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Inflation expectations are one of the most important drivers of long-term interest rates and financial markets. This episode, Stu Kedwell, Co-Head of North American Equities, discusses how these expectations are evolving as more aggressive central bank action takes place to quell inflation. Stu also examines how financial markets react to changes in monetary policy expectations. [13 minutes, 00 seconds] (Recorded June 15 , 2022)


Hello and welcome to The Download. I'm your host, Dave Richardson, and it is Stu’s Days on Wednesday. Boy, my travel schedules messing up with Stu’s Days. Stu, I'm sorry.

It's OK, Dave. I'm just glad we're doing it. You're a busy man.

At least Stwednesday kind of works. And you do look stupendous today.


Alright. Much, much better than markets lately. But one of the things we were just talking about before we came on; I think one of the things -- as I'm out talking to a lot of advisors and investors this week as I'm traveling around and in British Columbia -- always important to remember perspective. And you had something that crossed your desk over the last couple of days that really highlights that longer-term view of investing and having perspective regardless of what's happening in markets.

Well, it was interesting. A colleague is retiring who's been with the firm since it started in 1988. And she, Suzanne Gaynor, put out an archive of all the different mementos and big news events that had taken place over the years. She has it all spread out over the trading desk. It's just a great reminder about all the stuff that happens over time. Investing - it’s a long game. It's played sometimes in short increments, but it is a long game. And I think that kind of leads into a little bit what we're going to talk about now about the inflation reading from last week, and the headline was a little bit of a surprise. Core number was not too bad, but energy and food continue to kind of bang away at inflation and that's going to be important to getting to the path of descent. We still think inflation is in the process of peaking. There's some components actually that are annualizing over the last couple of months that declines in the consumer goods and things like this. But energy is going to be an important element in that. You did get this big inflation number. You had another move in the bond market, which ironically, maybe sets up a bit of a window here for the Fed, who is going to have to do so much tightening. And the absolute magnitude of tightening is not really that different than what it had been before. But maybe it'll happen faster. It'll be interesting to see whether or not, ironically, markets take some confidence from that because we've been discussing this notion that that a Fed that is going to remove liquidity to dampen inflation is positive for long-term investors, even though it's negative in the short term. A long-term investor definitely wants a stable inflation environment over a long period of time. So, we have the decision this afternoon and we'll take it from there.

And Stu, just to pop in on how quickly things are changing. In a fairly uncertain environment, which we talked about a lot on previous podcasts. But when we were sitting just over a week ago during the last episode of the podcast, most people thought that the Fed was going to raise interest rates 50 basis points this afternoon. We're here on Wednesday, June 15th, taping this just about an hour before the Fed announcement comes out. Now the market is pricing in a 100% likelihood of a 75 basis-point increase in rates this afternoon. Along with that the Fed futures that forecast how far the Fed's going to ultimately go with rates; that's moved from a little under 3% a week ago, to now almost 4%. So the higher inflation and this report has really pushed the market in terms of a higher expectation of where the Fed goes. I guess it's not surprising that at some point that the Fed is going to do what they need to do to control inflation. And at some point the market's going to look past and through what the Fed is doing right now and say, hey, at the other side of this, we have an environment with ultimately lower inflation; rates may even be able to settle down. And that could be pretty good for equity markets.

Yeah, that's what people are trying to think about. Because even as short-term rates rose, the yield curve flattened even more. Long-term interest rates moved a little bit, but not really the same degree to which you just discussed. This notion of, even today if the yield curve begins to invert, which likely signals a more significant slowdown, the equity market has discounted that to some degree. Right? We had a discussion this morning with an analyst where we went through a recession scenario on banks. It’s probably the fifth recession scenario that we've gone through with different analysts on banks. And if you ask people on sales and trading desks and in research departments, the number one question is show me the recession scenario. So that doesn't mean it's fully discounted, but it is the major topic of discussion. Then people are more prepared for it. So then you're looking, to your point, for the ingredients of, OK, how far does the Fed have to go? How do we get inflation back down? That stabilizes longer-term valuations, which then creates the environment for maybe we have to have lower earnings that then rebound. And that's those are the ingredients for better equity prices over time.

Yeah. And I think a lot of people, as I was going around talking to advisors and investors, and certainly investors of my vintage who remember the 1970s, point back to that as a as a historical period where we saw a lot of similar things happening. You had that inflation, you had higher energy prices, and you had geopolitical strife around the world. I think it's important to remember that back in the 1970s, one of the mistakes that they made early on -- as energy prices were starting to move out and inflation was starting to spiral out of control --, is they didn't take a hard enough stance against inflation. Ultimately meaning they had to go really hard at it in the early 1980s to finally kill inflation or at least get it under some form of control. So in some ways seeing the Fed act more aggressively now is a sign that they learned from the 1970s and they are going to take this seriously and get inflation under control. And again, hopefully it doesn't cause a recession – but it may. But it leaves behind a pretty stable base for the future of the global economy.

One of the books that I'm reading right now is written by the chief economist at the Wall Street Journal. It's about the Federal Reserve and the response during COVID. The first half of the book details some of the history of the Federal Reserve, how it came about, and some of the Fed governors over time. And there's a couple of things about the story. The first is, the episode where Paul Volcker is in Jimmy Carter's office before he becomes Fed Governor, and Jimmy Carter is not doing well in the polls, likely on the way out. And he asked Volcker about interest rates. Volcker says, “Well, I'm going to raise them a lot more than the guy that's there now.” And that proved to be successful. The only reason I tell the story is fast forward - to the point that you made - where they've learned from what to do in the past. The second thing is that it was that a head economist who wrote in the Wall Street Journal that the Fed would likely go 75 basis points. Which led market participants to say, well this guy was given a very good inside view to write the book that the Fed often uses a mouthpiece during the blackout period. And that's kind of why the markets jumped towards the 75 basis-point move. It does reflect that overall discussion about the terminal value of the investment. We talk so much about terminal value when it comes to ESG, when it comes to the cash flow that a business produces. The terminal value is how much cash is going to be there down the road, what type of earnings and earnings growth are we going to see, and what valuation are we going to apply to it? Inflation helped generate earnings to some degree, but it can take from that terminal value and its valuation. So that's why it's very important to kind of get out and get control of it.

Yeah. And as a lot of seasoned investors, who were around investing through that period -- what they remember about it, which is again, I think what we're experiencing right now in terms of that great uncertainty is that higher inflation and the unknown in terms of how high interest rates have to go to quell that inflation make it very, very difficult for managers, for CEOs, for presidents of companies to plan around their business because there's such a wide range of possible outcomes. And what's nice about that low inflation environment where you've got stable interest rates like we've had for so much of the last 25 years, is it makes it easier for business leaders to plan and run their businesses. So that's another reason why you've got to get this under control.

The other thing I'd add to that too is that even during past periods of inflation, you can say, well, the Fed funds rate needed to go above inflation in order to wrestle it under control. The other thing that is more difficult in this environment is the amount of leverage in the system is higher. So in past scenarios, you could say, well, this is required. But the leverage in the system quickly acts as a governor on the economy, which is very different than in the past. If you're running with inflation, that’s core at six or headline at eight, and people are wondering how high do interest rates need to go, the counter to that is the amount of debt stock that exists and higher interest rates immediately start to sap income out of your pocket and back to paying your debts. Higher commodity prices also are having a slowing effect as well. That is the delicate balance here, trying to figure out what level of interest rates is enough to quell inflation? Probably cause a bit of a slowdown, but kind of get past it, so that we can get on to what drives earnings growth over time.

Yeah, and important to remember that with inflation and the Volcker story; when they did finally raise interest rates dramatically -- and many people listening to this podcast will remember maybe paying over 20% on their mortgage rate in the early 1980s or the 1981 Canada savings bond at 19 and a half percent. You likely do not think that rates are going that high. But they took that critical step, killed inflation. It created a recession, but from there spawned the 17, 18 year bull market that was the greatest in history from 1982 to 2000. So if you can get it right, if you take care of things, you can lay the groundwork for an investment environment that is really positive.

That's right. As my dad would say, if you clean the stalls, eventually you get to ride the pony.

Sounds like that was his way of getting you to clean the stalls.


Alright. Well that's great. We’ll maybe focus a little bit more on equity markets specifically next week, because that's what you're doing every day. But good to reset around what's driving markets from an interest rate and inflation perspective today. Stu, always great to catch up with you. We'll talk to you next week.

Great. Thanks, Dave.


Recorded: June 15, 2022

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