Downshifting

Patrick O’Toole, Adam Ditkofsky and Pablo Martinez - 01/20/2023

Economic data

This week saw plenty of data to suggest growth and inflation are downshifting into a lower gear, giving some comfort to central banks that past interest rate hikes are working. U.S. retail sales fell -1.1% in December, the second consecutive decline. The less volatile retail sales excluding autos and gasoline fell by -0.7%, well below expectations, suggesting that consumers are feeling the bite from higher prices for food, energy and, well, pretty much everything else. It’s not just the consumer that is feeling the pinch—the business sector is softening too, with industrial production falling by -0.7% following a downwardly revised -0.6% in November. U.S. producer prices, or inflation at the production level, fell by -0.5% and cooled sharply from the double digit year over year rates seen last year. On the positive side, U.S. housing looks to be improving modestly from depressed levels: the National Association of Home Builders index improved for the first time in 13 months, and both single family sales and prospective buyers traffic did better. As well, U.S. housing starts were down less than expected at -1.4%. Finally, jobless claims fell to 190k, suggesting the broader labour market remains very strong despite recent layoff announcements in selective industries such as technology, finance and real estate.

The Bank of Canada will be encouraged to see the consumer price index (CPI) declining by -0.6% in December—even excluding the more volatile food and energy components, core inflation declined by -0.1%. It’s important to consider the base effect, i.e. large CPI monthly prints will fall out of the year over year calculations over the next 6 months, which will result in a materially lower inflation rate by the second half of this year. In a similar vein, Canadian industrial product prices declined for the 6th time in the last 7 months, suggesting inflationary pressures at the production level are waning. The Bank of Canada’s Business Outlook Survey for Q4 2022 was weaker, with notable softening in past and future sales growth, and investment in machinery and equipment. However, inflation expectations by businesses remain high and are a source of concern for the Bank of Canada should they persist much longer. Canadian retail sales fell -0.1% in November. Stripping out the more volatile components like gasoline and autos, retail sales declined by -0.6%. The flash estimate for December retail sales looks more encouraging at +0.5%.

Bond market reaction

Bond yields continue to fall on weaker growth and inflation data. Canada 10-year yields at 2.80% are approaching the lows of the recent 2.60-3.65% trading range. The 2 to 10-year yield curve remains firmly inverted at -75 basis points (bps), and continues to flag a potential recession coming our way. Interestingly, the Bank of Japan (BoJ) is one of the last central banks to keep short term interest rates in negative territory and employs quantitative easing (bond purchases) to keep their yields low. This week, the 10-year Japanese government bond (JGB) yield bumped up against the upper end of the BoJ’s yield target range of 0.50%, leading to speculation that the BoJ may give up on protecting its target range. Instead, the BoJ pledged to keep short term interest rates negative and doubled down by continuing large scale purchases of JGB bonds and committing to increase purchases on a flexible basis, if needed. Not surprisingly, 10-year JGB yields quickly fell 10 bps in response.

Stock market reaction

With the beginning of Q4 earnings season, investors are getting a glimpse into how 2023 earnings should evolve. To generalize, companies are cautious given the macro environment, record earnings from the past few years, and a weakening consumer. And we’ve seen layoffs pick up in a large way, centered for now around the technology sector. Over the past two weeks, large tech companies, including Microsoft, Alphabet and Amazon, have announced layoffs in the thousands. The Great Resignation of 2021 and 2022 is giving some outsized gains back—some of the companies mentioned above hired aggressively during this time! For context, in 2019, Alphabet had 119k employees vs. 187k today, and Amazon nearly doubled their employee count to 1.6m, driven by warehouse growth. So while a rightsizing of the cost base seems prudent, it also shows that management is cautious on the outlook for the coming year. Within the technology universe, Netflix announced management changes and subscriber gains after their new ad-supported tier helped bring customers through the door. Yes, that’s right, consumers can now choose to pay $7/month for a new plan if the ad-load isn’t too bothersome!

What to watch next week

Next week will be busy with the release of U.S. Q4 gross domestic product (GDP), the leading index, durable goods orders, jobless claims, new home sales, personal income and spending, and the personal consumption expenditures (PCE) deflator – the Fed’s favourite inflation indicator. In Canada we get the Canadian Federation of Independent Business’ (CFIB) business barometer, the Survey of Employment, Payrolls and Hours’ payroll report and the Bank of Canada’s interest rate decision on Wednesday. 

Disclaimer

Patrick O’Toole is Senior Portfolio Manager, Global Fixed Income; Adam Ditkofsky is Senior Portfolio Manager, Global Fixed Income; and Pablo Martinez is Portfolio Manager, Global Fixed Income.

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