Dominique Lapointe, Senior Director of Macro Strategy at Manulife Wealth & Asset Management, views the Bank of Canada’s (BoC) recent decision to raise its key interest rate as a necessary response to updated inflation forecasts. This marks the first rate hike by the BoC since the beginning of 2023. For the past two months, Canadian inflation figures have shown a slight elevation, largely attributed to the surge in global oil prices. Earlier in October, Bank of Canada Governor Tiff Macklem, during an International Monetary Fund (IMF) meeting in Bangkok, issued a stern warning. He indicated that persistently high inflation, fueled by escalating global oil costs, would necessitate a revision of the BoC’s inflation outlook. This revised outlook, according to Lapointe, has effectively mandated an interest rate increase and signals a strong likelihood of a further hike in December, barring a significant decrease in oil prices or a dramatic surge in Canadian unemployment.
Lapointe highlighted that Canada’s monetary tightening is not an isolated event, even as the U.S. Federal Reserve opted to maintain its interest rates unchanged in its most recent meeting, following a hike in September. While the economic starting points and the pace of rate adjustments may differ between the United States and Canada, Lapointe perceives an ongoing hiking cycle intrinsically linked to supply-side inflationary pressures. He acknowledged the potential strain these measures could impose on consumers and both economies, yet he offered a perspective for asset owners, suggesting that panic may not be warranted.
"With the forecast that the [BoC] put in today, and the very tight relationship that they seem to be putting between oil prices and their decision-making process, it’s going to be hard not to raise interest rates if oil prices don’t come down in the near term," Lapointe stated. He further elaborated, "So then when we go in Friday, we’re going to have a GDP print. We’re going to have another inflation print in 3 weeks, jobs reports. To me, awkwardly, they’re going to matter less because they’re all backward looking. And it seems that the Bank of Canada is very concerned about the future… For me, it’s really about oil at this point."
The Inevitability of Further Rate Hikes
Lapointe underscored the Bank of Canada’s Business Outlook Survey as a key indicator of future inflationary pressures. The survey reveals that, as of the latest data, most businesses are only passing on approximately 20% of the cost increases they have absorbed due to recent geopolitical conflicts. However, these businesses anticipate a significant increase, expecting to pass on 44% of these costs in the near future. This projected acceleration in cost pass-through is expected to further fuel inflation. Lapointe views a swift resumption of pre-conflict oil flows through the Strait of Hormuz as highly improbable. Consequently, as long as geopolitical tensions persist, he argues that inflation will likely remain elevated.
The U.S. Federal Reserve has been confronting similar inflationary pressures, Lapointe observed. However, their higher starting point for interest rates and the September rate hike provided Federal Reserve Chair Jerome Powell with sufficient justification to hold rates steady for the time being. An unexpected, albeit slight, uptick in unemployment also offered the central bank additional cover to maintain its current policy stance. Nevertheless, Lapointe remains convinced that the Federal Reserve will resume its hiking cycle in December and potentially again in March. He anticipates that the Bank of Canada, after its predicted December hike, will likely hold rates steady in January. This pause is attributed to the anticipated impact of auto tariffs, which are expected to take further hold in January unless a resolution is reached in ongoing U.S.-Canadian trade disputes. Following this period, Lapointe predicts the BoC will align with the Federal Reserve’s upward trajectory in March.
Understanding the Inflationary Landscape
The recent surge in inflation, particularly in Canada, can be understood through a confluence of global and domestic factors. The ongoing geopolitical conflicts have significantly disrupted global energy markets, leading to a sustained rise in crude oil prices. As a major energy exporter, Canada’s economy is particularly sensitive to these fluctuations. The Bank of Canada, in its mandate to maintain price stability, is compelled to respond to these inflationary pressures to prevent them from becoming entrenched in the economy. The central bank’s inflation targets, typically around 2%, serve as a crucial benchmark for its policy decisions. When inflation deviates significantly from this target, especially when driven by supply-side shocks, central banks face a delicate balancing act.
The specific drivers of elevated inflation in Canada have been multifaceted. Beyond the direct impact of oil prices on transportation and production costs, businesses have grappled with increased input costs across various sectors. The Business Outlook Survey cited by Lapointe provides empirical evidence of this phenomenon, illustrating a delayed but inevitable pass-through of these costs to consumers. This suggests that even if immediate inflationary spikes related to energy ease, underlying cost pressures remain, potentially leading to a more persistent inflationary environment.
In the United States, while the Federal Reserve has also been attentive to inflation, its approach has been influenced by a different economic context. The U.S. economy, while experiencing inflationary pressures, has seen its central bank implement rate hikes from a potentially different baseline. The Fed’s decision to pause in its most recent meeting, while keeping the door open for future hikes, reflects a strategy of carefully assessing incoming economic data. Factors such as labor market conditions and consumer spending play a crucial role in the Fed’s deliberations. The slight rise in unemployment, while not a cause for immediate alarm, provides a data point that the Fed can utilize to justify its current policy stance, at least temporarily.
Implications for Investors: Navigating a Shifting Economic Climate
Despite potential volatility in the bond market, Lapointe suggests that current higher yields available in balanced bond funds could make this asset class an attractive proposition for investors. He acknowledges that a continued hiking cycle might exert downward pressure on bond prices. However, he posits that solid yields, coupled with robust diversification strategies, could effectively cushion returns and mitigate potential losses. This perspective suggests that investors may find opportunities to generate income and preserve capital even within an environment of rising interest rates.
Turning to Canadian equities, Lapointe expresses a generally positive outlook. He notes that the Toronto Stock Exchange (TSX), with its comparatively lower exposure to the technology sector compared to its U.S. counterpart, offers attractive qualities for investors. While the energy sector is experiencing high demand, Lapointe also points to other commodities and mining stocks as potential areas of strength. The Canadian banking sector, with its high degree of sensitivity to financial market performance (beta), can often benefit from rising interest rates, which can expand net interest margins. Although Canadian financials have exposure to the housing market, a segment of the economy that can be sensitive to interest rate changes, Lapointe argues that this exposure is less pronounced than in previous cycles. This suggests that the impact of a housing market slowdown on bank profitability may be more contained.
Regarding U.S. markets, Lapointe believes the outlook is increasingly driven by perspectives on Artificial Intelligence (AI) rather than solely by the direct impact of higher capital costs. He observes that despite significant debt issuance by AI "hyperscalers," the intensely competitive nature of the AI race renders these companies less sensitive to interest rate fluctuations in their spending strategies. AI now constitutes a substantial portion of the S&P 500, extending across various sectors beyond pure technology. Consequently, investors with a bullish outlook on AI may perceive this as a positive development, while skeptics might view it as a significant risk. U.S. equity price-to-earnings (P/E) multiples have compressed, potentially making the market appear more attractively valued from a valuation standpoint, even as earnings continue to demonstrate strength. Lapointe cautions against an overly concentrated weighting in technology stocks at this juncture in the economic cycle. He suggests that a slightly more cautious, underweight position in the U.S. market, combined with a more optimistic view on European and Canadian equities, might be a prudent investment strategy.
Central Bank Confidence and Investor Messaging
While interest rate increases are rarely perceived as positive news by the general public, Lapointe emphasizes that they should not necessarily be interpreted as unequivocally negative. Instead, he advocates for understanding these policy decisions as indicators of how central banks assess the health and fundamental strength of the economies they oversee.
"The fact that central banks are raising interest rates in general is because the economy is in a good space in general," Lapointe stated. "Now we can say, well, this time is not good because, it’s about a supply-side shock from oil. But they’re doing it nonetheless. If unemployment was trending up in a significant way in the US and Canada and we see real issues like people selling their houses at a big discount, I’m confident that central banks would not raise interest rates," he explained. "The fact that they’re doing so and trying to front-run upcoming inflation means they’re confident about the fundamentals. And I think that’s the message investors should tell their clients."
This perspective suggests that central banks’ willingness to implement tightening measures, even in the face of potential economic headwinds like supply-shock inflation, reflects a broader confidence in the underlying economic fundamentals. The proactive stance aims to preemptively manage inflation, thereby preserving the long-term stability and growth potential of the economy. For investors, this signals an environment where, despite short-term challenges, the foundational economic structure remains robust, offering opportunities for those who can navigate the evolving landscape strategically. The emphasis on fundamentals underscores the importance of a long-term investment horizon and a diversified approach, particularly in an environment marked by evolving monetary policy and geopolitical influences.
