Lexicon Financial Group Weekly Update

Tuesday, February 22, 2022


Looking Back

The markets were mixed last week but overall they seem to be moving in the right direction. The S&P 500, the NASDAQ, and the S&P&TSX have all moved up from the January lows. That said, a number of geopolitical and economic uncertainties hang over the markets like the sword of Damocles.

The Russia-Ukraine stand-off continues despite ongoing diplomatic interventions and Russian statements that it has withdrawn some of its forces. A Russian invasion of the Ukraine will further disrupt the supplies of crude oil and could potentially result in higher prices for oil which are already at their highest in seven years. According to Capital Economics a Russian invasion of Ukraine or a severe ratcheting up of sanctions could add as much as 2 percentage points to inflation in developed markets. This could cause the Federal Reserve (the Fed) and other central banks to move even faster to raise interest rates to try and dampen inflation. (1) It is going to be interesting to see what the inflation rate is in February given that the U.S. annual inflation rate accelerated to 7.5% in January 2022 thanks to increasing energy costs, labour shortages, and supply disruptions coupled with strong demand. This beat the market forecasts of 7.3%. (2)

 

Canada's inflation rate hit 5.1 per cent in January, its highest level since 1991. Statistics Canada reported last week that if volatile items, like food and energy, are stripped out of the numbers, inflation went up at a pace of 4.3 per cent which is the highest dating back to 1999.

Rising inflation looks like it is here to stay and how the Federal Reserve and other central banks increase interest rates in March will set the tone for 2022 and beyond.

 

Looking Around

Rising inflation is not isolated to any single country. Citizens from Karachi to Kansas City are all experiencing rising prices.

The late US President Ronald Reagan once said that “inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.” Inflation adds uncertainty to markets, which is why central banks work to keep it within a narrow range, typically 2%. But a simple change in interest rates won’t solve the inflation problem over night. It takes companies several quarters to be able to pass along higher input costs to consumers. Inflation hits those on fixed incomes the hardest – they aren’t bringing in additional dollars, yet goods and services cost more. In effect, they lose purchasing power.

 

Looking Beyond

Since the 1930s, research suggests that almost every country suffered its worst real returns (nominal returns minus inflation) during high inflation periods. Think of the nominal return as what an investment generated over a given period of time. The real return is how much more purchasing power that investment has. So, for all environments, in order for purchasing power to be maintained, the nominal return must exceed the rate of inflation. Subtracting inflation from the nominal return gets you to the real rate of return.

Looking at S&P 500 returns by decade and adjusting for inflation, the results show the highest real returns occur when inflation is 2% to 3%. Since interest rates are usually increased to combat high inflation, the corollary is that in times of high inflation, equity investments may underperform. (3)

 

Further Reading

Markets & Investing – Raymond James

Charlie Munger on inflation: We're flirting with serious trouble

The rise in global inflation - the hit to living standards across the world

Putin's absurd, angry spectacle will be a turning point in his long reign

Ukraine-Russia crisis: What will happen if Vladimir Putin chooses all-out war?

 

The opinions expressed are those of Craig Swistun and not necessarily those of Raymond James Investment Counsel which is a subsidiary of Raymond James Ltd. Statistics and factual data and other information presented are from sources believed to be reliable but their accuracy cannot be guaranteed. It is furnished on the basis and understanding that Raymond James is to be under no liability whatsoever in respect thereof. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities. Raymond James advisors are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters.

 

  1. How a Russian invasion in Ukraine could disrupt life in America, Paul R. La Monica, CNN Business, February 14, 2022
  2. United States Inflation Rate, Trading Economics
  3. Inflation's Impact on Stock Returns, Kristina Zucchi, Investopedia, February 10, 2022

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