The first-quarter themes of inflation, tighter monetary policies and supply-chain bottlenecks persisted and even intensified over the past three months. The war in Ukraine continued, taking a catastrophic toll, with a ceasefire still looking unattainable. The conflict continued to affect the financial markets as well as the prices of many critical raw materials and commodities. It also created new challenges for supply chains that were already under pressure because of China’s zero-Covid policy and related lockdowns. These two situations only reinforced and intensified the upward pressures on prices, especially energy and food prices. Thus, the word of the year has become: inflation.

Of the issues cited above, it was expectations of interest rate hikes that once again roiled the bond market. At the end of 2021, the Canadian market was expecting five rate hikes in 2022. In the first quarter, the expectations rose to eight. At the end of the second quarter, the market was still forecasting eight hikes for the remainder of the year, knowing that the equivalent of five had already taken place, a standard increase being 0.25% according to the BoC. Moreover, the size of the hikes also increased, going from 0.25% to 0.50%. Lately, some have been expecting increases of up to 0.75%. The expectations vary greatly from one quarter to the next.

The graphs below aptly illustrate these variations. Whether on a year-to-date basis or even from one month to the next, the market is adjusting, pricing in ever-larger numbers of increases, as we can see from the graph on the left. These changes have a direct impact on estimates of the Canadian key rate. As at June 30, 2022, the market expected the BoC’s key rate to reach almost 3.5% by the end of the year versus an estimated 1.5% as at December 31, 2021 (see chart on the right).

Each time the central banks have spoken of inflation, expectations of rate hikes have reacted accordingly, impacting both bond and stock markets. Accordingly, fixed income declined once again in the second quarter. The FTSE Canada Bond Index had a quarterly return of -5.7% and a year-to-date return of -12.2%, the first such declines in 40 years.

As of June 30, 2022, the BoC had raised its key rate from 0.25% to 1.50% while the Fed had raised its target rate from 0.25% to 1.75%. As already noted, the bond markets are pricing in even more hikes for the rest of the year. Are the increases too little, just enough or too much? Achieving an equilibrium is a delicate matter.

The chart on the left below shows the Canadian sovereign rate since the start of the year. In the short term, rate hikes are clear, but beyond two years the curves do not seem to reflect inflation or growth. As for the graph on the right, it shows that rates are still historically low.

Supply-chain improvements, a slowdown in consumer spending after the recent rate hikes and recessionary concerns could all help contain inflation.

Even though rate hikes adversely affect bond prices, they also increase the current yield on bonds. The current yield of the FTSE Canada Bond Index was 3.9% at the end of the quarter versus 1.90% at December 31, 2021.

The second quarter saw the global markets again pull back sharply amid high volatility, as talk of inflation gradually gave way to concerns about an economic slowdown. Monetary tightening by the central banks, which are trying to curb the highest rate of inflation in 40 years in an unprecedented context, combined with geopolitical tensions and supply-chain issues, has caused investors to take a pessimistic view of future earnings growth.

In addition, expectations of higher interest rates also affect company valuations and, therefore, the prices of listed securities. Stocks with more distant future earnings tend to reflect expectations of more aggressive increases in their prices. This is the case for growth companies, which are often found in the Information Technology sector. This sector was the weakest performer in most global indexes during the quarter. All assets that had risen sharply since the start of the pandemic were also hit hard, including cryptocurrencies.

In the short term, the losses of the first half of 2022 seem significant. They take us back to the levels of late 2020 or early 2021, as shown in the chart below. But if we take a step back, we can see that longer-term returns are still very attractive.

The Canadian market was no exception in the second quarter. Its heavy Energy sector weighting was not enough to protect it from the market’s general decline. Exposure to the Financials sector and, to a lesser extent, the Materials sector, was also responsible for the decline. In the short term, the banks are facing more difficult stock markets, the possibility of a recession and a more demanding job market, which explains their performance. As for materials, fears of global monetary tightening weighed on the price of gold during the quarter, and gold stocks suffered the consequences.

The MSCI Canada Index returned -12.8% on the quarter and -9.7% on a year-to-date basis.

The U.S. market was also subject to volatility in the second quarter. The divergence in returns between sectors was pronounced. Defensive stocks, found in the Consumer Staples and Health Care sectors, performed best. The revaluation of stocks geared to long-term growth was felt acutely in several sectors, such as Information Technology and Consumer Discretionary, especially tourism and consumer industries with a technological component.

In Canadian currency, the MSCI USA Index returned -14.1% on the quarter and -19.4% year to date.

Global developed markets also ended the quarter in negative territory. In addition to the many geopolitical challenges and supply-chain repercussions caused by the conflict in Ukraine, the European Central Bank’s announcements of impending rate hikes and an accelerated withdrawal from its bond-buying program were poorly received by investors on the other side of the Atlantic.

In Canadian-dollar terms, the MSCI Europe Index and the MSCI All Country Asia Pacific Index ended the quarter with returns of -11.4% and -8.9%, respectively. Their year-to-date returns were -18.7% and -15.2%, respectively.

As for emerging markets, most countries also experienced a loss during the quarter. China stood out after announcements in May regarding relaxation of its zero-Covid policy. With its significant exposure to China, the MSCI Emerging Markets Index outperformed its developed market peers.

The MSCI Emerging Markets Index ended the quarter with a return of -8.4% and a year-to-date return of -15.7% in Canadian currency.

Equity market risks remain significant. First, a prolonged war in Ukraine seems inevitable and could continue to have repercussions. Second, the strategies adopted by governments to manage the war’s consequences, combined with the pandemic, are contributing to the uncertainty. Finally, central banks’ response to inflation continues to be a key issue; they must strike the much-discussed equilibrium between slowing price increases and minimizing the negative impact on global economies.

For our portfolio companies and their management teams, inflation and inflationary expectations are also on the agenda. On the one hand, companies can pass on higher costs to consumers to maintain their earnings. On the other hand, such companies also face wage pressure that could reduce their earnings but ease the pressure on consumers. Again, it’s a matter of finding a equilibrium between the two. 

Investors may be expecting a recession or may even be wondering whether one has already begun. There are numerous indicators monitored by economists to confirm that a recession is on the way, all with their own timelines. While determining the exact onset of a recession is not a straightforward exercise, the probabilities and expectations of a recession in the near future have risen. An economic slowdown would, however, also slow inflation. It would be a sign that inflation had reached its peak – news that would be welcomed by the markets. 

1. Year-to-date return as at June 30, 2022.

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