AI and Inflation

Spoiler – it could be positive for fixed income

Scotiabank Global Economics recently published a report entitled The AI Shock: How It Could Shape the Economy. The report examines the potential macro-economic impacts of Artificial Intelligence on the US and Canadian markets. While AI is attracting significant  debt financing in the US, although less so here in Canada, we are more interested in the effects this may have on productivity, and therefore on economic growth, inflation and financial markets.

While there are many variables to consider, the report considers the labour market as the key uncertainty, and surmises that the outcome for it depends on whether “AI mainly substitutes for workers or complements them”. Its impact on the share of labour in the economy will come down to whether it automates (substitutes) or augments (complements) certain tasks. Automation reduces labour demand and thus labour income, while augmentation enhances labour productivity in affected tasks.

At a high level, the implications for financial markets are straightforward. If AI enhances productivity, growth rates and / or profit margins should expand. This would be particularly well received by equity investors and markets but would also be beneficial to the capital markets at large. However, market expectations are high, both in terms of scale and timing, so any disappointment or lengthening of the timeline to achieve these outcomes would likely lead to a sharp repricing.

Scotiabank explores three scenarios - two upside scenarios, and one downside scenario.

The first upside scenario assumes AI’s effect is to raise productivity without any material disruptions to the labour markets – workers benefit from increased productivity more than the negative effect (lower demand for labour) from task automation. The level of employment is not materially dislocated. 

The second upside scenario theorises that AI has a positive impact on economic activity but labour markets face disruptions and displacement, as more tasks get automated. This scenario is perhaps more in line with previous technological-driven economic events.

The downside scenario is one where the expected productivity gains fail to materialize or do so on a slower timeline, and as a result markets reprice sharply.

Under both upside scenarios, the impact on GDP growth is forecasted to be positive and accelerates over the next 2-5 years.  The downside scenario sees a sharp negative impact on GDP growth in the next 24-48 months. The impact on unemployment is forecasted to be negative (meaning rising unemployment) in all three scenarios, to varying degrees however. It predicts that as one would expect, the impact would be lowest under the first scenario (where labour productivity increases at a higher / faster rate than jobs get automated). The report also predicts the largest negative impact on unemployment would occur in the second scenario (where labour is increasingly automated) and that it would be the longest-lasting. 

The downside scenario predicts that AI fails to deliver the expected productivity gains or profit growth within expected timelines. As stated, this would lead to equity re-valuations, and tighter financial conditions. It predicts a sharp negative impact in the immediate to the near future followed by a gradual recovery as labour adjusts and adapts to the new dynamics.

Fixed Income

In terms of our fixed income mandates, we are most interested though in the forecasted effects on inflation. The report concludes AI is likely to be disinflationary across a wide range of outcomes. This is either through stronger supply growth (increased productivity or automation) or weaker demand (the downside scenario as unemployment spikes quickly and financial conditions tighten). As such, this is potentially positive for fixed income assets as lower inflation generally means interest rate cuts by central banks (and these are positive for fixed income – remember, as interest rates fall, bond prices rise).

Reflecting on this report’s potential implications for the Kipling Strategic Income Fund, our robust investment strategies and processes makes us confident that the Fund is well-prepared to navigate these scenarios. The Fund has prospered under various financial and economic conditions over the past 9+ years (note to readers, the Fund’s 10-year anniversary is on August 5^th – here is to many more successful years!).

The Fund has fewer restrictions and more flexibility at its disposal to use to bolster returns or to mitigate risks.

The Fund uses moderate leverage to maximize its capital exposure to the market, to enhance returns and to better manage cash and risk. For example, in the disinflationary environment described above, interest rates would be expected to fall, and therefore bond prices would rise. The Fund would generate additional return due to the increased exposure in corporate bonds resulting from the borrowing and shorting of government bonds.

The KSIF is also able to invest in a wide variety of instruments (e.g. investment grade debt, non-investment grade debt, preferred shares, convertible debentures, commercial paper and bonds maturing in less than 1 year) to take advantage of opportunities and to increase diversification. For instance, in a disinflationary environment, the Fund might decrease its exposure to the basic materials and/or commodities sectors without abandoning them altogether by moving into senior and secured bonds as opposed to riskier but higher- yielding subordinated debt.

Finally, the Fund aims to minimize interest rate volatility or risk, by investing in short to medium dated bonds, whose values are not as sensitive to the rise and fall of the yield curve and interest rates. The risk is that Scotiabank’s thesis that AI will have a disinflationary effect is proven inaccurate, which would likely result in higher interest rates. That being the case which we think could be unlikely, the Kipling Strategic Income Fund’s short duration (and average term to maturity) and therefore lower rate sensitivity would serve to materially lessen this impact.

Enjoy summer and with kind regards,

Owen Morgan

Owen Morgan is a Portfolio Manager with Cumberland Investment Counsel Inc.(CIC). The Kipling Funds are only available for sale to investors who meet the definition of “accredited investor” as set forth in National Instrument 45-106 Prospectus and Registration Exemptions, or non-individuals who will be investing a minimum of $150,000. Please consult your advisor to determine your qualification status.

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