Why interest rates may stay higher for longer than markets expect

2023 has just  begun, but so far inflation and interest rates continue to dominate business headlines. Central banks around the world are deliberating what to do next after relentlessly raising interest rates to fight off the highest inflation we’ve seen in the last 30 years. Rate hikes have affected all asset classes and left investors with few places to hide. Inflation, although likely passed its peak, remains elevated and it could be a while until it’s under control.

How long will rates keep rising?

We believe that central banks will continue to increase rates. In particular, we expect a few more rate hikes from the U.S. Federal Reserve (the Fed) in the first half of the year, followed by a longer than anticipated pause to assess the effects – the Fed wants inflation to be under its upper target of 2%.

In Canada, we expect one more rate hike before the Bank of Canada pauses to assess the effects of higher rates. We believe the market is ahead of itself in anticipating a pivot to rate cuts as soon as later this year, and this represents a potential key risk for markets in the near term. We believe policy makers, both in the U.S. and Canada, will keep rates higher for longer as they reiterate their focus on fighting inflation even if it means that some parts of the economy suffer.

Some sectors may suffer

Also, as higher rates affect economic activity, we already see rate-sensitive sectors such as housing and manufacturing beginning to show a downturn. Housing has seen a sharp decline since both the Fed and the Bank of Canada began their tightening cycles. Home prices dropped from their highs, and indicators such as construction activity and builder’s confidence indexes are also slowing down sharply. When we look at one of our main global leading indicators of manufacturing activity, the Purchasing Managers Index (PMI), we clearly see a contraction due to tighter monetary conditions.

As the effects of higher rates are lagging in nature, we expect to see more pain, particularly in the labour market. A strong labour market means the economy is resilient, but on the flip side it also shows that wage inflation could continue to be problematic and feed into broader inflation.

Therefore, we lean our portfolio towards active management. Our active managers focus on investing in high quality companies that have defensive characteristics, which aim to benefit our portfolio allocation against a backdrop of global slowdown.

The views expressed in this article are those of the authors and are subject to change at any time. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any mutual funds managed by SLGI Asset Management Inc. These views are not to be considered as investment advice nor should they be considered a recommendation to buy or sell. Information contained in this article has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made with respect to its timeliness or accuracy. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.

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