First Quarter 2022 Market Update:
As 2022 rolled in we were all focused on inflation and what policy makers were going to do about consumer price inflation reaching multi-decade highs. Central banks no longer viewed rising prices as a transitory phenomenon and went as far as acknowledging they were dropping that language from their statement.
Expectations of more persistent inflation were ramped up as the onset of the Russia-Ukraine war resulted in steep rises in energy and food prices, which adds to already high inflation and leaves central banks with little option but to raise interest rates aggressively.
The number and magnitude of rate increases have become a new moving target for investors to decipher as they worry about the impact panicked central bank actions might have on their investments and the global economy.
While the amounts and timing of rate hikes can’t be predicted with one hundred percent certainty, market participants now expect the Bank of Canada and the Reserve Bank of New Zealand to increase rates steadily to 1.75% and to 2.5% by year end respectively.
Likewise, the US Fed is expected to announce some six rate hikes this year, ending the year at 2% to 2.5%. The central bank will also continue pushing forward with its quantitative tightening programme, further removing the liquidity that has been propping up financial markets.
Given the valuation of stock indexes, we expected the start of this rate hike cycle to have tumultuous impact on financial markets, with a more pronounced pullback in the sky-high tech sector likely. The Nasdaq is already further in the red this year, down 12.4% year to date, than the broad-based S&P500 Index, which has declined 5.8%. Stock markets are not moving in a straight line, with the tech-heavy Nasdaq bouncing back in early April. Canada’s S&P/TSX Index performance has contrasted with the other developed economy indexes, gaining 3% year to date.
Tightening monetary policy could see investors’ focus on growth over profitability in an era of easy money become more troubling going forward, and it’s for this reason that my investment strategy has been the antithesis of the growth-at-any-cost model. Given the lack of earnings and free-cashflow for many of these newer tech companies, we could see more volatility ahead in the sector as investors reconsider their risk appetite.
The impact of the monetary policy tightening could have the most significant ramifications since 1980 due to a significant increase in the debt-to-GDP ratio in the private sector, which will see them repaying that debt at higher levels as rates rise.
Inflation has already been running too hot for too long, so even if price increases do begin to slow this year, workers are going to demand higher wages because of the elevated level of the prices of everyday goods needed to maintain a household.
Persistent supply chain problems, which are unlikely to clear up now that war dominates the landscape in commodity and agriculture-rich Ukraine and Russia. Commodity prices soared on the news of Russia’s invasion of Ukraine but have since proved more volatile, peaking in early March, and then coming off during March before rebounding in early April. The outlook for energy prices is particularly uncertain. Europe is most reliant on Russia for gas and oil supplies and, to alleviate the impact on sanctions on Russia, the Kremlin recently demanded that “unfriendly countries” pay gas, oil, and other commodity contracts in rubles. Most European countries have refused to do so, but Hungary broke ranks in early April, announced it was prepared to pay rubles.
These supply dynamics will contribute to the persistence of inflation especially when policy makers try to resolve these problems with demand-side solutions. You end up in a classic inflation situation of too much money chasing too few goods. This is quite evident in the Canadian housing markets, where a plethora of demand-side solutions are being proposed to curb the problem. Following on this theme of demand-pull inflation, the Premier of Quebec, Francois Legault, has offered residents cheques of up to $500 to keep their heads above water, another attempt to put out the seemingly ineradicable inflation fire with more gasoline.
The enfeebled position of central banks is apparent – and has been exacerbated by – the Ukraine conflict and the sanctions imposed on Russia. Against this backdrop, the Fed, Bank of Canada, and ECB will be hard-pressed to tame inflation without causing a recession.
We know that equities have historically been a great hedge against inflation, hence our portfolios are adequately biased towards stocks, in line with each investor’s goals. Moreover, with the low to negative real yields offered by bonds in general, we find that dividend-paying equities are the preferred way to generate income in a portfolio, especially for clients seeking a cash flow from their investments.
However, as yields rise, bonds start looking attractive again and, given the multitude of challenges facing the global economy, I would not be surprised to hear market expectations turn towards lower or negative rates in the not-too-distant future. Should this transpire, we could end up being stuck in a low-rate environment again due to the longer-term demographic trends that prevailed before the pandemic.
We continue to believe that a focus on high quality but cheaply priced companies will pay dividends and perform relatively well in the coming higher interest rate environment. We also note the importance of cutting out the noise when it comes to successful long-term investing.
Garnet O. Powell, MBA, CFA is the President & CEO of Allvista Investment Management Inc., a firm with a dedicated team of investment professionals that manage investment portfolios on behalf of individuals, corporations, and trusts to help them reach their investment goals. He has more than 20 years of experience in the financial markets and investing. He is also the Editor-in-Chief of the Canadian Wealth Advisors Network (CWAN) magazine. He can be reached at firstname.lastname@example.org