«Welcome to the new normal»

Many of us saw 2021 as the year when we would write the Covid-19 pandemic off as a bad memory. The crisis was under control and, with the vaccination rollout, we were hoping to go back to our old lives. Twelve months later, we have to recognize that, despite scientific advances, our daily lives are still very much influenced by the notorious virus.

In a context in which returns were expected to be modest, bonds nevertheless demonstrated their diversification power at important times during the year: to a lesser extent, at the start of the third quarter when regulatory tightening in China roiled the stock markets but above all, more recently, in response to uncertainty over the Omicron variant. Even with a strong trend to higher interest rates, fixed income securities helped offset losses during stock market downturns, with the past year serving as a fine example. 

Expectations of a reversion to higher interest rates did indeed materialize and acted as the main headwind for this asset class. Interestingly, this increase largely reflected the pace of corporate earnings. As evidence, the following chart juxtaposes changes in the five-year government bond yield with the performance of the Canadian stock market, as represented by the MSCI Canada Index.

  Higher interest rates, provided the stock market is also going up!

This outcome reflects, among other things, the effectiveness of the central banks’ monetary policy. They adroitly telegraphed their intentions to avoid causing nasty surprises for the markets.

Thus, it is vital that central bankers continue to navigate deftly as economic developments unfold. The consensus is that global growth will slow, while remaining above potential throughout 2022. Inflation is expected to moderate in the near term to reflect supply-chain improvements. Such an environment would allow the monetary authorities to raise their key interest rates in an orderly fashion and without undue haste.

Monetary tightening expected in Canada

As shown in the table above, the implicit rate reflected by futures instruments is 1% by mid-year. The consensus is that the Bank of Canada will raise its key rate by 25 bps three times in the first half of 2022. Given the new framework, it is possible that the Bank will tighten less, provided that inflation moderates enough to give the monetary authorities the luxury of patience.

In the absence of a major event that affects economic activity significantly, monetary tightening will follow its course and detract from bond performance in the short term. In this context, fixed income has limited return potential over the next 12 months but offers increasing protection in the event of an unexpected stock market downturn.

After treading water in the third quarter, the Canadian market offered attractive potential, provided that certain conditions remained favourable. First, the price of crude oil had to hold steady, signalling that global growth was not in doubt. That proved to be the case, even though it was due partly to effective supply control by OPEC+. China also had to avoid a debacle in its real estate sector. This challenge remains, but so far the Chinese authorities have managed it adequately.

For Canada, the main factor was that the growth outlook had to hold up so that resource demand would continue. And nothing during the period compromised it in a meaningful way.

Also, with help from accelerating activity in sectors that had been constrained by measures to contain the Delta variant, the Canadian stock market resumed rising in the fourth quarter and returned 25.8% for 2021, as measured by the MSCI Canada Index.

In Canada, the drivers of success will be the same over the next year: global growth is forecast to remain above potential throughout the year and will favour markets with a cyclical bias. The relaxation of inflationary pressures expected in the short term will allow central banks to take a patient approach to monetary tightening. In addition to increasing consumers’ purchasing power and corporate profit margins, such an approach would reduce the risk of inadvertently stifling growth that is strong but decelerating.

We are, therefore, optimistic about the outlook for the Canadian stock market, especially if the current wave of infection accelerates the process of natural immunity. Even though it is still too early to make a definitive pronouncement, the most recent data suggest that this hypothesis is plausible. Looking at South Africa, where the Omicron variant first appeared, we see that this highly contagiousness variant caused a vertiginous spike in the rate of transmission, which nevertheless gave way to an even sharper decline in the R number. Thus, we can hope that by becoming the dominant variant, Omicron will result in immunity that undermines the survival of the virus.

Transmission rate (R)

At the start of 2021, we discussed some factors that could undermine the dominance of the U.S. market¹. Among other things, we said the cyclical rebound would favour the Canadian market on a relative basis. And, indeed, U.S. equities lagged Canadian equities for most of the year but, as if following a Hollywood movie script, managed to cross the finish line first. 

In local currency, stock market returns were slightly higher south of the border. Even so, in Canadian dollars, the two markets were neck and neck; as measured by the MSCI USA Index (in CAD$), the return was 25.9% in 2021.

The economic backdrop should allow the U.S. market to continue to do very well in absolute terms. Consumer demand remains strong thanks to accumulated savings as well as the wealth effect created by rising markets. The fly in the ointment is the labour shortage, which is slowing growth.

Without doubt, it was the uncertainty created by the appearance of the Omicron variant that, at the very end of the year, helped the U.S. market maintain its dominance. If we apply the same logic, the start of 2022 should continue to be more favourable to U.S. equities on a relative basis.

That being said, the rest of the year could see a geographic rotation toward more cyclical markets, such as Canada, or markets with lower inflationary pressures, such as Europe. Moreover, even if the United States loses its dominant position, its market should still outperform emerging markets over the entire period.

As the following graph shows, unlike goods, consumption of services has still not returned to its pre-pandemic level.

After the weakness of 2021, the current year could finally see a strong increase in the consumption of services. The hotel industry, public transport, personal care and all forms of entertainment (gyms, theatres, museums, etc.) may finally be able to operate under favourable business conditions. Such a scenario would support the U.S. economy at the expense of countries from which it imports many goods, such as China and Mexico.

The MSCI All Countries Asia Pacific Index the period with a return of -2.0% while the MSCI Emerging Markets Index returned -3.1%. In contrast, the MSCI Europe Index stood out in 2021 with a 16.0% return in Canadian currency. For all these results, it is worth noting that the loonie’s strength during the year reduced the returns recorded in local currencies.

The next year should bring us much the same as what we have just seen. China remains the focal point for risk. The country’s real estate market is an issue that will be resolved only in the long term. The latest figures confirm a steep decline in land purchases, housing starts and home sales. In addition, surveys indicate that the proportion of households considering a home purchase is in free fall. That being said, the Chinese stock market has already endured a lot of bad news. The question is the extent to which the Chinese authorities will intervene to support their economy and, consequently, their stock market.

Fortunately, the outlook is more promising elsewhere in Asia. In Japan, the economy will benefit from the new stimulus package announced last fall, and monetary conditions will remain very accommodative as inflation is still well below the 2% target.

Europe, for its part, should maintain its momentum. In the euro zone, inflation is less sustained than in the United States, and this will allow the European Central Bank to maintain its highly accommodative policy. Consumer confidence is even higher than in the land of Uncle Sam, as shown in the following table:  

The euro zone’s manufacturing sector is also brimming with confidence. According to the European Commission, a record number of manufacturing managers plan to make investments during 2022. In short, apart from the strategic issue of the energy supply from Russia, the stars are aligned so that the European market can once again have an excellent year.

At this stage, the emergence of new variants represents a risk that is probably not predominant. Over the next 12 months, new strains will most certainly spread but their impact on the economy and the markets is expected to diminish, especially given our increased ability to treat the disease once symptoms appear. Geopolitical tensions are also a risk factor. A Russian invasion of Ukraine would have an immediate impact on the markets. There is also China’s economic growth, which is not without its share of concerns. The authorities must strike the right balance between deleveraging and sustaining growth. They have the necessary leeway to avoid excessive consequences, however.

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