July 2008

Canada's inflation immunity

Food consumers are rioting over grain prices in the developing world. Gasoline prices are soaring just about everywhere. Inflation is well above central bank targets in Europe, Mexico, China and Australia, to name only a few such trouble spots. In addition, although the U.S. Federal Reserve has largely averted its eyes to a four per cent inflation rate while it fends off recession, its board members warn of a sterner policy once growth picks up. All of this reflects the impact of several years of strong global growth that has tightened markets for crude oil, metals and grains. Why, then, does Canada seem to have an immunity necklace in terms of price pressures, with both core and all-time Consumer Price Indexes (CPIs) well below the central bank's two per cent target as of March?

A half percentage point of the difference can be chalked up to this year's one per cent point cut in the GST (which does not hit all the components in the CPI), although that is netted out of the Bank of Canada's core CPI measure. However, there is also a nearly unprecedented gap between after-tax goods inflation rates across the Canada-U.S. border.

In part, that captures a recent sharp drop in vehicle prices as carmakers passed on a one-time benefit from the rise in the Canadian dollar into sticker prices. It also reflects a similar one-off savings on imported fruits and vegetables. Food inflation has also been held back by a grocery store price war that has squeezed margins in Canada, and by the role of marketing boards in smoothing out some food price increases.

None of those forces is likely to last into 2009. Grocery store margins will probably rise at some point to restore profitability. Cost increases from the global squeeze on grains and energy will show up in poultry, eggs and milk. There is no further GST cut coming, and the Canadian dollar is highly unlikely to see as big a year-on-year rise, given where it currently sits and the trouble that it is causing for manufacturers. Add in further increases in gasoline prices, and Canada's CPI will be in the range of three to 3.5 per cent next year.

Assuming the economy is back on a firmer growth path, the Bank of Canada will be doing its duty to wrestle those inflation pressures back down to earth. This year's rate cuts will give way to at least a 100-basis point hike over the course of 2009.

For investors, that puts a note of caution into the prospects for interest-sensitive equities such as financials, residential real estate and utilities. Earnings for financials could be relatively tame, even after the worst of the write downs pass, and Canadian residential real estate prices will slow in the face of rising mortgage rates. Government bonds, which benefited from a flight to safety bid in recent months, will be much less safe by late this year as yields rise in line with higher inflation expectations and upward pressure on the short-term yields from expected 2009 Bank of Canada rate hikes.

Instead, the winners will be in equity market sectors benefiting from the commodities inflation that will underlie the inflation risks - energy, materials and fertilizers - as well as related services in such areas as irrigation and biotechnology.

This will not be stagflation, or at least not a full-blown case of the disease seen in decades past that entailed coinciding double-digit inflation and unemployment rates. Nevertheless, inflation is going to again be a factor for Canadian investment decisions in the year ahead.

May 12, 2008

By Avery Shenfeld, managing director and senior economist, CIBC World Markets 

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