Invested: Walking the tightrope between inflation and recession

Myles Zyblock, Chief Investment Strategist of Scotia Global Asset Management – which manages over $200 billion* for millions of investors in Canada and around the world – shares his latest market and investing insights.

This month, Myles discusses the fine line central bankers are attempting to walk between taming inflation and avoiding recession.

This year’s outlook represents a fine balance between further monetary policy tightening (typically raising interest rates) and an economic slowdown. Inflation is hovering at an uncomfortably elevated level for most of the world’s major central banks, suggesting that higher interest rates are to follow. Yet, declining growth rates point to the dangers of further rate hikes.

An approaching pause in the monetary tightening cycle at some point in 2023 seems obvious. High-quality bonds should benefit. The severity of the economic slowdown will impact whether we see further price declines in the equity and high-yield corporate bond markets or we set the stage for an “everything” rally.

Powerful global economic growth beginning in late 2020 created the environment for a sharp surge in inflation. Central bankers initially saw this as ephemeral, but their viewpoints changed by the latter part of 2021. Given the continuous rise in inflation, the tremendous – even wartime-like – policy support delivered in the immediate aftermath of the initial COVID shock was no longer appropriate.

Central bankers around the world have raised interest rates 329 times over the past year, which averages almost one rate hike per day. All previous tightening cycles since the early 1980s have paled in comparison, given the breadth and size of the rate hikes seen this time around.

The central banks are walking a fine line by attempting to moderate the strongest inflation wave of the past 40 years without sending the business cycle off the rails. They have been focused on bringing inflation back down to their mandated targets, which are closer to 2% than the current 8% for advanced economies and 11% for emerging economies. This is an incredibly challenging problem to successfully navigate.

It was about 60 years ago when Milton Friedman, a well-known economist, shed important light on the recurring predicament faced by central banks. He said “[Central banks] tend to determine their action by today's conditions – but their action will affect the economy only six or nine or 12 or 15 months later.”

Financial markets have been gripped by this problematic delay between policy action and economic reaction, with tension visibly increasing throughout much of 2022. The focus is now turning to how these tensions might be resolved during the coming year. Professor Friedman’s observations from decades earlier point to a worrisome endgame given that the central banks have frequently chosen to look in the rear-view mirror rather than focusing on what’s on the road immediately ahead.

At this stage, the authorities have only offered hints that they are in the process of reassessing where interest rates might need to travel to get a handle on the inflation problem. Some major central banks, notably those in Canada and New Zealand, are signaling that their monetary policy cycles have matured. The U.S. Federal Reserve has indicated that the pace of its tightening program will moderate. Meanwhile, tightening cycles in some emerging economies, including Brazil, Chile, the Czech Republic, Hungary, and Poland, appear to be ending.

The economics community has been lowering their forecasts and now expect world GDP to grow by 2.1% in 2023. While this suggests that a marked economic slowdown is not baked in, the risks of such an outcome have clearly risen.

Several central banks are expected to cease their tightening measures in 2023. This might pave the way for a surge in most financial market asset prices. However, if the risk of a hard landing in the economy is realized, the rewards will most likely be limited to high-quality bonds. Context is everything.

Myles Zyblock is a recognized North American strategist, regarded for his investment insights that blend finance and psychology to capture major inflection points in financial markets. Myles has over 25 years of experience in guiding and advising on asset allocation for a diverse set of institutional and retail advisors globally. Myles joined the firm in 2013 as the Chief Investment Strategist, working closely with the Investment Team. His experience spans multiple asset classes and geographic regions.