The year just ended was tumultuous, with an unheard-of combination of factors: the beginning of the end of the pandemic, unprecedented monetary policies to combat record inflation, supply-chain disruptions and war in Ukraine. These circumstances caused a sharp correction on the equity and bond markets and are weighing heavily on investors’ outlook for the coming year.

At the start of the year, the U.S. Federal Reserve (Fed) and the Bank of Canada (BoC) argued that spiralling prices, caused by supply-chain disruptions and billions of dollars of stimulus, were transitory and would largely abate on their own. But it soon became clear that inflation was much more difficult to predict and to control, not least because of new and unforeseeable external shocks, such as the war in Ukraine. The Fed and the BoC hardened their tone throughout the year, raising their forecasts of the interest rate hikes needed to fight inflation. Both central banks ended 2022 with a key rate well above the market’s expectations at the start of the year.

The fourth quarter was relatively quiet on the bond markets in relation to the first half of the year, when interest rate increases were much more aggressive than initially expected. The hikes that occurred in the last quarter were largely anticipated by the markets but also smaller than the previous ones. In Canada, the October and December hikes were 50 basis points each, after 100 and 75 basis points in July and September, respectively.

Outlook

The BoC’s key rate was 4.25% as at December 31, 2022, and the market was already pricing in a further increase of 25 basis points in January 2023.

As in 2022, these expectations will continue to affect bond prices. Now the debate is whether a recession will actually take place. If so, how deep will it be and will it cause North America’s central banks to slow their rate hikes or even cut rates in response to an economic downturn?

Because of their short-term bias, the markets are expecting an interest rate cut, even though central banks, especially the Fed, have the vital responsibility of controlling inflation. Cutting rates too fast could lead to a new inflationary spiral, but further sustained increases and high rates over the medium term could cause a significant economic slowdown and, therefore, a recession.

The global stock markets ended the fourth quarter higher as a result of several factors: an anticipated pause in the rate hikes, better-than-expected corporate earnings and relatively positive economic data.

Even so, the markets posted significant losses on the year. The pronounced divergence between the world’s regions should be noted, however. Some countries with commodity-oriented economies recorded returns that were only slightly negative. In contrast, the U.S. market ended 2022 with its worst annual performance since the 2008 financial crisis.

The Canadian market advanced 6.2% in the fourth quarter, as measured by the MSCI Canada Index, owing to a significant rebound in November. 

Canada’s market was resilient in 2022, notably in relation to its neighbour to the south, thanks to the performance of the energy sector. The MSCI Canada Index returned -5.8%. The sectors with the biggest losses during the year were those that are most sensitive to interest rate fluctuations, such as information technology.

Outlook

Nevertheless, the Canadian economy ended the year relatively healthy. The job market remained very robust and the stock market benefited from its high concentration in certain sectors.

Canadians have a significant bias toward real estate investment, and assets of this type account for most of their household wealth. The biggest concern is how rate hikes will affect real estate values and mortgage payments, given the high debt load of the average Canadian consumer. In Canada, the average household debt-to-income ratio is 184%⁵. According to 2019 data, nearly two-thirds of Canadians owned a home and about half of those had a mortgage. Half of this mortgage debt was variable-rate mortgage⁶. The impact of rising rates on Canadian homeowners, especially those who have to renew their mortgages in the coming year, is likely to be significant. That being said, in terms of the overall population, the impact is relatively limited, contrary to what media headlines might lead us to believe. It’s an ever-changing situation, however.

U.S. equities also ended the fourth quarter higher, partially on hopes that the Fed will become less aggressive with its interest rate hikes. The MSCI USA Index returned 5.6% in Canadian dollars during the period.

Even so, the rate hikes hit the U.S. market hard during the year, with the MSCI USA Index returning -19.5% in local currency. With the greenback serving as a safe haven, its strength against the loonie helped limit losses. The return was, therefore, -13.6% for Canadian investors. The result was due mainly to exposure to technology stocks, which have a significant growth bias. As with the Canadian market, the energy sector had a positive performance, but its impact was limited because energy accounts for barely 5% of the weight of the MSCI USA Index. 

Over the past decade, growth stocks have benefited greatly from low interest rates and the Fed’s highly accommodative monetary policy. The abrupt reversal of this situation led to a significant asset correction and a rotation from growth to value stocks. At the same time, speculative assets, such as cryptocurrencies, also saw their valuations fall sharply. The end of accommodative monetary policy triggered a revaluation of all securities as well as a reassessment of the level of risk that investors perceive as acceptable. 

The United States faces challenges similar to Canada’s. The economy remains robust, especially the job market, but a slowdown is possible. The Fed’s credibility is being questioned by some, and the market continues to react significantly to each new piece of information.

Global equities saw a significant rebound in the fourth quarter.

On the European market, the return was enhanced considerably by the appreciation of the euro and the pound sterling, in particular. The MSCI Europe Index posted a 17.8% gain in Canadian dollars for the quarter. For the year, the return was -8.3% in Canadian currency.

As for the Asian markets and emerging markets, the reopening of the Chinese economy and the easing of Covid-19 restrictions improved overall investor sentiment toward China. As a result, the MSCI All Country Asia Pacific Index returned 11.0% for the quarter and -10.9% for the year as a whole in Canadian dollars. The MSCI Emerging Markets Index returned 8.3% for the quarter and -13.9% for the year in Canadian currency. 

There will be many challenges in the coming year. In Europe, the post-pandemic economic recovery was more fragile than in North America. The situation is not being helped by the war in Ukraine and inflation that is still very high and has barely been slowed by the European Central Bank's rate hikes. Moreover, a colder-than-normal winter could exacerbate the Continent’s energy crisis. 

The situation in China is a big question mark. Even though its reopening is viewed favourably by the markets, China is experiencing an exponential spread of the virus, for which it is not prepared after two years of restrictions. The reopening could also drive up energy prices and, thus, inflation. 

Equity market risks remain elevated for 2023. Even so, in contrast to the end of 2021, the risks are rather clear: inflation, interest rates and recession. 

A number of indicators are pointing to a slowdown in inflation, but the data are far from the 2% target. For example, the Fed forecasts that inflation in the United States will be 3.5% by the end of 2023⁷. Inflation in the United States and Canada will have to be watched closely. We need to see a more prolonged downward trend before we can declare victory.

Interest rates depend on inflation data. At the time of writing, a further increase of 50 or 75 basis points is expected in the United States at the end of January. But the yield curve indicates that the market expects a rate cut by the end of the year. Is it really justified or even prudent to think the Fed will take a short-term view and cut rates quickly, as the markets are hoping it will? 

The chances of a recession, or at least a slowdown, are high, and the disparity of expectations, in terms of its depth and duration, is widely debated. Have the markets already priced in a recession? And, if so, is it a mild recession or a severe recession? 

A degree of economic slowdown is likely to occur and is needed to mitigate inflation. For now, evidence that the economy can withstand a slowdown is present, such as the unemployment rate and the purchasing managers’ index (PMI).  Central banks will, therefore, have to find a balance between slowing economic growth and containing inflation.

Finally, illiquid assets, such as private equity, real estate and infrastructure, did not experience the same declines as publicly traded assets. Given that such holdings must be revalued periodically, is there a risk that large institutional investors could come under pressure in 2023?

Balance, agility and discipline are called for in 2023. Some companies have already lowered their forecasts, and fund managers are comparing these expectations with their own. This context, combined with the attractive valuations of some assets, continues to create opportunities for active managers.

After a 30-year downward trend for interest rates, a higher interest rate environment led to a revaluation of all major asset classes in 2022 and created a positive correlation between stocks and bonds. Historically, the correlation has been negative, making it possible to increase a portfolio’s diversification and to reduce its risk. This positive correlation could, therefore, prompt investors to question the role of a traditional portfolio of 60% stocks and 40% fixed income.

Does it make sense to abandon the 60/40 portfolio? Faced with a difficult economic environment, having a diversified portfolio can nevertheless offer a balance in the face of market volatility. There are a few things to consider. From 1981 to 2022, the FÉRIQUE Balanced Portfolio produced a positive return 86% of the time. Faced with a more difficult economic environment, a diversified portfolio can provide balance in the face of market volatility. 

Furthermore, a long-term perspective is also important. Despite a trying year, investment decisions should be based on long-term needs and appropriate risk tolerance.

1. CIBC and FÉRIQUE Fund Management
2. BGA, Addenda Capital and FÉRIQUE Fund Management
3. BMO, AlphaFixe and FÉRIQUE Fund Management
4. Addenda Capital and FÉRIQUE Fund Management
5. Connor, Clark & Lunn Financial Group Ltd
6. Connor, Clark & Lunn Financial Group Ltd
7. BCA Research
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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