Growth holds firm amid inflation drag

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

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Eric Morin, global head of research at CIBC Global Asset Management 

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The direction of travel for oil prices is lower, but we still see oil prices remaining higher than the level that they were before the war started because there will be a strong and inelastic demand to replenish oil inventories that have been depleted. This is something that should keep oil prices higher than what we had before. 

As a result, we do see the story of higher oil prices to have a negative impact on growth. The impact for global GDP is about minus 0.3% over the course of the next 12 months. So, we have a growth outlook for the global economy that is 3%. This is close to trend or potential. Without the oil shock, we would be at about 3.3%. So, a really compelling macro story of resiliency for global growth. This is something that remains attractive. But still, there’s a tax from higher oil prices, and that is something that’s going to reduce growth slightly. 

In terms of inflation, the impact will be proportional than the shock on growth. We talk about, in general, 0.3%, maybe 0.4% higher core CPI in most countries over the next 12 months. This is something that is an impediment to risky assets, but it’s manageable pain, simply because the impact is limited. But also, the macro backdrop is quite different than what we had in 2022. 

This time is different because we don’t have those inflationary demand shocks. We had a demand shock that, yes, brings higher inflation, but also brings weaker growth. And as a result, we see limited second-round effects on inflation. For example, in the case of Canada and the U.S., headline inflation will probably increase by about 0.5% to 1%, versus our counterfactual of no war. So, there is higher inflation there, but the impact is manageable. 

Now, turning to the policy rate, in the case of the Bank of Canada, we think that they will be able to look through the shock. There is upside pressure on inflation, but we think that the Bank of Canada will look through the shock for the next few quarters and do nothing. 

Why is that the case? Well, there has been disinflation taking place. The disinflation story gives time to take a breath and look through the shock. But also in Canada, what we have is a weak growth trend, which is a stark contrast with 2021, 2022. We have job creation that is near zero. If we look at job creation on a year-to-year basis, this is quite weak. This is much weaker than 2015-2016, where Canada experienced a material slow down. 

This is a symptomatic of two forces. First, we have cyclical headwinds, but also we have structural growth impediments that are keeping job creation quite weak. In terms of the structural story, we have falling demographics due to new immigration policies. 

All of this to say that we have a lackluster outlook in Canada. We also have an outlook in which private investment will remain weak and where housing tailwinds will likely decline. As a result, we think the Bank of Canada will be willing and able to look through the shock and do nothing. 

We think that most central banks will look through the shock, but some have to hike. It’s the case for the ECB and the Bank of Japan. They have to hike because their inflation shock is bigger, due to their reliance on liquefied natural gas. Basically, the LNG complex has been hit harder than oil, so they are facing a bigger supply shock with more upside on inflation. For the central bank, this means more upside risk on inflation due to second-round effects. The shock is bigger, but also monetary policy is accommodative in both cases. And so we think that central banks will move towards neutral. 

In Australia, we saw earlier in May, a hike by the central bank. But Australia is a little bit of a basket case, with inflation well above target and with the labour market being quite tight. So, this is a central bank that is a little bit like the outlier. 

If we go in the future, in Q4 2026, or Q1 2027, the Bank of Canada will have to look back at fundamentals. We think the Bank of Canada will have to eventually hike and move its policy rate closer to neutral. This is because we consider that the structural slowdown of immigration in Canada will result in a flowing transformation in the labour market. 

Currently there is slack in the labour market but, in nine to 12 months, we see that slack melting. And then we see the absence of slack as a driver for higher wage inflation, especially in a context where we have adverse aging — so there is more and more retirement — but also there is a shortage of skilled workers. So, we see a situation where wage growth will remain quite elevated. 

Hourly wage growth will be seen by the Bank of Canada as a leading indicator of future inflation risk. This is why we think that, yes, the Bank of Canada will look through the shock, but eventually the Bank of Canada will have to hike by 25 basis points to bring its policy rate towards neutral. 

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In the next 12 months, we think the behaviour of risky assets is compatible with the growth outlook being balanced, so we don’t see regions that are underappreciated over the course of the next 12 months. 

Europe, for example, is a case where there is a bigger energy shock, so Europe and Japan will suffer. Growth will be at or slightly below potential looking at the next four quarters. 

But instead, where growth is underappreciated is not in the next 12 months, but it’s over the medium term. We think that over the medium term — so beyond the next 12 months — we think that Europe and Japan could start to outperform because there is a lot of stimuli in the pipeline due to a changing world order. We think that there will be a lot of military investment tailwinds in both Japan and Europe. 

There will be also a rotation of tech investment. So, tech investment has been really a story for the U.S. and China. We think that there will be a rotation towards other economies, and that includes Europe and Japan. So that is another tailwind there. 

Another tailwind is that, for Europe and Japan, this is the second energy shock related to military conflict in about five years. We think that this will trigger a lot of investment into alternative energy and nuclear. This is something that should provide a growth tailwind over the medium term, and there’s also the supply chain resiliency concept that will bring an additional tailwind. It will be more pronounced for Europe and Japan due to higher oil prices. Growth will be lackluster, but nothing materially different than what’s priced or expected. 

Looking beyond the next 12 months, we think that Europe and Japan could outperform over the medium term. And this is something that we care about because that could bring downside pressure on the U.S. dollar eventually. 

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Where are we finding opportunities today that the broader market may be overlooking? The first one is the energy sector. There’s been a lot of tailwinds for energy stocks, but we think that there is still upside to that story. Why is that the case? Well, it’s because oil prices will decline, but they will remain well above the level that they were before the start of the war, and this is compatible with a material shock to free cash flow for energy producers. 

We assume $90 average for Brent in the next four quarters. This is a massive wealth transfer from energy importers to energy exporters. So, this is really positive for Canadian stocks, and also for the Canadian energy sector. This is something that we think has legs. So we see outperformance for the energy sector over the next 12 months. That’s the first opportunity that we have. 

Another one that we have is related to China. China is moving up the value chain and has a booming trade surplus. This is compatible with a tailwind for the whole emerging market complex. We think that emerging market — stocks and bonds and also currency — are a place where investors could find returns looking at the next 12 months. 

And last but not least, we think the market may be overlooking USD headwinds. First, the U.S. dollar is overvalued, and if we have a global macro backdrop that is compatible with downside pressure on the U.S. dollar, we think that the currency could depreciate. 

And another reason is the twin deficit. The U.S. has a big deficit related to the trade balance and also a large fiscal deficit. Those deficits result in downside pressure. That said, the magnitude of the downside pressure will be contained by the fact that the next 12 months, global growth will be close to its trend, and the U.S. dollar is a counter cyclical asset.

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