Nine months into 2022 and the market decline continues. The major economic factors behind this correction remain the same: high inflation, rising rates (to combat inflation), and commodity shortages resulting from the Russia-Ukraine War. Of course, the pandemic continues to impact the global economy.
Even though the preceding 12 years were mainly positive for markets, investors naturally get concerned during a decline. The concerns often relate to the scope and duration of the decline, which is difficult to predict.
The industry’s general solution to a market decline is to understand they are part of the market cycle and to stay the course. However, you do not have to remain completely idle during a correction. There are solutions and strategies one can undertake before, during, or after a decline to optimize portfolio risk and return. For example, portfolios can be risked down for the risk-averse investor or risked up for the aggressive investor.
As always, we welcome the opportunity to review your portfolio in detail and answer your questions.
This newsletter will cover the following topics:
- A market update, specific to inflation, fixed-income, and equities
- A historical perspective on previous negative market events and the case against market timing
- A discussion on the new First-Time Homebuyer’s Account (FHSA) account due to launch in 2023, the first true “tax-free” account in Canadian investing
- An update to the ever-increasing savings and GIC rate environment
- A reminder of our new office location
Investors began to anticipate a shift in tone from the world’s main central banks throughout the summer months; however, in recent weeks the authorities have poured cold water on this notion, warning that the fight against high inflation rates is far from over. We are instructed to brace ourselves for higher interest rates, which may have to remain elevated for a longer time period to bring inflation back down to the stated inflation objectives.
Elevated price inflation, whether for food, energy, or other countless numbers of goods and services, is a burden on the economic cycle. Without a meaningful change in the inflation trajectory, it is difficult to envision a sharp improvement in the economic outlook.
(commentary below courtesy of Myles Zybock, Chief Investment Strategic, Dynamic Funds)
The August U.S. CPI inflation report released this week dashed hopes that the Federal Reserve might choose a less onerous interest rate path through upcoming months. Both the headline and core measures of inflation for August came in stronger than anticipated. While headline inflation, at 8.3%, is below the 9.1% peak reading set in June, it is moderating at a slower than expected pace. Meanwhile, core inflation accelerated to 6.3% from 5.9% and is approaching its prior high of 6.5% recorded this past March.
The Federal Reserve’s message over the past few months has been to raise interest rates to a level that moderates the risk of further inflation increases. This would usually be accompanied by tighter financial conditions which include higher credit spreads and a flatter yield curve. But, overall, financial conditions have eased since mid-June.
After a huge – almost +20% – summer rally, September has been bumpier, and, for good reason. The U.S. Federal Reserve reiterated its commitment to fighting inflation at Jackson Hole. Easier financial conditions are not on the docket.
Conclusion: We are being urged to brace ourselves for higher interest rates, which may also remain elevated for longer than has been customary throughout previous monetary tightening cycles. Many central banks indicate they are ready to accept the higher risk of an economic downturn to lessen the trajectory of future inflation. This premise could be put to the test in the coming quarters.
The government bond market’s inflation forecasts are plummeting. For example, the 1-year Treasury breakeven inflation rate has just dropped from 6.4% in March to 2%. Expected inflation declines, while considerably less apparent, may be observed all the way to the 30-year point on the inflation breakeven curve. Nonetheless, nominal bond rates have been rising. The 2-year Treasury yield has increased from 2.87% to 3.52%, while the 10-year yield has risen from 2.50% to 3.26% since early August.
The nominal yield is calculated by adding inflation expectations to the real yield. The rise in real yields has more than offset the decline in expected inflation. The activity of central banks has a substantial impact on the dynamics of real interest rates. More restrictive monetary policy conditions, such as increased policy rates and quantitative tightening, usually push the real component of the nominal yield higher. Many of the world’s leading central banks have plainly signalled in recent weeks that monetary policy settings are likely to tighten further.
There is no doubting that global government bonds are massively oversold, with the benchmark index down 24% from its peak in late December 2020. However, a prolonged rebound in bond prices is likely to need a shift in the messaging from global central bank officials, and for this to happen, we’ll need a mix of considerably reduced measured inflation (rather than just inflation expectations) and economic growth.
Conclusion: Global government bond prices are falling again after a six-week rally that had them 5% higher by early August. The trigger for this fresh downturn appears to be hawkish signals from global central banks. To establish a floor in bond prices, monetary policymakers will most likely need to pivot.
Global markets (as defined by the MSCI All World Index) began a strong run in mid-June, propelling prices 14% higher by mid-August. Continued optimism from originally oversold levels had hinged on a monetary policy shift that transformed a nascent hope into an eventual reality. U.S. Fed Chair Powell’s Jackson Hole address, however, poured water on the fire. With interest rates likely to rise for an extended time period, equity market values have once again come under downward pressure.
However, the current concern for the equity market is about more than just possible further increases in the discount rate. Global earnings are predicted by the analyst community to increase by +10.3% over the next 12 months, which seems overly optimistic. Consider U.S. stocks, which account for 62% of global equity market capitalization and whose earnings are predicted to expand +13.8 % in the coming year. Our macro earnings indicator, which combines leading data such as the Treasury yield curve slope, CEO business optimism, and the U.S. currency, indicates the chance of a 15% decline over the same period. In other words, at this point in the economic cycle, profit estimates for the U.S. and the world appear far too high.
Several Wall Street analysts have argued that the price low in mid-June is likely to be the cycle’s primary bottom because the following comeback through August 16th retraced slightly over 50% of the earlier loss. Looking back to the 1930s, and focused on U.S. equity market data, these experts discovered that a new low is rare following a 50% retracement of a 20% drop. The lone exception among the 14 previous occurrences was in 1930, when the market went on to make even lower lows.
Conclusion: While the chances of stocks setting a new low appear to be minimal based on history, this cannot be ruled out given the continuous rise in interest rates and a possibly woeful profit growth trajectory over the next few quarters.
(end of Myles Zyblock commentary)