Dramatically higher interest rates, surging inflation and a prolonged energy crisis caused by the Ukraine war are leading many to the inescapable conclusion that the global economy is headed towards recession. However, central bankers are tackling the biggest inflation threat in decades with rapid increases in interest rates. The hope of an engineered soft landing that tames inflation while avoiding a recession have not dimmed completely; especially as falling prices for major commodities and strong employment are indications that the tide might be turning.
Canada is expected to have the highest economic growth rate from the developed markets this year and next. This huge outperformance is due to strong commodities prices and much stronger consumer spending as a result our delayed reopening from COVID-19 restrictions, which were longer and more broadly applied than elsewhere. A tight labour market and elevated savings during the pandemic have cushioned much of the economic decline. The Bank of Canada has raised interest rates five times to 3.25% to combat multi-decade high inflation, which has triggered a housing correction, although the bulk of this pain is behind us as inflation appears to be slowing.
The U.S. economy unexpectedly shrank marginally for the second quarter. It has lost a lot of steam and is very vulnerable to a real recession which could have a huge spillover effect on the rest of the world. The only questions now are how long can it last and how deep can it go? For now, household spending remains strong, corporate finances are limiting the downturn, and U.S. inflation has likely peaked and will probably fall faster than previously expected. Additionally, as inflation eventually slows, the Federal Reserve will be able to slow its interest rate increases and ultimately reach a neutral stance. Of course, the financial markets will be looking for this eventuality which should turn the losses into gains.
The European economy is again teetering on the brink of a recession brought on by scorching inflation and a severe energy crisis. The European Central Bank joined 80 international peers in lifting rates in the first of many hikes to fight red hot inflation. This was its first increase in 11 years as it confronts inflation that is surging toward 10%. The euro, which has fallen to a fresh two decade low, was dealt a fresh blow by renewed concerns that energy and gas prices have soared 180% this year.
Inflation in the U.K. hit 9.9%, close to its highest level since 1982. The pound is at its weakest against the dollar in 37 years. The Bank of England’s seven straight increases in borrowing costs has raised interest rates to the highest level in 14 years as a new recession descends. China’s currency weakened to a two year low as its economic growth declined to its weakest level since 1980. Japan stands nearly alone in its decision not to raise rates and is intervening to prop up the yen for the first time since 1998.
Canadian equities returned -1.4% in the third quarter and -11.1% for the year-to-date (all figures in Canadian dollar terms). U.S. equities gained 2.0% in the quarter and were down 15.2% for the year on the back of the decline of the Canadian dollar by 6.9% for the quarter and 8.7% YTD. International stocks fell 2.4% over the past three months and 18.1% for the year. Rapid interest rate hikes and soaring inflation have brought an end to a four decade bull market in bonds, which have fallen 11.8% for the year, but managed a small 0.5% gain in the third quarter.
The global economy could possibly avert a recession as data is starting to point to a potential soft landing; inflation appears to be moderating, wage pressures seem contained, and consumer confidence is stabilizing. The challenge is that increasing interest rates work with quite a large lag, meaning their peak impact and the success of the rate hikes will not be known until later. This leaves investors in a period of trepidation before momentum swings positive and markets rebound with gusto.
The S&P / TSX Composite Stock Index fell 1.4% in the third quarter and has lost 11.1% year to date as of September 30th, 2022. Although 2022 has been tough for markets globally, Canada has been the most resilient, outperforming most of the rest of the world. Inflation continued to dominate headlines. The Russian aggression is hurting consumers everywhere with a recession likely in the cards for Europe and the U.K. amid the fallout from the disruption of Russian gas imports. Despite having one of the largest proven oil reserves in the world, Canada is no exception.
As the most stable currency in the world, investors tend to flock to U.S. dollars as a safe haven when the price of oil rises too high which weakens the Canadian dollar. As the dollar weakens, importing energy becomes more expensive and the cost shifts to the consumer at the pump. The good news for Canadians is that in August, Canada’s annual inflation rate slowed to 7% and the third quarter saw the price of oil tick downwards, down 24.8%. Costs continued to climb for food as the price of groceries rose at their fastest pace since 1981. The labour market in Canada is encouraging. Despite a downtick in jobs the unemployment rate is the lowest on record with comparable data going back to 1976.
While a drop in energy prices helps consumers at the pump, it does not bode well for the Canadian economy with energy exports accounting for more than 5% of the country’s GDP. Canada’s trade surplus narrowed in August 2022 for the first time since December of last year. While Energy was only the fourth worst performing sector in the quarter (-6%), it negatively impacted the S&P/TSX more than any other sector as it contains several of Canada’s not only largest, but most successful companies. Real Estate and Communications Services, returning -7% and -10% respectively, were the laggards for the quarter as rising rates made fixed income investments an attractive alternative to stocks in these typically higher yielding sectors. Although Real Estate typically performs well in inflationary markets, the pace of rate increases including mortgages have seen residential investment fall significantly.
Positive news for investors is that the Bank of Canada, like its global peers, is focused on battling inflation. The bank implemented another aggressive hike, increasing rates by 75 basis points in September, the fifth increase in 2022. Canada now has the highest policy interest rate among G7 countries at 3.25%. Although a painful exercise, this is the stock market taking its medicine. Ignoring inflation can lead to a much more damaging scenario in which hyperinflation and eventually deflation could take place.
Looking ahead, Canada and its global peers will greatly benefit from a stabilization in oil prices, inflation, and the resolution of Russia’s invasion of Ukraine. With its strong regulatory environment, dominate financial sector and abundance of natural resources, Canadian equities are well positioned to attract investors looking to protect themselves from what is a very volatile period for markets across the globe.
During the third quarter of 2022 the mandate’s Benchmark Index gained 0.3% as central banks continued to notch up interest rates amid soaring inflation. Although inflation numbers came in at 7.0%, down from 7.7% on June 30th, 2022, consumers are paying higher prices at the grocery store. Food prices are up 9.8% year over year, rising at their fastest pace since 1981. 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 strict lockdowns.
Long term investors should take solace in understanding that central banks are steadfast in their efforts to combat inflation before it turns into hyperinflation or stagflation, unappealing scenarios to say the least. Since its first post pandemic rate increase of 0.25% in March the Bank of Canada (BOC) has made four more rate hikes. The latest increase was aggressive, 75 basis points, making Canada’s policy rate the highest among G7 countries at 3.25%. This did not come as a surprise as the BOC alluded to relatively aggressive rate hikes until the battle against inflation takes a turn and that it would also partake in quantitative tightening, a process in which the bank discontinues its purchase of treasuries, bonds and even stocks. By unwinding its balance sheet, the Bank is essentially taking cash out of the market in an effort to slow inflation.
Although increasing rates help to battle inflation, a higher interest rate makes it more expensive for companies to borrow and dampens investors’ willingness to pay higher prices for investments when they can earn an increased rate from owning safe treasury bonds instead. This was evident in equity markets where the typically highest yielding sectors underperformed through the third quarter as investors chose the safety of bonds over stocks.
Typically, when a country raises its interest rates, their respective currency also appreciates as investors will park their cash in the country’s fixed income opportunities to secure a higher yield relative to global counterparts. As rates have shot up through 2022, the U.S. dollar has appreciated against the Canadian dollar by 10%, a fortunate move for Canada’s trade balance as a weaker CAD typically leads to greater foreign investment into not only Canadian goods but capital investments as well. As such, Canadian fixed income outperformed its southern neighbor.
The business outlook is still strong. There is a swath of pent-up demand for travel and leisure. As consumers worry about what rising inflation will do to the prices of food, gas, and rent, they will naturally demand higher wages. The labour market in Canada is encouraging. Despite a downtick in jobs, the unemployment rate is the lowest on record with comparable data going back to 1976.
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 nine months 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. As rate volatility subsides and inflation remains at the forefront of investors’ minds, high quality cash flows from Canadian fixed income instruments will be at a premium and that will boost the quality and reliability of most investment portfolios.
The third quarter of 2022 was a challenging one for all equity investors with the S&P 500 Index declining 4.9% in U.S. dollar terms and decreasing 23.9% year to date. The quarter saw equities face similar headwinds to the previous six months of year; supply chain disruption, China’s zero Covid-19 policy and Putin’s attempted invasion of Ukraine has led to sky high prices across the globe. The primary culprit is the price of oil. Demand for gasoline raged higher as the world began its recovery from COVID-19 and attempted to get back to business as usual. This has been further exasperated by Russia’s aggression in Ukraine. Although Russian oil has a small footprint in the U.S. market, the price of oil is determined by many factors, and Russia cutting off gas supplies to Europe indefinitely is having a knock-on effect for U.S. consumers. Importing products internationally has become very expensive and transit times have increased, contributing to lower margins and operational inefficiencies. The U.S. economy shrank for the second straight quarter, sparking fears that the country is in recession.
Inflationary pressures are a rising market’s Achilles’ heel. A small, positive inflation rate is economically useful, especially to companies who can successfully increase their margins and cost structures to reap benefits. However, when inflation becomes persistent and gathers pace as is the case around the globe, consumer purchasing power erodes. The most evident example of this lies in the double-digit percentage increase in food prices Americans have experienced over the past twelve months. Expectations of future inflation tend to rise as well, leading to workers demanding larger wage increases which results in lower profit margins for employers.
Consumer Discretionary and Information Technology were the biggest losers for the third quarter 2022, with both sectors falling over 6%. These sectors are significant to the broader index, making up 38.6% of the S&P 500. With inflation and rising rates dominating financial headlines it should be no surprise that consumer and technology stocks are taking the brunt of the damage. A company’s stock valuation is determined by the discounted value of its expected future cash flows. As inflation and interest rates rise, these cash flows are discounted at a higher rate than they would be in an otherwise low-rate environment, resulting in a depressed valuation. Technology companies invest heavily in research and development (R&D). As rates rise, the cost of borrowing increases and companies may be less inclined to invest in both R&D and marketing, dimming prospects. In contrast, Real Estate and Financials typically benefit from a rising rate environment but they are two relatively small sectors in the S&P 500.
To combat inflation, The Federal reserve has been raising rates as they said they would back in May when Chairman Jerome Powell, indicated a strong commitment to bringing down inflation even at the risk of a recession. Following the high inflation figures reported in August, The Fed raised rates by 0.75%, the third increase this year and a 14 year high. By increasing borrowing costs, the Fed hopes to cool spending and growth enough to curb inflation without tipping the economy into a recession. This is the unfortunate cost of reducing inflation (the market’s equivalent of taking its medicine) failure to do so would result in more trouble for investors everywhere at the risk of hyperinflation.
It’s not all doom and gloom. Although elevated, the annual inflation rate in the U.S. eased for a second straight month to 8.3% in August, the lowest in four months. Even more encouraging is the normalization of the price of oil. Since the conclusion of the second quarter, the price of oil has fallen 24.8% and is down 35.9% since its June 8th high of $122.11. Other important commodities to the economy are also seeing relief with copper, lumber and wheat prices trending lower. Although inflation is sticky and takes time to truly come back to normal levels of around 2%, lower prices provide some relief to the consumer. That being said, a pullback in consumer demand is likely what’s necessary to bring inflation down materially. Any indication of inflation cooling or a calming of tensions in Europe will be a true catalyst for all equities.
Rising inflation is putting the squeeze on many countries around the world. Inflation has been fuelled by steady cutbacks in energy supply and bottlenecks in getting raw materials to the market. The disruptions to global supply chains caused by the COVID-19 pandemic have also played a significant role in pushing up prices, although this appears to be normalizing now. The concerted efforts of central banks to battle this situation with interest rate increases is squeezing consumers and employment challenges could feed into worries. Unfortunately, there Is no imminent sign of relief in the near term.
Inflation in Europe has broken into double digits, the highest level since 1997, as prices for electricity and natural gas soar signalling a likely winter recession. Energy prices were the main culprit, rising 41% over a year ago; food, alcohol and tobacco jumped 12%, and the region’s drought conditions added to the forces of high inflation. Governments are implementing a plan to reduce gas use by 15% and have passed tax cuts and subsidies to ease a cost of living crisis. The euro has slipped below parity with the U.S. dollar which can make imported goods more costly, particularly oil. The European Central Bank has started raising interest rates with its largest ever increase to combat this situation, lagging other global central banks which have acted sooner.
British inflation hit a 40 year high. The U.K. central bank has now raised rates six times to its highest level since late 2008 and have warned that a long recession is on its way. The pound has slid against the U.S. dollar to a rate last seen in 1985, reviving talk first heard following the 2016 Brexit referendum that Britain is behaving like an emerging market country with an increasingly volatile currency. The new Prime Minister is cutting taxes and raising spending on the gamble that loosening the fiscal purse strings will boost economic growth. Unfortunately, this is likely to be too late as Britain faces slower economic growth and more persistent inflation than any other major economy.
A revival in Japan has been hobbled by surging prices of commodities. Additionally, Japan’s outlook has been clouded by a resurgence in COVID-19 cases, slowing growth, and supply constraints that are boosting living costs. The Bank of Japan is the last holdout on rates and an outlier in the global monetary tightening sweeping across many economies amid surging inflation, even as inflation exceeded its 2% target. Rock bottom interest rates means a weaker currency, but the bottom line is that no policy change will occur for a while.
International equities have definitely been the performance laggard this year with the declines being consistently spread across the globe. International stocks fell collectively 9.3% in the third quarter and returned -26.8% for year to date (all figures in U.S. dollar terms). European stock dropped 10.5% in the quarter and are down 30.5% YTD; while Asian stocks declined 9.7% over the past three months and decreased 28.5% for the year.
The outlook is gloomy for many developed countries around the world. Most central banks are determined to crush inflation in the face of ongoing challenges, including a very tight labour market and soaring energy bills. A recession is likely in the cards for Europe and the U.K. amid the fallout from the disruption of Russian gas imports. Household incomes and corporate profit margins could also be hit by higher costs. For the time being this is likely to be a protracted situation until the tide turns in the future.
EMERGING MARKET EQUITIES
The world may soon be teetering on the edge of a global recession. Consumer prices have accelerated more quickly than expected as a result of higher food and energy costs, and lingering supply and demand imbalances. While Emerging Markets were down in the first half of the year as geopolitical tensions besieged global economies, they have demonstrated far greater resilience to economic shocks than in the past. So far there has been an unusually low level of volatility in emerging market currencies, however the increase in global borrowing costs could cause 60% of the world’s 75 poorest countries to be at greater risk of debt distress.
China’s economy is expected to settle into its second lowest rate of expansion in more than four decades. Home prices have now declined every month in the past year as the nation’s property bust deepens. Scorching heatwaves, power shortages, and mobility restrictions to stem COVID-19 outbreaks have disrupted activity and are having global spillover effects into already stressed supply chains. China’s inflation level is steady, leaving room for the central bank to add monetary stimulus largely focused on infrastructure spending. Future economic growth will depend on whether the government relaxes its zero COVID-19 policies.
Currently suffering from the war in Ukraine, eastern Europe’s main currencies are about to take another blow from a looming European recession. Most non-euro countries like Poland, Hungary and the Czech Republic are rapidly raising interest rates to help stabilize their currencies. Global food demand for some products has weakened which might offer some relief to consumers as they grapple with a deepening cost of living crisis. However, there could be further consequences to countries that have been impacted by drought or the Ukrainian refugee crisis.
Many emerging market central banks have been proactively tightening monetary policy since early 2021. Indonesia has raised its key policy rate as a pre-emptive measure to dampen the economic slowdown. Top manufacturers like South Korea are seeing weaker demand from China which is starting to bite into their economies. India has been negatively affected by inflation for its reliance on imports of fuel and energy. Thailand is set to raise its benchmark rate as inflation surged to its highest level since 2008 on elevated energy and food costs. A raft of bailouts pledged by the IMF have been sewn up with vulnerable nations like Pakistan, Sri Lanka, and Egypt. As the economic slowdown ripples across the globe, it spells bad news for major commodity producers such as Brazil, Chile, and Argentina. These countries do however have some buffer against recession through the gains achieved in the previous commodity bull market and raising interest rates early.
The third quarter was not particularly kind to emerging market stocks as they have experienced some of the largest declines. For the quarter as a whole they were down 11.4% and year to date they have fallen 26.9% (all figures in U.S. dollar terms). Emerging Asian stocks dropped 13.9% in the quarter and are down 28.6% YTD. Latin American stocks have been the sole region to buck the downward pressures gaining 3.7% over the past three months and 3.4% YTD. Eastern European stocks (excluding Russia) have just been crushed as a result of the Ukrainian war, falling 21.9% in the third quarter and 46.4% YTD.
Despite slower global growth, Emerging Markets are expected to lead the way when the imminent slow down eventually relaxes its grip. Supply chain problems are definitely easing, and global production is picking up. Producer price inflation, which is a broad measure of inflation, appears to have peaked in many countries. Chinese economic activity may have actually bottomed which could foreshadow a sharper rebound especially if central banks can whip inflation into submission.
GLOBAL REAL ESTATE
Real estate investment trusts (REITs) have been under pressure this year due to rising interest rates. However, publicly traded REITs still offer an enticing long term investment opportunity as most are generating growth substantially above historical averages. Most REITs will likely underperform the rest of the market if interest rates kept rising but this underperformance should correct itself when rate increase pause and shares will eventually return to their long-term valuations. Historically, the best returns in real estate follow periods of economic and capital market disruption.
The average Canadian home price is still above pre-pandemic levels but increasing mortgage rates and inflationary pressures are weighing on the market. At the start of the second quarter, home sales plunged, renovation activity pulled back, and while housing starts remained buoyant they are expected to decline as well; all of which has led to a deepening downturn in prices. Purchasers are concerned about potential value erosion and many are waiting on the sidelines to see where the market settles. Still, Canada has very robust immigration targets and the vast majority of these immigrants will locate in urban areas which will stabilize prices, especially if inflation continues to slide from its recent peak. On the other hand, the U.S. housing market has never been more overvalued despite mortgage rates rising. Nationally, U.S. housing prices climbed by 17% over the past year.
Given that we are at a crossroads with the pandemic and looking at a possible recession, it is encouraging that the retail side of the REIT market has benefitted from uninterrupted reopening. Of course, non-discretionary retail, such as grocery stores and pharmacies, have been operational during the pandemic but discretionary retail (including destination shopping centres) have seen some of the strongest recoveries.
As for multi-unit residential space, while some people moved out of major urban centres during the early part of the pandemic, that trend appears to be reversing and rents are climbing again. There has also been a return to physical occupancy of office buildings around the world with rates creeping back up. Leasing is also returning though it has not quite reached its 2019 pre-pandemic level. High quality offices with great environmental credentials and are located and close to transit tend to perform better than older buildings with fewer amenities and poorer locations. Still, the reality is that it is not going to be easy for office REITs in the near term.
REITs with shorter lease durations, such as self-storage and hotels, can adjust rents quickly to keep pace with inflation and are expected to do well. Technology will also play a key role in determining the winners and losers in different real estate sectors, with cell towers, healthcare facilities and data centers emerging secular winners. In logistics and industrial properties, the distribution hubs have been attracting the most attention and those valuations have been on an upward trajectory for a couple of decades.
The performance of REITs has not escaped the downdraft of global stock markets and in many cases have declined even more due to their heightened sensitivity to the impact of rising interest rates. Canadian REITs fell 7.5% in the third quarter and were down 24.0% for the year to date (all figures in Canadian dollar terms). Globally REITs were down a little less, dropping 4.7% in the quarter and have declined 20.0% so far this year.
As with any investment, REITs have risks and rewards. Over the long run, real estate should continue to perform well and it is still a place where investors can achieve attractive investment results. If inflation continues to decline then interest rates will fall as well. When the markets start to sense this reversal taking place, the outlook for fixed income will dramatically improve and that is when REITs should begin to soar.
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