Transcript — Inflation & Volatility: Here to Stay?

Length: 3:40

Patrick O’Toole
Vice-President, Global Fixed Income, CIBC Asset Management

We're seeing a move higher in bond yields as investors have said, well, we've got some changing things going on, there’s higher inflation expectations. You've had a change in the U.S. with the passage of the tax cuts, so there can be bigger deficits going. There’s going to be better profits for U.S. corporations. So investors are adjusting to that. So the first couple of weeks of January we saw that priced in, I think, in the stock market as investors there got very excited about corporate earnings this year. And then bond yields moved a little bit higher, and then as we come into 2018, we see the Bank of Canada hiking rates a little bit. You see the Fed talking about hiking rates three times, some now saying maybe four times for the Fed.

[Higher wages prompting inflation worries]

And then you got a report from the U.S. employment side saying that wages are finally moving up, and that's kind of the Holy Grail for those who are watching for inflation. So the Fed has been expecting this and talking about this the last couple of years, that inflation is not behaving as expected. They've been saying as you get to full employment, which we’re at largely in the U.S., you generally see workers sort of get more power in demanding wage hikes, and that translates into a better economy, maybe a little overheating. You tend to see some inflation. So average hourly earnings going up to just below three percent recently. That's enough for people to get a little excited and wonder, is maybe the Fed falling behind the curve.

[Return of volatility?]

Now looking at 2018, is it really what we're seeing here, the reason volatility is that anything to get excited about? It's healthy that we have some of that, we don't have the market just trading one way all the time, but is it anything out of what we were expecting for 2018. I'd say largely ‘no.’ We're actually around, if you look at longer-term bond yields, the early part of 2018 here, we’re about the middle of the range we expect to see for this year. We've been expecting to see some concern about inflation come back to start 2018, as some base effects, as they call it, fall out of the calculations. So it could get a little worse, as they say, before you see a bit of a rally in the bond market, but we think a little disappointment in growth in the second half of the year lets bond yields level off again, and maybe move a little lower.

[Headwinds for Canada]

Now you've got some headwinds for Canada in particular. We've got a stronger dollar. We've had some rate hikes last year, another hike to start this year. We've got changes to mortgage rules. We've got very high debt levels. There's a lot of things that are a little more worrisome. And so we don't think the Bank of Canada is going to be all that aggressive in hiking rates this year. Again that's going to act as a factor to limit the rise in bond yields.

[High equity valuations?]

Well everybody's talked about the stock market being expensive, and it has been expensive for a while and it can stay expensive for a while. Earnings have been good though, in 2017 - really stellar earnings. Then you get the added boost from the tax cuts, which adds about six percent to earnings forecasts for this year. Throw into the mix the multiple expanding last year as well and you had a very good backdrop for the stock market. It can't continue forever. You've got to get earnings pushing a little higher, not just to justify some of these higher valuations in the stock market. So maybe we're getting a little reckoning there that with rates moving up a little bit higher, that's a bit of a challenge for the stock market. The Fed maybe will go more than the market's expecting. That's another challenge for the stock market perhaps to get their head around. So it's not a surprise to see the stock market pull back a bit.

[Where should investors turn?]

Well, when you're experiencing volatility like this, the temptation is to go and rush and make an adjustment, move to cash, and that sort of thing, which we tend to argue that - just stay the course. Markets are volatile and that's part of investing. You diversify as always, you have some fixed income, you have some stocks but we're not expecting great returns this year. 2017 was a good year for both stock and bond markets. A little more moderating or moderation of returns for 2018 as the forecast - bonds low-single digits, stocks mid-single digits. If that's we get this year, we should all be pretty thankful.

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