Chief investment strategist breaks down his takeaways from an inflation reading that came in lower than expectations
Yesterday’s CPI numbers were greeted with a sigh of relief, or perhaps a gentle cry of “no whammies” as key inflation metrics came in once again under expectation. That news should give some cover for Bank of Canada Governor Tiff Macklem to announce another interest rate cut in September, as the focus of his mandate shifts from taming inflation to supporting economic growth and employment at a time when both are struggling.
Philip Petursson thinks that Macklem should have started cutting sooner and should be cutting deeper in September. The Chief Investment Strategist at IG Wealth Management explained that as inflation falls into its historic range between two and three per cent, there needs to be more attention paid to the state of the underlying economy. He outlined why he believes a normalization in the money supply has been key to getting inflation under control and how advisors can give their clients appropriate context around this news.
“The Bank of Canada has to look at the fact that inflation is within its target and is likely to remain within its target,” Petursson says. “Their focus now really needs to shift away from inflation to the economy which, we would argue, is showing continued signs of weakening. You have unemployment ticking higher and that is where the Bank of Canada needs to focus. It needs to accept that its inflation fight is won and its concern is to mitigate the economic risk that is present and forthcoming.”
Petursson admits that the BoC may start to see an odd narrative emerging from future CPI prints. The year-over-year number that tends to land on headlines is determined by removing an old month from the data and adding the new. The last four months of 2023 saw inflation sit slightly flat. That means we may begin to see a slight upward trend in year-over-year CPI going forward. Petursson argues, however, that Macklem needs to look past that trend.
Some of what gives Petursson confidence that this inflation fight is over is his view that the sudden and dramatic expansion in the money supply that emerged from the COVID-19 pandemic was the core cause of inflation. While supply chain disruptions and other factors played a role, Petursson cites the correlation between corrections in the money supply and the relative normalization of inflation as evidence.
Given his outlook, Petursson believes that a 50 basis point cut in September would be prudent. He thinks, however, that it’s presently unlikely. Markets are currently pricing in a little more than a 100% chance of a 25 basis point cut. He thinks that Macklem will follow the markets and limit his cuts to stay on the safe side.
In making the case for a deeper cut, Petersson notes just how significant a contributor shelter inflation is to overall CPI. That metric is largely driven by mortgage rates and Petursson notes that cuts to interest rates should actually serve to lower that aspect of inflation and may continue to bring CPI down overall.
In past meetings Macklem cited the risk of reintroducing froth into the housing market as potential reasons to hold back on cuts. Petursson is confident, however, that the overhang of unemployment and slowing GDP growth should be enough to keep the housing market under relative control. Other concerns around weakening the Canadian dollar have been cited as reasons to hold. Petursson notes, however, that CAD has strengthened against the USD lately, and with the high likelihood of a forthcoming cut from the US Fed in September as well, currency should give Macklem more cover.
As clients read and digest this news, Petursson thinks that advisors should be situating the potential moves by the BoC in the context of the portfolio. Opportunities to rebalance, take profits, and prepare for a weakening economy may be worth taking now.
“Defense is very important in portfolios, as we've seen, given the volatility over the past couple weeks,” Petursson says. “If we're correct, and interest rates are headed lower that's positive for bonds. Bonds also are a positive offset to equity market volatility. We have just come through almost two years of very strong equity market gains. There's nothing wrong with rebalancing, taking some profits out of equities, putting them towards fixed income, maintaining a healthy, balanced posture across your portfolio in preparation for any volatility that might arise.”
