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The U.S. Federal Reserve and other central banks have a tough task ahead: get inflation under control, while avoiding a recession. As uncertainty mounts as to whether they will be able to achieve this, markets are also responding with increased volatility – particularly bonds. What is the likelihood that central banks will achieve a ‘soft landing’ outcome? What will future interest rate hikes mean for investors? This episode, Stu Kedwell, Co-Head of North American Equities, weighs in on markets following the Fed’s latest monetary policy decision. [11 minutes, 10 seconds] (Recorded May 3, 2022)

Transcript

Hello and welcome to The Download. I'm your host, Dave Richardson, and it is (S)Tuesday. I had a couple of weeks where I was traveling, and Stu was, too, so we couldn't make the connection. But since Stu is currently locked down with “Stuvid”, we're definitely able to connect with him here. He can't get away or we’ll track him.

How are you doing, Dave?

Good. How are you?

Good. I'm up here on the third floor of my house for five or six days.

Solidly isolated, doing the right thing, as always. A good citizen.

Feeling not bad, actually. Feeling not bad. Some days, feeling a bit better than the market, which I'm sure we'll talk about today. It's been a bit bumpier recently.

Wow. It really is something to watch. And again, we've been off for a couple of weeks. Maybe rather than trying to come up with a fancy question, it's like, what the heck is going on, Stu?

Well, I think it's a combination of some of the things that we've talked recently about, maybe with a bit of the issues around the central banks and how they're going to raise interest rates and sell some of the bonds that are in their portfolios. The anticipatory stress is always something that's greater than what actually might take place. So, you've had some inflation data. You had the CPI, a couple of weeks ago, that was not great, but you could start to see that the price of used cars had fallen, and you could start to see maybe a glimmer of how that could unfold more positively. But then, you've also had some wage data that's been very robust. Wage data is something that people worry about, getting a little bit more entrenched. So, while the earnings from the first quarter were still quite strong— relatively speaking, many were above expectations—, the overriding factor is what will earnings be in the future and how far will central banks need to go in tightening monetary policy, and what impact will that have on the economy? Against that backdrop, importantly, sentiment has really crumbled. The positive here is how negative sentiment is. As the saying goes, buy fear and sell cheer. The problem that we face right now is, although sentiment is very negative, a pathway from the central banks would be quite important at framing the end of this volatility. As we've discussed in the past, we think volatility is likely to remain a little bit higher for an extended period of time because it's going to take a bit of time for the Federal Reserve to frame this for us. Whether or not it's a 50-basis increase or a 75-basis point increase, they look quite steadfast in the idea that they are going to bring inflation under control, which ultimately is a positive thing for a long-term investor, but it does create more volatility in the short term.

I just want to put a time stamp on this particular podcast because of tomorrow's Fed announcement. This is (S)Tuesday, May 3, that we're taping this, and the meeting is Wednesday, May 4, with the [U.S.] Federal Reserve. So the Federal Reserve is going to be coming a day after what we're talking about today. Your expectation is that they go up 50-basis points. Stu, a lot of what I'm reading and a lot of the angst around the Federal Reserve and what they're doing is just the idea that if you look historically, it is very difficult for the Federal Reserve or any of the central banks around the world— the Federal Reserve being the most important—, to engineer that soft landing. So you're looking at that high inflation; maybe we've seen the peak. Rates are going higher. They're going to be more aggressive and tightening. They've got to stick to their guns. They've got to prove that they're willing to fight inflation. So what the markets are telling us right now is you've kind of got the recipe for a potential recession.

Yes, I think that's what people are worried about. But at the same time, markets are always very forward looking. Even if they end up going on more interest rate tightening than might be ideal and causing a downturn, what markets will look for is some conviction that they understand how far the Fed needs to go. It's not dissimilar to getting Covid. On day one, you're like, oh, boy, how bad is this? On day two, if it's the same, you're like, oh, maybe I've seen the worst. Day three, still the same, you're like, well, if it was going to get bad, it probably would have already happened by now. Day four, you start to feel a little bit better. It's the same thing for the Federal Reserve. If it was 75 basis points and they said it was four more 75, and then that was it, then you could go and frame that. What markets are dealing with right now is just the uncertainty of how that might play out. I think when we sit here today, there's been a lot of discussion about how poor sentiment is, and that could be a bullish ingredient. But I think it will take the negativity in sentiment, coupled with some sight line on this is how much actual interest rate tightening there will be. And again, that is a very short-term focus. From an intermediate term standpoint, it doesn't really change what we're doing here. But in the very short term, I think those are the ingredients that people are trying to work their way through.

It just always comes back to the one thing people and markets don't like, uncertainty. Give me the answer. Maybe it's not even the answer I like, but give me the answer, because then I've got something to work with, something I can do the calculations. I can figure out what this company's worth and attach a value to it, instead of having that wide range of possible outcomes, all kinds of uncertainty, then I don't know what to do.

100%. And then, even if it might take six, nine, twelve months, if you can begin to frame how the tightening cycle could mature and end, then you can go and look at businesses that might do better. It sounds funny because it would be eighteen months from now, but in the early cycle, coming off of a tightening. We talked on the last podcast about some of the big U.S. investment banks and how their evaluation to drop from 1.5 to 1.6 times, closer down in some cases to book value. The things that happen early in the next cycle is right now, we're not having very much capital being raised because spreads are widening and there's uncertainty, but that delays that capital raising. It needs to be raised. As you get some idea and buyers and sellers can agree on what the future looks like, then the capital raising starts again and on goes their business. Anytime when we're looking at any business, we're looking at what they earn on a normalized basis, not what they're earning on the here-and-now, and what they might be valued at on a normalized basis. If you get a situation where you have earnings that are above what they might be right now and valuations that can improve relative to where they sit right now, you have two sources of potential winnings. For the stock market as a whole, earnings are okay, but might be a little bit pressured, and valuations, while they've come down, I think you would put them in the okay camp. That's why we're getting more volatility because there's these two sources of uncertainty in the near term

Stu, on the materials front; materials, energy, metals, other material, lumber, fertilizer have all been very strong but have softened up over the last couple of weeks, I would guess, with the concerns about how much the economy is going to slow down. Is that helpful on the inflation front or is it too early to tell?

Well, it's helpful because everything is based on the rate of change. Even looking inside of the inflation numbers, one of the big sources of inflation was goods inflation. When we look into the next twelve months, it does look like some of that will start to ease off, which inevitably helps the Fed being able then to claim victory over inflation. And 12 months from now, hopefully, I don't think inflation is going negative or anything like that, so you get inflation back to the low single digits and that allows the Fed to be focused on their dual mandate, inflation and employment. Right now, I think people are really focused on inflation.

Well, that's a great synopsis of where we're at and why we're seeing so much volatility, and really right across the board, some pretty challenging equity markets along with what's already been a really tough year in fixed income. Whether you're an equity or fixed-income investor, so far 2022 has not had a whole lot to smile at. But the really important point is looking at the potential that inflation may be peaking— may have already peaked— and that markets are always going to look forward and that's what investors have to keep an eye on.

100%, Dave.

I think a lot of investors listening to this podcast love your new raspy voice. You sound even smarter than you used to.

That's right. Well, I will eventually leave my third floor. That, I know for sure.

It'll be nice to have you back because we were supposed to be doing some traveling, so we'll miss you on the road if we can't get you out of lockdown. But hopefully you'll be better next week and we'll talk to you next Tuesday.

Great. Thanks, Dave.

Disclosure

Recorded: May 3, 2022

RBC Global Asset Management is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management Inc., RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management (UK) Limited, RBC Global Asset Management (Asia) Limited, and BlueBay Asset Management LLP, which are separate, but affiliated subsidiaries of RBC.

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