October 19, 2022Education Financial literacy Economy Commentary
The Upside-Down World
Lately, it feels as though the market has been living in an upside-down world. Good news is bad, and has been causing volatility to the downside. Oppositely, bad news appears to be good for the market, and it seems to cheer on data like lower housing starts, higher unemployment, and decreased demand. Most people would think of this as counterintuitive to what would be good for the market. So, what is the reason for this? Simply put, Federal Reserve Chairman Jerome Powell and inflation rates.
First, let’s discuss inflation. I’m sure many of you have noticed that the word “inflation” is widely considered the biggest buzzword of 2022. Up until this year, inflation was a statistic that nobody had thought too much about, aside from the early 1980’s and more mildly in the early 1990’s. That said, why is this statistic so important, and how did it get to where it is now? In its most basic definition, inflation is a broad measure of the overall cost increase of living in a country, like Canada for example. The job of the federal reserve is to keep inflation rates around the 2% point. Currently, we are sitting at 7% in Canada and over 8% in the USA. So why is inflation that is normally 2%-3% now at over 7%? The reason is due to the increase in the money supply into the economy over the past two years since the start of COVID. Between government assistance and extremely low interest rates, the amount of money in circulation has increased substantially.
Let’s look at a simplistic example to help understand inflation better. In January 2019, if there were 10 apples and $10 available in the economy, then each apple would be priced at $1.00. If by 2021, there is now $12.80 in the economy (which is the actual increase in the money supply in Canada from 2019 to 2021), then in theory, each apple would now cost $1.28. Now, let’s add in a supply chain issue and instead of 10 apples, we can only produce 8. Now the price becomes $1.60 per apple. Although simplistic, this is essentially what has happened to the economy only on a much larger scale.
In the last 6 months, we have seen the Central Banks starting to step in and say that these price increases are way too high and are figuring out how they can get them down. The way to cool the economy is to raise rates, which raises the cost of borrowing. If you raise borrowing costs, less people borrow money, which results in them buying less. Eventually the affordability of housing goes down leading to a decrease in the price of houses, and a chain reaction of less spending follows. In theory, this should eventually begin to lower inflation.
Now, let’s go back to why bad news is good, and vice versa, in the market recently. When employment levels are high, demand for goods is high and people are still building and buying houses. The market looks at this as a reason for the Bank of Canada and the Federal Reserve to continue to increase rates. If rates increase, a few things could happen: people could be pushed into poor debt situations, companies will have to pay more to borrow, and if they push it too much, the economy can slip into a recession. This is the delicate balance the market is currently in, and it’s why we are seeing so much volatility on a daily basis. Volatility that many people have forgotten existed.
As I have said before, the market is a forward-looking mechanism and it tries to predict out 12-18 months ahead. If you say, “it’s obvious that we are heading toward a recession”, it doesn’t necessarily mean that the market will continuously move lower as some of that potential is already priced into the current stock price. This is why the best times historically to buy are when markets are down. Remember, things don’t have to get better, they just have to get “less bad.” This is a concept that many investors struggle with, and they often give up on their strategy when they see the gloomy headlines we are seeing as of late. This isn’t the time to do that, it’s actually the time to do the opposite. In the early 80’s, as inflation started to abate but before it got back to a normalized level, the S&P 500 gained 154.33% and went on an 8-year positive return streak to close out the decade. Again, as Mark Twain says, history doesn’t repeat itself, but it often rhymes, so remember that markets do recover and always have. We will still have volatility and we can still go down further but at some point, news will get “less bad” and the markets, whether it be stock or bond markets, will rise again.
To close, there are a few brief points I would like everyone to remember as we head into the last quarter of 2022.
- The S&P TSX has only posted negative returns back-to-back during 2 periods since 1920. One being the great depression of the 1930’s and the other being the tech bubble in 2000-2001. (Source: Confluence)
- 74% of the time, Canadian equity markets have posted calendar returns above zero (Source: Confluence)
- The average loss in bear markets is 34% with an average length of 14 months (we are at 10 months). While the average gain in bull markets is 110% with an average length of 37 months (Source: Canadian Institute of Actuaries)
- As many times as I’ve heard this time is different, history shows that it hasn’t been. I can point out a major event in each year of my career that would cause investors to stay away from markets but over that period they have moved substantially higher, and this includes going through 2008.
- Assets across the board are down in value, not just the equity markets. However, equity markets are one of the few assets that are priced daily. Home values are down, used vehicle prices are down, collectible values are down, the list goes on. Make sure that we put that into perspective. If you don’t need the funds today, the daily valuations shouldn’t matter.
- As fixed income investments roll over, higher rates are locked in, and as mentioned before, this will benefit a vast majority of clients and will create a higher income in retirement. Last year the 1-year GIC rate was .75%, this year it is currently 4.55% as of 9/21/2022.
CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc.
Adam Slumskie is an Investment Advisor with CIBC Wood Gundy in Sault Ste. Marie. The views of Adam Slumskie do not necessarily reflect those of CIBC World Markets Inc.