RISK OF RECESSION A GROWING CONCERN

Global markets have been laser focused on inflation readings all year. And, while that was still a big preoccupation for investors over the past week, another issue has emerged that could soon overtake it as the predominant market concern: the risk of recession and its impact to corporate profits.

The U. S. Consumer Price Index ( CPI) for August was released last week and it was up 8.3 per cent year over year, below the reading for July but higher than expected. Food and energy price pressures remained elevated, although the latter declined as expected. More troubling may have been the core measure, which excludes food and energy. It was higher than expected and above the July reading. Moreover, it wasn’t driven by one particular category but showed relatively broad pricing pressures.

Nevertheless, the view on inflation remains largely unchanged. More specifically, it should recede in the months to come. One doesn’t have to look too far to understand why. Shelter is the largest component of inflation, accounting for nearly a third of U. S. CPI. It is made up of lodging away from home, rent, and housing- related costs. The latter two have shown no signs of slowing yet, and in fact increased in August. But, these two categories have historically followed home prices with a meaningful lag. We know home prices are under pressure as a result of substantially higher mortgage costs. As a result, it is just a matter of time, before trends in the largest component within the CPI basket begin to subside.

Inflation may also be at risk of falling victim to recessionary- like forces that appear to be on the rise. In recent days, a few industrial conglomerates ranging from aluminum and steel makers to shipping and parcel delivery companies have warned of deteriorating conditions in their respective businesses that have led them to issue profit warnings. I mentioned several weeks back this situation may transpire.

Part of the profit warnings appear to be cost- driven and a meaningful shift in demand away from goods towards services. Weakness overseas was also cited as a notable driver by some management teams. But, it’s hard to imagine weaker demand avoiding its way into the North American economy. After all, the Bank of Canada and U. S. Federal Reserve have been aggressively tightening financial conditions with the hope that demand and activity would slow. We may finally be starting to see the impact of their actions. Remember, there is a six to nine month lag between the time when rates rise and the effect of higher rates to the economy.

A deteriorating economy is by no means something to look forward to. But, it may have the potential to have a lasting impact on inflation. Ultimately, that may prove to be a very important and constructive development for the longer- term return prospects of most assets. In the interim however, expect equities to remain vulnerable as markets digest the risks to corporate earnings. Meanwhile, I am hopeful that high quality bonds, which have struggled mightily this year, may soon begin to see their yields stabilize as growth concerns eventually overtake inflation risks as the main market concern. This would be bullish for fixed income.

Mike Candeloro, Senior Portfolio Manager and Wealth Advisor with RBC Dominion Securities and the head of The Mike Candeloro Wealth Management Group supplied this article. RBC Dominion Securities Inc. and Royal Bank of Canada are separate corporate entities, which are affiliated. Member CIPF. Mike can be reached at Michael. candelo-ro@rbc.com or on his Linkedin page. You can also visit his website at www.michaelcandeloro.com