Research Report: Frontloading inflation

BY: Richard Croft
Central banks have been aggressively raising rates to slow economic activity so that global economies do not get caught up in a 1970s style wage and price spiral. While their aim is admirable, central bankers may be using a playbook that is not appropriate for the current situation.


Come with me to another dimension. A dimension not only of sight and sound but of mind. A dimension of unlimited possibility, where if you’re careful, the right decisions should help you find your way back out with greater happiness and wealth. It is a place that we call the “Inflation Zone.”

Pardon our twist on the 1960s TV series The Twilight Zone, but it seemed appropriate to introduce a thesis… specifically, that businesses have front loaded their 2023 inflation expectations.

Most of the dialogue around the current inflationary spike is predicated on historical data. Central banks have been aggressively raising rates to slow economic activity so that global economies do not get caught up in a 1970s style wage and price spiral. While their aim is admirable, central bankers may be using a playbook that is not appropriate for the current situation.

For one thing the 1970s wage price spiral caught most businesses flat footed. From 1950 through to the mid to late ’60s, economic activity was robust and wages, while rising, were in line with productivity improvements. Workers had job security and strong unions to protect their wages and benefits. Inflation only became a serious problem when price hikes led to outsized wage demands that outpaced productivity.

In the 1970s logistic challenges made it difficult to adjust prices quickly. At that time, retailers did not have the ability to manage just-in-time delivery. Remember when we could go to a furniture store, buy a new sofa and the warehouse staff would get the merchandise and strap it to your car? Same with auto dealerships that stocked massive inventory allowing prospective buyers to pick from the lot and take delivery of the new vehicle the next day. Try buying furniture or automobiles today without ordering weeks or months in advance.

Financing inventory did not become a major problem until central banks orchestrated double digit interest rates. Corporations had to raise prices to maintain margins, which led to outsized wage settlements. By the middle of 1977, when it appeared that inflation was moderating, the cost of goods began to surge and by the end of the decade were out of control (see chart).

Also by 1977, companies were feeling the pinch of double-digit interest rates to maintain their expected inventory levels. These challenges seriously impacted margins, which caused a series of layoffs and a surge in bankruptcies that resulted in a deep recession by the early ’80s. That playbook is very different from the challenges we face today.

Moving to the present day, until recently just-in-time inventory and low interest rates have provided a cushion for retailers, enabling them to maintain margins in a full employment environment.

Additionally, the drivers of economic activity have changed. The service sector – transportation, restaurants, travel and leisure – now makes up roughly 30% of GDP and consequently has an outsized impact on the consumer price index. Note in the accompanying chart, the weights applied to commodities, transportation, food and other expenses. The service sector does not have to finance massive inventory, so any post-COVID price adjustments tend to flow to the bottom line.

As prices for basic commodities spiked in mid-2021, in an environment of high savings and returning strength in employment, service companies were able to push through price increases with little pushback; especially in the restaurant business, which increased prices to compensate for lost revenue during COVID lockdowns. Most of those price increases have not been rolled back even though commodity prices peaked in the first quarter of 2022 and have fallen dramatically since then.

Tim Hortons makes an interesting case study that supports our front-loading inflation thesis. A tin of Tim Horton’s coffee now sells for just under $26.00. In 2021, you could buy the same tin for about $19.00. The price increase was driven by a spike in coffee futures (see chart) that peaked in the first quarter of 2022. While coffee futures have collapsed, we have seen no change in the price at the retail level. In short, that should lead to better margins despite higher wage demands.

The service sector can maintain those higher prices because it is not subjected to political blowback. The discretionary nature of the service sector is very different from, say, the energy sector where higher prices at the gas pump result directly in price-gouging rhetoric from politicians.

Since price rollbacks in the service sector are not likely, we think that front-loading inflation will benefit the bottom line of these companies. It is also unlikely the service sector will engage in another round of significant price hikes, which will eventually be reflected in future CPI comparisons. If this part of our front-loading thesis is correct, then much of the initial inflationary impact from the service sector has been priced in.


As a result, we are now seeing some green shoots that suggest inflation has peaked because, as witnessed in our coffee analogy, input costs are waning.

Another key input is energy prices, which impact heating, cooling, transportation and manufacturing inflation. Oil and natural gas prices had an outsized impact on Canada’s CPI during the first half of 2022. We recognize that prices at the pump are still elevated, but they are down more than 17% from June’s peak as world oil prices have declined more than 30% from their March peak.

The eventual impact on global inflation will be meaningful. For example, energy contributed more than a third of the 10.6% year-over-year inflation (based on data at the end of October) in the euro-zone. Mind you, much of that price bump was predicated on fears that natural gas would be in short supply over the winter months. Fortunately, storage tanks were filled faster than expected, and some mothballed nuclear power plants were restarted. While the price for natural gas in the euro zone is still elevated, it is well below the August peak. As new European import terminals come online into the new year and additional US shipments are off-loaded, we should see a positive impact on future inflation.

Food prices are also stabilizing, despite Russia’s attempts to thwart Ukraine wheat and grain exports. The price of U.S. wheat is down more than 35% (in U.S. dollars) from the May peak. Globally, the United Nation’s World Food Price Index has declined for seven straight months, now down more than 15% below the March high. The challenge is timing. Most of these inputs have yet to show up in stores and, by extension, in the comparative CPI data.

Circumstances unique to the housing sector have impacted the time lag associated with lower housing prices. We say that because the main input in the CPI data is the cost-of-carry associated with accommodation, including mortgage costs, which have been rising due to higher interest rates. As a result, the rising cost of carrying a mortgage has offset the benefits of lower housing prices, which are down 10% from their February peak.

The other accommodation input relates to rental costs, which are directly impacted by mortgage rates. Our best hope here is that landlords have already front-loaded their inflation expectations, which, if they did, should show up in the CPI data around the first quarter of 2023.

We are also seeing green shoots at the corporate level. Canadian firms ratcheted up prices to offset declines in the Canadian dollar and higher import costs. To that point, we note that recently input costs have risen at the slowest pace in 23 months, barely outpacing long-run trends.

Supply chains also appear to be stabilizing. Quarterly freight rates have fallen more than 75% since the fourth quarter of 2021. This massive decline in shipping rates is a two-edged sword. Lower shipping rates assuage inflation but are often seen as a leading recession indicator.

Economists have also been monitoring money supply as a constituent cause of inflation. Government initiated pandemic relief programs resulted in a 23% year-over-year surge in the global M2 money supply[1] during 2020. M2 has been declining since June 2022 as central banks reduce their balance sheets. The Canadian experience is similar. M3 money supply[2] surged 16.3% in 2020, peaked in June 2022 and is currently trending at 8.3% above pre-COVID levels.

With so many signs pointing to lower inflation, one wonders why central banks are maintaining their aggressive posture? We see it as a “better-safe-than-sorry” strategy, which central bankers defend by l observing that, historically, changes in rate policy take time to work through the system.

That’s a reasonable position if the current rate trajectory follows historical patterns. In theory, higher rates should dampen loan demand but, so far, that is not happening. The Bank of Canada has hiked its trend-setting overnight rate by 4.0% since March, yet loan demand has nearly tripled based on September’s data. It’s the same story across all G-8 economies, which may be the result of pent-up demand as consumers deal with pandemic after shock.

The worry is that higher rates may not have the desired effect of easing inflation. If not, we can take some comfort in our thesis that the recent softening of inflation is not about interest rates.

We recognize that peak inflation can only be determined with 20/20 hindsight. But given the steadily improving input costs that have yet to be reflected in the CPI data, one can hope that we are witnessing the beginning of an endgame. When the markets gain more clarity on the timing of the endgame, combined with our front-loading thesis espoused earlier, we should experience a major relief rally that will turbocharge global equities. Depending of course, on potential repercussions from any pending recession.


There was a train of thought that the prospect of a mild “technical” recession in 2023 is underpinning the recent strength in equity markets since the first week in November.

The optimistic scenario implies that 2023 will usher in a mild recession that leads to some corporate belt-tightening, slower demand for labour and lower inflation. In response, central banks should pivot, cutting rates as early as the middle of next year.

That hopeful combination would provide a jumping off point for equities, which, if true, suggests that stocks are somewhat attractive at current levels. The trick is to distinguish reality from fiction. To that point, consider the evidence.

A view from the bond market

In terms of predicting a recession, there is little doubt that U.S. and Canadian yield curves are flashing bright red. The yield curve measures the yield on government bonds of various maturities. Most of the time, longer-term bonds – ones that mature in 10 years or more – yield more than shorter-term ones maturing in, say, two years.

When that pattern reverses, and shorter-term bonds are yielding more than their longer-term counterparts, the curve is said to be inverted.

The deep inversion on display in today’s yield curve suggests that a recession is coming, probably in early-to-mid-2023. The catch is that the curve doesn’t offer any clues about how deep or long-lasting the recession will be.

On the positive side, unemployment has rarely been lower in both Canada and the U.S. Oil prices have contracted from their peak after the Russian invasion of Ukraine. At present, oil prices are only slightly above the levels seen prior to the Russian invasion.

As we have mentioned, supply chains are unclogging, and prices for durable goods (appliances and furniture) have fallen dramatically from their peaks, which just goes to show how quickly prices can abate under the right circumstances. These are encouraging signs for those in the mild-recession camp.

The key is not to become sanguine. There are some obvious negatives that cannot be overlooked. While durable-goods inflation may be subsiding, the CPI is still running hot in both Canada and the U.S. The hope is that the price slide in durable goods will spread to services as well (see our front-loading inflation section), which would mean that central banks may soon be able to ease up on their aggressive rate hiking stance.

Both the Bank of Canada and the U.S. Federal Reserve have been resolute that interest rates will remain high until inflation returns to target (i.e., 2% annual inflation). Given that, it is not a stretch to believe that interest rates will remain above trend well into 2023.

Clearly interest rates are having an impact on housing prices on both sides of the border and making it difficult for companies to borrow. Higher rates have also enticed us to look at bonds as a component within portfolios. Fixed income assets are now more competitive in terms of stability and returns relative to equities.

As bonds compete for investor attention, it will dampen demand for equities through the first half of 2023, a position espoused by many analysts presently.

Generally, we would expect the bear market to end when US stocks are trading at 13 to 14 times earnings. At present, US stocks are closer to 18 times earnings and there are many analysts who think those numbers will be adjusted downwards. Maybe… maybe not! We are not fully committed to that view based on our front-loading inflation thesis but are mindful of the possibility. In short, investing is always a game of probabilities.

If nothing else, we see analyst skepticism as a wake-up call that will keep us focused on value metrics when assessing new stock purchases. The dividend paying companies will provide robust cashflow until we see definitive changes in the economic trends.

As value hunters we see a more enticing case for Canadian stocks, which are trading at only about 12 times forward earnings. The catch is trying to decipher whether a mild recession is a reasonable thesis and, if so, can the global economy stage a strong recovery?

Our approach is to assign probabilities to the myriad of possible outcomes. Until we get some clarity on the depth and length of the downturn, we will continue to practice strategic patience.


Overcoming the desire to make decisions based on fear and greed is the most difficult aspect of investing. What looks like a blip on a long-term chart is only too real when experiencing the day-to-day choppiness of a bear market.

The Advisor’s principal role is to help investors stay the course during market turbulence. Regular communication that educates and dissects economic trends is critical and must go beyond Will Roger’s humorous folklore that one should “buy a stock that goes up, if it doesn’t go up, don’t buy it.” Most importantly, we must drive home the point that one cannot separate investing from investment planning.

That is not to challenge the view that investments are made to earn a profit. But making an investment with little or no thought as to how it fits within your personal financial circumstances is akin to investing in a vacuum. And “vacuum block” can lead individuals down a road to speculative excesses, and fear mongering.

We believe there is a better approach. Forget about the individual investments and concentrate instead on the overall risk and performance of the portfolio. Investors need to establish reasonable long-term performance objectives within the context of their ability to tolerate risk. Understanding an investor’s ability to tolerate risk is the most difficult assessment a financial adviser makes.

If advisers can help the investor address these issues, they are more likely to have regular financial check-ups. And we’re not talking about making small daily changes to a portfolio or scanning the Internet for up-to-the-minute stock quotes. We’re talking set intervals; at least once a year, perhaps semi-annually or quarterly or, most importantly, if your personal circumstances change.

In other words, often enough to maintain a level of comfort that long-term, you’re moving in the right direction.

Richard Croft, Chairman & CIO

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