Economic and Financial Markets Commentary – September 2022


The pandemic and the inflation surge

The COVID-19 pandemic stay-at-home orders from governments triggered a recession in the second quarter of 2020. This recession was short but extraordinarily sudden and deep[1].

Eventually, social distancing measures were gradually lifted, and vaccines came along. The recovery was swift later in 2020 and in 2021. Fiscal generosity by governments had smoothed over the pain of the recession, to such an extent that the average household in advanced countries saw their revenues rise during the recession. Consequently, savings rates soared while consumers sat at home, not spending. This only lasted so long, however. Soon, the extra income and those unexpected savings, and the travelling restrictions, all led to a shift in spending patterns away from services and towards goods.

The demand surge for goods that ensued and the pandemic induced supply chain disruptions built up inflationary pressures throughout 2021. This was widely recognized during the third quarter of 2021 but deemed by central bankers to be a transitory phenomenon that would fade away later. The absence of reaction by the bond market, with mid- and long-term interest rates staying low, was confirming this interpretation at the time.

By the last quarter of 2021, most countries were back to the mature phase of the economic cycle, where they were in February 2020 before the pandemic. With full employment and other late-cycle conditions in place, inflation did not fade away but persisted.

Interest rates respond

With a mature economic cycle at play and central banks tapering their easy monetary policies, sentiment changed suddenly at the beginning of 2022. Market participants concluded the inflation had already moved up to concerning levels months earlier, well above early expectations, and would not be so transitory after all.

Interest rates started rising, fast. The yield on the benchmark 10-year US Treasury bond went from 1.5% at the end of 2021 to 3.4% by mid-June 2022, a superlative jump over a short period. Rates for other maturities in Canada and the United States all saw extraordinary moves as well. Interest rates also rose in other countries.

The February Russian invasion of Ukraine added more uncertainty to the political and macroeconomic environment. It brought added impetus to energy and food inflation and exacerbated the economic deceleration, especially in Europe. We now expect this conflict to drag on indefinitely, turning into a war of attrition while Russia is mired in Ukraine.

The rapidly rising interest rates immediately started to act as a brake to economic growth. Households’ real income (nominal income less inflation) which had turned negative months earlier when inflation accelerated, fell further into negative territory. Households began drawing down faster their pandemic savings, which are estimated to have been exhausted by now.

The horizon darkened for economies worldwide.

Bonds, equities, and a recession

High inflation, rising rates and slowing growth have been a potent mix for bond and equity markets so far in 2022. Bonds suffered large losses in the first half of 2022 with the FTSE Canada Universe Bond Index losing 12.2%. They offered no protection to investors.

Equities also suffered. The S&P/TSX Composite Index fell 9.9%, the S&P 500 Index, 18.8%, and the MSCI EAFE, 11.8%.

Most other asset classes, such as real estate or private equity, have been experiencing poor performance as well, since they are impacted by the same combination of slowing growth and higher discount factors.

Central bankers adopted very accommodative monetary policies at the onset of the pandemic, which is understandable given the uncertainties of the time. However, they maintained that stance far too long given the obvious strength of the recovery. Spooked by their thorough misreading of the inflation surge, they fully pivoted their mindset early this year and began raising short-term rates.

Their aim is to decrease final demand and restore slack in the labour markets: in other words, choke off economies. Already, the GDP has fallen in each of the first and second quarters in the United States.

Inflation has stopped accelerating and should soon start decreasing as final demand falls and supply chains move back into equilibrium. Central banks expect ‘pain’ to be inflicted on the labour market along the way to restore its balance. This will take longer to pan out, but we already see layoffs and hiring-freeze announcements. Labour participation has stopped declining and unemployment rates are beginning to inflect upward.

Incidentally, the stagflation scenario will not materialize. Central bankers are too afraid of elevated inflation and will maintain a tight policy until inflation drops.

Expectations for 2022

In the first phase of the stock market correction, from January to mid-June, all stocks fell indiscriminately, due to the widespread valuation reset caused by rising interest rates.

This was followed by an eight-week rally that erased half the losses of the previous pullback, and which ended recently in mid-August. This rally was largely driven by the sentiment change by investors doubting the resolve of the Federal Reserve.

We have just entered the second phase of the bear market, which will be caused by falling earnings. We think stocks prices correlations will be lower and that each company’s performance in the equity market will be driven more by its own specific expectations.

This is an easier environment to navigate in and where capital protection becomes possible. Earnings expectations for 2022 held steady until July but have recently begun to drop, financial analysts finally recognizing poorer company prospects for the remainder of this year.

We forecasted six months ago that equity markets would provide positive returns in 2022, provided long-term interest rates did not rise beyond the 2.5% to 3.0% range. But they have done so, now hovering around 3.5% in the United States and 3.2% in Canada. The slow unfolding of the recession and higher rates will likely lead to negative equity returns in 2022.   

Another expectation at the beginning of the year was for the Canadian equity market to outperform the American market in 2022. We still own that view. The main reason is the higher weighting of the Energy sector in the Canadian Index and the higher weighting of growth stocks in the American Index. After eight months in 2022, the Canadian market is down 7.2% while the American market has lost 13.6%.

Equity markets will eventually rebound and move to all-time highs, but the severity of the inflation and interest rates shocks have pushed the next economic expansion phase and new bull market further out into 2023.

Portfolio management

Portfolios managed by Triasima were structured for a late-cycle environment at the beginning of 2022. They were overweight cyclical, resources, and growth stocks.

Portfolio structures have since been changed. Apart from the Energy sector, most portfolios have an underweight in natural resources. They are also underweighted the cyclical industries, including banks, and the technology and media growth stocks. Quality, stability, and defensiveness are now the favoured factors.

Cash reserves are also elevated, and, in the case of balanced mandates, portfolios have seen additions to their bond holdings. The weight invested in fixed income (cash, bonds, and preferred shares) is higher than any point over the past several years.

Unless otherwise specified, financial information presented is in Canadian dollars.

[1] We think of recessions as being of three different kinds. The first kind is event driven, such as the COVID-19 recession. They are sudden and sharp, but do not last and the recovery is short. The second kind of recession is caused by structural imbalances built up over time. A great example is the 2008 recession, which was caused by lax financing rules that led to a large residential overbuilt. They are the most severe and last longest. They are also more arduous to recover from. The third type of recession is the classic one, simply related to the normal economic cycle, with labour costs, inventory levels, inflation, and interest rates moving in a predictable pattern. It is this kind that has materialized in 2022. They take longer to unfold and are of average severity. Recovery is gradual in their aftermath.