Market Insights: Fourth Quarter Wrap-up

Market Update

After a challenging 2020, the global economy steadied and charted a course to recovery in 2021. This was even more commendable as we faced several hurdles along the way. Most notably the COVID-19 delta variant in the spring and the omicron strain in winter, stubbornly high inflation, and supply chain disruptions. There was also ongoing uncertainty and discussion about when central banks would raise rates and wind down their pandemic stimulus plus the Evergrande debt crisis in China. Despite these challenges, we ended the year positively and in much better shape than when we started.

The global economy took news about the omicron variant in its stride this December. After dipping in November, for only the second month in 2021, North American equity markets stabilized in December with U.S. and Canadian equities ending the year up significantly, approximately 20-25%. Other parts of the world didn’t fare as well last year, with the MSCI Europe, Asia & Far East Index (CAD) up only 8.3% on a price basis which represents the rest of developed markets, while emerging markets suffered with the MSCI Emerging Market Index (CAD) declining over 5%.

The overall bond universe, which tends to move much slower and, at times, in the opposite direction to equities, saw U.S. treasury yields and eurozone bond yields falling slightly during December. However, yields ended up strongly for the calendar year. The closely watched US 10-year Treasury yield rose from 0.92% to 1.51% while the Canadian 10-year Government bond yield increased from 0.68% to 1.43%. It is worth noting that this accelerated in early 2022 with both of those rates moving above 1.7%. With the market-weighted broad bond index dominated by longer-term government bonds, the S&P Canada Aggregate Bond Index declined 2.5% on a total return basis which is a poor result for what most consider one of the most conservative asset classes.

Commodities markets, particularly energy, had an extraordinarily strong 2022, with WTI crude oil prices rising 56% to close the year at US$75.21/bbl and Natural Gas prices increasing 47.5% to finish the year at US$3.76/MMBtu. Key drivers included the threat of Hurricane Nicholas in the U.S. gulf, depleting U.S. crude and fuel inventories, the debt crisis of mega Chinese property developer Evergrande and many supply chain disruptions. For many who may have done some home renovations would know, lumber prices increased almost 60% in 2021, but were up a staggering 140% at one-point mid-last year. Gold prices, on the other hand, fell 4%.

In foreign exchange markets, the Canadian loonie and U.S. greenback seesawed subtly over the course of 2021 with the loonie ending marginally up by 0.8%. However, the Euro fell significantly to our dollar, down 7.6%. In December, Bitcoin experienced its biggest monthly drop since May, although it is still up approximately 60% for the year, and cryptocurrencies attracted more assets in 2021 than all previous years combined. The world’s second largest cryptocurrency, Ether, rose 400% last year.

In Canadian capital markets, one of the biggest acquisitions in banking history occurred. Bank of Montreal purchased U.S. based Bank of the West for US$16.3 billion. This transaction is BMO’s largest ever deal. In other notable domestic news, the COVID omicron variant caused the province of Ontario and many Canadian financial companies to pause reopening and return-to-office plans, however the tone has started shifting away from more lockdowns.

U.S. Inflation climbed again, to 7% year-over-year as of December, its highest level in 40 years. Astoundingly, the 12-mth rate of change in year-over-year inflation is nearly unprecedented, accelerating at a rate of 5.6%. Going back the last 70 years, the only other times it has accelerate at a similar or higher rate were in 1951 and 1974.

Source: Bespoke Investment Group

The Fed stated it expected inflation to begin cooling by the second half of 2022. It had previously projected in September a rate hike by late 2022, but in December it hinted at least three raises were coming this year. In addition, the Fed announced it will double the pace at which it reduces its pandemic stimulus, from US$15 billion to US$30 billion a month, putting it on track to complete the program in Q1 2022.

In Canada, inflation remained at 4.7% year-over-year as of November, its highest level since 2003. The Bank of Canada noted it could be ready to start hiking rates as early as April 2022. It had already announced in October it was ending its pandemic stimulus. The bank’s five-year mandate was also renewed by the federal government. This directive included a new measure, to consider the labour market when making interest rate decisions and use the flexibility of its 1-3% inflation target range to support employment if necessary. Bank of England became the first major central bank to raise rates since the pandemic. The bank said this was in response to inflation likely hitting 6% in early 2022, three times above its target.

More recently, while the Omicron wave has captured much of the headlines, investors appear to be more concerned about inflation and central bank tightening of late resulting in market instability and sector rotation. As we move through potentially the first round of central bank tightening, the Omicron wave peaks, and quarterly earnings/guidance reports roll out, we anticipate another quarter of choppy trading as investors try to make sense of it all.

Milestone Strategy and Outlook

As the emergency stimulus of central banks is ending, we expect to experience some near-term volatility as market conditions shift. Some of the frustrating sideways market action and ongoing rolling sector takedowns and rebounds may continue in early 2022. While the omicron variant is concerning, it should not stop the global economy’s recovery which is strong in our view. Economic fundamentals and corporate earnings remain healthy. Inflation will likely cool, we would even venture to say is peaking right now, as supply chain disruptions ease, but settle at a higher rate than we had pre-pandemic. It’s also inevitable the pace of growth will slow after the record-breaking double digits returns of 2021. However, although there is likely economic growth deceleration in the cards, the level of growth will likely remain at a relatively strong level as we are coming off historically high levels.

It is important to note that our positive core fundamental thesis is centered on the direction of earnings, because equity markets correlate mostly to the direction of earnings per share (over 0.90 correlation factor), not the rate-of-change. This principle means that absent a credit-based recession which we view as extremely low at this point (little stress in credit markets), any market correction/consolidation caused by slowing in the second derivative of stimulus measures and economic growth rate should prove temporary and a buying opportunity. The outlook for the North American economy is robust and supportive of equity markets. We see firm evidence that our economy is in the mid-phases of the business cycle, which has been historically beneficial for the performance of most risk assets. Uncertainties remain high; cause for concern remains low.

Coming into 2021, we strategically positioned our fixed income exposure away from long-term government bonds, into short-term investment grade and high yield corporate bonds, as well as preferred shares and private credit. This panned out very well with this important part of a balanced portfolio, returning in some cases, over 10% in our core mandates against a negative 2.5% return for the benchmark. In addition, we raised cash across our mandates prior to the September dip (largest monthly drawdown last year) and added it back in October, as well as added to some pockets of real assets where we saw opportunities last summer, both of which worked in our favor. Our core mandates mitigated anywhere from 50-100% of that September dip against their respective benchmarks.

The U.S. Federal Reserve has recently communicated to the markets that they will be raising rates at least three times next year, with the markets telegraphing potentially four. This announcement has recently shaken the technology sector, particularly the small to mid-cap space, as high interest rates are said to put pressure on lofty valuations that are based on long-term growth profiles and what has historically been an incredibly low discount rate. We think with many uncertainties still in play this year, the rate hikes may more likely be two to three times. Although some of the higher growth areas of the market are under some stress, it may ultimately prove to be a buying opportunity as it has in the past, especially with credit markets still strong.

Why do we think we may not see four rate hikes this year? The Fed does not know how much of the current inflation is monetary-induced and how much is a shock response to the pandemic. They have no precise estimate of how large its balance sheet ‘should’ be but know it must cover its liabilities. They do not know what ‘real’ interest rate is suitable for a post-pandemic recovery. They do not know what two successive years of declining U.S. life expectancy will do to the insurance industry, nor how many working-age Americans will have some kind of long-COVID disability. And of course, none of us know, including the Fed, whether another COVID variant is coming. We believe they will tread lightly and consider incoming data as the year progresses, as opposed to acting too swiftly based on what could be peak inflation period right now.

A higher inflation and interest rate environment than the recent past should favor those companies and sectors with pricing power. We continue to favor areas such as real estate and some other real assets, energy, financials and some pockets of industrials and consumer discretionary. High quality and dividend growth should again become important, and actively managed portfolios should benefit, versus a more passive approach that performed well pre-COVID when core inflation was extremely low favoring the higher growth technology sector that dominates the market-weighted U.S. market.

The playing field of U.S. equities vs. the rest of the developed world could become more equitable, and this may add some tail winds for the S&P/TSX Composite which has a higher relative exposure to those sectors. The U.S. has a huge and historically wide valuation premium over the rest of the world, and rightfully so, as it has grown revenues and earnings faster in the past. However, we are seeing signs now that rest of world earnings are growing faster than the U.S. contrary to the expectation. This revelation could result in a reversion to the mean. U.S. analyst expectations for that relative profitability are at extreme levels which may be vulnerable to disappointment, especially if high inflation sticks around for longer than projected.

Although there has seen some market fluctuation of late, the latest highs we experienced recently were accompanied by strong breadth readings which is an encouraging sign of underlying strength. That stated, even though our fundamental core thesis is likely to remain positive until money availability changes - we believe the current monetary, economic, fiscal, and geopolitical uncertainty should lead to more volatility relative to the past year and may limit returns in comparison. On the other hand, mid-year decelerating inflation expectations and easing supply-chain constraints, a stable credit backdrop, and positive economic and earnings growth should buffer the downside. Ultimately, the market moves with the direction of earnings which will likely remain positive until the money availability shuts down by the Fed becoming too tight. We are far cry from that with historically low Real Fed Funds Rate (even with three hikes), a 3-mth/5-year U.S. Treasury yield curve steepening, continued excess liquidity, loose financial conditions and easy bank lending standards, growth in domestic consumer services should more than offset goods slowdown, and positive, albeit mixed, global growth expectations

Regardless of where we are in the market cycle, it is important to take a disciplined approach to investing and stay focused on one’s long-term financial goals. We recommend maintaining a diversified mix of asset classes, including allocations to real assets and alternative strategies, to maximize potential returns and minimize risk. Regularly reviewing and rebalancing your portfolio back to the target asset mix also ensures it remains aligned with one’s objectives.
Thank you for your continued trust in Milestone as we navigate the tides ahead, and for the opportunity to assist you in working toward your financial goals. We are with you every step of your investment journey, identifying strategies and opportunities, reviewing performance, and rebalancing your portfolio to help you remain on track. Should you have any questions regarding your portfolio, please do not hesitate to contact us.

Here is our Milestone Market Report on economic data, capital markets, commodities, and currencies through December 31st, 2021: (click image for PDF version)