By the FÉRIQUE Fund Management Investment team
After a tumultuous first half of the year, the global stock markets continued their downfall in the third quarter. Investors who were looking for good news early in the quarter responded favorably to some earnings announcements in July. These second-quarter results exceeded expectations, especially in the case of U.S. Big Tech companies. Risk appetite started to increase again, and the month was positive – perhaps too positive. In August, statements by the world’s major central banks snapped investors back to reality. At the end of the month, central bankers met for their annual symposium in Jackson Hole, Wyoming, where they coalesced around a simple message: they are prepared to follow through with higher interest rates.
|MSCI Canada||-1.7 ▼||-11.2 ▼|
|U.S. equities (CA$)|
|MSCI USA||1.5 ▲||-18.2▼|
|MSCI Asia Pacific (all countries)||-5.2 ▼||-19.7 ▼|
|MSCI Europe||-4.2 ▼||-22.1 ▼|
|MSCI World (excl. Canada)||0.1 ▲||-18.8 ▼|
|MSCI Emerging Markets||-5.6 ▼||-20.5 ▼|
|Interest rates %
|Key rate||3.25||1.75 ▲||3.00 ▲|
|3 months||3.58||1.50 ▲||3.42 ▲|
|2 years||3.79||0.69 ▲||2.84 ▲|
|5 years||3.32||0.22 ▲||2.07 ▲|
|10 years||3.16||-0.07 ▼||1.74 ▲|
|30 years||3.09||-0.05 ▼||1.41 ▲|
|Oil (WTI)||$79.49||-25.0% ▼||5.5% ▲|
|Gold||$1,671.80||-8.0% ▼||-7.4% ▼|
|CAD / EUR||0.75||0.6% ▲||7.3%▲|
|CAD / JPY||105.49||0.1% ▲||15.0%▲|
|CAD / USD||0.73||-6.2% ▼||-7.8%▼|
In a much-anticipated speech, Federal Reserve (Fed) Chair Jerome Powell reiterated that rate hikes will continue at a steady pace until the bank is confident that inflation is under control, while acknowledging that the policy could have adverse impacts, including the risk of recession. In September, fears of a global recession intensified. Investors’ main concern was sticky, accelerating inflation. The global stock markets were hit hard by this pessimism, falling at month-end to their lowest level in nearly two years.
Various factors are contributing to a situation that could become a perfect storm. In the shorter term, the inflation drivers that have gradually taken hold are numerous and for the most part unprecedented. As we have explained in previous Financial Letters, the pandemic and the resulting supply-chain issues are major factors. In addition, the conflict in Ukraine has intensified, placing even more upward pressure on prices, especially for energy and food. Finally, expansionary monetary policies in the wake of the pandemic have also fuelled inflation. The expansionary outlook that has prevailed since the 2008 financial crisis has made the markets dependent on the Fed’s very low interest rates, a situation never seen before.
The combination of these factors has created the predicament facing today’s economies. The speed and size of the rate hikes introduced to curb inflation are putting an end to expansionary policy and constitute a key turning point.
|Net of fees returns as of September 30, 2022 (%)|
|Q3-2022||YTD||1 year||3 years||5 years||10 years|
|Aggressive Growth Portfolio
|Short Term Income
|Global Sustainable Development Bond
|Globally Diversified Income
|Canadian Dividend Equity
|Emerging Markets Equity
|World Dividend Equity
|Global Sustainable Development Equity
|Global Innovation Equity
The central banks’ fight against inflation was again the main issue for the bond markets in the third quarter. In Canada, for example, the Bank of Canada (BoC) opted to raise its key rate by 100 basis points (1%) in mid-July. The move came as a disagreeable surprise for investors because the consensus was calling for a 75-basis-point increase. The additional 25 basis points had an outsized impact on Canada’s stock and bond markets, not because of the size of the hike but because of the message it sent to investors: like its U.S. counterpart, the BoC is ready to do anything to reduce inflation, despite the risks of recession.
Even so, the Canadian bond market ended the quarter more or less where it started. Expectations of monetary tightening are already priced into the market, so subsequent rate hikes should be absorbed more smoothly. The situation was slightly different in Europe, where the rate hikes started later and the market had to adjust accordingly.
When the concept of transitory inflation fell by the wayside at the start of the year, especially after the invasion of Ukraine, the market promptly adjusted its expectations of rate hikes. Such expectations caused bond prices to fall significantly in the first half of the year. Since then, expectations have gradually become more aligned with monetary policies.
In the short term, fixed income offers a higher current yield. Indeed, the yield to maturity, namely the total expected return on a bond if it is held to maturity, has increased significantly. For example, the FÉRIQUE Short-Term Income Fund had a yield to maturity of 3.131% as at September 30, 2022, and the FÉRIQUE Canadian Bond Fund was yielding 4.412% (These returns are not guaranteed and can change from one day to the next.).
The size and speed of the 2022 increases have rarely been seen, and the markets have clearly reflected this pessimism in the short term. In a more stable economic environment, however, the role of bonds in a portfolio remains the same over the long term: to generate current income and to provide protection in a stock market downturn.
Around the world, stock markets ended the quarter lower. Their weakness was due to several factors, but mainly central banks’ hawkish tone as well as fears of a recession.
The Canadian stock market was down slightly on the quarter, with sector returns that differed significantly. The oil price fell during the quarter (-25.0%), and the Energy sector dragged the index down. The components of the Financials sector posted varied returns; some insurers benefited from higher interest rates, while other financial companies suffered because of specific issues affecting a number of securities.
Four of the 11 sectors ended the quarter in positive territory, including the Materials sector, which continued to benefit from the high cost of raw materials.
The MSCI Canada Index had a -1.7% quarterly return and a -11.2% year-to-date return.
Even though the Canadian index is made up of many appealing companies, its return is heavily influenced by the price of oil and the performance of the Financials sector, especially that of banks. At present, both sectors are grappling with quite a few issues.
In the Energy sector, a number of factors will affect the oil price in the short term, such as the war in Ukraine, sanctions imposed by Western countries, OPEC’s desire to be a good citizen and fears of an economic slowdown, to name only a few. Balancing these factors is anything but easy.
As for the Financials sector, particularly Canada’s banks, the impact of rate hikes on indebted Canadian consumers with mortgages coming up for renewal is a serious issue. As far as investments go, these banks were among the best capitalized during the financial crisis, and the regulation governing them has since been tightened. Their balance sheets still emphasize caution and quality. As shown by the following charts, Canadian households are more indebted than their U.S. counterparts. The BoC monitors such matters closely, because they are among the factors that set the Canadian economy apart from the U.S. economy and they could limit the BoC’s ability to keep pace with the Fed.
In local currency, U.S. stocks also ended the quarter in negative territory. Some growth stocks, such as tech companies, which were hit hard by interest rate hikes in the first half of the year, performed well during the quarter. As already noted, favorable earnings announcements early in the summer and attractive valuations are the reasons for these positive returns. Even so, fears of a recession dampened the gains toward the end of the quarter, even though some technology stocks in the Consumer Discretionary sector posted significantly higher returns. Finally, in contrast to the Canadian market, Energy and Financials advanced, while Communications Services and Real Estate declined.
The U.S. dollar was up 6.2% during the quarter against the Canadian dollar, reflecting its role as a safe haven. As a result, when translated into Canadian dollars, the returns are much less negative than in local currency.
In Canadian currency, the MSCI USA Index recorded a -1.5% quarterly return and a -18.2% year-to-date return.
Despite the short-term performance of some growth stocks, the risks on the stock markets in the United States and around the world remain high. The strong U.S. dollar, which remains a haven, and interest rates that are attractive to foreign investors are helping tamp down U.S. inflation somewhat. In contrast, the strong greenback is likely to amplify inflation in some importing countries. Moreover, high rates are starting to have a negative impact on the U.S. housing market, which in July recorded its first decline in a decade. The equity market risks, as well as recession issues, are discussed below.
|The difference between indexes
Weighting by sector – 3rd quarter 2022 average
The end of the quarter was trying for Europe, especially the United Kingdom. The impact of Brexit continued to be felt and the lack of faith in the new government (much like the lack of faith in the previous one) hit the bond market and the pound sterling. The United Kingdom is the only G7 country whose economy is smaller than it was before the pandemic. The euro also fell to its lowest level against the U.S. dollar since its inception. The broad European market also ended the quarter in negative territory. Not surprisingly, the Energy sector closed the quarter with a positive return, as natural gas prices have been at record levels since the start of the conflict in Ukraine. All the other sectors were down.
The MSCI Europe Index had a -4.2% quarterly return and a -22.1% year-to-date return in Canadian currency.
As for Asia and emerging markets, the Chinese market fell significantly after a positive second quarter. The country’s zero-Covid policy weighed on industrial activity, and the real estate market, one of China’s key sectors, continued to struggle. China is one of the region’s main economic players, and its weight has a considerable impact on the stock market indexes, especially in emerging markets.
The MSCI All Country Asia Pacific Index recorded a -5.2% quarterly return and a -19.7% year-to-date return in Canadian currency. The MSCI Emerging Markets Index returned 5.6% for the quarter and -20.5% year-to-date in Canadian dollars.
The challenges facing the European market are numerous and complex. The war in Ukraine is one of the main ones and its outcome is highly uncertain. As for inflation, it is undermining Europe’s economic health. As winter approaches, the cost of energy will be a major worry.
As for the Asian countries, China’s economy faces challenges that differ significantly from those of its Western peers. Inflation isn’t a problem, and the country’s monetary policy is even accommodative. But its economic slowdown and housing bubble have roiled the market, already hit in recent months by significant regulatory changes in a number of industries. Against this backdrop and with the Chinese Communist Party congress taking place this fall, more aggressive monetary easing is possible.
As for market risks, we’re back to where we were in the second quarter! You can read our second quarter Financial Letter. The risks are the same and are even becoming reality in the wake of the Jackson Hole meeting at the end of the summer, with the Fed determined to fight inflation at any cost.
Moreover, the Fed itself is a risk. Its ability, or even inability, to control inflation is a major issue. The markets’ lack of faith in the Fed when it comes to inflation is only increasing the uncertainty. The much-vaunted 2% inflation target, adopted in the 1990s, is perhaps a vital aspect of the Fed’s credibility, but the data far exceed that level today. Even though some inflation-related economic indicators, such as supply-chain issues and inventory levels, show positive trends, other factors, such as the war in Ukraine and the situation in China, offer little visibility on future events and counteract some of these improvements. Moreover, the impact of rate hikes is starting to be felt in the economy.
Finally, with few or no historical comparisons to today’s circumstances, it is difficult to predict what will happen. Some economic indicators, such as the yield curve and certain GDP data, are already signaling a recession to come, whereas other important data, such as the unemployment rate, are still very healthy and, thus, offset the negative indicators. That being said, some companies have already started cutting back on hiring or even laying off workers. A new equilibrium between job seekers and employers could come about. Even so, apart from extreme cases, consumers have, on average, higher levels of savings than during other comparable times. Another factor to consider is the impact of a slowdown on companies and their earnings. Generally speaking, earnings have been resilient, so it will be important to see the issues that companies cite when they announce their results. All these factors have to be considered in the event of a recession.
So the question may not be whether we are entering a recession, but rather what kind of recession? The market declines already experienced this year are indicative of a short recession in 2023. Will that scenario materialize? And how will the markets perform? To be continued!
All the factors discussed above confirm the vital importance of a diversified portfolio. Over different periods, different types of companies perform better. In the long run, different styles complement one another and reduce stock market risk.
But we must remember that the economy isn’t a company. A well-managed company can continue to create shareholder value with some predictability in a challenging business cycle. Economic forecasts involve far more factors, and historical comparisons are almost non-existent. Investors therefore benefit from having their investments adapted to their risk tolerance and liquidity needs, and from keeping a long-term perspective in order to achieve their goals.
To discuss the markets and your investment strategy, contact your Financial Planner and Mutual Fund Representative of FÉRIQUE Investment Services, main distributor of FÉRIQUE Funds.
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8. Index that measures the activities of a country’s manufacturing sector and services sector, thus representing the main economic trends.
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