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As the summer months bring temperatures soaring, one thing that’s been moving in the opposite direction has been inflation. After massive government spending to fight COVID all around the world spiked inflation to double digits, central banks have been desperately spiking interest rates to bring inflation back down.
The theory was that by increasing the cost of money, the amount of spending in the economy would go down, resulting in less demand and therefore lower prices. In practice, this meant repeatedly taking a baseball bat to anyone holding a variable (or in Canada’s case, even fixed-rate) mortgage, spiking their monthly payments and sucking their budgets dry. Interest rate increases hurt people with debt, while inflation hurts everyone, so sacrificing indebted homeowners who signed up for massive mortgages to save everyone else seemed to be the mantra of 2023.
Well, it looks like it worked.
Canada’s inflation rate dropping to 2.8 per cent in June is a “milestone moment” that Canadians should find some relief in, according to Deputy Prime Minister and Finance Minister Chrystia Freeland.
Down from 3.4 per cent in May, the annual inflation rate has not been within the Bank of Canada’s target range of between one and three per cent since March 2021.Canada’s finance minister calls inflation rate dropping within target range a ‘milestone moment’, CTVNews
Wowza. Inflation with a 2-handle? That’s something I didn’t think we’d see for a while, let alone so soon in 2023. We’ve all endured a lot of negative surprises over the past 3 years, so it feels rather nice to have a positive surprise for once.
Inflation in the G7
How does Canada’s inflation rate compare to the US, and other countries in the G7? Well, according to a tool published by the Financial Times, here is a country-by-country breakdown of the annualized inflation levels as of June 2023.
|Country||Inflation % (annualized)|
Canada’s inflation number is, for now at least, the lowest in the G7!
Before we go on, can we take a moment to recognize how incredibly unusual it is for Canada to be #1 at something? We can’t claim to be the biggest, or the richest, or the strongest militarily. In the Olympics, when we’re in the top 10 in terms of medal count, our media will crow “Hey, that’s pretty darned good!” Generally, we don’t expect to be the best at anything, we’re just happy if the US, the EU, or China looks over, pats us on the head and goes “Well, you sure tried your best there, sport!” So the fact that we’ve somehow managed to bring inflation down faster than any other country in the G7 is pretty impressive.
That being said, the US and Japan is not far behind. They’re so close, in fact, that I fully expect that in a month or two one of them will take the top spot. But until then, IN YOUR FACES, BITCHES! At least temporarily, anyway. Canadians take our fleeting moments of glory when we can get them.
France, Italy, and Germany, though, have a bit more work to do, with their inflation rates still hovering at 4-7% level. They’re making good progress, as their inflation numbers were all in the double digits in 2022, but they still have a bit of a ways to go.
However, I would not want to be in the UK right now. They’re sitting in dead last, having started raising interest rates way later and slower than everyone else. They also have to deal with the added hit of Brexit, since as it turns out taking control of your borders actually means that you can’t get goods, services, or workers into your country cheaply anymore. Their inflation will likely remain sticky for quite some time, since I really don’t think the EU is in any mood to let them back into the club anytime soon.
But no need to shed any tears for the UK. They had plenty of opportunities to undo the Brexit vote, yet they voted for it in multiple elections despite knowing the consequences, so let them reap what they sowed.
Everyone else, on the other hand, can pat themselves on the back for the progress they’ve made so far.
What Happens Next With Interest Rates
Any prediction on the future of interest rates is always, at best, an educated guess since none of us can read the minds of central bankers, but my educated guess is that Canada is likely done with interest rate hikes.
Interest rate changes take 6-12 months to fully work their way through the economy, so even if the Bank of Canada keeps its rate steady, inflation will still probably fall a bit more before it stabilizes. Where that stable level ends up is anybody’s guess, and it’s entirely possible that a rate cut could materialize if the Bank sees inflation drop too far, but that likely won’t happen until 2024 at the earliest.
The US Federal Reserve is widely expected to hike its benchmark rate one more time on July 26, and barring any unexpected world event hitting them (please no, I can’t take anymore excitement), it will probably stop there as well. The EU has some more room to go, so don’t expect the ECB to take its foot off the gas anytime soon.
And the UK is screwed, but once again, they did it to themselves, so whatever.
Effect on Investments Choices
With the current interest rate hiking cycle apparently coming to an end, how does this affect the investments we hold in our portfolio? Great question, imaginary straw man I just made up!
As an index investor, our overall portfolio allocation is based on our fundamental risk tolerance rather than anything we read about in the news, and because our ability to withstand volatility remains quite high, our allocation will remain at 75% equity/25% fixed income.
The equity indexes we invest in will also remain unchanged, evenly split between the TSX (Canada), the S&P 500 (USA), and the MSCI EAFE Index (Europe/Australia/Far East). The economic recovery may continue to be uneven around the globe, but I don’t see a strong enough reason to bias towards or away from any particular country, so we will remain globally diversified in our current configuration.
Our fixed income portion, on the other hand, may change. Right now, our 25% fixed income allocation, which is usually invested in an aggregate bond index, is currently invested in preferred shares (Ticker: ZPR). Preferred shares are a floating rate instrument which pay higher yields when interest rates rise, which is why we’re currently enjoying a dividend of about 6% from this asset class. Bonds, on the other hand, are currently paying about 3.5%. So we’re getting a nice boost in our portfolio yield by holding these.
However, now that Canada is shifting away from a rising interest rate environment into a neutral, or even slightly negative interest rate outlook, the time may be coming soon to move back into a plain vanilla bond index. I’m not in any rush, though, since I want to see a sustained period of no changes from both the Bank of Canada and the Federal Reserve before I’m fully convinced that interest rate hikes are over. Plus, the longer I wait, the longer I get to keep collecting that sweet sweet 6% dividend!
So there we have it. Inflation in Canada has officially hit our 1%-3% target, with the US and Japan due to hit theirs a little while later. Personally, I’m super stoked that something seems to be going according to plan, because for a while I wasn’t convinced that anyone knew how to solve this stubbornly high inflation we’ve been seeing since 2022.
The future remains uncertain, as always. Economists still widely predict a recession, though who knows when/if that will happen. There’s still a vicious war in Ukraine going on, and a US election coming down the pipe next year that promises to be even more chaotic than the last one (if that’s even possible). But rather than worry about all the stuff that could go wrong, I choose to focus on the one thing that appears to be going right, which is inflation finally going back to normal.
What do you think? Do you think we’ve finally beaten inflation, or is this yet another fake-out? Let’s hear it in the comments below!
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