Research Report: Winning The Inflation Battle?

BY: Richard Croft
are causing the imbalances. What impact are global transportation bottlenecks having on prices along the supply chain? How much of the demand surge is a desperate attempt by consumers to feel normal again? What impact is the Ukraine war having on food and energy prices? Did government sponsored pandemic relief programs provide too much stimulus? Each of these factors has an impact. The chart to the right is our best guess as to the relevancy of each of these components.



At its core, inflation is caused by supply / demand imbalances – too much money chasing too few goods. The challenge is in 1) identifying and 2) weighing the elements that are causing the imbalances.

What impact are global transportation bottlenecks having on prices along the supply chain? How much of the demand surge is a desperate attempt by consumers to feel normal again? What impact is the Ukraine war having on food and energy prices? Did government sponsored pandemic relief programs provide too much stimulus? Each of these factors has an impact. The chart to the right is our best guess as to the relevancy of each of these components.

We will adjust these weightings as new data emerges. For example, we will dramatically raise the weighting for Embedded Expectations if consumers believe inflation is a longer term problem. That belief would lead to a wage-price spiral that might collapse the economy much like a light breeze could blow over a house of cards. Not surprisingly, this is the number one concern for central bankers who are pushing up rates expeditiously in an attempt to hobble inflation before it becomes so entrenched in the consumer mindset. The problem with outsized rate hikes is that recession becomes the necessary endgame.

Turning back to the inflation discussion, we note that it is rare to find scenarios where the “this time is different” discourse is relevant. However, it applies to the current situation. We have never in modern history experienced such widespread restrictions and resulting dislocations sparked by a global pandemic. Even the Spanish Flu playbook does not provide a prism for the current situation. In 1918, there were no government programs to support displaced workers, technology that sustains work-from-home interactions did not exist, the First World War was winding down, and inflation was not the major concern among economists.

Understanding these differences allows us to examine the macroeconomic picture through the lens of the COVID-19 pandemic. In our view, remaining concerns about COVID, the demand surge and resulting supply chain friction are the key factors underpinning the inflation bubble.

As much of the industrialized world re-classifies COVID to an endemic[1] status, freedom of movement has caused a surge in pent-up demand. At the same time, zero-covid policies in China and parts of the Asia Pacific basin are the major factors contributing to supply chain friction.

Zero-covid policies in China, which is the manufacturing hub of the world, have led to lockdowns that, at times, have crippled China’s export capacity.

Currently, lockdowns are doing more harm than good. The population is suffering from mental fatigue, which could have long term negative implications for the Chinese economy.

We expect to see China relax some of their more authoritarian anti-COVID policies in the second half of 2022.  Such a moderation should ease congestion at China’s main export terminals. We are already seeing some positive signs as recent supply chain data reveals some slack at China’s major ports.

Another gauge is to look at the U.S. supply chain, where port congestion has been steadily improving (see following chart). Think of the U.S. supply chain as the mirror image of China, with U.S. ports mostly importing product manufactured abroad.

As we move into the third quarter, another factor that supports our view that inflation will wane is the inventory build up across the retail sector. Many retailers now have excess inventory because they ordered more product for fear that backlogs would hamper consumer choice. Look for price cuts from major retailers like Walmart, Target and Amazon over the coming weeks, which should factor into the end-of-year inflation data.

If price cuts play out as we suspect, this should have a positive impact on inflation expectations, which are the number one concern for central banks. To reiterate its importance, allowing the recent bout of inflation to become embedded in the psyche of workers, households and businesses could fuel a wage-price spiral that would continue to feed inflation over the long term. So far, based on inflation expectations indicated by U.S. Treasury yields, that does not appear to be the prevailing view among market participants.

We note, for example, the yield on ten-year U.S. treasuries (see chart) where rates initially surged 200 basis points from the February lows. However, since mid-June, the ten-year rate has fallen below the critical 3% demarcation point. If the prevailing view is that initial inflation prints will continue in coming years, investors would need a higher interest rate to induce them to keep buying U.S. treasury bonds.

In relative terms, yields have been muted, indicating that market participants are not expecting inflation to remain elevated over the longer term.

From our perspective, inflation persistence is less to do with worker and business expectations and more to do with the leverage employees have to protect their incomes from inflation. Workers have such leverage in the current tight labour environment, resulting in above-trend nominal wage growth. This may be temporary as the tight labour market is driven, in large part, by the recent sub-variant COVID wave, which should fade quickly.

Even with that, one could argue that the above-trend nominal wage growth is, in and of itself, not enough to cause serious upward pressure on prices. We can see that in the enhanced profit margins that companies have registered since the beginning of the year.

We expect, as the economy normalizes and workers’ bargaining power abates, any inflationary shock stemming from non-wage factors (like the current outbreak) will put downward pressure on real wages reducing the need for price increases being passed through as a result of rapid wage growth.

We are already seeing this normalization in some sectors (technology being the classic case study) as layoffs are beginning to have a pronounced impact on wage deceleration. Given the relentless policy attacks on workers’ leverage that began in the Reagan years, it seems highly unlikely that future wage gains will amplify inflationary pressures.

The same argument can be used with demand surges, which do not necessarily translate into higher prices. The key is choice. Where are consumers choosing to spend their disposable income?

If consumers are buying goods – appliances, automobiles, houses – that adds to inflationary pressures. If the hawkish tone emanating from central banks can transition that demand to the service sector, the inflation impact is less severe. That seems to be working as housing prices have fallen off and inventory buildup for big ticket items (except automobiles) is surging.


Coming full circle, we need to examine the likelihood that interest rates will continue to increase at the current pace. On that front, we think the current aggressive interest rate policy by central banks will remain intact for the next two quarters. If so, policy rates will rise to the ‘neutral’ 3.25% to 3.75% objective. Such rates should be high enough to dampen demand for big ticket items (and investments) without doing serious long-term damage to the economy. Once we hit the neutral level, we suspect central banks will pause to evaluate the impact their policies are having on inflation.

As for the macroeconomic impact, we believe there is a 50-50 chance the current round of tightening will result in a minor “technical” recession. A recession that slows growth for a couple of quarters with no serious impact on the job market.

In terms of our investment thesis, a pause in rate hikes once we reach the neutral zone will be viewed positively by the stock market – a especially among the growth stock spectrum, which would include names like Alphabet (Google), Apple, Microsoft and Amazon. We suspect many of these names will end the year higher than where they are currently.

The money-center banks (considered value plays) should also benefit from a pause because loan margins should improve. It is possible, if this thesis plays out as expected, we could end the year in financial sector investments higher than where we started. Canadian banks are well-positioned as are some of the big names south of the border (J P Morgan Chase, Bank of America, Morgan Stanley and  Goldman Sachs). In fact, executives at three of these U.S. banks recently announced dividend increases, further supporting this thesis.


U.S. recessions are officially confirmed ex-ante by the National Bureau of Economic Research (NBER). Historically, a recession was declared when the economy experienced a decline in GDP across two consecutive quarters. More recently, the NBER has reassessed that position and now defines a recession as a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and both wholesale and retail sales.

Since the onset of the industrial revolution, capitalist economies have enjoyed long stretches of economic growth fueled by manufacturing and, more recently, technological innovation. Unfortunately, long-term growth trends are subject to booms and busts as economic activity transitions through the business cycle. Economic expansion is punctuated by episodes of slowing growth and sometimes negative growth. These recessionary downturns can last six months up to several years.

Recessions are a normal, albeit unpleasant, part of the business cycle. They are characterized by a rash of business failures, slow or negative growth in production, elevated unemployment and, often, bank failures. The economic pain caused by recessions, though temporary, can have major effects that alter an economy. This can occur due to structural shifts in the economy as vulnerable or obsolete firms, industries, or technologies fail and are swept away. It can also be affected by dramatic policy responses from government and monetary authorities, which can literally rewrite the rules for businesses; or social and political upheaval resulting from widespread unemployment and economic distress.

Recession Predictors and Indicators

Despite a wealth of economic reports, trying to predict when a recession will occur is at best, subjective. Aside from obvious ex-ante observations that show GDP declining for consecutive quarters, economists can only make educated guesses by assigning probabilities to trends using historical data. To that point, there are some generally accepted predictors that, when combined with anecdotal observations, provide analytics that help forecast the likelihood of an oncoming recession.

The most common indicator is the Index of Leading Economic Indicators (LEI), which is a weighted composite of economic statistics. These include the ISM Purchasing Managers Index which, by the way, spooked the U.S. Federal Reserve (FED) during their last meeting and led to the 75 basis point hike in their overnight lending rate. Other factors include the Conference Board Leading Economic Index, the OECD Composite Leading Indicator and the U.S. Treasury Yield Curve.

Economists and business leaders pay particular attention when the LEI turns down, which it has done recently (see chart). Economists also pay attention to data produced and released by various government agencies representing key sectors of the economy. This data series includes, but is not limited to, housing statistics and new orders for capital goods, both published by the U.S. Census Bureau.

Changes in this data series have, historically, led or moved in tandem with the onset of a recession. This is not surprising, given they are components used in the calculation of GDP, which ultimately defines the existence of a recession. As well, economists look at a basket of lagging indicators that are used to confirm an economy’s shift into a recession after it has begun. The most notable in this basket of indicators is the unemployment rate.

So far the results are mixed. The challenge, as mentioned earlier, is that we have no context for analyzing the potential for a pandemic induced recession. What we know is that the North American economies are relatively strong, spearheaded by strong consumer demand backstopped by pandemic related government stimulus programs. We are also in a period of strong employment, as noted by the most recent employment data. The 3.6% U.S. unemployment rate is just one tick above the lowest rate ever recorded.

What Causes Recessions?

There are numerous models that attempt to explain why economies transition from expansion to contraction. These theories generally encompass observable economic conditions, financial factors, or psychological considerations, with various overlays that attempt to bridge gaps across the spectrum.

Structural shifts, if they are significantly influential, can also trigger a recession. Some economists focus on structural shifts such as the spike in oil prices and increased basic materials costs, resulting from a geopolitical crisis (i.e., war in Ukraine), which affect input costs across many industries. There are also shifts from the onset of new technologies (i.e., streaming services, online advertising), which can make entire industries obsolete.

The real world onset of the COVID-19 epidemic that led to public health lockdowns throughout 2020 is an example of an economic shock that can precipitate a recession. Especially, if the shock occurs when other factors like elevated price-to-earnings multiples have been simmering under the surface. We saw that unfold in real time during the first quarter of 2020.

Fast forward to 2021, where financial factors such as government stimulus programs, quantitative easing, ultra-low interest rates and minimal inflation, all provided a backdrop that rendered global economies susceptible to an economic shock. The subsequent monetary contraction and rising interest rate environment falls within the monetarism mantra as a recession precursor. One theory, set out by Investopedia, is the Austrian Business Cycle Theory[2] that bridges “the gap between real and monetary factors by exploring the links between credit, interest rates, the time horizon of market participants’ production and consumption plans, and the structure of relationships between specific kinds of productive capital goods.”

Psychology-based theories, on the other hand, track the fear / greed rollercoaster that vacillates from irrational exuberance and speculative excesses during boom times to deep pessimism and anxiety during contraction phases.

Famed economist John Maynard Keynes argued that once a recession begins, for whatever reason, investor pessimism can become a self-fulfilling prophecy. Loss aversion curtails new investments, which means less investment income and, ultimately, lower consumption spending.

Economist Hyman Minsky extended Keynes’ hypothesis by assessing the impact of leverage as a root cause of recessions. Minsky theorized that financial crisis are endemic to capitalism because periods of economic prosperity encourage borrowers and lenders to be progressively reckless. This excess optimism creates financial bubbles that inevitably burst. As such, capitalism is prone to move from periods of financial stability to instability. In short, success breeds excess, which leads to crisis.

Recession Driven Bear Markets

History suggests that bear markets, in which stocks decline by 20% or more from their recent highs, always accompany recessions. However, bear markets can occur without the onset of a recession. When you think about it, recessions are a decline in economic activity. The value of publicly traded stocks reflects market expectations about the future direction of the economy. For example, when analysts issue earnings downgrades stock prices decline. But sometimes, as we see in the current environment, stocks sell off in advance of a recession; and sometimes the recession never ensues. Stocks trade on expectations and those expectations are not always correct.

Strategies for a Bear Market

It was all but impossible to prepare for the onset of this bear market. There was simply nowhere to hide. Normally, we would increase portfolio allocations towards fixed income assets. However, this time that would have done little to defend one’s portfolio. We were starting from a point where interest rates were at or near zero. As rates began to rise, bond prices fell almost in lockstep with equities.

Having been bitten by the bear, it is helpful to understand how we are approaching the current market environment. The first point is to continue investing. If you have been adding capital regularly to your portfolio, continue to do so. This is not the time to stand on the sidelines. Dollar cost averaging is one of the best strategies to stare down the bear.

The second thing is to continue rebalancing the portfolio. Bear markets are typically more volatile, which offers more opportunities to bring portfolios back in line with your risk tolerances. Even fully invested portfolios can take advantage of bargain hunting via prudent rebalancing into positions that have declined, and which now should offer higher prospective returns going forward.

Tax loss harvesting also makes sense in the current environment. Securities and ETFs sold at a loss can be replaced by similar but not identical substitutes.

From an investment perspective, one of the best strategies is to invest in companies with low debt, good cash flow, and strong balance sheets. Conversely, avoid companies that are highly leveraged, cyclical, or speculative.


The objective for a well-constructed portfolio is to deliver above average risk-adjusted returns. The key element being “risk-adjusted.”

Portfolios are not just about performance; optimized portfolios should deliver a unit of return that is greater than what one would expect for a unit of risk. Generating the required return with less risk is preferable to seeking high-octane performance that also requires a significant upward adjustment to the (downside) risk quotient. If the risk within a portfolio is greater than the variability an investor can tolerate, emotions will underpin buy and sell decisions and that will end badly.

By applying multiple levels of diversification managers can fine-tune the risk quotient. When we talk about portfolio diversification, we apply a top-down approach that begins with the asset mix, geography (i.e., the inclusion of domestic and international assets), sector allocation and, finally, management style.

Style defines how fund managers select securities for a fund’s portfolio based on their knowledge, skill, and understanding of the market. Style includes features such as large-cap versus small-cap stocks, value versus growth, indexing versus sector rotation. Assessing the style of actively managed equity ETFs comes down to company size (large versus small cap) and value versus growth characteristics.

Value managers tend to look for out-of-favor situations seeking good quality companies that are trading for less than their book (i.e., breakup) value. Ideally, value managers gravitate to out-of-favor situations or stocks with healthy sustainable dividends and low price-to-earnings multiples.

Within an actively managed value ETF, diversification across sectors and size is important. Value managers typically invest in low-beta blue chip mature companies in mature industries and, through a rigorous screening process, seek out-of-favor cyclical situations to generate upside growth. The blue-chip companies provide stability that can offset potential losses from out-of-favor situations that never garner investor interest.

Growth managers look for companies that are growing earnings faster than the market. If companies in a benchmark are growing earnings at 10%, growth managers would look for companies whose earnings are growing at 15%, 20% or 25% – buying, say, Shopify rather than Bank of Nova Scotia.

Growth stocks are more volatile because investors will pay a higher price, or ‘multiple’, to own them; and so will discount them more heavily when market expectations become negative. The price-to-earnings multiple one would pay for growth stocks is always higher than a value stock will illicit. The objective is to buy a growth stock when the price-to-earnings multiple does not fully reflect the growth prospects for the company. Some managers compare the price-to-earnings multiple to the company’s growth rate, perhaps paying 20 times this year’s earnings for a company that can grow earnings at 20% or better a year from now.

Momentum is another take on the growth approach. A momentum manager believes that a stock’s price will move along the path of least resistance. Structurally, momentum managers look for companies that are not only growing earnings faster than the market but are also growing the rate of the earnings growth. For example, a good momentum stock is one that is growing earnings at 20% this quarter, is expected to grow earnings at a 21% rate next quarter and 22% the quarter after that.

The market will grant enormous price-to-earnings multiples to these kinds of companies because there is no good quantitative tool to value what the stock is really worth. Remember the path of least resistance theory. If a company could grow earnings indefinitely it could, in theory, have an infinite value.

Over the long term one investment style is not necessarily better than another. Over long periods, each investment style will have its own day in the sun. Hence the logic for style diversification in your investment portfolio.

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Richard Croft, Chairman & CIO

[1] Endemics are a constant presence in a specific location. For example, Malaria is endemic to parts of Africa, ice is endemic to Antarctica.

[2] The Austrian business cycle or ABCT is a monetary theory of the business cycle. The authors theorize that when credit expands inappropriately relative to the level of real savings it results in an unsustainable boom that transitions into a recessionary bust.

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