Higher rates but less inflation panic: What CIBC’s Benjamin Tal predicts for stocks, home prices and the economy

Benjamin Tal, deputy chief economist at CIBC Capital Markets, in Toronto on June 7, 2019.Tijana Martín/The balloon and the mail

Growing fears of a recession have gripped equity markets, with the S&P/TSX Composite Index now firmly in correction territory. The S&P/TSX is down 13 percent from its closing all-time high of 22,087, hit on March 29.

The Globe and Mail recently spoke with Benjamin Tal, deputy chief economist at CIBC Capital Markets, who shared his perspectives on the risk of an economic downturn, monetary policy and the implications for the housing market. Mr. Tal also provided some suggestions on what actions might work well in this challenging environment.

Inflation is at a multi-decade high, negatively impacting business probability and consumers. However, inflation is a lagging indicator, so I wonder if there is a risk that the Bank of Canada will continue to raise rates while economic growth contracts, putting the economy at risk of recession. Was there ever a time when the Bank of Canada struggled with inflation exceeding 5 percent and there wasn’t a recession?

No, that’s the point.

I look at four sources of inflation, but before you start looking at any of that, you need to have a working assumption about COVID: We are in the process of transitioning from a pandemic to an endemic one.

Now we can analyze those four sources of inflation.

We’ll start with energy. If you look back in history, almost every time we had an oil shock, we had a recession right after. So the question is, to what extent is oil as inflationary as it used to be? So here we have three things. One, the shock that we are experiencing now is not as bad as in previous years in real terms. Second, the economy’s sensitivity to high energy prices has been reduced. If you look at the last 10 or 15 years, energy consumption per unit of GDP is going down, so we’re more efficient. The other thing is Alberta’s response. In the past, when oil prices were rising, Alberta’s oil executives were busy investing. That is not the case now because everyone knows that green is replacing black.

Given that lack of investment, are we now in an energy supercycle?

I’m not sure about a super cycle, but I think it’s fair to say that oil prices will stay high. But remember that we are talking about inflation. Inflation is the exchange rate. It stands to reason that at this level energy is flat or stable, meaning that, year after year, energy will not be a major inflationary force.

And the other sources of inflation?

The second source of inflation is the supply chain, and it is very important. If we are able to ease the restrictions on the economy with respect to COVID, then I think it will remove a large part, maybe 60 percent, of the inflation that we are seeing.

The third is rent inflation. If you look at the price-to-rent ratio of the house, it went to heaven. The combination of higher rents and lower home prices will help return this relationship to semi-normal. Higher interest rates will increase rental demand because people can’t afford to buy houses. We still have new immigrants coming. Many foreign students come. We are underestimating the number of people looking for units so that there is demand. Supply is very limited, and more and more what we see is that builders are not building because of rising construction costs. I’ve had conversations with at least six big builders and I can tell you that big projects, especially rental projects, get delayed or canceled entirely because they just can’t make money, margins are slim.

The fourth source is the labor market: wages. Wages are rising, especially among low-wage earners because that’s where the shortages are.

So the Bank of Canada can control two things: one is wages, one is rent, and the rest they can’t control, because it’s energy and the supply chain.

What you need to remember is the story of the supply chain. If the supply chain over the next six months starts to loosen up, I think the Bank of Canada will be less concerned because they know that a significant part of the inflation is going to go away. So I look at supply chain inflation, not now, not next month, but in September, October and November. I need to see some softening. The risk we face, and it is a big risk, is that while the supply chain will eventually ease, it may not ease soon enough for the Bank of Canada to stop rising.

At the end of the day, it’s not about inflation. This is the cost of reducing inflation to 2 percent. The Bank of Canada and the Federal Reserve tell you that they will do whatever it takes, even if it means pushing an economy into recession, because they believe that is the only way to keep the economy going, from a broader perspective.

So where do you think rates are headed?

The market forecasts an interbank rate of 3.5 percent by the end of this year. Our official call is that they will stop at 2.75 to 3 percent. Now, in my opinion, the difference between 2.75 to 3 percent and 3.5 percent could be the difference between no recession and a recession. The enemy of the economy is not only higher interest rates, but also rapidly rising rates.

The effectiveness of monetary policy in Canada is actually stronger than in the US Per capita, we have more debt, which means we are more sensitive to higher interest rates. Second, their mortgage terms are 30 years, our typical terms are five years or less, so we’re more sensitive, which means the little Bank of Canada is more powerful than the mighty Federal Reserve when it comes to try to shock the consumer. In those terms, we estimate that a 1 percent hike by the Bank of Canada is equivalent to a 2 percent hike by the Fed, theoretically speaking. Therefore, the Bank of Canada is more effective in its ability to slow the economy and this increased sensitivity to interest rates could slow the economy enough for the bank to stop raising rates from 2.75 to 3 percent. percent, assuming the supply chain is behaving . There’s a 30 percent chance that won’t happen and we could go overboard.

So do you think there is only a 30 percent chance that a policy mistake will lead to a recession?

That’s fair. You generally have a 10 percent chance of a recession at any time. The probability of a recession is much higher now, three times higher than usual, so it’s not a rosy scenario.

With rates rising rapidly, do you expect to see a sharp correction in home prices?

The housing market is very vulnerable to higher interest rates. If you look at some areas in GTA and Vancouver, in the low-rise segment of the market, single-family homes, prices are already down 15-20 percent. Prices will continue to drop, I think. But remember, prices are up 50 percent in two years, so this is just an adjustment because we’re borrowing activity from the future.

The lack of supply will act as protection against a significant drop in prices.

My fear is that the economy will slow down. The housing market will slow down and in the next two years that will remove the sense of urgency about supply. But when we get back to semi-normal, the supply will not be there and there will be another wave of upward pressure on prices.

The S&P/TSX Composite Index recently fell to its lowest level in the past year. Is the market sell-off a buying opportunity? Are we close to a bottom?

I’m not sure where the bottom is. Synchronizing the market is impossible. But if your time horizon is two or three years, I think there are good bargains at this point.

Our research suggests that dividend-paying stocks actually do well during a period of higher interest rates. Telecommunications and public services work well, historically speaking.

Also, financials could be oversold at this point. The market is discounting a lot of bad news. I think from a long-term perspective, there are some opportunities there.

Are there exposures to countries you prefer?

I like Canada better than the United States in this environment for two reasons. If you look at the dividend yield in Canada, it’s double the dividend yield in the US Also in Canada, we’re benefiting from commodities.

When I interviewed him in January, I asked for his 2022 stock market prediction. He said he would assign the highest probability to a single-digit gain for the S&P/TSX Composite Index. Do you agree with this prediction?

Yes, I think it is still reasonable to go for a flat or low single digit profit, at least we hope so. With so much bad news already priced in, the market might have plenty of time to get there.

If you had to summarize your outlook for the second half of 2022 in one word or sentence, what would you say?

Higher rates, reduced inflation panic.

This interview has been edited and condensed.

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