Canadian Inflation: Expecting lower inflation while also being prepared for alternative outcomes

While some of the uncertainty about inflation has faded, the headline Consumer Price Index (CPI) inflation rate remains above the Bank of Canada’s (BoC) target of 2.0%. We expect that inflation will come back to the BoC target by the end of 2024 based on a few factors including a slowing of the Canadian and global economy.

However, given the complexities associated with forecasting inflation, Canadian investors should still be prepared for higher inflation in the near-term. The path towards lower inflation may not be linear, and so we discuss scenarios that may lead to higher for longer inflation. We believe that inflation will trend lower over the long term but it’s always better to prepare than to predict.


Portfolio construction in this environment is most important. We offer some perspective on individual assets classes under different inflation scenarios over the near and medium term. Regardless of the inflationary backdrop, there is no substitute for proper portfolio diversification (asset classes, regions, currencies), while doing our best to avoid certain behavioural biases.


Part I. Inflation – Looking Back

Inflation has risen to forty-year highs following the global pandemic. It has become one of the most pressing issues facing investors today. Inflation is an important consideration for investors because any degree of inflation results in a loss of purchasing power. It erodes the value of money if left unchecked for too long. Inflation is also damaging to the broader economy. Business confidence tends to decline when inflation is high. Business owners may find it difficult to make pricing and capital allocation decisions when there is a high degree of uncertainty with respect to the level of inflation and interest rates.

The rise in inflation began during the pandemic with a surge in global consumer demand for goods like cars (new and used), exercise equipment, computers, appliances, etc., as global supply chains were disrupted/shutdown by public health restrictions. In early 2022, there was a sudden spike in commodity prices following the Russian invasion of Ukraine, which added to the rise in inflation.


Despite the meaningful interest rate hikes by the BoC and other global central banks, inflation continued to increase throughout 2021-2022. And although inflation in Canada has been less pronounced than in several developed countries, including the United States (Chart 1), Canadian inflation over the last few years has been high relative to history.


In Canada, like in most developed economies, inflation gradually shifted from global to domestic factors and from goods into services inflation as lockdowns were lifted. Inflation began to broaden beyond a few categories. For instance, the share of spending on goods and services that saw price increases of more than 3% jumped from about 20% in January 2021 to about 60% by December 2021, according to Statistics Canada data. As the Canadian economy began to reopen in 2021 and consumers shifted purchases from mostly goods into services, businesses that had laid off employees during the pandemic couldn’t find enough staff to meet the demand from consumers. As a result, businesses were forced to raise prices for services to supplement higher wages paid which further contributed to the inflation. (Chart 2)


Notes: The Canadian Consumer Price Index (CPI) is an indicator of the change in consumer prices. It measures price change by comparing through time the cost of a fixed basket of consumer goods and services. As the most widely used measure of inflation, the CPI is an indicator of the effectiveness of government policy. In addition, business executives, labor leaders and other private citizens use the index as a guide in making economic decisions.

Part II. Inflation in Canada: Where We May Be Headed

The good news is over the last year we are beginning to see signs that the rate of inflation is slowing. For instance, towards the end of 2022, prices for many products and services (i.e., food and shelter costs driven by higher mortgage rates and rents) remained high, but price increases were decelerating. As shown in Chart 2, Canadian Annualized Goods CPI peaked at around 11% in June 2022 (gold line), and Services CPI may have also peaked at around 5.6% in December 2022 (blue line). Additionally, while the latest headline inflation rate in April was slightly higher month-over-month, headline inflation remains well below the highs of 2022.


Drivers of this slowing inflation include slowing leading economic indicators as interest rates have risen rapidly, and a weakening outlook by Canadian businesses as per the Bank of Canada’s Business Outlook Survey – First Quarter of 2023 that showed a subdued sales outlook and easing labour market pressures from high levels. We’ve also seen a decline in most commodity prices, while supply chain pressures have abated, global shipping costs have declined, and prices for goods like used cars have come off their peak. Today, the picture in Canada appears less complex than many of its global counterparts. Inflation expectations have dropped, and the Bank of Canada expects inflation to slow to 3% by mid-year before returning to target in 2024.


Providing further confidence in the outlook for lower inflation ahead, we show in (Chart 3) a close relationship between the Canadian Industrial Product Price Index, advanced by 1-year, and the BoC’s preferred inflation measures – Trimmed Mean CPI, and Common CPI. As the chart implies, lower prices faced by producers should translate into lower core CPI measures over the near-term.


Notes: CPI-trim is a measure of core inflation that excludes CPI components whose rates of change in a given month are located in the tails of the distribution of price changes. This measure helps filter out extreme price movements that might be caused by factors specific to certain components. CPI-median is a measure of core inflation corresponding to the price change located at the 50th percentile (in terms of the CPI basket weights) of the distribution of price changes in a given month. This measure helps filter out extreme price movements specific to certain components. This approach is similar to CPI-trim as it eliminates all the weighted monthly price variations at both the bottom and top of the distribution of price changes in any given month, except the price change for the component that is the midpoint of that distribution. CPI-common is a measure of core inflation that tracks common price changes across categories in the CPI basket. It uses a statistical procedure called a factor model to detect these common variations, which helps filter out price movements that might be caused by factors specific to certain components.


As detailed in (Chart 4), we forecast Canadian inflation to moderate at a lower and more stable rate, and towards the BoC’s 2.0% target over 2023-2024.


Admittedly, while we see inflation headed lower over the next two years, inflation is a complex subject and despite the recent string of lower inflation readings there remains persistent inflationary forces in the housing and labour markets. We attempt to summarize the complexities of inflation in (Chart 5) as inflationary or disinflationary over the near, medium, and long-term time periods.


It’s worth touching on some of the longer-term drivers of inflation/disinflation:


  • Green infrastructure, including energy transition – these include public and private investments to move away from less expensive sources of energy, which may initially be inflationary. However, it is likely that over time as these alternative energy sources achieve economies of scale through tax incentives and greater adoption rates, they will be disinflationary.
  • Deglobalization and onshoring – this includes projects meant to move away from long lead times and extensive supply chains, companies moving product and suppliers closer to home, and moving away from ‘just-in-time’ to ‘just-in-case’ inventories may initially be inflationary.
  • Lower workforce participation – as individuals have dropped out of the labour force (retirement, otherwise), a shortage of labour may place more bargaining power in the hands of labour, placing upward pressure on wages. Offsetting this is the potential for productivity growth from technology advancements (e.g., artificial intelligence, robotics).


Where could we be wrong in our outlook for inflation?


Understanding potential downside risk to our outlook is formed within our investment philosophy of preparing, rather than predicting. Here are some counterpoints to our inflation outlook:


  • Inflation may not have peaked just yet. While declining, inflation remains above the BoC’s 2.0% target. There are external factors beyond the control of the Bank of Canada such as global energy prices that may persist and contribute to rising global inflation and inflation expectations. It’s possible that while goods inflation has eased, and wage growth is subsiding, both could increase again in the future. We note that relative to the U.S., a higher percentage of unionized workers in Canada may result in additional wage growth pressure over the near-term.
  • The path back to 2.0% could be slower than we expect. Canadian inflation may have peaked already, but the easy comparison periods are over. Inflationary pressures are also broad-based, meaning that more than 50% of CPI components are still growing above 5% on a year-over-year basis at the time of writing. Lower shelter and housing costs may take longer to show up in the overall inflation measures like CPI putting our forecast at risk. At the same time, risk of a stagflation scenario where growth is slowing and inflation remains high is possible.
  • Inflation expectations may start to rise: History tells us that if inflation remains too high for too long that it may become entrenched. There are several measures of inflation expectations that we pay close attention to, including observable inflation expectations in the bond market. The good news is as of May 15 2023, both the 5-year and 10-year Canadian inflation expectations are close to or just below the BoC’s 2.0% inflation target.

Part III. Building Sustainable Portfolios – Prepare Rather Than Predict:

As we’ve mentioned previously, it’s better to be prepared than to predict. Inflation is a complex and important issue facing investors that hasn’t really been an issue for the last few decades. Although we expect inflation to continue to come down over the next two years, investment portfolios should be prepared for any environment.


The economic regime that dominated the last few decades, which was low growth and disinflation, may not persist in the future. There is an inherent disinflationary bias if you were to draw assumptions solely from these periods in the past which may result in a few distortions, including, for instance, overestimating the role of fixed income in reducing portfolio risk.


At Morgan Stanley, we look to reduce the impact of a disinflationary bias on our forward-looking assumptions by recognizing the potential for different macroeconomic regimes through the economic cycle. Our methodology attempts to correct this unintentional disinflationary bias by synthesizing data that is representative of the deeper historical record. Within our approach, we find that cash, real assets, and international equities may become more attractive in a portfolio context than recent cycles would imply, while fixed income assets and interest-rate-sensitive equities may be less attractive.


Our current tactical asset mix favours cash, short-duration bonds, investment grade credit, global dividend growth stocks, and Canadian/International Equities relative to U.S. Equities. And from a currency perspective, we expect an appreciating Canadian dollar vis-à-vis the U.S. dollar over 2023-2024.


Every investor faces their own unique investment objectives, risk tolerance and capacity for risk, liquidity needs, and unique circumstances are all determinants of the asset allocation decision. As such, there is no substitute for proper risk management principles of diversification by asset classes, region, style, and currency during any point in the economic cycle.


Reach out to your Morgan Stanley Financial Advisor for any other questions or concerns you may have.

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