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Why Inflation is peaking, Rates are Coming Down, Bonds are Going Up, and Hybrid Funds are Best.

Updated: Oct 22, 2022

This chart of consumer prices vs money supply (M2) growth rates in the US shows that consumer prices have historically followed the money supply fairly closely. To the extent that this relationship holds, the gaping divergence from this pattern in the last three years means inflation will likely come down a lot! bringing mortgage rates and bond yields down with it (bond values go up when yields come down). The two economies are so intertwined I believe this chart is a good leading indicator for Canada 🍁 as well. The implication is we are about to get a break from rate hikes, followed by the recession central bankers seem to think we deserve.

What does this mean for mortgage holders?

If my forecast is correct, there will be significant advantages to variable or short-term fixed-rate mortgages over the next five years. It may take a year for the BOC to begin lowering rates, but they probably will, and by a lot! Here is a link to my favourite Canadian Housing Market Forecaster, Will Dunning. He thinks Canadian mortgage rates will be falling again next year.

What does this mean for Investors?

In my crystal ball, stocks and bonds will likely recover some YTD losses between now and year-end 2022. 2023 may be lacklustre for stocks if we have a recession, but bonds will recover their diversification benefits. Stocks will outperform again once the recession approaches its nadir. Global 60/40 Stocks/Bonds split portfolio allocation should start performing well again for retirement income-oriented investors. This can be closer to 70/30 with a generous allocation to dividend funds.

If the recession hits earnings hard and/or inflation is stubborn, dividend stocks will hold their value better. The model portfolio now incorporates 40% Hybrid (75/25 Stocks/Bonds) Canadian and Global Dividend funds, which should perform better in various environments now that most of the rate hikes are behind us. The reason hybrid funds are so attractive here is the automatic rebalancing between stock and bond asset classes, which results in buying low and selling high. These benefits have been muted in the rising rate environment, but they will be back next year.

To capture the accelerating growth in capital expenditures by governments and industry to address energy costs and climate change, the Rigden Financial Model Portfolio now includes an Infrastructure fund.

Large technology stocks tend to do well in stable and falling rates environments because their future earnings growth becomes more valuable. Technology will be central to solving many problems ahead, and these stock prices have decreased YTD sharply.

Finally, for long-term investors and estate planners, Participating life insurance (PAR) is a tax-efficient portfolio component. PAR provides access to stable growth through direct investment in real estate and commercial mortgage portfolios. There is no downside risk, and the current average dividend yield has been around 5.75%. PAR dividends compound tax-free for your estate. It is possible to borrow against the cash value - at reasonable rates and without having to make payments to help fund investments or retirement. You can also simply take dividends in cash, but these will be taxable.

Good luck to us all in these interesting times!

Layth Matthews

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