Given just how sensitive the market is to interest rates these days, it isn’t a surprise that all eyes remain focused on central bankers trying to figure out when they will not only slow the pace of their hikes, but cut them and return to the good old days of quantitative easing and easy money.

For example, we’ve read that the bond market is currently factoring in a 70-per-cent chance of a 25-basis-point rate hike this week by the Bank of Canada, with its first rate cut coming in September, after last week’s Canadian consumer price index print of 6.3 per cent.

The probability of a recession in the United States stands at 65 per cent among analysts, according to Goldman Sachs Group Inc. Not surprisingly, 20 per cent believe the U.S. Federal Reserve will cut rates this year while 52 per cent are expecting a rate cut the first half of 2024.

Strategists and economists have been talking about the relationship between inflation and interest rates for some time now, but we still think many, including the pundits themselves, are missing the bigger picture. Or, to paraphrase the old saying, “When the sage points to the moon, most can’t see past the finger.”

What happens if the global economy does not enter a deep recession or even a recession at all, and inflation moderates but not below the targeted two per cent and stays in the four-to-five-per-cent range? Why would central bankers reduce interest rates should this play out? Why is their target two per cent? Isn’t it about having positive real rates?

We think with China’s economy reopening, continuing wage hikes due to demographic trends and persistent large fiscal-deficit spending by left-leaning governments in the developed world will all provide a floor to just how low inflation will fall and, with it, interest rates without sending the world into a recession.

We are already seeing hints of this taking shape.

The stock price of Caterpillar Inc., which is a go-to bellwether of the health of the global economy, is now back to all-time highs. During its third-quarter conference call, management indicated it is witnessing increased sales across all regions and business lines. Shares of LVMH Moet Hennessy Louis Vuitton SE, the Paris-based conglomerate specializing in luxury goods, are also setting new all-time highs.

While in the early stages, global commodities are showing some strength, with copper now up more than 25 per cent from its July 2022 lows, SGX TSI Iron Ore up nearly 60 per cent from November, and RBOB Gasoline Futures up over 23 per cent from December.

This could make it extremely difficult for central bankers to reduce interest rates back to 2020 levels, despite the tremendous pressure being exerted on them by their respective governments, which are eager to keep borrowing and spending on agendas such as climate change after having been given a taste following the COVID-19 lockdowns.

Should this transpire and inflationary pressures persist, there will be an acceleration of the movement of capital away from high-growth sectors toward those companies and sectors that offer strong cash flows even in a higher-rate environment.

As a result, we would recommend looking once again at good old-fashioned value plays that have underperformed for the greater part of the past decade such as energy, some parts of health care, industrials, finance, consumer staples and utilities.

Or, as Yasunari Kawabata, a Japanese novelist and short story writer, so eloquently said in Palm-of-the-Hand Stories, “The true joy of a moonlit night is something we no longer understand. Only the men of old, when there were no lights, could understand the true joy of a moonlit night.”

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc, operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning.

_____________________________________________________________

 If you like this story, sign up for the FP Investor Newsletter.

_____________________________________________________________