Is North America headed for a recession?
- Keywords:
- inflation
- recession
- interest rates
The North American economy continues to send conflicting signals. While the U.S. Federal Reserve and the Bank of Canada struggle to curb record-high inflation with a string of rate hikes, their moves have done little to cool equity markets and employment gains. When will rising interest rates start impacting the economy and will higher borrowing costs and continued rising inflation tip North America into a recession?
To address these questions BMO Financial Group’s U.S. Chief Executive Officer David Casper convened a panel titled “Will We or Won’t We? Inflation, Rising Interest Rates and the Threat of Recession” to explore how this unprecedented economic moment may unfold. He was joined by Scott Anderson, Chief Economist at Bank of the West, which after the recent acquisition by BMO is the newest member of the BMO economics team, Brian Belski, BMO Capital Markets’ Chief Investment Strategist, and Earl Davis, the Head of Fixed Income and Money Markets for BMO Global Asset Management.
While the panel was reluctant to say if or when the U.S. or Canada might enter a recession, they said investors need to prepare for a bumpy ride. “The U.S. and Canadian economies are in an unfamiliar twilight of an economic and financial boom,” said Scott Anderson. “Forecasting through this pandemic has been one of the most challenging of my career, maybe for economists all over the country, including at the Federal Reserve.”
Resilience and volatility
Anderson said there’s a high risk of a U.S. economic recession in 2023, possibly in the next three to six months – although it’s not a sure thing. “I put the probability at around 60%,” he said. He expects a two-quarter downturn possibly starting in the second quarter of 2023, with a 0.8% decline in U.S. GDP from peak to trough, a loss of a million jobs and the U.S. unemployment rate moving up to 4.8%.
Overall, Anderson said he expects inflation to be lower at the end of 2023 than when the year began and believes it will take until the end of 2024 before the Fed reaches its 2% inflation target.
While Anderson said there is a high risk for recession, Earl Davis noted that fixed income markets are sending a different signal. “We read the (bond) market as pushing out the probability of recession and reducing the probability of one in 2023,” he said.
Regardless of the level of risk of a recession, the panel agreed it won’t be a smooth ride. According to Davis, the only certainty about fixed income in 2023 is increased uncertainty and volatility. “Keep in mind that it’s not just about the destination now – rates higher, rates lower – it’s about the path to get there,” he explained. “Similar to 2022, we’ll see interest rates spike higher and then spike lower.”
Economic data in March and April will play a major role in how high the Fed ultimately raises its target range for the fed funds rate. “If you get two strong prints, that’s a tentative trend,” said Davis. “And if you get three, that’s a trend.” In February, it rose by 25 points to 4.75%, from 4.5%, a smaller increase, but an increase nonetheless, based on January data that showed strong employment, strong retail sales and a rebounding consumer price index.
At the moment, the bond market is signalling that the Fed will top out at 5.5% in late summer, but Davis said the March economic data will determine if that sticks. “There’s not a lot of slack in the economy,” noted Davis. Against that backdrop, he said the Fed may need to raise interest rates to as high as 6%, although he thinks if the Fed and the Bank of Canada do raise rates again, it will be by 25 basis points.
A return to fundamentals
As for the equity markets outlook, Brian Belski remains optimistic that the slide has stopped. “We still think the U.S. stock market is in the midst of a big 25-year secular bull market that started in 2009,” he said.
Belski noted that historically, the stock market has only experienced three consecutive negative years – all during moments of economic crisis: 1938-40 (Depression), 1972-74 (oil embargo), and 2000-02 (tech bust and 9/11). “I don’t think we have a crisis like that right now,” he said, but investors need to play it smart.
He believes that too many people are trying to figure out what the Fed’s next move will be and where the economy is headed. “That’s really difficult to do, and when it’s difficult, you default to quality,” said Belski. “It’s time for fundamentals to lead.” In this environment, Belski said he would look to value stocks, small and mid-cap stocks, quality stocks and growth at a reasonable price.
This is a return to normal, he argued. Until recently, interest rates have been well below long-term averages since the 2008 financial crisis, so Belski said he expects there will be a rebalancing in the next three to five years. “We’re going to normalize valuations, we’re going to normalize earnings growth to single-digit earnings growth and high double-digit performance in the stock market.”
With that will come a shift back to investing fundamentals like stock selection and diversified portfolios, like the 1980s and the early 1990s. “In ’94-’95, you could own both stocks and bonds and from a total return perspective, they worked very well together,” he said.
A new reality
All of the panellists shared the view that financial markets are entering a new era. “We’re undergoing a secular change in inflation,” said Davis, in which modestly higher inflation of three and 4% will be acceptable. He pointed to the five-year mandates central banks in Canada and the U.S. signed in 2021 to keep inflation between 2% and 3%. “When those expire in 2026, the inflation mandate is going to be set higher. The central bankers realize it’s going to be a 10- to 20-year period of higher inflation, higher volatility, generally higher interest rates,” he said.
Anderson also sees a larger shift underway. When inflation first broke out, most economists blamed supply chains and the war in Ukraine. But now, he sees the impact of the Fed more than doubling the size of the balance sheet and the U.S. federal government spending trillions of dollars on major spending packages. “Inflation might be around for a while,” said Anderson.
“This will be unlike any recession period we’ve seen in most of our working careers,” noted Anderson, who explained that you have to look back to the 1970 and ’80s to find a comparable scenario. “I’m old enough to remember the inflation we had in the ’70s and early ’80s wasn’t an easy animal to dispense with. The Fed has got to be prepared that this might be a bigger battle.”
Despite the economic challenges, Belski said he remains bullish on equities. “I still believe that the U.S. stock market is the best equity asset in the world,” he said, adding that investors should be able to find opportunities in every sector. “You don't have to own everything, just be very selective.”
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DAVID CASPER: Good afternoon, everyone. I'm David Casper, U.S. CEO with BMO, and welcome to today's event. We all feel a bit of a shift in the economic environment, rapid high inflation, increased labor costs, continued fight for talent, and the Fed and the Bank of Canada repeatedly raising rates trying to prevent a recession. What we're also seeing is stellar job growth, great stock market performance one month, off the next, pretty volatile. And the real question is, are we heading towards a recession? That's the question today. Every industry is different. Every business is different. We have businesses represented all across both countries today. Understanding the economic context will be very important for everyone. And to that end, we have three of our experts today to give us that context. I'm really excited to introduce, for the first time in a BMO event, one of our newest colleagues, Scott Anderson, based in our San Francisco office, Chief Economist at Bank of the West, and he joined BMO's economic team after our February 1st acquisition of Bank of the West. And we have two of our mainstays on the call today as well, Earl Davis, Head of Fixed Income and Money Markets at BMO, he will explain what the Fed and Bank of Canada are doing to get us out of the inflation spiral and his perspective on if he thinks they will be successful. And the world-famous and my great friend, Brian Belski, Chief Investment Strategist at BMO Capital Markets, who will talk about how the markets are performing. Scott, let's get started right away with you. Again, welcome to BMO. Help us understand, Scott, some of the macroeconomic conditions that we're working through right now and what you expect in the near term.
SCOTT ANDERSON: Thank you, David, for that warm welcome. It's so great to at least virtually meet my BMO colleagues today. For those that aren't familiar with my background, I've been a professional macroeconomics forecaster now for nearly 30 years. And I've forecasted successfully through the Great Recession, the dot com bubble. Forecasting through this pandemic, to be quite honest with everybody on this call -- it's been one of the most challenging of my career. Maybe for economists all over the country, including at the Federal Reserve. Resaw -- just to get a sense of where we've been over the past 2 1/2 years, we saw Great Depression levels of job loss in 2020. There were a few months, the economy lost 22 million jobs, the unemployment rate peaked at 14.7%. It looked very, very dire. The U.S. government came in and close to $5 trillion in total of fiscal COVID support. The Fed Reserve doubled their balance sheet from 4 to 9 trillion, with all kinds of credit facilities that came in. So here we are, fast forward two years later, witnessing one of the fastest inflation rates in the U.S. in more than 40 years, one of the tightest labor markets in my lifetime. You have to go back 54 years to see a labor market tighter than it is today. So this economy -- and the Canadian economy -- is in an unfamiliar twilight of an economic and financial boom that is being rapidly (?) by both the Federal Reserve and the Bank of Canada. We're seeing restrictive monetary policy. And while we're not yet in recession -- we've had welcome rebound in economic indicators in the U.S. and Canada in January -- the risk of recession I still think is very high for the U.S. economy at least in 2023. I think the probability -- around 60%. So it's not a sure thing. It's not a slam dunk. I put about 50% probability that it's going to be a mild recession by historical standards. We're looking at something like a 0.8% decline in GDP, peak to trough, and maybe a loss of a million jobs with an unemployment rate in the U.S. moving up from 3.4% up to -- in the first quarter of 4.8%. But we're not there yet. And, you know, it looked pretty bad in the fourth quarter of last year. We ended on a weak note in the U.S. economy. We actually had a decline in real consumer spending in both November and December, so that consumer -- we've seen throughout the people really seemed to stall out and it looked like a recession might be imminent starting as soon as the first quarter this year. The strong January pushed back recession forecasts, including last week we thought we would have a mild contraction in GDP. Now it looks like it won't start to contract until the second quarter at the earliest, and it might even be the third quarter. The surprise is the resilience and strength and the tight labor market. We continue to see job growth numbers, January, 570,000 jobs created, 11 million positions in the United States, jobless claims in the early part of February are at historically low levels. Consumer spending jumped in January. A lot of that -- I'm going to be careful reading too much into that January jump. We had an 8.7% increase in the cost of living adjustment to Social Security. So we saw a really huge jump in disposable income in January, 18% pace. And a lot of that income growth was spent in January. 14.5%, we saw a nice jump in light vehicle sales, for example. A couple other things that play into the strong January numbers, possibly issues because of the middle winter. We saw for January both in the U.S. and in Canada. And as Dave alluded to, we have a strong stock market performance in January. We saw interest rates were falling, mortgage rates dropped in November down to 3.6 at the end of January. So we even saw some better news on the housing market front, the index jumped 7 points to its highest level since September. A lot of mixed signals. A real strong bounce, positive in the first quarter. Why I don't think it's going to last -- one, services inflation, inflation itself is quite sticky right now and it's still higher than the Fed or the Bank of Canada would like to see. So we expect continued rate hikes from the Fed at least for the next several meetings. My forecast, we've got rate hikes in March, May, and June. Tightening is going to continue all this year. The Fed balance sheet, 95 billion a month. And this one-time income gain that we saw in January isn't going to be repeated. The final point I'd make is just on the credit side, we do think monetary tightening is starting to bite some of the real economy. Where with see that showing up is a little bit on the bank side. If you look at the Fed's latest survey data, banks are tightening credit now across the board in almost all their loan portfolios. And we're seeing gold demand weaken. Even in the multifamily sector space, credit cards that have been really strong late last year, starting to show some signs of decrease. More traditional measures we look at, when we look at conference boards, leading economic indicators, it's been headed in one direction down over the past ten months since the Fed started hiking interest rates. It's been down -11 the past 13 months. And that seems to suggest a recession in the next three to six months. We've also got -- treasury spread, it's highly negative. That's been great financial market indicator of recession, usually negative on average 11 months before a recession starts. And that inverted in November. So the timing of this recession is not set in stone. There is a chance we get off with a fairly soft landing, but I think most of the indicators still point to a recession ahead. And the final thing I'd mention is maybe the housing market side. We're definitely in a housing recession. We've had six months of negative home price growth. Sales are down 30-40% in most markets. We haven't had a housing recession that didn't end in a U.S. recession. Starting in the second quarter, looking at decline, 0.8% and unemployment rate peak of -- 8.8. It's not anything like we've seen in past recessions that went from a boom to a bust because of the tightening. I did want to say a couple of things before we move on, a little bit on the inflation front. We have seen some positive developments on inflation. We mentioned a couple of them. But January's inflation data was disappointing, both on the consumer side and on the producer side. First the good news, we are seeing container prices dropping, supply chain pressures are easing. If you look at the Fed's supply chain index, it's not back to normal, but it's gone from a tightening four standard deviations to maybe one standard deviation. We've seen retail gas prices are still down 33% from peak. Container prices from China, the west coast of the U.S., L.A., are down about 94% from the peak in 2021. And we're still seeing early commodity price declines, broad commodity price indexes are down 23% from the peak. And just over the past month we've seen continued declines in aluminum, copper, and even oil. So we are still seeing those pressures easing. It's going to be a slog. It's not going to be -- one thing -- now from the January data is the service sector inflation remained hot in January, running 8%. Housing inflation, rising rents starting to come down, but housing inflation is still going up. And the rent component of CPI continues to go up and it's still rising at a 10% pace on an annual basis. So, it's easing, but it's too early for the Fed to declare victory here. I do think inflation is going to be lower at the end of the year than it was at the start of this year. We've seen high inflation in the U.S., 3.3% at the end of the year. The Fed's preferred measure of inflation, subtracting out food and energy, maybe around 3.6 from the start and 4.8. We're in a much better position a year from now, but it won't be until the end of 2024 -- inflation. Kind of how we see things here in San Francisco.
DAVID CASPER: Scott, thank you. Very thorough. And very helpful. Let me -- a couple things. I note our speakers are everywhere. You're in San Francisco, Brian is in New York, we have Toronto, and I'm in Chicago. Your comment about rents -- I don't know that they're going down in New York. I was there recently and they're going the other direction. San Francisco, they probably are going down, I assume. That's not my question, that's just -- my question really is back to labor. You talked about labor. Our sense is our clients over the last couple of months have taken the foot off the gas a little bit. The sense of urgency to make sure that they get every hire in they can before the next kid kits, that seems to be lessened. I'm just really looking at what your prediction -- you're precincting unemployment going up to close to 5, the high 4s?
SCOTT ANDERSON: 4.8.
DAVID CASPER: How many years out?
SCOTT ANDERSON: About a year, I think. So I do think we'll see some net job loss this year, but the timing is somewhat uncertain because of this lingering strength that we're seeing. We still have open positions in the United States. Jobless claims at this point are not showing a lot of layoffs, outside of Silicon Valley,it's been a drop in the bucket. It's still broad-based job growth. So, this is unfamiliar territory here, going from this boom situation. It's just -- I think if we don't get the loosening of the labor market the Fed is looking for they're going to have to push even harder, Dave. And that's this thing. The more resilience we see in inflation and the labor market, the more the median is going to go up and expect it to hike rates even further.
DAVID CASPER: We'll be watching it carefully. Thanks, Scott. We've seen the Fed and the Bank of Canada trying to get this under control. I'm going to hand it over to Earl to talk about the monetary policy changes and have him give us his view as to whether it's enough. So, Earl, over to you.
EARL DAVIS: Good afternoon, everyone. Thank you, Dave. I just have to say, I've been in fixed income markets since 1994 and it's the first time I've been described as a mainstay as a presenter. (Chuckling) The five minutes of fixed income thing from 2022, someone say infamy, has extended to two years now. Nonetheless, let's talk about monetary policy and bonds, testing 4% today, which is a big number in the U.S. But starting in the monetary policy, it's interesting. I look at 2023 as the year of easy hikes, so to speak. Trying to catch up with inflation. We saw the big numbers. The Fed had to get more restrictive. 2024 now is the year of hard hikes. And the reason why it's the year of hard hikes is twofold. One is the Fed has to take into account the lag impact of the hikes of last year. Typically it takes 18 months for those to flow through the market. We haven't seen the full impact. On the other hand, we have the resiliency of both the economy and inflation. And these are things that -- the Fed is trying to balance in regards to what to do next, how much to hike. And let me walk through why they're hiking. When the Fed hikes -- and Bank of Canada -- what it does, it reduces growth because the funding cost for businesses are higher, so you have less businesses because you have a higher hurdle. You have less businesses, what that results in is less employment. Less employment reduces inflation two ways. One is there's less people employed so there's less total income. Every dollar earned is a dollar possibly spent, so that's demand. And as well as it reduces the need to increase wages that 5% or 4% level instead of 2%. And both these things impact inflation. But the key is to get into what they call restrictive. And restrictive means it's less growth. But what we're seeing now is resiliency. And the Fed doesn't really know if they're restrictive yet. They believe they're restrictive, but it's the data they look at to confirm. We have one-off things in January -- strong employment, strong retail sales, rebounding PC. Those are just that, one print. So, the data for March and April is extremely important because you get two strong prints. That's a tentative trend. If you get three, that's a trend. That's going to determine what our Outlook for the terminal Fed fund rate is. The market right now is discounting the terminal is going to be 5.5. They see that basically late summer. That will change depending on the numbers we get in March. If we get a confirmation of the numbers we got last month, that will raise the terminal rate to 575. If we get the confirmation again in April, it will raise it to 6. People think 6%, can the economy handle that? I would reverse that argument. The reason why we're getting to 6% is because the economy's doing very well. And there's not a lot of slack in the economy. So that's an important thing to remember. And I believe the Fed and the Bank of Canada will lower hikes rather than higher, because of that lag effect. So we see 6% as a possible terminal, but now we can move to ten-year bonds. The drivers of ten-year bond rates are different than the drivers of monetary policy. You say monetary policy is inflation, what the central banks do. Ten-year bond rate is inflation-driven. That's one component. The second component is what they call real rate-driven, which is a reflection of growth, actually. So, part of the way you get lower growth is you increase the interest rate so people would rather invest in ten-year bonds than invest in a company. And then there's that risk that the Fed may be behind the curve so you need risk premium. There could be more inflation than expected. So, because of that, it's our sense that we tend to view the market in terms of pushing out and reducing the probability of a recession for 2023, because we believe the economy's more resilient. So there's a lot of credible paths here in regards to interest rates higher, interest rates lower. The one thing that will be for sure is increased uncertainty, increased volatility. So one of the key things to keep in mind is that it's not just about the destination, are rates higher or lower, it's about the path to that. Because similar to 2022, we see interest rates spike higher and then spike lower. And these are key things to remember in regards to the path dependency of interest rates. So, just to conclude here, the two key words for fixed income this year is resiliency and volatility. We see Fed funds terminal rate at around 50 -- possibly up to 50 base points higher than market, between 550 and 6%. And we do believe that this 4% ten-year yield now is a very important yield. If we do break it, which it seems like we will, we could go to 4.25, 4.5 before rebounding again. And with that, I'll conclude.
DAVID CASPER: Earl, I'm going to put you on the spot. You're now in Vegas. Okay. 100 basis points increase from today in interest rates. And you can pick five, ten, or two-year. What are the chances it will be more than a hundred or less than a hundred? You can tell me -- I'm going to hold you to this, so I want you to tell me what index you're thinking.
EARL DAVIS: You know what, it's an interesting question, because right now ten-year rates are 4%. And three weeks ago they were 330.
DAVID CASPER: I know.
EARL DAVIS: They've sold off by 70 basis points. You would argue getting to 3% is easier than 5%. However, I do believe in the resiliency of the market and I won't go into the details now, but because of QE, the impact of the Fed hikes is being blunted. So I do believe that the economy could be very resilient and surprise to the up side this year, which means I think we see the 5% level before we see the 3%. But there will be more people that would tell you 3% than 5%, and I'll take the other side. >> DAVID CASPER: All right. That's on the record. And not only will I remember it, but our next speaker will remember it as well. So, thanks a lot, Earl. Now we're going to Brian, Chief Investment Strategist for BMO. Brian has been our right in terms of the direction of the market since I think 2010, maybe 2009. And he's a long-term guy. He's always been optimistic on the markets. And I guess the first question to you, Brian, are you still optimistic?
BRIAN BELSKI: Well, Dave –
DAVID CASPER: And welcome.
BRIAN BELSKI: Oh, my gosh. What an honor. I must say that you are my favorite U.S. bank CEO, let me just say that. Thank you so much. We remain resolute. I believe it. Eight out of ten years historically the stock market is positive, so we'll take those odds, number one. Number two, we still think the U.S. stock market is in the midst of a big 25-year secular bull market. When you go back and look at history, you actually have seen several secular bear markets -- I'm sorry, secular bull markets where you can have down years, or you can have a flat year. And through this secular bull, Dave, that we think started in 2009, we've had flat years and we've had three negative years -- 2018, 2020, and 2022. If you go back to the 1930s, there's only been three periods in the history of the markets -- three -- where we've had consecutive negative years. 1938, 39, and '40, 1973 and '74, and 2000, 2001, and 2002. What are the parallels to those three? Crisis. America was at crisis. First we had the Depression going into World War II, then the oil embargo, double dip recession. Then we had the CapEx-led recession thanks to tech and then, of course, the terrible occurrence of 9/11, which caused even deeper recession. I don't think we have a crisis right now. I don't. And yeah, I think you can either be bitter or you can be better. And so let's be better. And I think the U.S. stock market is amazingly resilient. You talked about in the beginning of the call, January was good, February was bad. It's been a little bit Charles dickens, you get the best of times, the worst of times. Investors should get used to that. I wrote my first research report in 1989 when I was six years old. And, you know, I've seen a lot in my career. I've been very blessed. I've been doing this for a long time. And one of my very first mentors on Wall Street used to tell me there's always something going on. There's always something interesting going on. That hasn't changed. What I think has changed is the binary nature, Dave, of how people are trading their accounts and looking at investments, not long-term, more short-term, very reactionary and looking at macro-statistics, again, no disrespect to the two prior speakers, but it's time for fundamentals to leave. And I still believe that the U.S. stock market is the best equity asset in the world, period. I live by this rule that stocks lead earnings which lead the economy. I believe there's so many people focused on trying to figure out the Fed and the economy -- I think it's really, really difficult. And when it's difficult, you default to quality. And so I really tend to want to be in more like value stocks, small mid-cap stocks, quality stocks, and growth at a reasonable price. The market environment we think that we're heading into for the next 3-5 years -- we haven't used the term on the call -- is normalizing. So in Earl's world, the average ten-year treasury since 1979 is 5.8%. The average ten-year treasury if you don't include the financial crisis is 7.6%. The average ten-year treasury since the financial crisis is 2.4%, Dave. If you've only been in the business since 2009 or 2010, what we have now is, of course, higher interest rates. But we're normalizing. So, we can normalize interest rates. We're going to normalize valuations. We're going to normalize earnings growth to single-digit, high double-digit performance in the stock market, so kind of back to the '80s. A great decade of packer teams -- not really. Not great biking teams, either. Better Minnesota Twins teams. But it was a period where fundamentals led, and we had different sector dynamics. From a sector perspective, Dave, we love financials in Canada and the United States. And we still believe that Canadian financials are the most excellent stewards of capital in the world. We do a great job with respect to paying dividends and buying back stock, but managing our businesses, in Canada, we also like the material sector. We love gold and we love communication services in both areas. In the United States we like more of the growthier areas like Netflix and Google within communication services, but we think the communication services in the United States is the quintessential barbell, growth and sector. Healthcare had a great year last year. There's a lot of great value dynamics within healthcare. And lastly, don't abandon tech stocks. Just be much more selective. You don't have to own everything. Just be very selective and on kind of what we like to call the consumer-stablish type tech that have great earnings, leaders in the marketplace, important not only dividend-growers over time, but very strong earnings growers. So our year in target is 4300. That's our base case. Earnings are going to be down 5%. That's much less than what everybody else thinks. Given where cash flow is and operating performance of companies in the United States, we don't see the earnings recession like everyone is scaring everybody because they're looking at the index level. And I'll leave you with this. The stock market is a market of stocks, okay? So many people out there are focused on what the S&P 500 is doing, or the Dow Jones average. What you said in the beginning, you hear in the financial press about recessions or inflation. Every company is different. Every industry is different. Every sector is different. And that's why you have to really focus on the stock market is a market of stocks, look for positive returns ahead. With that, Mr. Casper, back to you. >> DAVID CASPER: Hey, thank you, Brian. And thank you for that shameless plug on Canadian bank stocks.
BRIAN BELSKI: (Laughing)
DAVID CASPER: We got a lot of questions. People are asking is he really only 38 years old?
BRIAN BELSKI: (Laughing)
DAVID CASPER: So, let me -- before I turn it over to other questions, I hear a lot lately -- you touched on it. The market has been pretty up and down. And you've got a call of 4300, is that what you said?
BRIAN BELSKI: Yep.
DAVID CASPER: But it could be 38, could be 35, you don't know. What do you say to the people that say hey, I can just wait that out and get almost 5% with a two-year? Brian, I know you're optimistic, but it's a 25-year bull. Why do I have to take my lumps?
BRIAN BELSKI: Well, no one can time the market. That's why you have to be a long-term investor and have a great relationship manager. I would say this. I think, you know, one of the things that frustrates me the most is that we in the investment world love to pick on the stock market, but the bond market had a 40-year bull market and was contentious and frothy. And I think if Earl's right and we're going to be at higher levels than go down, then you probably should have a mixture of treasuries. And this notion of 60/40 becomes a lot more relevant, to have that with respect to a much more diversified portfolio. We always think in the investment world of we're only stocks, we're only bonds. I think we're entering a period, much like the '80s and the early '90s, if you remember what happened in '94 and '95 where you could own both stocks and bonds together and they work very well together. So I think we're entering one of those periods again.
DAVID CASPER: Great. Thank you. We actually had over 100 questions that came in ahead of time. We've gotten through a number of them already. We're not going to be able to answer all of them, but I will try to consolidate. I'll start with you, Scott. This came a couple of different times. What do you really think the long-term effects are of this sustained inflation that we're in right now?
SCOTT ANDERSON: Well, this inflation broke out, we blamed it on supply chains, and then the war in Ukraine. But I think there is a demand element to this, no doubt about it, with the Fed doubling -- more than doubling the size of the balance sheet and federal government continues to spend trillions of dollars in COVID relief and other big spending packages, including the CHIPS Act and others. This might be around for a while. I mean, I'm old enough to remember the inflation we had in the '70s and early '80s, and it wasn't easy to dispense with. So I think we have to be humble. And I think the Fed's got to be prepared that this might be a bigger battle, which means higher interest rates probably for longer, normalization, whatever you want to call it. But it's away from global stagnation scenario that Larry Somers has been talking about for the last 20 years. This is really a different environment. And I've been telling our clients and customers that this -- recession we've seen in most of our working careers. You really have to go back to those recessions in the '80s or '70s to see a sort of scenario like this for the economy. It's not one of these slow job creation recoveries that we saw in the '90s or 2000s. Financial bubbles, deflationnary recession. We're in a different sort of situation.
DAVID CASPER: Thanks, Scott. Earl, along those lines, but a different angle. When you look back over the last 18 months, what changes do you think the central banks might be -- what changes in their behavior might we see now going into the future based on the surprise we've had over the last 18 months?
EARL DAVIS: You know, I think it's somewhat of what Scott said. It's an acceptance of higher inflation, not 5, 6, 7%, but maybe 3 and 4. In 2021, both central banks, Canada and the U.S., signed agreements with their governments saying we have an inflation mandate for the next five years to get it to between 2 and 3. What I think -- when those expire in 2026, that inflation mandate will be higher. So what we're undergoing is a secular change for central bankers. It's going to be a ten, 20-year period of higher inflation, higher volatility, generally higher interest rates. And that will be reflected in the higher inflation target and acceptance of higher inflation, which is not necessarily a bad thing. And I think they would rather do it sooner, but they have this mandate they have to live up to.
DAVID CASPER: Thanks. Brian, I remember probably a little bit over a year ago, right when the war was breaking out with Ukraine. And you had a pretty good view at the time of what might happen, which I think has been generally right. But what do you think the impact on the markets is now going forward in terms of the war in Ukraine and the likelihood that it may last for a while?
BRIAN BELSKI: That's a great question. And, you know, when you're bullish in a down year, it's humbling. You have to be humble sometimes in the market. The minute you think you know everything, it's probably time to get out of this business. Everyone is so convinced now on the opposite side. So think there needs to be actually a little bit more humility on the bears, to be frank with you. But in terms of the timing of things, we were right in the direction, we were wrong in the timing with respect to some of these things unwinding. And I think people digesting what's happening on a geopolitical front -- think about last year from an equity perspective, how well European stocks did and emerging market stocks did last year, Dave, in the midst of what was happening in Europe. In Europe, Earl can speak to that with respect to what they're doing on the monetary policy side of things, but they're just beginning to clean things up. So, I think obviously there's always -- in this marketplace, there will be events, now we have increasing tensions with China as well. You know what you can know. You have to control what you can control. And that's why from an equity perspective, you have to have quality. Now, I will tell you, Dave, many of my more seasoned institutional clients that maybe have a little bit of this did not believe in the January rally and have been sitting on cash and they're kind of waiting for this thing to flush out a little bit. And so I think that's also a sign of, kind of, being prudent and waiting. And there is going to be some volatility, but you have to pick your spots and not try to time it.
DAVID CASPER: Okay. Scott, we have had the supply chain issue has been with us for a long time. And the pendulum has probably shifted now. I don't know that in some cases, that demand is still outpacing supply. Where do you see it going from here, and do we have the chance of maybe going the other way with demand really falling off and supply picking up? What's your sense there?
SCOTT ANDERSON: We've got some great -- today China, releasing their manufacturing -- big jump, some of the best numbers they've put out in more than a decade. So they're back up and running, right. Zero COVID is over there and their factories are up and running. We've seen evidence in our data in the U.S. and Canada, they're starting to rise. We're seeing some inflation of inventories, supply delivery times are coming down, manufacturing. There's other data, too. You look at container price from the China to the west coast, that's down 94%. The Fed's got a supply chain measure they put out every month. That's been continuing to come down for more than a year. It's not back to normal, but it's moving in the right direction. There's a lot of uncertainty around if there was conflict that broke out in the south China sea, or the war in Ukraine worsens or broadens out, there could be emergence of some of these issues. I think we're going to continue to see supply issues in spotty markets in certain industries as we try to bring more production back to the U.S. and places like Canada and Mexico and other southeast Asian nations as we try to move some production out of China to Vietnam, India, and other locations. So that could raise costs of production. Big companies now know they need to have robust supply chains, probably more than one supplier in some cases. And so that's going to raise the cost of doing business beyond just the labor market shortages that we've already talked about.
DAVID CASPER: So, before I go to the next question, Brian or Earl, do you have anything to add to that?
EARL DAVIS: I do not, no.
DAVID CASPER: Brian, you're good? So, Earl, you probably -- I'm interested in anybody's view on this. We get a lot of noise about the debt ceiling and what might happen. What's your view on what impact that is or has already had or might have on rates?
EARL DAVIS: There's a definite impact. Because right now what the treasury is doing, they're using their cash to pay off their bills instead of issues more treasuries. Once the debt ceiling is solved, there will be a higher issuance of treasuries, which could put more pressure on that ten-year bond, which is another reason why I'm erring towards the side of higher yields. So I think that's the important thing. The other thing is, if they go past the 11th hour, that leads to increased volatility and higher yields on the back end as well, too.
DAVID CASPER: Okay. Thanks. Scott, we've got a lot of Canadians on the line asking about the Canadian housing market. I don't know if that's for Scott, Earl, or both of you. We have a number of questions on our earnings call yesterday.
SCOTT ANDERSON: I'll take a shot at it. Canada is going through a lot of the same issues as the U.S., but maybe even more on steroids because of the demographic, markets like in Toronto. So the general view -- economics of BMO is we'll continue to see home price declines this year. Maybe another 5 to 10% decline in Canadian home price this is year from what we've already seen already. So it's a decline in home prices. But remember, we were up 40-50% in home prices before the pandemic began. So a lot of folks are still going to see -- housing's still not going to be super affordable as-is. Mortgage rates continue to move higher. We think they're going to be 7% sometime this year. The housing affordability issues are going to continue to be in place. Some of the stability we saw in housing stocks and confidence in January might be a little premature. We could see those numbers coming back down.
DAVID CASPER: Great. Brian? I know you love North America, but one of our questions is what about emerging markets specifically India and China? How much would you invest there? What's your advice?
BRIAN BELSKI: Well, a lot of the performance in emerging markets last year was due to the dollar, quite frankly. And so from a fundamental perspective, we still like the quality and stability of North America. I kind of go back to a story I've told a lot that I was very blessed and fortunate to have the ability very early in my career to meet Warren buffet. He Said Never Buy Anything unless you can reach out and touch it and understand it. We have thousands of companies in North America we can buy. I don't think there's any reason why you have to own things overseas unless you have this want and need to be diversified in those areas. There's a lot of great companies in Canada and the United States that keep you away from geopolitical risk and India or China. Remember, this major theme of on-shoring with a lot of companies coming back to North America is going to put pressure on some of these emerging markets areas as well. So why not stay home?
DAVID CASPER: Why did I know you were going to say that? Okay. Here's one that's going to hit very close to home. And this could be someone in the U.S. or Canada. The question is -- I can't read it. To those of you who have an imminent mortgage renewal, ours being August 1st, what would be the recommendation regarding the type and term for the next renewal? Okay, you guys. This is going to affect somebody's pocket. Earl?
EARL DAVIS: I had to answer this for my brother-in-law. He asked me this question.
DAVID CASPER: It might have been him that asked. If it was, Earl, by the way, he didn't like your answer.
EARL DAVIS: I didn't ask what he did. I stay in my happy world. What I said to him, I said, by locking in term you could create a win-win scenario. Let's say you lock in a three-year fixed term and rates go down. Your mortgage would have been less, but your house price goes up. Say you go variable term and rates go up, you're going to be out of luck on the pricing valuation of the house. So fixed income guy, I'm more conservative, obviously. I prefer the term and not taking the bet on the variable and create a win-win scenario for myself versus the asset value of the house. That was what I told him.
DAVID CASPER: Anyone else want to weigh in?
SCOTT ANDERSON: Yeah, I'd say lock in now. Rates are probably going to continue, at least for the next 6-12 months. If you're in the market, lock in that rate. We did see that nice drop in 30-year mortgage rates in November. It has come up quite a bit already. But it could be even higher.
EARL DAVIS: One more thing. The curve is inverted. Locking in for term is less than your variable.
DAVID CASPER: Brian would say borrow as much as you can and put the rest in the market. You guys have been great. I think our time is up. I can't thank you enough. I thank all of our clients and our employees, and anyone else that's on this call for joining it. And we'll be watching carefully. We'll keep track of what you guys said. And it's been my pleasure to be with all of you. So, thank you very much. >> Thank you.
David Casper
U.S. Chief Executive Officer, BMO Financial Group
David is responsible for the overall performance of BMO Financial Corp., BMO Harris Bank N.A. and their subsidiaries. He is also responsible for ensuring effective …(..)
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Brian Belski
Chief Investment Strategist
Brian is the Chief Investment Strategist and leader of the Investment Strategy Group, provides strategic investment and portfolio management advice to both ins…(..)
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Earl Davis
Head of Fixed Income and Money Markets
Earl Davis joined BMO Global Asset Management in 2020 and brings over 25 years of fixed income experience. Prior to joining BMO, Earl led an investment division res…(..)
View Full Profile >The North American economy continues to send conflicting signals. While the U.S. Federal Reserve and the Bank of Canada struggle to curb record-high inflation with a string of rate hikes, their moves have done little to cool equity markets and employment gains. When will rising interest rates start impacting the economy and will higher borrowing costs and continued rising inflation tip North America into a recession?
To address these questions BMO Financial Group’s U.S. Chief Executive Officer David Casper convened a panel titled “Will We or Won’t We? Inflation, Rising Interest Rates and the Threat of Recession” to explore how this unprecedented economic moment may unfold. He was joined by Scott Anderson, Chief Economist at Bank of the West, which after the recent acquisition by BMO is the newest member of the BMO economics team, Brian Belski, BMO Capital Markets’ Chief Investment Strategist, and Earl Davis, the Head of Fixed Income and Money Markets for BMO Global Asset Management.
While the panel was reluctant to say if or when the U.S. or Canada might enter a recession, they said investors need to prepare for a bumpy ride. “The U.S. and Canadian economies are in an unfamiliar twilight of an economic and financial boom,” said Scott Anderson. “Forecasting through this pandemic has been one of the most challenging of my career, maybe for economists all over the country, including at the Federal Reserve.”
Resilience and volatility
Anderson said there’s a high risk of a U.S. economic recession in 2023, possibly in the next three to six months – although it’s not a sure thing. “I put the probability at around 60%,” he said. He expects a two-quarter downturn possibly starting in the second quarter of 2023, with a 0.8% decline in U.S. GDP from peak to trough, a loss of a million jobs and the U.S. unemployment rate moving up to 4.8%.
Overall, Anderson said he expects inflation to be lower at the end of 2023 than when the year began and believes it will take until the end of 2024 before the Fed reaches its 2% inflation target.
While Anderson said there is a high risk for recession, Earl Davis noted that fixed income markets are sending a different signal. “We read the (bond) market as pushing out the probability of recession and reducing the probability of one in 2023,” he said.
Regardless of the level of risk of a recession, the panel agreed it won’t be a smooth ride. According to Davis, the only certainty about fixed income in 2023 is increased uncertainty and volatility. “Keep in mind that it’s not just about the destination now – rates higher, rates lower – it’s about the path to get there,” he explained. “Similar to 2022, we’ll see interest rates spike higher and then spike lower.”
Economic data in March and April will play a major role in how high the Fed ultimately raises its target range for the fed funds rate. “If you get two strong prints, that’s a tentative trend,” said Davis. “And if you get three, that’s a trend.” In February, it rose by 25 points to 4.75%, from 4.5%, a smaller increase, but an increase nonetheless, based on January data that showed strong employment, strong retail sales and a rebounding consumer price index.
At the moment, the bond market is signalling that the Fed will top out at 5.5% in late summer, but Davis said the March economic data will determine if that sticks. “There’s not a lot of slack in the economy,” noted Davis. Against that backdrop, he said the Fed may need to raise interest rates to as high as 6%, although he thinks if the Fed and the Bank of Canada do raise rates again, it will be by 25 basis points.
A return to fundamentals
As for the equity markets outlook, Brian Belski remains optimistic that the slide has stopped. “We still think the U.S. stock market is in the midst of a big 25-year secular bull market that started in 2009,” he said.
Belski noted that historically, the stock market has only experienced three consecutive negative years – all during moments of economic crisis: 1938-40 (Depression), 1972-74 (oil embargo), and 2000-02 (tech bust and 9/11). “I don’t think we have a crisis like that right now,” he said, but investors need to play it smart.
He believes that too many people are trying to figure out what the Fed’s next move will be and where the economy is headed. “That’s really difficult to do, and when it’s difficult, you default to quality,” said Belski. “It’s time for fundamentals to lead.” In this environment, Belski said he would look to value stocks, small and mid-cap stocks, quality stocks and growth at a reasonable price.
This is a return to normal, he argued. Until recently, interest rates have been well below long-term averages since the 2008 financial crisis, so Belski said he expects there will be a rebalancing in the next three to five years. “We’re going to normalize valuations, we’re going to normalize earnings growth to single-digit earnings growth and high double-digit performance in the stock market.”
With that will come a shift back to investing fundamentals like stock selection and diversified portfolios, like the 1980s and the early 1990s. “In ’94-’95, you could own both stocks and bonds and from a total return perspective, they worked very well together,” he said.
A new reality
All of the panellists shared the view that financial markets are entering a new era. “We’re undergoing a secular change in inflation,” said Davis, in which modestly higher inflation of three and 4% will be acceptable. He pointed to the five-year mandates central banks in Canada and the U.S. signed in 2021 to keep inflation between 2% and 3%. “When those expire in 2026, the inflation mandate is going to be set higher. The central bankers realize it’s going to be a 10- to 20-year period of higher inflation, higher volatility, generally higher interest rates,” he said.
Anderson also sees a larger shift underway. When inflation first broke out, most economists blamed supply chains and the war in Ukraine. But now, he sees the impact of the Fed more than doubling the size of the balance sheet and the U.S. federal government spending trillions of dollars on major spending packages. “Inflation might be around for a while,” said Anderson.
“This will be unlike any recession period we’ve seen in most of our working careers,” noted Anderson, who explained that you have to look back to the 1970 and ’80s to find a comparable scenario. “I’m old enough to remember the inflation we had in the ’70s and early ’80s wasn’t an easy animal to dispense with. The Fed has got to be prepared that this might be a bigger battle.”
Despite the economic challenges, Belski said he remains bullish on equities. “I still believe that the U.S. stock market is the best equity asset in the world,” he said, adding that investors should be able to find opportunities in every sector. “You don't have to own everything, just be very selective.”
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