The year 2022 was volatile and difficult to navigate with seemingly very few places to hide in either equities or fixed income investments. This created an understandable general feeling of anxiety and pervasive bearishness among investors. With that said, while we expect volatility to remain, economic momentum should pick up (from low levels) as we move through 2023. As we have noted in previous commentaries, securities markets are primarily influenced not by absolute numbers but by the trajectory of key macro variables. On that front, the situation is already improving for inflation – though it may be a slow trek to get back down to the Bank of Canada’s desired 1-3% range. As always, the stock and bond markets will discount and price in these improvements well before we see the evidence in the “real world”.
We are seeing early signs that better times are coming, and perhaps sooner than many investors expect. The environment has been volatile and downbeat for most of the year but with inflation showing signs of peaking, things are falling into place, including a peak in long-term interest rates (the two are very clearly related), better credit market trends, and a sharp improvement in beaten down cyclical areas of the stock market. Now, inflation is still leading to price increases, but what the market looks for is trends in data and not necessarily absolute values. What matters most right now is that the pace of price increases is decreasing.
Are we past peak inflation in this cycle? With the absolute level of inflation coming down in recent months, it would seem that it is thankfully behind us. The CPI (consumer price index) figure is still far too high for comfort, but the trend is improving and expected to continue further in the coming months and possibly more quickly than many bearish investors believed. This is part of the reason the stock market has been behaving better recently. Vast improvements in supply chains largely help explain this. Anecdotally, the cost of shipping a full container from Asia has dropped to about US$4,000 currently from about US$20,000 last year. Also encouraging is that consumer inflation expectations are coming back down to trend which implies that individuals still have confidence in Central Banks’ abilities to break the cycle of price increases.
An important question investors are asking is, how much of the inflation threat and potential economic growth slowdown is already embedded in stock prices? It would seem quite a bit after a very difficult stretch for the market. While inflation remains a large concern, there are early signs it may be peaking in North America. In Canada, the latest CPI figure came in below expectations, though still notably high. Central banks in Canada and the US have aggressively hiked rates thus far in 2022 from historical lows during the pandemic and markets are adjusting to these higher levels.
After starting the month strongly, equity markets in North America ended up giving back those gains in the last week of August to end flat to slightly down. Comments from Fed Chairman Jerome Powell about interest rates having to be higher for longer to combat inflation prompted the late month sell-off.
North American central banks continued their tightening cycle in July leading to higher short term interest rates. The Bank of Canada caught the market off guard, raising it’s target overnight rate by a full percent, while in the US, the Federal Reserve increased it’s fed funds rate by 0.75%. Both banks are trying to reign in surging inflation numbers in their respective country. Despite these increases to interest rates by the central banks, longer term bonds rallied (meaning their prices rose), leading to a monthly gain for the Canadian Bond Universe Index for the first time in 2022.
The S&P 500 falling into a bear market (down over 20%) has generated a number of worrisome headlines in the media. The leading causes for stock weakness remain the same and should not surprise market followers: stubbornly high inflation, rising interest rates and fears of a sharp economic slowdown. It is worth noting that the S&P/TSX has held up far better than its US counterpart this year, given its relative higher exposure to Basic Materials and Energy which are traditional inflation hedges. Canadian stocks’ more attractive relative valuation has also helped cushion the blow.
After seeing significant losses in each of the first four months of the year, May saw markets end the month relatively flat, though not without significant price swings. Equities continued their slide early in May, declining over 5% in both Canada and the U.S., but ended a 7-week losing streak with a strong upward reversal later in the month. For the month of May the S&P/TSX was up marginally, gaining 0.06%, while the S&P 500 increased 0.18% in USD terms (though down 0.94% in Canadian dollars). Fixed income markets also found some footing during May as the CDN Bond Universe was down only 0.07%.
The shape of the interest rate yield curve has caused much concern of late. In the U.S., rates inverted briefly with the 2-year bond yield slightly higher than the 10-year bond yield for a moment. This closely followed relation has predicted each U.S. recession since 1969 – but has also incorrectly predicted many recessions as well. The situation should be monitored, but the silver lining is that the inversion this time was very brief and the signal tends to have a long lead time (12-18 months). If we are in a flat (or even inverted) yield curve environment, equity leadership will likely rotate into more defensive or less economically sensitive sectors. For the month of April, markets in Canada and the U.S. were off significantly, with the S&P 500 down about 6.5% in Canadian dollar terms, while the S&P/TSX was about 5% lower.
The central bank’s job is getting more complex with a geo-political conflict adding to an already challenging first quarter environment of high inflation, low unemployment, signs of slower economic growth and still high monetary stimulus. Perceptions stood that central banks were already late in starting to remove the stimulus and the persistent price pressures only confirmed the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) are behind the inflation curve and much work is needed.
As market focus shifts from a slowing pandemic, another more concentrated risk has appeared in the form of a Russian invasion of Ukraine. The result of the conflict on financial markets remains uncertain, however it clearly will have an impact on the developed world through higher energy and food prices. Between them, Russia and Ukraine are significant exporters of crude oil, natural gas and wheat.
After an extremely strong 2021, January presented investors with more volatile stock swings. No sector was harder hit than high multiple technology stocks as concerns about rising inflation and associated higher interest rates took center stage. Although Omicron continues to be in the headlines, it is not the primary market mover at this point and is the belief of many that COVID-19 will soon morph into something more akin to a bad flu (more infectious but less severe than it’s original iteration).
Despite a second calendar year of a global pandemic, in 2021 equity markets in North America - and many parts around the world - climbed to new all time highs. Expectations for a global economic recovery from a weak 2020, as well as continued historically low interest rates helped fuel performance.
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