to the Congress information on the State of the Union.  But then it goes on with more.  It says that the President shall recommend to Congress consideration of such measures as he shall judge necessary and expedient.  And that language basically creates two speeches.  Half of the speech traditionally looks backward at all the accomplishments of the past year, often times happy talk.  And half of the speech looks forward to what often becomes a kind of an unfortunate laundry list of all of the things that every department and every agency and every former of the Federal Government would like to see Congress do in the next year.  It is the process or the product of what is known in Washington as the Inter-Agency Process, which I always thought were the three worst words in government. 

And I remember back when I was in the White House, the joke that would go around with respect to the State of the Union was, somebody would shout out, "Wait a minute, what about the recommendations from the Fish and Wildlife Service?"  And honestly, around 10:00 at night on a Tuesday night, the American people really aren't concerned about that stuff. 

And last night, I think that the events that we talked about a moment ago basically turned two speeches into three speeches.  There was the State of the Union; there were the recommendations to Congress; and there was the first part of the speech about the first 15 minutes, where the President talked about the Ukraine. 

And I think it's fair to say that that was the most successful part of the speech.  I think it was the most successful, most fundamentally, because it demonstrated national unity on the subject.  There were repeated standing ovations from people on both sides of the aisle, which is something you haven't seen in a while during the State of the Union.  You know, I personally was touched by the moment when the President introduced the Ukraine ambassador and she teared up as a result of the ovation that she was given.  And I suspect that this part of the speech, the part on Ukraine, is the part that most people will remember the best.  If I were to critique the President -- and I remember when I was in the White House, nothing I hated more than people outside the White House critiquing what we were doing.  But if I were to do it, I would say that if I were doing the speech, I would put more about the Ukraine and less about other stuff -- more about why it's so important to the American people; the sacrifices that are going to be necessary; why they're worth it.  I think tortious interference sum it up a little bit more Winston Churchill in the speech probably would have gone a long way even if Joe Biden is not Winston Churchill. 

And I think it's fair to say that these are extraordinary times, very extraordinary times, for a whole lot of reasons.  But it kind of felt like the White House had a State of the Union address in the can, and then when the Ukraine situation came front and center, they wrote 15 extra minutes and kind of stapled the stuff that they already had to the back.  And I think a lot of the power that the President wanted in the speech might have gotten lost in the shuffle. 

Now, I was taking notes last night because I knew that I was going to speak to you this morning.  But my guess is that those of you who weren't taking notes probably can't list most of the laundry list of things that the President covered.  And it's [inaudible] problem.  It turned what is and certainly could have been an extraordinary moment, a turning point not only for his administration but for the United States and for the world, into what was a good, solid, workman-like speech. 

So what did he end up saying last night, after he talked about the Ukraine?  Well, first of all, as Brian said, he talked about COVID.  He talked about what his administration had done, some of the things that the administration is planning to do.  In my view, the single most important thing that happened last night with respect to COVID was the visual.  It was TV and the visual was that virtually no one in the room, including the President, wore a mask.  And I think what the President was trying to say and really what everyone else in that room conveyed, is that COVID no longer needs to control our lives.  And I think that was a very important part of the speech. 

The second part that he talked about is what seemed to be a real effort to pivot his administration back towards the center.  I've known Joe Biden for many years.  I can tell you that in the center is the place where he is personally the most comfortable, and clearly he spent a lot of time last night talking from the center.  One of the really highlights of the speech, and certainly the most memorable -- one of the most memorable lines in the speech, was when he was talking about crime.  And he said, "Don't defund the police, fund the police."  Later on, he talked about the fact that he knows what works, and you don't have to choose between safe streets and equal justice.  And I do think that those are points that are -- resonate with probably people on both sides of the aisle. 

He talked about bipartisan, the Bipartisan Innovation Act, which is a piece of legislation that is working its way through Congress, that is designed to help the United States to compete with China.  And toward the end of the speech, he talked about what he referred to as his Unity Agenda, combatting the opioid crisis, more support for mental health, supporting our veterans, ending cancer, his cancer moon shot.  And it -- these are things that are kind of hard for anyone on any side of the political spectrum to do anything but support. 

The third thing he talked about, and he talked about it a lot, was inflation.  He did say it was his top priority.  It might have gotten missed among some of the other stuff.  But he said very clearly that his view is that the way you solve inflation is not to drive down wages, but to lower costs.  To -- as economists would say, increase the productive capacity of the economy.  And he had a list of things that either had been done or that he planned to do to try to address the inflation question.  One was invest in infrastructure.  Another good line in the speech, he talked about the fact that there -- this was no longer infrastructure week, it was infrastructure year.  And he talked about the 65,000 miles of highways and 1,500 new bridges that he planned to build in 2022. 

He talked a great deal about reshoring of manufacturing and the parallel concept of buy America, certainly by the Federal government.  He talked about lower prescription drug prices.  There was again a poignant moment when he introduced a young man who was just beaming up in the balcony, who has diabetes and whose family has a difficult time paying for the insulin that he needs to take.  I will say while Joe Biden is perhaps not Pericles, that when he talks to an individual -- and this sort of went through the whole night, when he would look up into the balcony and introduce someone, that was when he really connected.  And I think that was when he was at his best. 

He talked about cutting energy costs.  The couple of things that he specifically mentioned were the release of 60 million barrels of oil from the Strategic Petroleum Reserve, in a country where we use about 20 million barrels a day.  He talked about tax credits for homeowners who increase the energy efficiency of their homes.  He then talked about cutting costs of a variety of other things.  One of the things he specifically mentioned was childcare.  And not only the impact on costs, but the ability of working women to get back into the workforce because they can't afford the childcare that they need for their kids. 

He talked about beefing up the Internal Revenue Service and on the tax front, increasing taxes on people who make over $400,000 a year.  He talked about corporations paying their fair share of taxes, which got some groans from people across the aisle.  He talked about enhancing antitrust policy, and I think two groups that ought to be kind of worried about this are the meat packers and the ocean carriers, who he singled out in his discussion. 

And I'm going to leave to my BMO colleagues discussion about how some of these things are going to impact on the economy, on jobs, on inflation, on the markets.  And also, are there other things that the president didn't talk about with respect to the economy that might have influenced it in positive ways. 

I will make a couple of quick observations, though, before I stop, one political and one geopolitical.  And given my background, I probably ought to start with the political.  It's no secret to any of you or certainly to the people in the White House that the president's approval ratings are incredibly low.  They're in the low 40s.  I would anticipate both because of what's going on in Ukraine and because of the way that he's handled it, which I think quite frankly is pretty good, that you're going to see a bump in those numbers.  Maybe it'll get up to the high 40s.  Maybe it'll even get up to the low 50s.  But I also believe that because we are so locked in in the United States in our politics that it is going to drift back south after a month or two.  So I don't see the speech that he gave last night, unless there are some real -- there's some real good news coming out of the Ukraine or out of Russia, that there is going to be some sort of lasting bump that the President is going to see. 

On the other hand, there's the geopolitical piece of this.  And I think it's fair that if you were to ask diplomats, scholars, around the world, even in countries that are not terribly friendly to the United States, about the importance of the United States' leadership in the world, most of them would tell you that without that leadership not much is going to happen.  It's referred to sometimes as -- the United States -- as the indispensable party.  And I think what you have seen over the last couple of weeks is a great example of the reassertion of that leadership, which had kind of waned over the last several years.  And that may be something that does stick, and sticks for the better.  So you know, is this going to change the domestic political front?  Probably not.  But might it help the United States and the rest of the world to coalesce around some of the values that we all share?  Yeah.  I think it will. And with that, I will turn it over to my colleagues for their thoughts.  I look forward to your questions and particularly the easy ones. 

Brian Belski: Thank you so much, David.  Before we hand it off to our subject matter experts, I just have three quick questions for you.  Number one, we can only assume that you also listened to the Republican response; do you have any kind of quick commentary on that, what your view is? 

David Jacobson: Yeah.  Well, let me say this.  That is perhaps the worst job in politics.  It is described often as the place where political careers go to die.  For those of you who watched both last night, you understand this.  You know, the President walks into a joint session of Congress in a moment of incredible majesty, with the Sergeant at Arms of the house shouting out, "Madam Speaker, the President of the United States," and then there's some ovation.  And then after that subsides, the Speaker says, "I have the high privilege and distinct honor of presenting to you the President of the United States," and there is another ovation. 

And the response to the State of the Union, it doesn't matter if this is delivered by the out-of-power Democrats or the out-of-power Republicans, as it was last night, is given from sometimes a TV studio.  Last night, it was from a rooftop in Des Moines.  And quite frankly, it just doesn't measure up.  It never does. 

Now, given all that, I think that Iowa Governor Kim Reynolds didn't do too bad a job.  I will say my wife is from Iowa.  I believe in Iowa Nice.  If any of you have seen my wife after this, please tell her I said so.  Governor Reynolds doesn't exactly fit that mold.  She is very much a Trumpy.  She's kind of made a name for herself by not imposing COVID mandates in Iowa, and not surprisingly, she talked about that last night. 

The best line that I've heard about her remarks was that it was kind of a word cloud of grievance.  I don't think it changed any minds.  But it was probably good for [inaudible] career. 

Brian Belski: A second question, David.  In your prepared remarks, you talked about how President Biden moved even more to the center, and actually really resides more in the center.  Can you talk about the impacts on the mid-term elections for his colleagues and what he said last night in his position?  What kind of success does this set up for, objectively, for the midterms for his colleagues this year? 

David Jacobson: Well, it particularly gives them something to talk about.  It's no surprise that there is some despondency, if that's a word, among the Democrats not just in Congress but Democrats in general.  And so it's probably good in that regard.  Is this going to be -- you know, is one speech going to turn it around?  No, it's not.  It never does.  But maybe, maybe, if they start focusing more and more on the middle, maybe it will make a difference.  And if they start spending more time talking about the things that Americans care about, around their kitchen tables, and not on cable news, that maybe [inaudible]. 

Brian Belski: My third and final question is, if you could give us some historical perspective.  Several times, the President of the United States has gotten in front of the American people during times of tremendous duress, from FDR in terms of the Depression and World War II, to President Johnson following -- very near-term following Mr. Kennedy's assassination.  And then lastly, the most -- and more recently -- President Bush following 9/11.  If you kind of measure up that duress that those other presidents went through, what kind of -- objectively, how did President Biden do in delivering that unification?  You talked a little bit about that.  But obviously those other times are hallmarks in American history.  How does this kind of measure up, especially given the fact that a new cold war and the potential for further escalation of what's happening in Ukraine, in Russia? 

David Jacobson: Well, first of all, the -- it was an extraordinary time, not just for the Ukraine situation.  But we have been through two terrible years in the United States and Canada and around the world.  This has been really an incredibly trying time.  And now we're going through inflation and then you have this geopolitical crisis that you refer to.  So in some ways, I mean, it's obviously no one was -- a president was not assassinated, thank God, and you know, 9/11 was an attack on US soil.  Franklin Roosevelt dealing with the depression, with Pearl Harbor, those -- those were cataclysmic events for the American people.  But in some ways, I think this -- the situation that the President faced was in some ways worse because of the two years that we've just been through. 

You know, was it the only thing we have to fear is fear itself?  And was it a day that lives in infamy?  Probably not.  You know, Joe Biden is a wonderful human being, as I said earlier.  He connects incredibly well with people.  He is a genuinely empathetic guy.  But would I give him an A+ under the circumstances?  No.  I probably wouldn't. 

Brian Belski: Thank you so much, David.  We're going to switch over now to our subject matter experts.  Our clients really value everything that you said, David, with respect to kind of putting a historical perspective.  But we're going to be back to you with more Q&A following our subject matter experts. 

Now, let's talk about the economy and what's going on.  Now joining us is the Deputy Chief Economist for BMO Financial Group, and head of US Economic Research, Mr. Michael Gregory.  The floor is yours. 

Michael Gregory: Thanks, Brian.  Well, I think it's a nice sort of segue here to talk a little bit about that speech last night.  The first thing the President talked about was Russia's invasion of Ukraine.  And the second thing, once that was sort of dealt with, was American consumers' struggle with inflation.  Those were one and two, and I think unfortunately, I think the consequences of the invasion are going to worsen that struggle with inflation in the months ahead.  And that is with CPI inflation already running at a 40-year high of 7.5% in January. 

Now, we see three channels through which this struggle is going to worsen.  The first of those are oil prices.  Of course, we know Russia is a major oil producer and although the sanctions put in place so far have not really dealt with that sector, and I say, so far.  And -- but nevertheless, you know, the market is getting very nervous that maybe some disruptions would eventually result from this conflict.  And this morning we saw oil prices hitting $111 a barrel, a huge spike we saw overnight. 

Now, something to keep in mind is that in that sort of January CPI that I referred to, that reflects the fact that oil prices were averaging $86 through the month.  And if -- you know, if $111 sticks, and not sure if it will, but it might -- and given the fact that every $10 increase in oil results in about headline inflation jumping up around 0.4% to 0.5%, what that tells us is that there's potentially looming, a full 1 percentage point increase in inflation from current levels down the road, again, if oil stays where it is.  So this is a powerful impact this will have on consumers. 

The second channel is food prices.  Now, Russia and Ukraine are major exporters of grains and vegetable oils.  And we already saw before the conflict that things like wheat and corn prices were already drifting higher.  And we all shop, and we all know how much food prices have really gone up over the last little while. 

And the third channel is through a further disruption of global supply chains.  And we're already seeing that impact unfold with -- in the European automotive sector.  Just as that sector is having to deal or slowly coming to terms with the issues of shortages of microchips, lo and behold, yet another cog in the wheel so to speak.  And I think this is sort of quite important here, because not only -- I mean, it's further disruptions, but here in the US we've actually had to -- we're still sort of recovering from the production disruptions that were caused by the surge in absenteeism that was related to the surge in Omicron cases.  And so you know, we had those labor shortages.  We had those product shortages.  And these things are still combined together.  And as we've seen, that's one of the sort of the catalysts for higher inflation. 

So, add up all these things together and it does seem that over the next month or two, that you know, we'll likely be heading well into the 8% range in terms of inflation and quite frankly, with still some upside risks.  Now, sort of meanwhile, the invasion and the consequences of it have increased the downside risks to the outlook for not only the global economy but the US economy, as well. 

Now, the sanctions, the very onerous sanctions that the US and other countries put in place will cause a recession in Russia.  Russia is not quite in the top 10 but just slightly below that in terms of the size, the heft of its economy.  So that will have an impact.  And of course, some of those sanctions are going to be impacting some US businesses.  But I do think that the major sort of impact on the sort of the growth outlook for the US is coming from the ripple effects of slower European growth, further disruptions of supply chains, and of course the impact of higher oil and other prices. 

Now, you know, it's kind of hard to right now figure out where this thing is going to end.  Where's the end game for this?  And therefore, it's very difficult to sort of say exactly how this is going to impact, say, our forecast for the economy.  And I'll just heed Fed Chair Powell's words from this morning, it's important to be nimble in situations like this.  And nimble we will be, for the time being.  We continue to look for GDP growth, real GDP growth this year, to average around 3.5% which is still a very strong result.  But arguably, there are some downside risks now to that outlook.  We'll just have to see how things unfold. 

What we do know, quite frankly, is that apart from the speed bump created by Omicron to start the year, that there was a lot of strong momentum in the US economy.  We saw that in jobs.  We saw that in consumer spending and CapEx and housing.  And I think that momentum will give us, if you like, a little bit of a running head start to whatever kind of headwinds, whatever kind of economic consequences we're inevitably going to feel from this conflict. 

On the inflation side, you know, we think that the spike in prices that we had last spring as we were reopening and that creates a nice comparison on a year-to-year basis, to help maybe cause inflation to fall a little bit as we head into the summer.  On top of that, you know, we do think that these supply bottlenecks and other supply chain disruptions are slowly getting remedied, and that will sort of ease some of the pressures.  And finally, we're going to get some continued shifting away from goods demand back to services demand.  People are taking vacations again.  They're eating in restaurants en masse again.  And that takes some of the pressure off the goods side of the economy, where the -- you know, where the -- where the inflation pressures were really sort of centered. 

But -- no, we do think that there remains upside risks to our inflation call in spite of the fact we do think that we're probably average around 6.5% inflation, [inaudible] inflation for this year.  When you think about, well, downside risk to growth, upside risk to inflation from this conflict, literally this is a -- it's creating sort of a stagflationary risk for the US and global economy. 

Now, we happen to think that we could think about the risk, that there's probably still more upside risk to inflation than there is downside risk to growth.  I mean, it's skewed more on the inflation side and that's simply because you know, we had that momentum on the economy side, which helps.  But we also had momentum on the inflation side.  And the part that's really sort of worrying us, did before the invasion and it continues to worry us, is that there is still a sea of excess savings and liquidity sloshing around the US economy.  And that provides, you know, a -- it literally causes supply bottlenecks to be remedied a little more slowly than it otherwise would be simply because demand can continue to remain strong. 

And at the same time, all that liquidity does provide an avenue for consumers and businesses to keep paying higher prices, higher wages, higher costs, than they would otherwise without that kind of largesse at hand.  So that's a little bit unsettling for us.  Meanwhile, we continue to see evidence of a wage/price spiral slowly beginning to form in the economy.  You know, when you look at some of the major wage metrics, they're all hitting their highs, the highs they've had since the early 1980s, very much like we're seeing on the consumer prices side.  Wages and consumer prices both accelerating to the same extremes.  We take a look at the surveys of small businesses across the country, you have record numbers of firms that are both raising wages and lifting their selling prices.  And so there does seem to be a bit of an inflation psychology beginning to form.  And I think that is particularly worrisome for the Fed. 

And it's not really surprising.  When you really think about it, for the slight majority of Americans that are 40 years and under, this is -- they are now experiencing the fastest inflation they've ever seen in their lifetimes.  How can inflation expectations and inflation behavior not be influenced by that?  And I think given these inflation risks, and the need to help curb demand a little bit through higher interest rates, the Fed has signaled that it intends in exactly two weeks' time to start raising those rates.  And in fact, that was reiterated by Fed Chair Powell this morning.  Yes, there are risks to the outlook caused by the geopolitical situation, but the risks to inflation are more paramount at this stage. 

And I think when it comes to interest rates and the Fed and things like that, I'll turn things now over to my colleague, Earl Davis. 

Earl Davis: Thank you, Michael.  I'll talk about two over-arching topics today, the first one to be the good, the bad, and the ugly of interest rate hikes; and the second one being the implications of the Ukraine-Russia crisis on the US, which I actually believe is counter to what the market is discounting right now.  And then I'll close off with our expectations for interest rates and how we're preparing our books and looking at risk assets. 

In regards to the good, bad and ugly of interest rate hikes, you know, as was mentioned before, Chairman Powell had his speech to the House this morning and in it he basically said interest rates are starting to go up this month.  So what's the good about that?  The good is the reasons why.  The reasons why that are good, that are two-fold, are one, the US is at full employment.  And they're expecting another bang-up employment number this Friday, so that's good.  They feel comfortable that they can raise interest rates. 

The other thing, which I think is more important, is that the Fed feels comfortable that growth is self-sustainable.  And what I mean by that is, you know what, you're seeing wages go up, consumption go up, wages go up.  It's feeding upon itself.  So we don't need that accelerant of stimulative rates anymore. 

So I think from a good perspective, it's -- the economy is doing well.  Our starting point for raising rates is really good.  Look at the growth last year.  The growth expectations for this year and next year.  If anything, if you want to talk about possible implications on recession and getting to it, to me that's a 2024, maybe even 2025 story.  Like, the objection of the Fed is to expand or lengthen this expansion, and that is to be remembered. 

So what's the bad?  The bad is inflation.  And specifically, inflation is basically, it's a consumption tax, you know.  You pay more in gas.  You pay more in food.  You have less for discretionary items.  And I think the Fed is well aware of that, and that's what they're trying to control. 

Having said that, this consumption tax, and the Fed having to raise rates to try to control it and arguably raise rates fairly high based on levels of where we're at now, I would say there's a great offset.  The great offset are banks' ability to lend, and we're seeing that through commercial credit numbers.  So although the cost of capital is increasing, the access to capital is also increasing.  And I feel that will help temper the impact of higher rates and allow the Fed to get back to more normalized rates without dramatically impacting the market. 

And I'd like to point out to Bank of Montreal in our recent purchase of Bankwest in the US, and we've seen it with another Canadian bank and another regional bank purchase.  I think to me, those are marks of confidence in the economy, in the future of growth, regardless of where interest rates are.  You know, these purchases are long-term purchases based upon growth for all intents and purposes, because that's where banks make their money. 

So I think although we have the bad there, of this consumption, there's a lot of good that has to be measured with that and put in the context that the Fed is trying to expand out this -- or lengthen this expansion. 

So what are the ugly?  The ugly, now, is if inflation expectations become unanchored or unmoored.  So what do I mean by that?  What I mean is, although -- and we're seeing inflation trends right now in regards to that 7% and hearing talk of it going even higher because of the crisis.  When you look at the market reflection of inflation expectations, which they call 10-year break-even inflation, is what do the -- does the market expect inflation to be at over the next 10 years?  It's 270, which is within that 2% to 3% range.  So that's a good thing, seeing inflation expectations are still what they call anchored in this 2% to 3% range.  And that's very important to maintain price stability and lengthen the expansion. 

The ugly is if they become unanchored, and they're on the verge of doing so.  So we have to keep a close eye on those numbers, right.  If you look back in the history of 10-year break-evens, which goes back to roughly 1999 when the inflation bonds were first issued, the highest quarterly print that we had was 270.  Where are we now?  272.  So there's  danger of it becoming unanchored because of the higher inflation prints we're getting monthly, and that's where the danger of that, if that becomes unanchored, that goes back to the Volcker times, basically, where you get aggressive 50-basis-point hikes successively until we get the inflation genie back in its bottle. 

And that is something that the Fed does not want to go to.  That brings on uncertainty and instability.  It's not my base case.  The Fed and the Central Banks are doing a good job as reflected by where inflation is now, but they have to start hiking.  And they said they will, and they will continue to do so to maintain those inflation expectations.  So that's something to look at. 

Before I close with our view of the market, I'd like to talk about the Ukraine-Russia crisis, the geopolitical crisis.  I believe the implications of that on the US would arguably make the Fed more hawkish, not less.  We've seen uncertainty; we've seen the flight to quality recently, which is warranted because it is uncertainty and defines it.  We don't believe it's sustainable.  Why is that? 

The true implication, inflation implications in areas of concern coming out of that crisis are fossil fuel and the inflation driven by oil, and agriculture based off of Ukraine being a bread basket not only for Europe, but arguably the world with 10% of the wheat exports. 

Having said that, those two areas are basically self-sustained areas within the US.  We're not dependent on wheat from Ukraine.  Not dependent on fossil fuels from Russia.  And arguably, on the margin, it might actually increase jobs in the US, you know, liquid natural gas, the increased demand for that in other areas. 

So because of that, I don't believe it lessens the hawkishness of what we're expecting from the Fed.  It may actually increase it.  So where do we expect interest rates to go?  Right now, we believe terminal rates are where the Fed will stop at this point in time, is 3%.  So we do see 150 basis points in hikes roughly this year, and 150 basis points roughly in 2023.  And the reason why we see 3%, it has to go above what individuals believe is the natural rate of growth to actually lower demand on the market, you know, which the Fed feels comfortable doing.  They don't need the accelerator anymore.  Arguably a little bit of break over time to get inflation down, and we'll be in good standing. 

And how did that change?  It depends on your view of whether inflation is structural, which means it's here for the next 5, 10, 15 years, or cyclical, which means, you know what, after the next couple of years we'll get inflation on the lower side of expectations, which there's a number of individuals who believe very strongly in. 

We fall in the structural camp, which is why we believe the risks are higher actually than 3%, but we believe the Fed will get there and stop and see where we're at, all else equal. 

And with that, I'll hand it back to Brian for some Q&A. 

Brian Belski: Thank you so much, Earl.  We're first going to have an equity person and two fixed income people basically talking, so this could get interesting. 

I have a question with respect to perspective.  I always like to bring it back to perspective.  And Michael, I know you very well.  I've been in the business over 30 years.  Earl, I know you've been in the business a long time.  Something that we talk to clients about all the time, and it's really starting to increase, is this notion of not trusting the Fed, that the Fed's got it wrong.  They always had it wrong.  It's very similar to what we encountered back following the great financial crisis when clients wanted them to take QE off a little bit and raise rates.  I go back to 1994, 1995, the Fed had it wrong in '94 and then quickly pivoted in '95. 

In your collective memories with respect to doing your jobs, let's start off with Michael.  How do you manage that, and how do you feel the Fed is right now relative to some other points of history in terms of potentially being wrong?  And how would you combat that question? 

Michael Gregory: Well, a couple things.  Firstly, unlike those other episodes, the Fed has changed its framework for conducting monetary policy.  It has a little more leeway for tolerating higher inflation for longer, this average inflation targeting regime.  So that's a little bit different.  And I've heard several Fed officials say it's probably bad timing we did that, because it -- and we're stuck here with that for reasons not related to the change in the framework, but with very high inflation. 

And we've also seen the balance sheet just balloon quite significantly.  A lot of liquidity generated by the Fed within the banking system, and that has kind of then ripped through the kind of excessive liquidity we have in the economy at large.  And you know, that was by design.  When you do have these traumatic experiences, whether it's the global financial crisis or the pandemic, what tends to happen is you tend to put -- avoiding deflation more important than perhaps fueling inflation.  Because that's -- it's a more serious growth problem and you want to avoid being a deflationary spiral.  And the Fed has said all along, we know how to fight inflation.  We've done it basically every business cycle since the second World War.  So we know what we have to do for that. 

So I think we've set ourselves up here for a situation where the risks are all that the Fed is going to have to do a lot more to arrest the situation than they're letting onto or perhaps the market is even pricing in at this stage.  And I do think at the end of the day, we will be surprised by how much the Fed tightens, and are they going to make a mistake?  AS we've seen lately, a lot of the talk now, Fed talk, is all about inflation.  The number one sort of job for them is to bring inflation down and despite all these talks about inclusiveness and the breadth of the recovery and things like that, it's all come down now to inflation.  And I'm one of these big people that -- these people that believe that yes, the market has a certain way of thinking about inflation.  But it's not Wall Street's inflation expectations that matter, it's Main Street's inflation expectations that matter.  Because that affects how people set their prices.  It affects how people enter into their wage negotiations. 

So I think the Fed has got a bit of a problem here.  Things may turn out okay and we get modest increases.  Our own view, or a little bit below what Earl was suggesting, but not by much.  But again, where we could get the risk of them being wrong is having to actually tighten a lot more aggressively than it let on. 

Brian Belski:  Earl? 

Earl Davis: Yeah.  I'll answer this quickly.  There's two things we're looking at:  the yield curve and commercial credit, both impacted by each other.  So the yield curve, we've looked into the environment where the curve should flatten.  If the curve inverts, goes negative, 2-year to 10-year yields, that is an indication that you know what, the Central Bank has gone too far and they're only making a mistake.  The thing that's different now, the Fed can control the yield curve through quantitative tightening, through selling bonds that they own.  And the benefit of keeping a curve with some steepness in it is banks make money.  They borrow short, lend long.  Because they're making money, they're more open to lending to the economy and that helps the adjustment. 

So those are the things we're looking at, and we believe the curve will have some steepness to it.  It'll be flatter, but it'll have some steepness.  And our financial institutions should do well in that environment and therefore continue to lend to the economy and keep it going. 

So those are the things we're looking at as indicators of the Fed making a mistake or not. 

Brian Belski: One more very quick question for both of you.  We've heard several times, rates are going higher, rates are going higher, rates are going higher.  I'm going to challenge both of you, and you can't use the word, "recession."  You can't use the word, "recession," okay. What would make your forecast change in terms of how many interest rate increases?  What's the magic bullet there?  What is -- what -- what could happen that no one's thinking about?  Michael? 

Michael Gregory: Sure.  Well, I think the key thing, it's all about inflation.  And we will get some reprieve, and some of it's baked in from year-ago comparisons and things like that.  And several Fed officials say what we really have to watch now are, what are those month-to-month changes?  Because that will give us a hint as to whether or not we do really have a problem or whether things are starting to calm down.  If we start seeing 0.2s and 0.3s again, then I think all of a sudden the view about how many rate hikes are -- the Fed should conduct will change quite radically. 

If the next few months, or two, or three, we see the 0.4s and the 0.5s and the 0.6s persisting, then of course we're going to get that other scenario beginning to unfold.  So I think it's all about inflation, the month-to-month changes in those price indicators.  That's going to be the ultimate judge as to what the Fed has to do. 

Brian Belski: Earl? 

Earl Davis:  Great question, Brian.  Our team actually had a meeting on this yesterday talking about risk assets and our position.  So the one thing that changes it is if the Ukrainian-Russian war goes outside of the Ukraine borders and it becomes more involved.  That is the thing that changes it, and that -- that's a game changer for us.  That's when we change our views.  Right now, we like risk assets.  It's not our base case by any means, but we're looking for opportunities to buy to risk assets, buy to credit, and add as things get repriced because of higher rates.  But the time we start reversing that and hedging our exposures is if the Ukrainian crisis goes beyond the Ukrainian borders, from a hot war perspective.  And that is it. 

Brian Belski: Thank you so much, guys, and we'll bring you back in with some Q&A after our prepared remarks with respect to how to tie all this up into a bow, with respect to how we're looking at investments in the United States in terms of stocks, and also Canada. 

Now, on a near-term basis, I'm going to talk to you about three things:  near-term some perspective, and then positioning.  Near-term, the market actually does what it does, and is comfortable actually with geopolitical events.  If you take a look at how the market has been amazingly resilient in both Canada and the United States, this follows the script historically what happens around geopolitical events.  Geopolitical events, with respect to -- and the efforts, pressure on the markets, typically don't last very long.  And you see that traditional V-shaped recovery. 

The market still is dealing with headlines on an hourly basis in terms of the conflict with respect to Ukraine and Russia, but also the after-effects and the potentials that Earl actually just spoke about.  Be that as it may, the market has corrected here in the United States, more than 10%.  Canada has outperformed, which is not surprising, especially given its strong reliance on energy.  But what we have found in our research through the years, since 1970 there's been 29 price corrections of more than 10% -- and only 7 of them went into a full-blown bear market.  And the average return following a 10% correction is 27% over the next 12 months. 

And so I think there's a lot of solace to be had there.  Actually, history is not predictive of future results.  But I think the market is dealing with more uncertainty with respect to inflation and interest rates, so let's go there. 

Our work shows that stocks should go up along with interest rates.  And the reason why interest rates go up is because the economy is improving.  Stocks lead earnings, which lead the economy.  And the stock market has been an amazing discounting tool with respect to what's gone on and what's going on with respect to the economy and the recovery following the COVID-19 pandemic.  And what's going forward now, in our work, we believe that the market is in the early stages of transitioning toward a fundamental market and toward more normalcy.  And I think through that, we're going to be focusing more on fundamentals. 

Now, one of the things that most people are talking about at the downside in markets and downside in valuation, earnings have held in there pretty decently.  And we do think the American companies in particular are amazingly consistent in terms of their earnings.  And then there's areas in Canada as well, especially those areas that are more tied to the United States.  We think over the next 3 to 5 years, North America is the place to be in terms of consistency, and we believe that foreign investors will pay for that consistency.  And so that's why we remain bullish on both Canada and the United States. 

In terms of positioning over the next 12 to 18 months, we are more cyclically and value oriented over the next 12 to 18 months, being overweight financials, industrials, consumer discretionary and materials in both countries.  However, over the next 3 to 5 years, our favorite sectors are technology, communication services, and consumer discretionary.  Remember, never discount the US consumer or the Canadian consumer, for that matter. 

As well, there's lots of cash on people's balance sheets.  The consumer has rebuilt a lot of that, paid off debt.  There's lots of cash on corporate balance sheets, and we think just the real low level of interest rates, double-digit earnings growth and attractive valuations still tells investors that they should maintain their equity positions. 

So in closing, with respect to our market comments, now is not the time to make a binary decision and sell.  Reach out to your relationship manager and find out what means most to you with respect to your positioning in terms of inflation interest rates and the consistency of fundamentals both in terms of the US and Canada. 

And with that, I'm going to turn it back to a quick question for Mr. Jacobson.  Most of this call, and especially the subject matter, was all about inflation and interest rates, inflation and interest rates.  And you said earlier, you said earlier, that President Biden's speech had three parts.  Do you think now, after listening to all of this, that he spent enough time talking about inflation and interest rates? 

David Jacobson: Well, you know, as I said, it used to drive me crazy when I was in the White House that people outside the White House would complain about, we didn't talk about this, you didn't talk about that.  What I've been struck by in listening to you, Brian, and Michael, and Earl, is I didn't hear anything about the fact that fiscal policy is somehow or another, causing inflation.  You know, the reason that we don't have a Build Back Better bill that passed the Senate was because of Senator Manchin, who was of the view that inflation was going to be ignited if we passed the thing.  And you know, look.  I do think he should have talked about inflation.  He did talk about it.  He probably should have talked about it more.  But that would have meant that he would have to had to talk about something else less. 

It is something that I think, as somebody said, that this is a real worry of Main Street, which is what he's concerned about.  But you know, he didn't have a whole lot of tools at his disposal to fix it in the short term.  Now, maybe Michael and Earl will correct me on that, but it's -- you know, there's not a whole lot he can do.  He is -- he's saddled with the situation and the hand that he was dealt. 

Brian Belski: Thank you, David.  We have a question from the audience, and I'm going to start with Earl on this.  And Michael, you can chime in and make sure I got this.  And this is, by the way, a very, very hotly consensus call.  A lot of people are asking me this.  Why is the Fed anchoring inflation expectations of 2% to 3% and not 4% to 5%?  Wouldn’t that allow the Fed to meet expectations more quickly?  Earl? 

Earl Davis: Yes, it would.  But it would also mean that the Fed would have to raise rates to 4% to 5% to get to neutral, and to -- you actually have to raise rates to where you believe long-term inflation is, to be neutral.  You have to raise it above that to reduce it, technically.  If you look at the history of interest rate raises.  So I think raising expectations of inflation up that high risks unanchoring it even more.  But it also brings in higher interest rates, and they don't want to. 

Brian Belski: Michael? 

Michael Gregory: Yes, sure.  I'll add on just a little bit there.  Studies show not only historically in the US but around the world, that when you start having higher targets for inflation, those are a lot harder targets to achieve because inflation gets very unhinged very quickly in terms of expectations.  Low and stable is -- almost feeds upon itself.  And if you're going for 4s and 5s, or whatever the case may be, to Earl's point, you've got to raise rates that high as well.  But also, it's very difficult to keep at 4% or 5%.  It tends to go higher over time. 

Brian Belski: Thank you so much, and thank you so much for joining us today.  As a reminder, please reach out to your relationship manager to get a review of this.  As I said earlier, we'll have a podcast up right away.  And also, please take a look at BMOCM.com and BMOHarris.com/commercial. 

I want to personally thank David Jacobson for joining us, just a wonderful perspective from the political side and all of your great years in Washington.  Thank you for serving our country.  And of course, Michael, with your great perspective on the economy.  And from a client perspective at BMO Global Asset Management, Earl, your comments were very forthright and value-add. 

Again, we thank you on behalf of BMO Financial Group.  Please stay well, everyone, and we hope to see you very soon.  Thank you so much.