The End of an Era – Inflation Kills Market Momentum

Talk about a cold shower. After two years of phenomenal stock performance, the S&P 500 has entered bear market territory as countries face off against a long-forgotten foe – inflation. Consumer prices rose 7.7 per cent year-over-year in May, their largest increase since 1983, while prices in the US saw an even larger jump of 8.6 per cent, fueled by ongoing supply chain disruptions and the very stimulus measures that were intended to avoid disaster when the pandemic first struck. Now, central bankers are frantically reversing those stimulus measures via interest rate hikes and quantitative tightening (see Fixed Income and Interest Rates).

The move comes at a difficult time. For one, there is the ongoing invasion of Ukraine, the horrendous humanitarian crisis in Europe that, in addition to causing over 11,000 civilian casualties, comes with severe economic consequences. Surging prices for wheat, precious metals, oil and natural gas, key exports of the region, have contributed to broad-based inflation globally, with Russia alone supplying 40% of the European Union’s gas consumption. While higher oil prices have been a boon for Canada’s battered energy sector, they bode poorly for the economy at large.

We also can’t forget COVID-19, which has continued to apply pressure to still-struggling global supply chains. While new daily cases have normalized and daily deaths have thankfully dropped to their lowest point since the onset of the pandemic, China in particular is still grappling with its “Zero-COVID” policy, which saw the country effectively shut down Shanghai earlier this year as cases spiked in the region. China alone represents a quarter of global manufacturing, and while Shanghai is now easing out of its lockdown, the risk of future restrictions has some investors wary.

Taken together, the risks of a recession are high, with some even worried that, with oil prices up and inflation running hot, we could see a repeat of 1970’s stagflation. At the moment, those claims are based on little more than surface-level similarities: households (with their high savings and improved budgets), central banks (with their early move to hike rates), and the global economy as a whole (which is 57% less dependent on oil) are much better-positioned to tackle high inflation. So, while I have been told that the bellbottom jeans of the 70s are making a comeback, we are far from seeing a repeat of that troubling decade, and through this uncertainty, sticking to a diligent investing strategy while monitoring risks remains the prudent course of action for investors.

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Equities

So far into 2022, the S&P/TSX Composite Index ($TSX) has fallen 11.1 per cent (9.9 per cent after dividends). While the poor performance has been broad based, Information Technology and Health Care have been the hardest hit sectors, seeing price returns of -55.3 per cent and -54.2 per cent, respectively, thanks in part to sky-high valuations that preceded the year. Fortunately, the sectors together make up less than 6.0 per cent of the country’s market index, while energy, a much bigger weight, has eased the decline with a 23.5 per cent price return, the only sector to achieve a positive result. Canada is also poised to post the strongest GDP results for the quarter of the G7 nations; as a net oil and wheat exporter, the country has been a beneficiary of surging commodity prices.

The United States, meanwhile, has not been so lucky. With over a quarter of index performance tied to technology, and less than 5 per cent to energy, the S&P 500 Index ($SPX) is down 20.0 per cent (inclusive of dividends), pushing the index into a bear market. While the strengthening US dollar does offer some respite, bringing the performance figure to -18.3 per cent in Canadian dollar terms, the country’s key industries are experiencing a strong downward correction.

Markets outside of North America have not fared much better. The MSCI EAFE Index ($MSEAFE) has seen a total year-to-date return of -19.3 per cent, with European countries dependent on Russia and Ukraine for key resources seeing disruptions from the ongoing war and sanctions.

Fixed Income and Interest Rates

Rising interest rates have been a key headwind for stocks. In Canada, the central bank policy rate has been hiked three times this year, with a 25-basis point jump in March followed by two 50-basis point increases in April and June. Meanwhile, the bank has slowed bond purchases in preparation for quantitative tightening, a process that will increase longer-term rates. Bank of Canada Governor Tiff Macklem remains confident that the economy can cope with these changes, but credit market debt remains close to it’s record of 185% of disposable income, and households that stretched their finances to enter Canada’s hot housing market during the pandemic could suffer; a 5-year mortgage rate renewal from pandemic lows to the current median rate of ~4.5 per cent would see median monthly payments increase by $300, while high loan-to-income borrowers would see a jump of $490.

The rate hikes have caused bonds, traditionally considered to be a lower risk investment than stocks, to experience similar volatility to the stock market. The FTSE TMX Canada Universe Bond Composite Index has so far fallen 12.7 per cent year-to-date, with central bankers guiding for more hikes ahead.

Down south, the Federal Reserve has already brought its federal funds target range to 1.50 - 1.75 per cent after a 75-basis point hike this June, the largest such increase since 1994. The Federal Reserve is likewise pursuing quantitative tightening in an attempt to shrink its colossal $9 trillion balance sheet. Despite this, shorter-term rates have risen faster than longer-term loans, which has caused the yield curve to invert several times already this year, seen by some as a leading indicator of recessions.

Currencies

While the Canadian dollar had an impressive 2021, reaching a high of 83 cents US, it has since dropped closer to its pre-pandemic level, with the loonie’s exchange rate ($CDW) ending the first half of 2022 at $0.78 USD, a decline of 1.6% year-to-date. Concerns around oil are likely playing a role; while crude prices remain elevated, fears of a recession have some worried that falling demand will outweigh the supply shortage currently keeping prices elevated.

Another important factor, however, is the strength of the US dollar. Despite record inflation and money creation through the pandemic, a function of heightened lending activity, a sizeable portion of investors have opted to absorb the loss of purchasing power to keep their cash out of the market. This, combined with new contractionary monetary policies, has contributed to the US Dollar Index, a measure of the greenback’s strength against a basket of other currencies, to rise to its highest level since 2002.

Commodities

In addition to the COVID-related bottlenecks, the war in Ukraine has piled on further disruptions to an already battered global supply chain. In Europe, Russian sanctions have contributed to a natural gas shortage that has seen the Dutch benchmark price more than double since the initial invasion in February. The shock has also contributed to the rise of oil, with the West Texas Intermediate ($WTIC) surpassing $120 a barrel in June. Fresh concerns of a recession have, however, brought the commodity back down, with the benchmark ending the first half of 2022 at $105.76 a barrel, still up 40.6 per cent for the year.

Gold meanwhile has had a somewhat surprising start to the year. While the invasion of Ukraine initially sent the precious metal to an all-time high of $2,074.88, the precious metal ended June down 0.9 per cent year-to-date at $1,806.87. The move is somewhat strange given that the risk of a recession, from which gold is theorized to provide a safe haven, has only increased since the invasion. Many believe the strength of the dollar is behind the poor performance, with the greenback seemingly replacing gold as the preferred refuge of investors, especially those overseas who earn a return in domestic terms when their US dollars appreciate.

This report is provided for your information. Conclusions and opinions given do not guarantee future events or performance. Facts and data provided are from sources we believe to be reliable, but we cannot guarantee they are complete or accurate. This report is not to be construed as an offer to sell or a solicitation of an offer to buy any securities. Before making an investment or adopting an investment strategy, each investor should review his investment objectives with their investment advisor. Watson Di Primio Steel (WDS) Investment Management Ltd. and individuals and companies who are related may, at any time, buy or sell securities that are hereby described in this report.