Canada’s inflation rate eased in August, suggesting aggressive rate hikes may be starting to take hold. But Michael O’Brien, Portfolio Manager at TD Asset Management, tells Greg Bonnell even with a cooler reading last month, higher rates and market uncertainty will likely continue.
- Canadian inflation eased for a second month in a row in August, but it's still sitting at an annual rate of 7%. Of course, that's much higher than the Bank of Canada would like to see. Joining us now for what it means for interest rates and the economy overall, Michael O'Brien, portfolio manager at TD Asset Management.
Michael, great to have you back on the program.
- Yeah. Thanks for having me back.
- All right, so the big fight this year, obviously, has been against inflation, front and center for the central banks. And then we get a little cooler than expected print. Does it do all that much for the path of bank policy in this country?
- I don't think it has a big impact on the next decision or two. I think the Bank of Canada is pretty locked in as to what they want to do in the next meeting or so, but it's clearly a step in the right direction. No question about it.
I think everybody realizes we need to see inflation come down so that the central banks can back off, and we probably need the central banks to back off before equities as an asset class start to move significantly higher. And so the fact that we've now had a couple of months in a row where inflationary pressures seem to be peaking, if not backing off too, too much, that's got to be taken. Let's take the wins where we can get them. This was a good news report.
GREG BONNELL: We'll take the wins where we can get them. At the same time, we talk about eventually, down the road, what it means for equities and for our equity portfolios. After the little summer rally, it's been a tough go again. As we said, the Fed is on deck for tomorrow. And depending on how tough Jerome Powell wants to speak to us, so let's-- no, I want to get your opinion on that.
How tough is he going to speak to us? Because we had that summer rally, and then you get Jackson Hole. And sometimes Jackson Hole can be a bit sleepy. But he had some stirring words, and they seem to be taken to heart, finally.
MICHAEL O'BRIEN: Yeah. Well, I think that's exactly it. So if you think back to earlier in the summer, pre-Jackson Hole, I thought that the FOMC, the Fed committee, had been pretty clear about what they wanted to accomplish. They wanted to move fast, quickly, sort of the front loading of the policy rate hikes, the same as the Bank of Canada, the same playbook.
And they communicated, we want to get them up to a level that's going to slow inflation and accordingly, slow growth. And then we want to hold them there for a while and see what happens.
But if you go back to-- I think it was July, there was a lot of market enthusiasm about a so-called Fed pivot, which was to say that the Fed was on the verge of backing off. And clearly, that was not at all the intention. So I think Jackson Hole was really Chairman Powell setting the Street straight and saying no, no, no, that's not what we're talking about. Rates are going to be here for a while.
And so I think that really, the wake-up call was back then. I think more and more people, as the weeks have gone by since Jackson Hole-- more and more people are getting the message that you know what? Rates are going to go higher from here, and then they're going to stay there for a while. I think that was the disconnect that the FOMC was probably troubled by in the summer.
Most of the investors, most of the forecasters had rates going up to 3.75%, 4%, 4.25%, which I think is a realistic landing point for the Fed policy rate. But then they had these interest rate cuts coming in in the second and third quarters of 2023, and I don't think that was acceptable to the FOMC. That's not what they wanted to communicate.
So I think most people are on a more realistic plane right now, on the same page as the FOMC. So I wouldn't expect the same magnitude of surprise coming out of tomorrow's decision. But at the same time, I don't think we should be under any illusion that they view their job as being done. There's more work to do here.
- More work. They said there would be pain as well. So when we take it back to the health of our portfolios, we do know the central bank, whether it's ours or whether it's the Fed, are pretty serious about trying to tame inflation.
In that pursuit, of course, the big concern is, they go too far and then you don't get a soft recession, or a gentle recession, or whatever it is that we hope a recession could look like that won't hurt us too much. You get some tough times. That doesn't sound like a great outlook for equities if they can't sort of land that soft landing
- No, and obviously, we've been seeing that reflected in the broader market action for several months now, right? We've got to be realistic. This is a difficult environment for equities as an asset class.
By that, I mean if central banks are tightening pretty much in unison across the planet with the possible exception of China and Japan, everybody else is tightening policy rates. Growth is slowing because it needs to. Inflation is enemy number one, like I say, not just here in North America but across the planet.
That is, generally, a difficult time for equities as an asset class to shine. It doesn't mean there aren't opportunities in the market. It doesn't mean that some stocks don't present opportunities, and it also doesn't mean that we're going to be in this state forever. What it means to me is we just have to be a little patient here.
Better days will come. But in order to get to that point, we do need the central banks to stop raising rates. And the only way the central banks are going to stop raising rates is if they collectively see inflation beginning to come down not just in a one-off, not just one good report but on a consistent basis across a broad spectrum of measures.
And so, like I said at the beginning, this was a nice outcome for the Canadian CPI report today. Because not only did you see the headline number come down, and not only is it down nicely on the month, it's also down over a percent from June. So we're making progress.
But more than that, it's sort of beneath just the energy shock and, OK, gasoline prices were up, gasoline prices were down. The broader core measures of CPI in Canada actually trended in the right direction this month.
And so I think what we need to see to get really more constructive on the market as a whole is, we need a few more prints like this, where the core measures, the broad swath of incoming price data is indicating that the worst is behind us. Because that's what the central bankers need to see to back off.
Once the central bankers feel that they've done enough and can communicate to the markets that policy rates probably aren't going up a lot more, I think that's when we get more constructive, sort of the all-in-on-equities trade. But that isn't today. We still have a ways to go to get there.
- You mentioned patience, right? Is that going to be the hardest bit of discipline here for investors? I feel like we've gone through a long period where we didn't have to be patient, where were the Fed or someone else would meet our needs if we weren't happy with the state of things. And now, we're just being told, listen, it's a long road, and we're not going to run to the rescue.
Patience seems to be-- I should have it at my age, and I feel like I don't have patience for anything more anymore.
- Yeah, who does?
GREG BONNELL: Yeah.
- No, I think you hit on a really important point, which is, this is a different environment than most of us have gotten used to over the last decade. Over the last decade, the issue was that central bankers couldn't get enough inflation. They kept undershooting the policy targets. And so because of that, every time it seemed like growth would waver, like you said, or there was trouble on the horizon, something happened, something broke, the central banks were very quick to come in and fix it. Because what they were fighting was inflation that was undershooting the target.
So that's why the Fed was always our friend through that whole period. You hear the reference to the Fed Put. In other words, the Fed's going to save the day. And they pretty much did for the better part of 10 or 15 years, I guess, going back to 2009.
This is a very different environment. Right now-- so that was an alignment of interest. Investors and policymakers both had the same interests, which was to protect growth so that inflation could get back to target.
Now those two parties are no longer aligned. Investors don't want the same thing as the central bank wants. The central bank wants slower growth and higher rates, less inflation. We tend to want lower rates and higher growth. [LAUGHS] We're no longer on the same team.
And so when you get this divergence, when they're no longer aligned, that old maxim, don't fight the Fed, tends to carry the day. It's the central bankers that will prevail in this battle. And so to your point, that's why we have to just be patient and let this process play out.