2022 will go down in the record books as an abnormal year for the financial markets. As inflation reached 40-year highs, it caught the central banks by surprise and led to a rapid tightening of monetary policy through interest rate increases. What has made this tightening cycle unique is the speed and magnitude at which rates increased (chart).¹ Many argue that these actions have been necessary because the central banks acted too late to control inflation. However, this created significant volatility in 2022, with declines to both fixed income and equity markets. The declines may have felt particularly significant because for much of 2020/2021, asset values increased with little interruption, supported by the availability of low-cost capital and use of leverage, an increased money supply due to pandemic stimulus and excessive exuberance.
What Can We Expect in 2023?
The central banks have been focused on achieving “price stability” to prevent inflation from becoming entrenched. The good news is that we are seeing the effects of the rate hikes take place (they often lag), such as with the cooling of rate-sensitive areas of the economy like the housing market. Yet, it will take time for inflation to substantially ease. As such, if inflation persists, the central banks are likely to continue raising rates, with the intent of slowing economies, and this may lead to market volatility.
More recently, there has been a growing belief that the tightening policies may be slowing. In December, the Bank of Canada said it would be “considering whether the policy interest rate needs to rise further.”² This may be positive news because rising rates have put downward pressure on the financial markets. For fixed income, investors will recall that bonds have an inverse relationship to interest rates: when rates rise, bond prices generally fall. For equities, higher rates mean valuations generally go down because the future value of cashflows is lower when a higher discount rate is used — this is especially true for the way in which growth stocks are valued. If a significant slowdown in inflation does become apparent in 2023, it will then allow for a return to less restrictive monetary policy.
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