Investors had few places to hide as the world became a more dangerous place. Volatility has doubled and tensions have increased due to heightened geopolitical risk from the Russia-Ukraine conflict, rising inflation, and the threat of interest rate hikes. Additionally, continued disruption caused by the pandemic and highest lever of total global debt in half a century has undermined growth prospects and kept investor confidence low.
Russia invaded Ukraine, confirming the worst fears as the biggest attack by one state against another in Europe since World War II began. In the short term this has caused a lot of volatility, with oil prices rising above $100 a barrel for the first time since 2014 and stock markets slumping. But history shows that military attacks and geopolitical events pass eventually and if there is no major global economic impact, markets tend to rebound.
The direct economic impact on Canada from the Russia-Ukraine war may be inconsequential, as both countries represent less than 1% of Canadian trade. However, the indirect impact on food and energy prices is high with prices up 15% in agriculture and energy prices up 10%. The impact of high oil prices on inflation and economic growth are top of mind, prompting concerns about inflation and accelerating the Bank of Canada’s rate trajectory. The current level of price gains has only occurred four other times, in 1973, 1979, 2005 and 2008. That there will be interest rate hikes is not in question, it is only a question of how high they will go.
U.S. corporate profits in 2021 hit a record high (leaping 25% which is the largest gain since 1976), despite widespread supply and labour shortages that have raised costs and contributed to high inflation. Although companies are paying higher costs, they have still managed to increase profits. As a result, firms have more money to invest and can afford to pay workers more. Wages are rising at the fastest pace in four decades. Last year, the U.S. economy grew at its fastest rate since 1989, bouncing back from the devastating coronavirus recession. As such, America is experiencing its highest inflation in 40 years, which will likely force the Federal Reserve to move rates up multiple times.
Since Russia’s invasion, Europe has been racing to evaluate how badly sanctions, trade disruptions and surging energy costs will affect its prospects. Inflation in Europe soared to a record, adding pressure on the central bank to raise interest rates and wind down monetary stimulus. European countries that do not use the euro, including Britain, Norway, the Czech Republic, and many emerging market countries, have already begun raising interest rates and are expected to dramatically ratchet up their efforts to clamp down inflation.
Most stock markets stumbled during the first quarter, while bonds saw their worst losses in at least five decades. The one notable outlier was the Canadian stock market which gained 3.8% (all returns in Canadian dollar terms); as investors who piled into commodities generated massive gains in everything from oil to nickel to wheat. The U.S. stock market fell 5.9%, with the S&P 500 experiencing 35 down days in the quarter, the greatest number of daily drops in a quarter since 1984. Other markets were even worse, with international exchanges falling 7.1% and Emerging Markets dropping 8.3%. Canadian bonds did not escape the carnage as they declined 7.0% in the quarter.
The range of possible outcomes for the global economy remains wide and depends critically on the persistence of the challenging situation in Ukraine, longer lasting inflation, ongoing supply chain and labour force issues, and new COVID-19 variants. If these stresses ease, there may be scope for the global economy to bounce back and perhaps even make up some lost ground.
Geopolitics dominated most of the headlines in the first quarter after Russian troops invaded Ukraine at the astonishment of the entire world, thereby igniting one of the most explosive crises since the second world war. The move, which triggered a package of unprecedented economic sanctions against Russia by Western nations, severely weighed on the global supply of commodities and added inflationary pressures. The Canadian economy, with its energy bias, was impacted positively with energy benchmark prices surging to multi-year high amid lower global supply. Despite the geopolitical headwinds, the Canadian economy has extended its streak of monthly gains as governments lifted further COVID-19 restrictions. As of February, GDP was 1.2% above its pre-pandemic level, following nine months of growth. Not surprisingly, the unemployment rate fell to 5.5%, the first time it has been below its pre-COVID level and near a five decade low. The Canadian markets responded strongly and stretched to fresh highs. The S&P / TSX gained 3.8%, outperforming the S&P 500 which posted a 5.9% loss (all returns in Canadian dollar terms). This marked the strongest quarterly return differential between the two indices in more than a decade.
Sector-wise, Cyclicals continue to dominate, in line with most analysts’ predictions. Energy returned an outstanding 36.2%, followed by Materials with 19.7%. Energy price shock was one of the notable headlines with prices surging to highs not seen for a decade. The WTI (West Texas Intermediate), a global Oil Benchmark climbed to more than 70% while its Canadian’s peer – the WCS (Western Canada Select) gained 75% compared to a year earlier. Information Technology detracted the most from the index with 20.7% loss, followed by Consumer Discretionary with 8% loss. The former has been under pressure over the last few months as growth stocks are experiencing multiple compression amid rising rates. As for the latter, it suffered from decreasing consumer confidence on the backdrop of rising inflation and its detrimental impact on spending.
With inflation at three-decade high, the Bank of Canada raised the key rate to 0.5% in March and increased its hawkish tone. It is poised to ramp up the hiking cycle with more aggressive highs as more evidence of economic resilience emerges.
The Canadian economic outlook points to decent GDP growth and a continued hot job market, although global growth could slow amid the spectre of tighter monetary policy, the war in Ukraine, and lingering inflation. The hawkish stance of the Canadian central bank to abate unprecedented levels of inflation has led to a slight flattening of the yield curve. Some analysts stressed that although fighting inflation is needed, trying to engineer a faster return to 2% core inflation could be a catalyst for recessionary risks.
As long anticipated, the economic environment has proven suitable for Canadian markets to shine. The war in Ukraine and high inflation created a perfect situation for commodities and the S&P / TSX outperformed the S&P 500 by the most it has in thirteen years. With the imminent shift in monetary policy to avert inflation, investors would likely second guess higher valuation companies and rotate to cyclicals names. Though the S&P / TSX has caught up in the last few months, the valuation discount is still in its favour relative to the S&P 500. The forward price / earnings ratio (PE) hovers around 14 times earnings, below its 10 year average of 15 times earnings. Thus, the S&P / TSX should still have some room to run.
During the first quarter of 2022 the FTSE Canada Universe Bond Index lost 6.97% as central banks began to increase interest rates. The Bank of Canada hiked its key interest rate a quarter point to 0.5% on March 2nd, the first rise after cutting rates in the aftermath of the pandemic. The increase is expected to be the first in a series of hikes necessary to tame inflation which has risen to its highest level in decades. The U.S. Federal Reserve (Fed) also raised its target for its fed funds rate by a quarter point to between 0.25% and 0.5% at its March meeting. Yields on 10 year Government of Canada bonds have recently averaged 2.4%.
DBRS Morningstar, a credit ratings agency, confirmed Canada’s AAA credit rating by citing the rebounding economy which is supported by output that returned to pre-pandemic levels in the fourth quarter of 2021. While government finances were battered by extraordinary fiscal support directed to help households and businesses weather the pandemic, it is expected that the strong recovery will allow government finances to improve. DBRS noted that the federal fiscal deficit is expected to decline from 14.6% of GDP in fiscal 2020-2021 to just 2.2% in fiscal 2022-2023, while also mentioning that provincial government finances are also improving. Canada may benefit from higher commodity export prices but escalating geopolitical tensions could also materially weaken demand from key trading partners, worsen existing supply chain disruptions, and add to inflation pressures.
There will be no ambiguity ahead of Canada’s next policy decision on April 13th as the Bank of Canada’s deputy governor, Sharon Kozicki, recently telegraphed a relatively aggressive half-point increase, instead of the customary quarter-point change. She also indicated policy makers will likely stop buying government bonds, a process called quantitative tightening. Her boss, Tiff Macklem, said after he and his deputies raised the benchmark rate a quarter point on March 2nd that the pace of future increases would be guided by data. The data over the past few weeks show the economy is considerably stronger than the central bank expected at the start of the year. The jobless rate was 5.5% in February, and at a level consistent with full employment as Statistics Canada reported there were 915,500 unfilled jobs in the fourth quarter, 63% more than a year earlier. Furthermore, inflation heated up as the consumer price index averaged increases of 5.4% over the first two months of the year.
The bond buildup was key to the bank’s first ever quantitative easing program where central banks buy market assets in order to press down on market interest rates. The bank started buying bonds at a rate of $5 billion a week early in the pandemic and then started reducing its purchases in October 2020. By late last year it had whittled its buying down to just enough to replace bonds that reached maturity. The next step is to stop replacing bonds as they mature which could affect the bond market as the Bank of Canada now owns about 43% of the total supply of Government of Canada bonds. The biggest buyer is poised to leave the market in what should still be a pretty heavy year of government bond issuance, which in turn should tend to push up market interest rates.
With a war raging in Europe and price increases at a four decade high, U.S. Fed Chair Jerome Powell will seek to engineer a soft landing; a gradual slowdown in economic activity while keeping the job market and economy expanding. The Fed, by its own admission, underestimated the breadth and persistence of high inflation after the pandemic struck. By raising rates, the resulting pullback in spending should slow inflation. Strong consumer spending, fueled by stimulus cheques and steady hiring, has collided with supply shortfalls to raise inflation to 7.9%, the highest rate since 1982. If the Fed succeeds, the economy should keep growing and the unemployment level of 3.8% should stay low or fall further.
In this low rate environment, yield-hungry investors had been ditching the safety of bonds in a search for returns in riskier real estate investment trusts and high dividend yielding stocks. This can be a dangerous game as these investments do not have the defensive characteristics of high quality bonds held over time.
U.S. equities fell in the first quarter of 2022 amid concerns of the war in Ukraine, surging inflation, ongoing supply chain disruption, soaring gas prices, and uncertainty over the Fed’s rate hikes. The Standard & Poor’s 500 index lost 4.6% in U.S. dollar terms. Investor resolve is certainly being tested; and just as countries around the globe began lifting COVID-19 related mandates and reopening their economies, Russia launched a full-scale invasion of neighboring Ukraine. While markets were cautious about geopolitical tensions surrounding Russia, a full-scale invasion was not priced into markets.
Inflation was no surprise to markets as investors have been cautious of rising prices going back to November 2021. The CPI index rose 7.9% year-on-year in February 2022, its biggest rise since January 1992. Fed Chair Jerome Powell attempted to ease concerns of inflation by labelling it as transitory, stating bottlenecks in supply chains would normalize as the global economy recovered from shutdowns associated with the pandemic. However, adding to robust consumer spending and worker shortages, Russia’s invasion of Ukraine has resulted in the disruption of oil and gas imports to the rest of the world while Europe and the White House have crippled the Russian economy and their ability to export goods with sanctions. Russia’s ability to do business in dollars, euros, pounds and yen has been severely limited and there is even a domestic embargo on Russian gas imports. President Biden vowed to do anything he could do to alleviate Americans at the pump, unveiling a plan to release some of the country’s strategic reserves. Despite these efforts to increase oil supply, it has become clear that inflation has reached unhealthy levels and needs to be addressed.
To reign in inflation, The Federal Reserve had to initiate tapering in late 2021, with additional rake hikes expected through 2022. The key question for monetary policy in 2022 is by how much and how often these tapers are expected. Fed Chair Jerome Powell has made it clear that tapering does not automatically lead to tightening, and in late March he laid out plans for “ongoing increases in its policy rate.” The Fed did not give details of how it will shrink its balance sheet, as economists largely expected. Markets expect the Fed to raise its policy rate by six quarter-point moves this year, however there is still uncertainty in both the timing and magnitude of these increases. The Fed faces the incredible task of soft landing the largest economy in the world for the first time since the early 90’s. If the Fed is does not act quickly enough it faces the risk of losing a grip on inflation and if the Fed overreacts, it faces the risk of tipping the economy into a protracted recession.
As the market processes the uncertainty and volatility of the first quarter of 2022, there are reasons to be optimistic moving forward. The Federal Reserve is committed to combating inflation. Americans are increasingly going back to work. The U.S. labour market is bouncing back, adding another 431,000 jobs in March and bringing the unemployment rate down to a new pandemic low of 3.6%. Although the war in Ukraine continues, there is a little more clarity, and the inflammatory language of a third world war has calmed considerably. These are anti inflationary pressures and positive for the U.S. Dollar.
Although the S&P 500 had its worst opening six weeks to a calendar year, stocks reversed this downtrend to close out the quarter. Since Russia launched an invasion of Ukraine on February 20, 2022, the S&P 500 Index has returned just over 5.2% to investors and since the March 8th lows, the index has returned 8.6%. This is the type of resiliency one would hope to see in their portfolios. We expect strong corporate earnings to continue, although forward guidance remains unclear. As we move on to the rest of 2022, investors can take comfort in knowing that the economic backdrop for U.S. equities is strong. In times of market volatility, stocks tend to get oversold as they have so far this year. A de-escalation of the war in Ukraine and clarity on the interest rate curve could be the impetus this market needs to reset its upward trajectory.
Investors who have been able to navigate a global pandemic are now being confronted by problems on a number of fronts, exacerbated by the geopolitical drama of Russia’s decision to invade the Ukraine. The sheer level of bearishness is at its highest since May 2016, just before Brexit. As tensions and uncertainty have increased the volatility of financial markets has climbed. This has also fanned the flames of inflationary pressures. Economic, political and market consequences of the Russian invasion could possibly create significant headwinds for the global economy if the tensions drag on.
While Russia plays a relatively marginal role in the global economy, it is a key player in a few commodities: 12% of global crude exports; 40% our European natural gas; 29% (including Ukraine exports) of the wheat market and 20% of the world’s corn; it also supplies 20% of the world’s nickel and potash. Sanctions and trade disruptions have been felt strongly in Russia, evident by the collapse of the rouble and interest rates spiking to 20%. However, the spillover effect to the rest of the world should be much less severe. Case in point; when Russia annexed Crimea in 2014, the U.S. stock market sold off 6% and started climbing again after two weeks.
Europe’s manufacturers appear to be weathering the Omicron storm better than prior COVID-19 waves, due to some abatement in supply chain problems. However, the supply chain improvement is by no means evenly spread across the eurozone and could become moot depending upon the length of hostilities in Ukraine. The European Central Bank finally acknowledged mounting inflation risks and has even opened the door to interest rate increases this year.
Inflation in Britain rose at the fast rate in nearly 30 years, intensifying a squeeze on living standards and putting pressure on the Bank of England to eventually raise interest rates multiple times in the future; after having been the world’s first major central bank to tighten policy since the start of the pandemic. The prices for food, hospitality and household goods were the key factors pushing up inflation, while fuel prices are expected to further exacerbate the problem.
Japan’s economy shrank in the third quarter of 2021 as supply constraints and curbs on factory output and consumption took its toll. However, the gradual recovery from the damage of the COVID-19 pandemic has allowed activity since then to grow at its fastest pace in four years. Japan has not been immune to the impact of global commodity inflation with wholesale prices rising at a record pace. Still, the Bank of Japan is in no rush to change its ultra loose monetary policy for now; although it is starting to telegraph an eventual interest rate hike, likely next year.
The first quarter was one of the weakest on record for the performance of stocks around the world. As a whole, international stocks fell 5.8% (all figures in US dollar terms); European stocks dropped 7.2%, with Ireland and Austria leading the declines at -20%; the U.K. was one of the few non-commodity centric countries to generate positive results, climbing 1.8%. Asian stocks collectively fell 5.7%, but the range of returns varied widely, from Australia’s 7.3% gain to Japan’s 6.5% decline.
Russia’s invasion has been rough on international stock markets, wiping out trillions of dollars in value. However, keep in mind that stock markets are not the same as economies. The economic threats are not likely to make a big splash and the ripple effects should diminish over time, depending on how long and involved this conflict becomes. In all likelihood, the knee jerk reaction of stock and commodity markets, while not insignificant, will be manageable.
EMERGING MARKET EQUITIES
Despite the conflict in Ukraine, sky high inflation and commodity prices, and the uncertainty of post-pandemic fiscal and monetary policies, the global economy appears to be transitioning to stable growth phase. For Emerging Markets, the recovery is less synchronized and more fragile; and highly dependent upon the efforts of major developed nations to overcome the same headwinds. Several emerging market central banks have already hiked interest rates to combat the situation. The two year pandemic has seen greater currency volatility, stuttering global trade, a buildup in debt and a lower living standard, which has increased inequality in many countries.
Russia’s invasion of Ukraine will undoubtedly complicate monetary policy decisions. Among other things, sharply higher energy prices could ramp up inflation expectations and trigger an unprecedented commodity shock. This is bad news for countries that import oil and food, but largely a positive for commodity exporters such as Latin American countries. Unfortunately, the emerging markets stock market universe is now largely a bet on four superstar Asian economies: China (32% of the index), Taiwan (16%), India (13%), and South Korea (12%), all significant commodities importers, so economic prospects are at risk.
After an initial rapid recovery, the Chinese economy has lost steam. China’s strict zero-tolerance COVID-19 measures, decelerating industrial activity, property sector slowdown and ongoing regulatory actions are risks to the economy. China’s barrage of regulations over the past year and the drive for common prosperity have led to market value losses of more than $1 trillion. Thankfully, actions are being taken to try to stave off a deeper slowdown, such as reducing bank constraints and drafting new rules for Chinese companies to meet regulatory overseas guidelines.
Central banks in countries such as Brazil, Mexico and Chile have all raised rates to contain inflation. Brazil slipped into recession in the third quarter of 2021 for the second time since the pandemic started after extreme weather, supply chain disruptions and heightened inflation weakened Latin America’s largest economy. Recoveries in Mexico and Argentina are losing steam amid elevated inflation pressures. Many countries now have substantial reserves of foreign exchange and deep local capital markets, which offer protection from swings in exchange rates. Of course, surging commodities prices have been resoundingly beneficial to the region.
The Indian stock market has been the beneficiary of strong inflows, pushing stocks 20% higher, as its continuing efforts at economic reform make it a particularly interesting proposition for long term investors. India’s GDP has grown 8% over the past year. Elsewhere, zero COVID policies have been a drag on the economies of South Korea, Taiwan and Hong Kong; which coupled with oncoming supply chain issues will force much of this region to limp along.
The vast majority of emerging market stock exchanges were significantly negatively impacted by the collective issues that have piled up across the globe. Emerging Markets as a whole fell 6.9% (all figures in US dollar terms). Asian stocks dropped 8.7%, paced by a 14.2% decline in Chinese stocks; Latin American stocks surged 27.3% (obviously the spike in commodity prices at play); Eastern European stocks we just decimated, plunging 78.3%, although they were only down 10.2% after stripping out the annihilation of Russian stocks.
The course of growth across Emerging Markets will undoubtedly be linked to a number of deep uncertainties: the path of the pandemic, government response to the pandemic, whether inflation is transitory and the state of global geopolitics. The trajectory of recovery continues to be ambiguous, but many emerging economies are much better placed today to withstand such difficulties than they were in the past.
GLOBAL REAL ESTATE
In a world devoid of income producing investments, REITs and the reliable income they provide, have attracted investor interest as the pandemic wanes and economic activity stabilizes. As difficult as the situation in Ukraine is, the financial linkages are really quite small. Increasing inflation from a low base is usually taken as a sign of improving growth prospects and a diminishing risk of deflation, both of which are supportive for real estate valuations. Economic growth is surprisingly resilient; a hot jobs market and broadening price pressures may push policymakers into a more hawkish stance, but that should not be a reason for investors to shy away from real estate.
REITs have been sensitive to changes in the outlook for interest rates, both short and long term. Historically, REITs have performed well during 85% of the periods of rising long term interest rates. REITs have also historically outperformed during periods of above average inflation. This is due to the fact that strengthening macroeconomic conditions typically lead to higher occupancy rates, stronger rent growth, increased funds from operations and net operating income, rising property values and higher dividend payments to investors. Over the past 5 years, REITs have raised significant amounts of equity capital and have lengthened the average maturity of outstanding debt, which further enhances their appeal.
Competition among homebuyers remains fierce, with extraordinarily tight conditions. The biggest trend is around mortgage rates and home pricing which are both expected to rise. However, quickly increasing mortgage rates should help to slow property price growth. Raw material costs remain high, and builders continue to struggle to keep up with homebuyer demand. As rents also increase, more and more renters will need to reassess the costs of owning a home.
The commercial real estate sector is offering indications that Canada may be heading in the direction of pre-pandemic normalcy. Generally, the main themes are lower vacancy rates and higher average rents. The formerly bustling office sector is nowhere near what we saw before the pandemic. However, in Q1 2022, more people returned to the office as companies have begun to implement their return to office strategies.
Growth in the industrial and logistics sector is a counterbalance to the reduction in physical retail due to the move to online shopping. Low availability has enabled landlords in the industrial markets to demand premiums. Logistics has become a strong asset class, with good levels of yields and substantial capital. The major data centre operators continue to expand.
The industrial market is more robust than it has ever been. The industrial sector in particular saw rents soar. The market is hot with very little supply. Government supports have helped to shelter the hospitality sector, particularly hotels, from the worst impact of COVID-19. However, for hotels to return to pre-pandemic levels, corporate travel and events need to return. Despite the challenges for hospitality, hotel values are holding up well as investors predict increased post COVID-19 spending. Still, the greatest levels of stress in the real estate market can be found in retail.
Canadian securities were amongst the strongest performing in the world in the first quarter; this extended to Canadian REITs which finished the quarter down 0.4% (all figures in Canadian dollar terms). International REITs, while down 6.9% in the quarter, still did quite well relative to other global stocks.
COVID-19 has passed its critical pandemic phase and the worlds economies are expected to grow at a more modest pace. In the current environment, many central banks are signaling higher rates which would be a positive growth signal for REITs. Rising inflation expectations would also support owning inflation protected assets, as replacement costs rise along with inflation as do rents. Investment activity will likely increase with the prices of higher quality assets improving.