As investors continue to grapple with high inflation and increasing volatility in financial markets, the prospect of slowing economic growth driven by rapidly rising interest rates presents a more challenging threat. Greg Bonnell speaks with Michael Craig, Head of Asset Allocation and Derivatives, TD Asset Management, about the outlook for markets going forward.
GREG BONNELL: Well, investors have been grappling with red-hot inflation and what it means for our portfolios. Well, our feature guest today says another storm is making its way to the markets. Joining us now is Michael Craig, Head of Asset Allocation at TD Asset Management. Michael, it's great to have you on the program.
MICHAEL CRAIG: My pleasure, Greg. Great to be here.
GREG BONNELL: So we are all well-acquainted with the inflation storm. We all live it when we go out and buy groceries, when we gas up the car. Tell us about this new storm.
MICHAEL CRAIG: So the inflation story has really been about supply, mostly. And that certainly has come under pressure this year. And to bring that down, you've seen tremendously aggressive hiking policy-- Bank of Canada, Fed, other central banks-- hikes that we haven't really seen in about 40 years in terms of magnitude. And that's going to have material impacts on growth. Certainly, you are already seeing the interest rate-sensitive parts of the economy slow. And I don't think central banks are anywhere near finished.
And that is really-- now we're kind of seeing these two things. We joke about-- it's a Fujiwhara effect, where you have two cyclones collide. My sense is, though, that while inflation is really kind of the topic du jour, it's the growth and/or recession story that's going to be on people's minds over the next six to nine months. And, arguably, we might already be in technical recession in the US right now.
GREG BONNELL: Now, the way you frame it, it might be one thing to see one storm pass and the new storm, which is slowing growth, as you say, come in. But you're talking about two storms colliding. That doesn't sound good at all.
MICHAEL CRAIG: Well, the challenge is that you want to see inflation fall quickly, because then central banks can take the foot off the gas in terms of hiking rates. The challenge is-- and so it's a bit of a race now to see-- you know, on one hand, you've got materially slowing economies. On the other hand, you have inflation that is still quite sticky. And some aspects of inflation aren't really going to roll over. The rent aspect isn't going to roll over anytime soon.
And so, for investors, the key thing or decision right now is, what's falling quicker? I think we'll have a better idea by the fall. It takes a few quarters, typically, for policy to start to tame inflation. And I think we'll have a better idea of it then. Until then-- I think days like today-- days like last week, the markets were quite jubilant. Today, not so much-- so continuing to see quite a bit of volatility across equities, fixed income, and currency.
GREG BONNELL: That's something I've particularly been curious about because I've done so much central bank coverage over my career-- the fact that when you get used to either 25 basis points to the upside or the downside, depending on what part of a rate hike or cut cycle that they're on-- but you start getting these jumbo hikes-- 50 basis points, 75. Does that have a quicker effect, even if it's just psychological, on a country? Because we do know that it takes time for a monetary policy set to work its way through economy. But these jumbo hikes-- does that sort of pull forward some of that reaction?
MICHAEL CRAIG: Yeah, so the economist's textbook answer on the slower hikes-- about seven quarters before you see it come up. That's how long it takes to work its way through the economy. And then previously, you did have those 25 basis points move because they were just trying to tilt it a little bit. They weren't trying to shock it. They were just trying to gradually slow the economy down without causing a recession.
This time around-- well, look, when the economic historians look back at this time, they will say that central banks made a mistake by being too slow and then therefore had to catch up. And, right now, it's really about a credibility issue. And the challenge is, I actually think that inflation is going to fall materially. But at what cost? How deep of a recession will they need to create to see that happen?
And I would say, certainly, the parts of the economy that have done very well in a low-rate world are tremendously vulnerable. Housing and-- they call it FIRE-- finance insurance real estate-- those parts of the economy are quite vulnerable because, quite frankly, people are seeing moves. And, particularly, those are on floating rate. When they start to reset those, they're going to see materially higher costs. And ultimately, it's just like a tax on your livelihood. It's like paying another new tax because you're paying a materially higher rate against your mortgage.
GREG BONNELL: Now, given that, there are some, I guess, participants in the market-- and even maybe the bond market is sending a signal that, yes, we're going to get these aggressive rate hikes, whether it's the Bank of Canada, the Fed, or other central banks. But it won't be long before they're cutting again. I mean, is that just a bit of an overly optimistic dream, saying, oh, it's going to get bad for a while, but then it's going to get easier again real soon?
MICHAEL CRAIG: Yeah, so, if you ever have a dinner party and you want someone with a really dark sense of humor, invite a bond person because they tend to have a very cynical view of the world. And yeah, you do see it. You see it in the euro-dollars markets where-- the back 1/2 of '23, you see about 80 basis points of cuts.
And what the bond market is telling you is that the Fed is going to shift the economy into recession to raise unemployment and create enough slack in order to bring down wage and other forms of inflation. And look, if you're out of work, you're not going to go on a trip. You're going to spend less. And you can't really do much about supply. Supply is being affected by the war in Ukraine and by COVID policy in China. That will take time to adjust. And there's no monetary cure to solve that.
But monetary policy does affect demand. And what the bond market is telling you is that it's going to slow sharply into the end of this year and early '23. And the expectation is that we'll see cuts. Now, that's just an expectation. It doesn't mean it's going to happen.
But it's a bit ironic, as we see these rapid rate rises, that the forward-looking nature of the bond market is are already telling you that, yeah, the economy can only withstand so much before you have a pretty material downturn. And then we'll be back to cutting by the fall of '23. A lot of volatility ahead, right? That's a view that, again, if inflation stays sticky-- which I don't think it will. But this is an industry of adjusting to new information. It could be quite a challenging period if rates stay high for a longer period of time.
GREG BONNELL: Is there any chance-- and I guess there's always a chance. But is there any chance that central bankers can achieve the soft landing? I mean, the perfect point was, like, we slowed things just enough to bring everything back in balance without triggering a massive recession triggering big job losses. I think they would want to be there. Can they get there?
MICHAEL CRAIG: Empirically, it has happened. Based on what they're trying to achieve today, I think the real question is, is it a run-of-the-mill soft recession? Or is it a deep one? To me, that's a bit more of the pressing question. If we go into a few quarters of muted to slightly negative growth, if unemployment backs up to 4.5%, it's not the end of the world. That would technically be a recession. But I think the central banks would take that outcome.
The question, though, is, is it more of a 6% or 7% unemployment rate? And do we see a real material slowdown? I think that is what we're kind of weighing now. Any time you see rates move this quickly, it will generally-- particularly in our economies, which are very consumption heavy-- have huge impacts on growth. And I struggle to see it. Is it possible? Sure. Is it possible that I can get my weight and health in check in the next six months? Possibly, but unlikely-- yeah, unlikely.
GREG BONNELL: I know what you're talking about on that front. Before we finish our chat, I did want to ask you just about entering another corporate earnings season. And a lot of the discussions we've had on this show and discussions being had in the market seem to be-- we're going to start to hear about earnings revisions to the downside. Is that too dour a forecast?
MICHAEL CRAIG: So we actually-- within our asset allocation team, we do a lot of-- we'll call it top-down analysis. So we'll use purchasing manager indices-- macro data to get a gauge of where we think earnings are going. Our earnings models would say that we're probably facing an earnings recession next year. Earnings will be, at best, negative or zero to negative. And I think the market-- you remember that analysts don't like to move in huge locksteps.
In '21, actual earnings were way ahead of analysts' expectations because, as an analyst, it's hard to make a call and say, I think earnings are going up 5% and then come back next week with new information and say, actually, I think it's 25%. It's hard to keep your credibility doing that. So the Street tends to be a bit slower in adjusting. I think we're in for the next shoe to drop.
So the sell-off this year has been all valuations. So the markets traded at 21 times in January. Now they trade at 16 times earnings. So there's been a derating on the valuation front. I think the latter innings of this equity bear market will be a rerating of lower earnings. And I think that is absolutely likely. Energy probably does OK. But other parts of the market, I think you're going to see major earnings-- negative revisions over the next six to 12 months.