Optimism in the financial markets seems to be very scarce. Pessimism is rampant but fortunately, the conditions that got us here are not permanent. The current painful conditions that got us into this bear market will be the stuff that gets us out: society is slowly recovering from COVID-19 and the return to normal; geopolitical conflict, the Ukraine war will eventually be resolved; central banks should reduce their hawkishness at some point in 2023 as they tame some of the inflation; supply chain issues are mostly resolved; and energy prices have risen and fallen. While there were few places to hide with both bonds and equities being impacted, when this bear market ends the rebound could be significant.
The Bank of Canada (BOC) has effectively signalled that it is about to end one of the most tumultuous interest rate hiking cycles after seven straight increases in 2022 to 4.25%. The BOC is becoming more concerned with economic activity and less so with pure inflation numbers. While inflation is slowing (i.e., three month core inflation is negative), Canada’s economy is also slowing sharply, but the prospects of averting a recession are still quite high. The main risk to achieving a soft landing is a more severe housing downturn, although prices are starting to stabilize after falling 15% from their February 2022 peak.
U.S. inflation readings have come off the boil after hitting a 40 year high. As such, there are hints that a change in the pace of rate hikes is coming after the Federal Reserve has pushed interest rates to their highest level since 2007. While the U.S. economy remains quite resilient, even in the face of some significant global headwinds, the prospect of a downturn in 2023 remains elevated. A slower pace of rate hikes and softening inflation might just be the right medicine to avoid a dramatic surge in unemployment, which would allow financial markets to continue their exploratory recovery.
Europe is expected to enter a recession in early 2023 as the continent’s energy crisis has likely become too much of an obstacle to overcome. Despite the souring outlook, the European Central Bank will likely continue to combat high inflation by raising interest rates. Still, with energy prices in decline and global food prices falling for an eighth month in November, signs that inflationary pressures may be easing are appearing. The U.K. on the other hand has only itself to blame for some of the most dramatic and painful economic and inflationary conditions seen anywhere as political turmoil and chronic mismanagement looks likely to extend the anguish well into the future.
Economic downturns to various degrees are being anticipated around the world but markets tend to anticipate a brighter future ahead long before it becomes clear in the economic data. As such the strongest gains have historically occurred immediately after a bottom and may have already begun. While returns were almost universally down in 2022, the final numbers are well above the worst results seen during the year. The fourth quarter saw returns rebound sharply, even after a December decline. Canadian stocks gained 6.0% in the fourth quarter and were only down 5.8% for the year (all figures are in Canadian dollar terms). U.S. stocks also climbed 6.0% in the quarter but fell 11.2% in the year. International stocks recovered brilliantly in the last quarter surging 15.8%, which trimmed its yearly loss to just -7.1%. On the back of crushing interest rate hikes Canadian bonds finished 2022 with some of the worst performance tumbling 11.7% for the year.
The markets are currently at an important crossroad. While a third of the world economy could contract this year and the three largest economies, the U.S., China, and Europe might continue to stall, it is vitally important to remember that over the past 50 years there have been numerous recessions. In most of these instances financial markets bottomed either in the quarter the recession began or the following quarter. History has shown that being invested early in an economic downturn can be more rewarding than waiting for a recovery to be confirmed.
The Canadian economy was remarkable for most of 2022 with stronger than expected GDP growth in the first and second quarters along with unemployment numbers at historical lows. The removal of pandemic restrictions was the main catalyst for the strong economic rebound with consumer spending as the key driver. This economic exuberance occurred despite global pressures such as the Ukraine war and skyrocketing inflation. The Bank of Canada (BOC) was at the forefront to curb the rapid change in prices with an unprecedented seven consecutive rate hikes in less than a year. The second half of the year saw some cooling signs in domestic demand, labour markets and inflation. Subsequent to the aggressive pace of rate hikes, the BOC indicated its willingness to review the policy rate when supply and demand become more balanced. The strength of the economy did not fully spillover into the markets as sometimes there is a divergence between economic and stock market performance. The S&P/TSX closed the year down 5.8% despite a positive 6.0% return in the fourth quarter. Most global markets declined double digits and as a whole, they shed $14 trillion U.S. dollars. This makes the S&P/TSX one of the better performing global markets, especially compared to the S&P500 which lost 11.2% in Canadian dollars terms.
In the fourth quarter, Canadian markets crept up some with new momentum after bottoming in October as all but two sectors were positive. However, the pace of restrictive monetary policies as well as growing fears of a global recession weighed more on investor sentiment throughout the year. All sectors of the S&P/TSX except Energy, Consumer Staples, and Materials had negative annual returns for 2022. Energy led the pack in a breakthrough year returning 48.6%, followed by Consumer Staples up 7.86%. The oil industry has been undercapitalized to meet demand according to the International Energy Agency (IEA). A resurgence in this sector post-COVID signals its importance, and the strong fundamentals of Canadian energy companies position them well to close the demand gap in the future. On the flip side, Health Care and Information Technology detracted the most from the S&P/TSX with annual returns of -57.8% and -35.9% respectively.
2022 ended as one of the most turbulent years on record with global losses in the trillions. As we enter 2022, the bulk of the macro headwinds; the Ukraine war, lingering inflation, and to some extent the slowdown in China, have yet to abate. Yet among all, the most pressing issue is inflation and how central banks will manage to mitigate it within some acceptable range. For major central banks including the BOC, the responsibility of macroeconomic stability leads them to a dilemma: move the policy rate slowly and experience the destructive impact of inflation on household finances; or embark on quick, large scale tightening that induces the economy into a recession. In Canada, the central bank is betting that the latter option would make more economic sense and with an unprecedented seven consecutive rate hikes in 2022. That move is gradually flowing though the economy with some downward trends evident in the latest inflation numbers. The housing market is notably the most impacted sector with price decreases nine months in a row and the market has yet to absorb the full scale of higher rates.
Although recent rate hikes have been aggressive, the BOC is hopeful that their approach will lead to a preferred slowdown instead of a full-scale recession. Its latest communication seems to telegraph that rates are near peak, and the current strength of the economy makes the slowdown scenario more likely. As for the markets, the value biased S&P/TSX should relatively protect capital like in 2022. With prospects of moderating economic activity amid higher rates, the S&P/TSX is not expected to post outsized returns.
2022 was a year that investors will want to put behind them, especially when it comes to bonds, which have had their worst year in the last half century, returning -11.7%. Bonds, especially Treasuries, generally have a low correlation with other asset classes and their addition to a balanced portfolio brings diversification benefits, mitigating the impact of market fluctuations on an investor’s portfolio. This premise didn’t hold in 2022 as fixed income performed as poorly as equities. Driving prices lower throughout the year was the unfavourable combination of rising inflation and the seven straight interest rate increases in an attempt to lower prices.
The impact of soaring global inflation has been impossible to ignore. Global supply chains have been a mess since the COVID-19 brought the world to a halt nearly three years ago. China’s zero COVID policy has played a major factor here. As the world’s largest exporter and second largest importer, China plays a major role in the production and distribution of goods worldwide. Russia launched an invasion on neighbouring country Ukraine in February, sending gas and oil prices through the roof. Energy is key to so much of the global economy and when its production and transportation costs rise, consumers pay the price.
The fight against inflation is crucial and central banks are using restrictive monetary policy by raising interest rates. Increasing the interest rate can be an effective tool in slowing inflation and cooling the economy but the risk is greatest at the top of the cycle when the central bank may overestimate the economy’s momentum and/or underestimate the effects of restrictive policies. This could lead to a contraction which it may not be able to immediately counteract or control. There is asymmetry in monetary policy. Expansionary policy is like pushing on a string, whereas restrictive policy is like pulling on a string.
When interest rates rise, the value of existing bonds falls. This is because newly issued bonds will have a higher yield, making them more attractive to investors and lowering demand for existing bond issues. Higher interest rates aren’t fatal. 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. The latest data showed that the Canadian economy grew an annualized 2.9% in the third quarter of 2022, beating expectations for a modest 1.5%. Still, the central bank noted it would consider if the interest rate needed to rise further, suggesting slower rate hikes or a possibility of an end to the tightening cycle.
The Canadian economy remains strong and that is great news for bonds. Canada experienced stronger than expected GDP growth in the first and second quarters and unemployment fell to 5.1%; after beginning the year at 6.5% and drastically lower than its 2020 high of 13.7%. Fortunately, inflation is slowing. In November 2022 Canada’s annual inflation rate was 6.8%, down from its peak of 8.1% in June 2022; the slowest increase in prices since April 2022. Simply put, this is a bullish signal for investors.
Investors will be glad to see the end of 2022. The anticipated “Santa Claus” rally never occurred, and the S&P 500 finished down 18.1% for the year. This makes 2022 the worst performing year for stocks since 2008 and the collapse of the U.S. housing market. The financial crisis in 2008 was caused by a combination of factors, but the primary culprit was inadequate regulation in the overuse of complex financial instruments and domestic subprime mortgage lending. The past 12 months were a capitulation of a remarkable bull market. In just three years, the S&P 500 grew 100.4% (2021: 28.1%; 2020: 18.4%; 2019: 31.5%) and has had a five-year run of 133.4% (2018: -4.4%; 2017: 21.8%). Since the COVID lows of March 2020, the market has recovered 71.61%.
Stocks got too hot, too quickly and the Federal Reserve lost track of inflation. When the economy overheats, it is the Fed’s job to cool it and the primary tool at their disposal is the ability to lower or raise interest rates. Fittingly, 2022 saw the most dramatic change in interest rate policy since the financial crisis of 2008, when the Fed dropped the federal funds rate to 0.0-0.25% to jump start the economy. The year began with a modest 25bps increase in March 2022 bringing the Feds Fund rate to 0.50%, only to be followed by six more increases raising the rate to 4.25-4.50%. As interest rates get higher like they did throughout the 2022, so too does the return and growth rate required to satisfy investors. The Fed also expects unemployment to reach 4.6% in 2023, up from its September estimate of 4.4% (currently at 3.7%). In its statement, the Fed indicated that further rate increases may be necessary and could potentially reach above 5%, citing a strong employment market and the lag time between interest rate changes and their full economic impact.
The index posted a 5.8% decline for December after gaining 5.6% in November and 8.1% in October, which left Q4 2022 up 7.6%—the best three-month period of the year. Unfortunately, 7.6% was nowhere near the level needed to compensate for the loss of 23.9% for the first nine months of the year. Energy was the only positive performing sector for the year, returning 65.7% and Communication Services was the bottom performer, down 39.9%. Information Technology, the largest sector in the country, returned -28.2% and was responsible for 40% of the Index’s decline. 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. Elevated inflation hurts the economy.
Fortunately, inflation is slowing. The annual inflation rate in the US slowed for a fifth consecutive month to 7.1% in November of 2022, lower than the expected rate of 7.3%. The cost of energy increased by 13.1%, a decrease from the October rate of 17.6%. Prices for used cars and trucks decreased by 3.3%, while the cost of housing increased. Although encouraging, inflation and interest rates can be “sticky” because they can be slow to adjust to changing economic conditions. 2022 was certainly an eventful year for the market but it is important to remember that the market is long term; and if that is your approach then 2022 must be interpreted via its highs, lows, events, and history.
There has been little confidence in the global economy in 2022 and it could deteriorate further if constraints get any worse. However, there are slivers of optimism peaking over the horizon as energy and food costs are declining which will allow central banks around the world to ratchet down the inflationary doom rhetoric and likely halt significant future interest rate hikes. The reversal of the monetary support fueled by the pandemic has clearly been difficult for markets to stomach and while more economic pain is still to be felt, it is important to remember the economy is not the same as financial markets which march to the beat of a different drum and are poised to sprint forward.
The growth outlook for the European economy has improved to a mere shallow recession from a possible disaster. The European Central Bank is raising borrowing costs at the fastest pace on record; with further hikes almost a certainty as unwinding a decade’s worth of stimulus will take it well into next year. The problem is that inflation is far above the target and even a recession may not be enough to let the Bank ease off the brakes. The euro had dipped below parity with the U.S. dollar and remains near its 20 year low. A weaker Euro worsens inflation by raising the price of imported goods. Manufacturing output has crawled upward as energy prices have declined and snarled supply chain issues have been resolved.
The U.K. economy will shrink in 2022 (and likely fall in 2023 as well) as businesses and households continue to face high inflation. Surging U.K. household energy bills and food prices pushed British inflation to a 41 year high. British manufacturers are contracting at one of the quickest rates of the past 14 years. The Bank of England made its biggest interest rate increase in three decades as it tries to beat back stubbornly high inflation. For example, the cost of milk has increased by almost 50%, pasta prices have increased 34%, butter 30% and cheese 27%. The U.K. government is planning a vast program to help the poorest residents after a political mess for the ages rocked the country. This gloomy outlook is unlikely to improve in the near future.
The Bank of Japan had been keeping interest rates at ultra low levels and as such was the global outlier; actually inviting inflation into the nation which has suffered chronic deflation for decades. They got their wish, with Japan’s core consumer inflation hit an eight year high. This policy has helped to trigger a sharp decline in the Yen to its weakest level since August 1990. As a result, the bank was forced to take an unexpected hawkish stance which sent shockwaves through global markets as the developed world’s last holdout for rock bottom interest rates inched toward policy normalization. This should have some positive implications as a weaker currency is positive for corporate earnings.
International equities had just a scintillating fourth quarter, climbing so much that the returns would have been outstanding for any normal annual period. Unfortunately, end of the year gains could not offset early year pain. International stocks surged 17.4% in the fourth quarter, but still remained down 14.0% for the year (all figures in U.S. dollar terms unless otherwise stated). European stocks climbed 19.1% in the last quarter of 2022 and finished the year down 14.5%. U.K. stocks had a fairly good fourth quarter gaining 17.0% and declining a relatively minor 4.8% for the year (and would have been up 7.2% YTD except for the massive decline in the pound). Japanese stocks rose 13.3% in the final quarter but were still down -16.3% for the year.
The global outlook has become more challenging and less clear. The year started on a bright note with hopes of moving past COVID-19 but were overtaken by U.S. inflationary concerns, the Ukraine war and growth fears in China. Now the focus has likely even moved past the potential energy crisis in Europe this winter. With the pace of interest rate hikes anticipated to slow shortly, the worst conditions that could be thrown at the financial markets appear to be waning. Now it is just a matter of sitting tight and reaping the benefits of the inevitable bounce back.
EMERGING MARKET EQUITIES
Investing in Emerging Markets in 2022 will likely be remembered as the year when reality truly did bite. The reality of higher inflation affected global markets and economies and induced the first prolonged bite into investment returns since 2008. The exorbitant liquidity unleashed to combat COVID-19 was being reversed and the great unwind toward normalcy had begun. All of the news is not dire as this great unwind is actually very good news, although we expect some bumps and bruises along the way. This process will be a marathon, not a sprint, so patience will be needed.
China’s exports and imports contracted briefly in the quarter for the first time since COVID-19 appeared in 2020 as curbs and disruptions at home and global recession risks dented demand and further darkened the outlook for a struggling economy. Almost three years into the pandemic, China has stuck to a strict zero COVID-19 containment policy that has exacted a heavy economic toll and caused widespread frustration and fatigue; even while much of the world tries to co-exist with the virus. Finally giving into economic reality, the government rescinded its restrictive policies which saw at any given time more than a fifth of China’s GDP under lockdown, a share bigger than the U.K. economy. While the end of the zero COVID-19 policy will eventually lead to an economic revival once infections begin subsiding, the way it is being done is going to cause a lot of disruption, volatility, and chaos in the near term.
India is set to become the world’s third largest economy and third largest stock market in the coming decade and is poised to drive about 20% of global growth. It is one of the few emerging market countries that is actually gaining from the disruptive global trends of demographics, digitalization, decarbonization and deglobalization. India is likely to increase its share of global exports, thanks to a surge in outsourcing, and the pandemic has only enhanced India’s attractiveness as the office to the world. New developments are also allowing India to gain traction as a factory to the world.
Inflation and rate hikes may be peaking in numerous emerging market countries as many began ratcheting up rates in early 2021. Brazil’s central bank recently hinted that rates may have peaked. That is welcome news for investors, especially as other emerging market central banks may not be far behind. A number of countries like Brazil have been outperforming expectations as inflation seems to be moderating and unemployment declining steadily. The U.S. dollar’s tumble from multi-decade highs is giving most emerging market currencies a big lift, especially if the reversal can be sustained. Already most currencies are up nearly 5% from their lows and have notched their best monthly gain in about seven years. If this trend continues, along with sustained higher commodity prices, the prospects of a meaningful recovery are very promising.
Emerging market stocks had a resoundingly good fourth quarter jumping 9.8%. However, despite these gains they still finished the year with horrendous results, down 19.7% (all figures in U.S. dollar terms). Eastern European (excluding Russia) stocks truly spiked upward in the fourth quarter gaining 38.6%, but still remain down 25.7% for 2022. While Asian stocks did not see the same level of gains in the final quarter of the year, climbing 10.9%, the full year returns were not as bad, down only 20.9%. Latin American stocks backed by high commodity prices were the true winners not only amongst emerging market countries but against all nations, gaining 6.0% in the quarter and were up 9.5% for the year.
Emerging market economies are well positioned as key structural drivers like demographics and urbanization trends propel growth. Though growth has slowed, Emerging Market valuations remain attractive. Additionally, central banks in emerging market countries raised rates before their developed market counterparts and could also lead the way as rates come down which will support stock prices. All of which bodes well for this asset class as the world rights itself.
GLOBAL REAL ESTATE
The Canadian economy started the year on a positive note with stronger that expected GDP Growth in the first and second quarters, fueled by household spending and business investments. The momentum cooled in the latter part of the year on the backdrop of soaring inflation and seven consecutive rate hikes by the Bank of Canada (BOC). In other major global markets, economic headwinds dominated most of headlines including the Ukraine war, high inflation, and hawkish central banks. The combination of high rates and slower growth induced a re-evaluation of assets of any type. REITs saw a stiff re-evaluation to the downside. Although most recouped some of their losses in recent quarters, they closed the year with double digits losses. The MSCI Global REIT index lost 18.23% in Canadian dollar terms and its Canadian counterpart, the S&P/TSX REIT index declined 17.02%. Investors’ concern for the sector hampered the deployment of new capital as it has been estimated that globally, fundraising has decreased by 46% as of the third quarter of 2022. However, in some parts of the world, these numbers mask outstanding operational results that REITs have produced since the pandemic, with record earnings during 2022 despite the mass exodus from investors.
Sector dynamics exhibit a divergence in returns both globally and domestically. A quick overview reveals that in most markets, the Office sector has mostly rebounded from its pandemic lows. The office market is active but momentum is below pre-pandemic levels, as the national vacancy rate is at a 20 year high and many firms have yet to fully return to the office. The industrial sector has been particularly resilient with strong fundamentals and demand. Globally, the US has shown most resiliency with industrial leasing activity steady. In Canada, a CBRE report in the third quarter revealed a growing trend in the industrial sector with decreasing availability. Most analysts agree that Canadian industrial REITs are mispriced. The sector has been trading at deep discount to its NAV despite outstanding fundamentals and continued appeal in the online space. In Canada, the retail sector saw lot of improvement with the stabilization of market fundamentals and vacancies after the removal of restrictions for brick-and-mortar store capacity. From the end of 2021 to mid 2022, the retail sector saw about $13.2 billion new investment primarily in lower risk properties and centres. The Canadian apartment sector has strengthened considerably amid low supply and relentless demand. Average rent soared to more than $2000 in 2022 for the first time ever. With increasing immigration as well as high mortgage costs, that trend is unlikely to abate soon.
Economic headwinds will continue to filter through REIT sectors in major, given protracted inflation and higher interest rates. However, in a recent report, NAREIT (National Association of Real Estate Investment Trust), a U.S. based organization, estimated that U.S. REITs (representing the lion’s share of global REITs) are well positioned to withstand economic uncertainties due to their strong balance sheets. In Canada, some sectors such as office space will continue to lag, especially with decreased or delayed leasing activities. However, there is a disconnect between Canadian public REIT valuation and their fundamentals. While rising borrowing costs are generally unfavourable to REITs, rents are increasing in lockstep and should help to offset these costs. A key point to consider in Canada is the rate of population growth which is well above the G7 nations’ average. Canada is on track to welcome a record 500,000 new immigrants in the near future which is supportive to Canadian REITs in various sub sectors.
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