The Market

Downside volatility was the name of the game for the second quarter of 2022 as global market participants balanced four-decade high inflation levels driven by everything from gasoline to airline tickets, restaurant meals, and new & used vehicle prices, against hawkish central bank policies and a deteriorating macroeconomic environment.

Inflation contagion has permeated beyond energy and food costs (whose prices have been driven up by on-going supply chain imbalances related to the COVID-19 pandemic and Russia’s invasion of Ukraine) to other goods and services.  Global central banks have responded by aggressively tightening the cost of borrowing by raising interest rates which has put significant pressure on global equity and bond markets and has challenged the growth narrative.

The table below shows the market performance as of market close on June 30, 2022, in Canadian dollar terms:

Performance

Given the current market environment, we are holding higher than normal cash balances in accounts but we still remain slightly overweight equities and underweight bonds compared to the benchmarks.

The YouFirst Growth and Conservative Growth composites have performed better than their respective FPX benchmarks on a year to date and quarter end basis.  Refer to the following table:

Portfolio Activity

Portfolio activity over the quarter was relatively muted.  We haven’t subscribed to “buying the dip” just yet since valuations haven’t improved sufficiently given rising rates and a weaker corporate earnings outlook.  By the same token, we remain slightly overweight global equities and have not materially trimmed growth positions given our thesis that central banks will ultimately decide to live with inflation higher than pre-COVID levels instead of raising policy rates to a level that completely destroys growth.  Refer to our comments in the Outlook section of this newsletter.

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Outlook

We’ve long said that a sign when the global economy is returning back to normalcy after the pandemic will be a spending rotation for consumers away from goods back towards services.  Blackrock Investment Institute with data from the US Bureau of Economic Analysis now sees this shift back towards services gaining momentum.  This is important because the spending on goods in the pandemic has been a key driver of inflation with the surge in demand creating supply chain bottlenecks and shortages, in turn causing prices to rise.  As demand normalizes, these supply chain issues should ease and inflationary pressures will start to subside, all else constant (a key distinction is that we may not see prices fall, but the rate of change of price growth should wane).

However, what has now changed in the backdrop of rising interest rates to counter these inflationary pressures and adding to further risk to the economy, is that consumer spending, both on goods and services, could come to a standstill as the cost of borrowing becomes prohibitive.  The overall output of an economy is measured by GDP and negative GDP growth over two consecutive quarters is a typical, albeit slightly outdated, definition of a recession.

As inflation and the risk of a possible recession are now at the forefront of everyone’s mind, it would be worth discussing our investment thesis and how this could play out for equity and fixed income investments over the coming months.

There are several macroeconomic leading indicators that have historically signalled the start of a recession, refer to the figure below:

Figure 1: Typical signs of a US recession are not yet present, but conditions are worsening.

Source: Adapted from Manulife Capital Markets Strategy, Q2 2022 and Bloomberg Capital Markets Strategy.

There are currently two of seven signals that are flashing red at the moment however many of the other indicators are now deteriorating.  The strongest indicator of an impending recession is an inverted yield curve which needs to remain persistently inverted over the 2y – 10y maturities [for reference, we’ve written about yield curves in our 2019 Q3 Portfolio Review]. 

Equities

At this time, global central banks are faced with a difficult trade-off between growth and controlling inflation.   Raising interest rates too much, too soon, could risk triggering a recession while not doing enough could create unanchored inflation expectations which become a self fulfilling prophecy.  From the June 2022 US Federal Reserve report, the Fed has made it clear that they are ready to dampen growth with their priority on fighting inflation, however in a more recent press conference, US Fed Chair Jerome Powell backpedalled and toned down the harshness of the policy response.  Similar sentiment can be seen with the European Central Bank.  In either case, the risk of a “policy mistake” increases in the latter half of the rate-tightening cycle which can only be seen in hindsight.

We believe that interest rates will increase rapidly at the start of the tightening cycle and policy makers will hold off to see the economic impact.  When this hawkish-to-dovish pivot happens, we expect that market sentiment will shift back to risk-assets again however investors must be ready to stomach more volatility in the meantime.

Fixed Income and Cash

We are underweight fixed income, with higher-than-normal cash balances in most portfolios on a tactical basis against the backdrop of rising interest rates.

Traditional fixed income (corporate bonds, treasuries etc.) have not been spared in the first half of 2022 as rising market interest rates continue to put pressure on bond prices.  However, there are pockets of opportunity emerging in the investment grade credit space as the large selloff this year is starting to present good value opportunities so we may increase our tactical weighting of corporate investment grade debt. 

For now, we would rather take the risk in higher-quality dividend paying equities (instead of bonds from the same issuer) which provides investors with higher growth potential at the expense of volatility.

We continue to watch the trends closely as market dynamics evolve day-by-day.  Please reach out if you have any questions or concerns.

Doug Garner, P.Eng., CFA
President, Portfolio Manager

Jane Garner, BA, EPC
VP Operations and Client Experience

Simon Chun, P.Eng., CFA
Director, Associate Portfolio Manager