Asset prices experienced another difficult quarter as economic headwinds began to mount, and financial conditions tightened in response to inflation continuing to trend higher than expected. Capital markets became almost wholly focused on an inflation inflection point, which has been complicated by both the spike in commodity prices, further exacerbated by the tragic and unending war in the Ukraine and supply chain problems arising from COVID lockdowns in China. Central banks were compelled to take the looming threat of out-of-control prices more seriously, hiking rates faster than anticipated, which in turn raised concerns on the impact of higher borrowing costs on economic growth.
In Canada, the consumer price index (CPI) has reached levels not seen since the early 1980s. In May, prices climbed 7.7%, up from 6.8% in the previous month, with the key driver being energy prices which were up 35% in May (on an annual basis). When stripping out food and energy, the CPI (median) measure rose to 4.9% in May year on year, versus 4.6% in April, suggesting that inflation is not only increasing, but potentially broadening out across sectors.
With inflation at a 40-year high, both financial markets and consumer confidence understandably remain on edge. To restore price stability the Fed raised its benchmark lending rate 75 basis points – the biggest increase since 1994 – to a range 1.5% to 1.75%. The Bank of Canada raised rates to 1.5% from 1.0% further noting that it was ready to act ‘more forcefully’ if necessary – and followed on in July with a supersized 1% hike. Central banks are now engaged in a delicate balancing act of trying to dull inflation while not dulling economic activity or worse – tipping the economy into recession.
Consumers have responded to higher prices by turning more negative on their economic outlook, while consumer sentiment and discretionary spending forecasts drop to their lowest levels in over a year. Expectations for the unemployment rate one year out have also increased, albeit from a very low base. It is, however, worth noting that longer-term inflation expectations remain stable and at normal levels.
While economic activity continues to be robust, signs of a slowdown are emerging., The composite purchasing managers’ index although still in expansion territory has been steadily declining, shifting 53.6 to 51.2 in June, while the services component shifted from 53.4 to 51.6. And, manufacturing sentiment has aggressively declined with new orders coming in at the bottom 10% of readings in the last 20 years. On a perhaps a more positive note, higher inventory levels coupled with observed shortened delivery times suggests supply chain pressures are no longer a major concern further indicating the pandemic is exerting less of an impact.
With central banks around the world firmly set on combatting uncomfortably high rates of inflation by raising interest rates, markets will be paying close attention to economic indicators. Higher rates will moderate demand, and while some moderation will help dampen inflation and bring prices back into line, too much will increase the risk of recession
The rout in equity markets continued to deepen, as the earnings outlook was further clouded by concerns of slowing economic growth caused by aggressive monetary tightening due to higher-than-expected inflation pressures. As a result, several major indexes either moved into a bear market or are flirting with the prospect of one.
The S&P 500 declined -16.5% (USD) on the quarter or -20.6% (USD) year-to-date. The MSCI AC World finished only marginally better, at -14.1% (USD) on the quarter and -18.5% (USD) year-to-date. The S&P TSX, the standout performer of Q1 due the inclusion of those companies that benefit from inflationary pressures (i.e., energy and materials), provided a total return of -13.2% (CAD) in Q2, as commodity prices consolidated in response to increased recession risks.
There were no bright spots on the quarter, with declines being observed across all sectors. The least bad of the bunch were the safe haven sectors of Utilities and Consumer Staples. Energy also continued to outperform the market amid supply constraints due to the ongoing conflict in Ukraine, but turned negative in the final weeks as recession fears began to take a toll on energy prices.
While valuations initially came off earlier in the year as higher interest rates normalized multiples, Q2 was when investors refocused on recessionary risks and associated earnings expectations. As the economy went through COVID, high demand for consumer durables, coupled with low supply and the solid dose of government stimulus, allowed firms to pass on additional costs through higher prices resulting in record corporate profit margins. This will be difficult to repeat, as rising wages, higher borrowing costs, higher commodity prices and waning consumer demand are placing an ever-increasing set of challenges on firms, calling into question earnings expectations.
A recession will of course lead to a decline in profits, which will further unsettle equity markets, however, it will also eventually lead to less wage pressure and a return to easier monetary policy. This, along with the more attractive asset valuations, means that the long-term environment for equities moving forward will ultimately improve
High inflation, falling unemployment and the increasingly hawkish stance of central banks continued to push bond yields higher across the curve. However, bonds rallied into the quarter-end as rising growth concerns begin to set in, slightly curtailing the quarter’s negative returns.
The FTSE Canadian Overall Universe Bond Index finished down 5.7% on the quarter as central banks in the developed world began to aggressively hike rates in response to higher-than-expected inflation. The 10-year bond in Canada experienced another relatively big move, increasing 82.4 bps on the quarter to finish at 3.23%, while the U.S. 10-year increased 64.9 bps to finish at 2.97%. Both yields have effectively doubled year-to-date.
The spike in interest rates has been understandably disruptive, as the cost of borrowing is a defining factor in our modern economy. There has been considerable repricing in mortgage rates, which have nearly doubled since the outset of the year. The Bank of Canada’s 2022 Financial System Review published in June stated that the typical mortgage payment could be 30% higher in 5 years’ time, which should begin to impact the housing sector in short order and contribute to the slowing of the economy.
Corporate bonds underperformed government bonds as spreads widened markedly and concerns over the economic outlook grew. The BofA Global Broad Market Corporate Index experienced a decline of -8.5% (USD), while BofA Global High Yield Index declined -11.4% (USD). High yield credit was hit particularly hard as the spread expansion drove the average yield in the US market to 7.53% over the quarter, up 131bps from Q1 after little change over the past year.
In the latter half of 2022 pricing pressures will be the key focus for bondholders, given that central banks are committed to tightening policy aggressively. However, on a positive note, the move in government bond rates and widening credit spreads has led to some of the most attractive bond yields in recent history, thus making bonds a more investable asset class.
While the near-term outlook seems challenged, not all economic downturns are catastrophic; something that may be hard to remember given that the last two downturns (COVID-19 and the 2008 GFC) were so severe. A more typical slowdown is likely to be shallower than prior episodes, particularly since the global economy’s starting point is one of strength.
Households enjoy a solid financial position with elevated savings, a strong labor market and relatively higher incomes. The corporate sector does not seem overleveraged, which is what often characterizes the beginning of an economic downturn. In fact, corporations are in the opposite position, after having refinanced their balance sheets at all time low rates of interest.
Inflation is likely to persist at least in the short term, even as growth slows. Unfortunately, central banks have limited options to fight inflation, even if that means slower growth and poor financial market performance, as they are unable to directly produce more goods and staff airports. What they can do is temper demand to give supply the opportunity to catch up.
The key variable under consideration continues to be inflation. Once inflation pivots, as it eventually will, the economic and financial recovery will be in sight. Until then, volatility will remain the dominant theme. In the meantime, we have moved to hold sufficient cash to cover liquidity needs where appropriate, so forced selling is not a factor. Our bias towards higher credit quality bonds and equity in companies with strong business models that thrive in a myriad of business environments will continue to serve the portfolios well over the long term.
