This has been one of the most chaotic and unpredictable periods in decades. It began with the pandemic; then lockdowns; a massive stimulus; re-openings; supply chain and labour shortages; inflation; war in Europe and then the fears of hiking interest rates. The first half of 2022 has brought a lot of negative numbers. It has clearly been a challenging time for investors as stocks and bonds have both sold off at the same time. There has really been no place to go for good returns.
While Canada was getting back on its feet, the highest inflation since 1991 erupted as the war in Ukraine elevated already high oil and commodities prices. The Bank of Canada has moved forcefully to combat this situation and is expected to push rates as high as 3%. Since Canada is relatively insulated; it is a commodity driven economy, enjoying its lowest unemployment rate in modern history, and has a huge glut of household savings built up over the pandemic, the overall pain has been mostly mitigated. If inflation peaks quickly and supply chain problems associated with the pandemic reverse, Canada stands to benefit from any economic recalibration in short order.
The U.S. economy contracted in the first quarter. Still, there is enough economic momentum to sustain the expansion as financial conditions, and consumer and business confidence remain strong. Inflation is stubbornly high, and the labour market remains extremely tight, which has forced the Federal Reserve to put its foot on the brake pedal to cool demand and begin raising interest rates. While households and businesses have accumulated significant cash reserves to smooth their spending, anticipated interest rate hikes could increase pressure.
The European Central Bank (ECB) will shortly begin raising interest rates for the first time in 11 years as it plays catch up; pivoting from supporting the economy during the pandemic to squelching soaring inflation, which was 8.1% in May, due to rising energy prices. As a result of the ECBs dithering, the Euro has dropped to a five-year low. The U.K. has had four rate hikes this year, as inflation is about to hit double digits.
Since the onset of COVID-19 investors have wondered when the world will return to normal. Japanese stocks dropped modestly thanks to a weak yen which declined 18% this year (its lowest level since 1998) and the Bank of Japan’s dogged commitment to super easy policies. Many emerging market central banks began to raise interest rates last year to fight rising inflation. China might be a point of growth because they are zigging while everyone’s zagging. While the rest of the world is raising interest rates, China, on the other hand, is cutting rates, cutting taxes, increasing fiscal policy, and stimulating aggregate demand.
So far, 2022 is notable as the year in which very little has worked. The purchasing power of cash has been eroded, stocks have been volatile and perhaps most challenging is that bonds have not fulfilled their traditional role as a ballast. As a resource-heavy market, Canadian equities weathered the storm better than most, declining 13.2% in the second quarter and only 9.9% for the year to date (all figures in Canadian dollar terms). U.S. stocks fell 13.0% in the quarter and 18.3% for the year. International stocks slipped 11.2% over the past three months and 17.6% year to date; while emerging market stocks declined marginally less; down 8.2% for the quarter and 15.8% for the year. Bonds fell 5.7% in the second quarter and 12.2% for the year.
In the minds of many investors, the stock market is a mysterious animal; wild and unpredictable. Yet the reality is that stock markets do follow cycles, the most important of which are linked to the economy. Of course, inflation is extremely high and if it remains high, central bankers will have no choice but to raise rates to punitive levels. However, when inflation comes down, investors should breathe a sigh of relief, patting themselves on the back for riding through the turmoil and most importantly looking forward to watching markets rally again.
The first half of the year saw the Canadian economy move mostly beyond full employment with unemployment at 5.1%, the lowest rate in 45 years. Although some preliminary estimates for May suggest that the economy may have suffered a slight setback, the overall trend has been strong as pandemic restrictions have been broadly being lifted. With an overheated economy and record inflation, the Bank of Canada, like its global peers, switched the narrative on inflation from transient to lasting and acknowledged the urgency of higher rates and lesser stimulus. The Bank hiked aggressively with 75 basis points in March, then May posted CPI (Consumer Price Index) at 7.7%, the highest in almost 40 years. This reinforced the view that runaway inflation is here for the longer term and the Bank should counter more aggressively.
The markets, unlike the economy, have been under pressure from the aggressive moves by the Bank of Canada to fight inflation. Recessionary fears resurfaced with investors increasingly betting on softening demand in the coming months. The S&P / TSX responded negatively with a 9.9% loss for the first half of the year.
Sector returns were broadly negative. Apart from Energy, it was a rough start for the first half. Year to date, Energy outclassed all sectors with an impressive 39.8% gain. The sector benefited from record inflation and tight supply caused by Ukraine war. The biggest detractors for the first six months were Health Care and Information Technology, returning -49% and -39.8% respectively. The former, historically a defensive play, has been disappointing with mixed earnings and fresh lows in the Cannabis industry. The latter has been under pressure amid rising rates which are historically unfavourable for growth stocks, as well as lower long term growth forecast by investors.
After a spectacular post pandemic rebound most GDP forecasts are on the downside. The International Monetary Fund for instance cut global growth for 2022 to 4.4%, a half point lower than 2021. Key macro risks continue to weigh heavily on global economies such as the war in Ukraine, inflation, along with hawkish central banks across the globe, and supply chains woes. Heading into the second half of 2022, these risks remain as a recession could be in the cards if an adequate level of inflation becomes unattainable. Similar concerns are also prevalent in Canada, particularly due to the May GDP contraction as recorded in the flash estimate from Statistics Canada. Nonetheless, many analysts believe that a potential slowdown will resemble a soft landing rather than a widespread recession with strength in important pockets of the domestic economy such as Energy.
In this environment of rampant inflation on the backdrop of skyrocketing energy prices, the Canadian market has overtaken most of its global peers on a relative return basis, though still trading at a loss year to date. The S&P / TSX underperformance compared to the S&P 500 over the past several years has been extreme and coincided with a periods of lower energy prices. The sudden regime shift in the last few months with a renewed interest in commodity stocks has reinvigorated the resource heavy S&P / TSX. With upward earnings revisions notably in the Energy sector, the Canadian markets now appears to be a defensive play for equity holdings and well equipped to withstand stagflation.
During the second quarter of 2022 the Fund’s Benchmark Index lost 3.1% as central banks continued to notch up interest rates amid soaring inflation. Inflation numbers came in at 7.7%, the highest rate since 1983 and more than double the rate of inflation one year ago. In some areas of the country, like Prince Edward Island, rates rose as high as 11.1%. Gas prices rose across the country by over 12% in May alone and 48% over the last year. The cost of edible fats and oils skyrocketed by 30%, and grocery bills have increased by over 10% in the past year. Global turmoil has been a major contributor to the uptick in prices.
Skyrocketing Inflation has been a result of a perfect storm including the war in Ukraine disrupting oil and gas supply, retaliatory sanctions limiting the flow of goods out of Russia, and continuing supply chain issues in China, exacerbated by recent lockdowns of Shenzhen and Shanghai. The fear is that China’s strict anti-COVID policies will add more disruptions to worldwide trade, further slowing the global economy.
Since its first post pandemic rate increase of 0.25% in March, the Bank of Canada (BOC) has made two 0.50% rate hikes on April 13th and June 1st, with an expected increase in July. Inflation numbers disappointed in late May, leaving expectations open for a 0.75% rate increase, the largest hike since August 1998. This would not be a surprise to markets as the BOC alluded to relatively aggressive rate hikes until the battle against inflation takes a turn and that the BOC would partake in quantitative tightening, a process in which the Bank discontinues it’s purchase of treasuries, bonds and even stocks. By unwinding its balance sheet, the Bank is essentially taking cash out of the market in hope of cooling inflation. Although increasing rates help to battle inflation, a higher interest rate makes it more expensive for companies to borrow and dampens investors’ willingness for paying higher prices for investments when they can earn an increased rate from owning safe Treasury bonds instead. As a result, investors are less inclined to allocate cash to equities where there is no guarantee for returns. Unlike during the pandemic when low rates allowed house hunters to buy more expensive homes and make payments, this higher rate environment will drive prospective home buyers back to renting. Less buyers in the market should cause Canadian home sales to drop materially, however given the steep price increases through the pandemic, home prices are still higher than their pre-pandemic level.
The business outlook is still strong. There is a swath of pent-up demand for travel and leisure, with a record number of flights being booked, particularly for the summer months. As consumers worry about what rising inflation will do the prices of food, gas and rent, they will naturally demand higher wages. Job vacancies are still elevated, companies have labour shortages and consumer spending remains robust with exports anticipated to strengthen from high global demand.
After decades of positive returns due to low interest rates and secular disinflation, bonds suffered deep losses in the face of rising rates through the first half of 2022. The currently depressed bond values make fixed income ownership more appealing and will tend to bring in value investors and fresh capital into the market.
Markets around the world were faced with similar challenges in the second quarter of 2022; the war in Ukraine, the Federal Reserve’s plan to combat inflation and rising fuel prices, along with the lingering disruption of the global supply chain. The Standard & Poor’s 500 index lost 16.1% in U.S. dollar terms during the quarter, making the first half of 2022 the worst performance for U.S. equities (-20.0%) since 1970. It is important to note that in 1970 the market rebounded in the second half, recovering the entirety of its losses.
Russia’s continued aggression towards 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. Adding to supply chain pressures, China enacted yet another strict lockdown in March. Chinese authorities locked down several large cities, including Shenzhen which is a major economic hub, and Shanghai, the second most populous city in the world. The fear is that China’s strict anti-COVID policies will add more disruptions to worldwide trade, further slowing the global economy. China’s approach to stamping out the disease will be an important development moving forward.
The world runs on fuel, so when prices rise consumers are strongly impacted. As the price of fuel rose throughout the quarter, consumers spent considerably less on goods, transportation, and services. This was perfectly exemplified by the performance of the Consumer Discretionary sector which returned -25.5% for the quarter. Only four sectors (Energy, Consumer Staples, Utilities and Health Care) lost less than 10% in the second quarter and every sector in the S&P 500 finished the quarter in the red. Oil prices climbed as much as 65% in the quarter and other commodities such as cotton, milk and wheat were up a staggering 65%, 35% and 40% respectively. As these and other key economic inputs shot up in price, consumers and the market paid heavily. A major question coming into the year was by how much and how often would rates rise. As of January 31st, the 10-year Treasury yielded 1.51% and shot up to a high of 3.45% before closing the quarter at 2.88%. In May, several Fed policymakers, including Chair Jerome Powell, indicated a strong commitment to bringing down inflation even at the risk of a recession, signaling another 75-basis point rate increase in July. He also noted that the Fed “wouldn’t hesitate” to push the benchmark rate to a point that would slow the economy if needed. It is not certain what that would be, but Fed officials peg it at about 2.5% to 3.0%, roughly triple its current level. By sharply raising borrowing costs, the Fed hopes to cool spending and growth enough to curb inflation without tipping the economy into a recession.
On a positive note, valuations have come down significantly. As of June 30, 2022, the forward price-earnings ratio (P/E) of the S&P 500 was 17.73 times, trading at a 26.4% discount to its forward valuation of 24.09 times as of December 31, 2021. Although cheaper valuations won’t be enough to lift markets alone, establishing a floor is a critical step. When investor sentiment is at its low, it is typically the case that the selling of securities is largely exhausted. Lower valuations make equity ownership more appealing and tend to bring value investors and fresh capital into the market. Inflation is clearly the key driver behind the recent change in market sentiment. Any signs of a peak in inflation could potentially alter the Fed’s plans, spurring the market to rally.
Supply chain disruptions created by COVID-19 have been amplified as another seismic event, the war in Ukraine, has created worldwide economic shocks. Even prior to the onset of the conflict, the world had entered a new inflationary period, with energy and food price volatility adding an extra layer of complexity. Fiscal policy responses, both in terms of defense spending and measures designed to offset the impact of commodity prices is likely to be significant. Global trade patterns are shifting abruptly and could remain altered for the long term.
Europe’s growth gained speed in the first quarter after a lackluster 2021 despite Russia’s invasion of Ukraine. However, the negative impact of the war is expected to be felt in the second quarter, as growth is expected to slow significantly. Europe’s inflation accelerated to an all time high, 8.1%, as energy prices jumped a startling 38%. This has intensified the debate about how rapidly to raise interest rates from record lows. The European Central Bank has signaled that its first interest rate increase since 2011 is imminent. Europe’s employment level was also revised upwards and has finally exceeded its pre-pandemic level; however, the euro sank to a two-decade low versus the U.S. dollar.
The U.K. is teetering on the edge of recession as inflation battered consumer spending and the Bank of England ratcheted up interest rates. Soaring food and energy prices pushed British inflation to a 40-year high, with worse likely to come. Inflation is expected to peak at more than 11% later this year. The scale, pace and timing of any further interest rate increases will reflect energy prices and ongoing Brexit-related friction. Developments around the war in Ukraine will also be key. The pound is down more than 10% this year. Consumer confidence fell to its lowest level since records began in 1974.
Japan is gradually reopening from a quasi state of emergency. Unfortunately, while this shift is positive for Japan, the Russia / Ukraine conflict has brought heightened uncertainty and volatility for global markets. Japanese companies have little direct exposure to the war, but Japan’s economy and corporate profits are sensitive to global growth and commodity prices. Inflation has remained surprisingly subdued. The Bank of Japan also has maintained its vow to keep interest rates near zero which has caused the yen to hit a 20 year low compared to the U.S. dollar.
Australia’s central bank became the latest to extend its interest rate tightening cycle. It lifted its benchmark interest rate for the first time in more than 11 years to combat inflation driven by a surge in fuel, housing costs, and food shortages created by recent floods. Jumbo sized interest rate hikes in New Zealand are boosting market confidence as the central bank is on track to tame inflation. In Asia, Singapore’s central bank also tightened monetary policy and the Bank of Korea hiked rates again.
International stocks declined 14.3% in the second quarter and 19.3% for the year to date (YTD), all figures in U.S. dollar terms. European stocks fell 15.6% in the quarter and 22.3% for the year; U.K. stocks showed more resilience, declining 11.3% in the quarter and only 10.8% YTD, surprisingly making it one of the least hard-hit countries. Asian stocks slipped 14.5% for the quarter and 20.8% for the year; Japanese stocks were down by roughly the same amount, returning -14.8% and -21.2% respectively.
The global economy continues to grapple with the prospect of persistent inflation and tighter monetary policy. Amid market sell offs, central banks are searching for a sweet spot in monetary policy to deliver enough interest rate rises to dent inflation but not push economies downward. Geopolitical events and economic shocks have raised global stock market volatility and reverberated across countries so quickly that no one knows where the cycle will end up.
EMERGING MARKET EQUITIES
Global financial markets face an unprecedented environment. Many emerging market economies were benefiting from pent up demand after the worst of the COVID-19 pandemic passed and monetary stimulus continued. However, the onslaught of high inflation is spurring tighter central bank policies and rising rates which have become highly disruptive. The real question is whether this is a long or short term phenomenon given that 60% of low income countries are already in debt distress. Throw in the reversal of a 100-year trend towards globalization, which started in 2008, and the long-term outlook for Emerging Markets becomes even murkier.
China’s export growth, consumer spending and manufacturing activity are in the worst shape since early 2020 when the pandemic began. Draconian COVID-19 restrictions have resulted in lockdowns that are exerting a major drag on the economy. China is in danger of significantly undershooting its annual targets that have been in place since the aftermath of the 1990 Tiananmen Square crackdown. Global supply chain woes have been exacerbated by the latest lockdowns and significant backlogs have built up, which is adding to global inflationary pressures. The government is applying fiscal, monetary and regulatory stimulus measures; however the benefits will likely be modest and gradual until the restrictive lockdown measures are fully removed.
A strong U.S. dollar is encouraging capital outflows from Emerging Markets and tightening financial conditions. Mexico’s inflation is rising at its fastest pace in more than two decades. Government subsidies on gasoline prices have helped to keep energy inflation relativity in check, but food costs are rising at a double-digit pace, forcing the central bank to raise rates eight times this year. Brazil’s inflation has increased to a 19-year high and its central bank has been raising its benchmark interest rate from a record low of 2% to 12.75%. This pattern is similar in other Latin American countries, though most have benefited from higher commodity prices which has dampened the economic pain.
Emerging Asian markets have been reluctant or unable to print huge sums of money to stimulate their battered economies. Southeast Asian markets like Indonesia and Malaysia have benefited from reopening, post pandemic recovery, higher commodity prices and still relatively accommodative central banks compared to other countries. However, increases in fuel and food prices, exacerbated by the invasion of Ukraine and pandemic related supply chain disruptions are playing havoc across the region. Even India which stands to benefit from a tailwind of demographics, urbanization, rising health care standards, and generally good transparency is seeing its stocks tumble due to the battle against inflation.
Emerging market equities are trading at historically low relative valuations versus developed markets, and while not able to escape all of the downdraft, they have still fared better. Overall, emerging market stocks fell 11.3% in the second quarter and 17.5% for the year to date (all figures in U.S. dollar terms). Eastern European stocks declined 23.5% for the quarter and are down a crushing -83.4% YTD due to the war in Ukraine. Latin American stocks returned -21.7% last quarter but due to their commodity based economies are only down 0.3% for the year. Asian stocks have declined 9.2% in the second quarter and 17.1% for the year.
Increasingly, emerging market economies are finding their post pandemic normal which involves reversals of some temporary COVID-19 economic measures and permanent changes to others. Russia’s invasion of Ukraine was a considerably risky and dramatic event that continues to reshape the geopolitical map, stroking inflation and adding volatility to equities. It is also putting debt in the crosshairs of a crisis. The key risk is the degree to which the conflict slows global growth, ratchets up inflation, and tightens global financial conditions.
GLOBAL REAL ESTATE
As the Omicron variant receded in early 2022, the reopening of global economies had an initially positive impact on certain areas of the real estate market and created opportunities for investors in search of broader portfolio exposure outside of the traditional public equities. However, the Bank of Canada, like its global peers, started putting the brakes on rampant high inflation with an half a percentage point increase in March, the largest single increase since 2000. This has triggered some re-evaluation across both domestic and global real estate markets.
The global real estate income trusts (REITs) index, the MSCI Global REITs, returned -17.76% in Canadian dollar terms year to date. In line with the broader equity market, volatility has been prevalent year to date with disparate monthly performance as well within regions and sectors. In the U.S., four out of five months were negative, while globally, some of the world’s largest companies succumbed to earnings misses which has led investors to re-evaluate the impact of monetary policy tightening across the globe.
The Canadian REITs index also underperformed the broader S&P / TSX in the first half of 2022 amid intense volatility that persisted until mid-year, with a 17.9% loss versus 9.9% for the S&P / TSX. The underperformance was widespread as most REIT sectors were in negative territory year to date. As in the global market, Canadian investors also are becoming increasingly bearish on REITs as they anticipate lower long-term growth on the backdrop of rising rates.
In the commercial REITs market, expectations were high at the start of the year as the widespread easing of restrictions was supposed to support economic growth. In fact, the sector emerged from the pandemic in good shape with increased activity across the country as well new capital flows. However, the sector is still not completely out of the woods yet. In the retail sector, restrictions that were in place until the beginning of the year forced some tenants to close or reduce their operations. Though many entities in the sector have structured their portfolios conservatively with loan to value ratios under 30%, some were overleveraged and experienced greater pullback over the last six months.
The industrial REITs sector has exhibited extreme strength in the last few years, especially during the lockdowns as electronic commerce became the main tool for businesses and drove the necessity of building more warehouses to transit goods. Rent in Canada soared in the industrial space and that demand led to the conversion of many farmlands into industrial properties. But the sector has been experiencing some downside risks over the last few months, driven by softening demand for warehouse space. A Bloomberg report in May found that some of the world’s largest online retailers such as Amazon are planning to scale back millions of square feet of overbuilt capacity. This has ignited some pessimism in the sector as investors reassess, although the pullback has created rare opportunities for long term investors.
The global REITs sector underperformance seems to overshadow the degree of interest investors have exhibited in the last few years. In Canada for, though select REITs are trading at an average discount of NAV (Net Asset Value) of more than 15%, some in the commercial landscape remain appealing with average cap rates decreasing. For the industry, it is estimated that cap rate spread versus 10-year bond yields are above 200 basis points, well in the range of historical averages and an indication that the sector still has lots of upside potential over the long term. A key risk is the rapid pace of interest rate hikes which should add downside pressure to performance, especially to the over leveraged entities in the sector. However, while higher yields result to expensive debts, an inflationary environment historically has been favourable to REITs in the form of higher rents as REITs remain traditionally a natural hedge against inflation.
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