Market Insights: First Quarter Wrap-up

Market Update

 

After a volatile and difficult start to 2022 from both an equity and bond market perspective, there were signs in March that markets are rebounding and perhaps stabilizing. More rate hikes are coming to combat inflation, which will likely remain high in Q2, but should cool later in the year as supply chains normalize, prices ease, and hopefully peace is restored in Ukraine. After the record-breaking double digit returns of 2021, it’s inevitable that the pace of growth will be slower this year. However, economic fundamentals and corporate earnings remain healthy, and the post-pandemic recovery continues.

U.S., Canadian and global equities posted gains in March. However, apart from Canada and its energy rich TSX Composite Index that benefited from the market turbulence, markets were down strongly year-to-date in the U.S. and globally. As noted in our Milestone Quarterly Market Report at the end of these comments, the S&P 500 and Nasdaq fell 5.5% (6% in CAD) and 9.1% respectively, led by a steep sell off in technology stocks. Internationally, the MSCI EAFE and EM Indices are down 6.6% and 8.5% YTD in CAD, with Europe down 10% affected by the situation in Ukraine.

In bond markets, U.S. and Canadian yields rose rapidly on expectations of more, larger rate hikes. The middle part of the yield curve continued flattening, reflecting tighter Fed policy and forecasts for slower economic growth. The FTSE Canada Bond Universe Index is down a whopping 7% on the first quarter. This is a big hit to what most consider a conservative asset class.

Pressured by supply chain chaos and the Russia-Ukraine conflict, oil soared to US$110 a barrel, before falling on news the U.S. would release millions of barrels of its reserves to help ease prices, finishing the quarter at just under $100 for a rise of 29% on the year. Natural gas prices rose an incredible 62% to settle at US$5.72/MMBtu. Meanwhile, gold also rose 5.3% YTD to close out the quarter at US$1926.

In currency markets, our Loonie rose close to 1% against the Greenback, but the Euro and Pound both fell 3.8%. The Japanese Yen was the weakest on the quarter, falling almost 7% to our dollar.

The biggest headlines in the first quarter were the tensions arising from the Ukraine/Russia conflict and global inflation. The situation in Ukraine has only exacerbated rising inflation and will likely continue to remain a geopolitical wildcard. U.S. inflation climbed to 7.9%, a 40 year-high, on rising energy, food and housing costs and may increase further near-term before easing in the second half of this year. The U.S. Federal Reserve chair Jerome Powell said, “inflation is much too high” and it might be appropriate to raise rates more aggressively to get inflation under control. The Fed hiked rates from near zero to 0.25%, its first increase in three years and signalled six more hikes by year end. Powell noted the Fed was ready to make 0.50% hikes if required.

In Canada, inflation surged to 5.7%, its highest level since 1991, again off the back of rising prices. According to Statistics Canada, housing costs in particular rose at the fastest pace since 1983. The Bank of Canada also raised rates a quarter percent from 0.25% to 0.50% for the first time since the pandemic began. BoC governor Tiff Macklem said the economy was now ready to adjust to a normal, higher interest rate setting. As opposed to the U.S. stock market, which has a higher weighting to growth sectors like technology, the Canadian stock market has benefitted from rising energy and materials prices due its larger presence in our market.

Milestone Strategy and Outlook

Although overall equity markets have been mired in a correction most of the first quarter, we believe the bigger theme is the continued fall of government bond markets, possibly ending one of the longest secular bull markets in history that began 40 some years ago when interest rates peaked out over 15%. There is an inverse relationship in the price of a bond and interest rates, resulting in negative rates of return when rates spike. This past quarter was the worst for U.S. bonds (-6%) in more than 40 years. The rout has robbed many investors of a traditional haven from stocks, making this past quarter difficult for balanced portfolios.

Back in late 2020, Milestone forecasted rising rates for 2021 and shifted most of our fixed income exposure away from government and long-dated bonds, towards higher yielding corporate bonds, convertible bonds, preferred shares, and private credit, where parts of those markets can relatively benefit from rising rates. This decision was the most crucial factor for our core mandates last year. This year, bond markets have suffered even more, which continues to favor our strategic positioning, although it has certainly been much more difficult this year to produce positive returns in this important asset class.

In equity markets, our exposure towards Canadian equity markets, and clearly the energy names we own, has helped our portfolios from a global equity benchmark perspective. This is no doubt a pleasant change of pace, with the Canadian equity markets underperforming the U.S. for nine of the last ten years. The tech heavy S&P 500 is underperforming the TSX/S&P Composite by about 9% YTD.

The key talking point in the media lately has been the fact that the middle part of the yield curve has flattened and even briefly inverted. An inverted yield curve is when a longer-term interest rate falls below a shorter-term one, thus signaling slowing growth, and thus is often referred to as a recession indicator. Although some risks have risen over the last few months, the U.S. economy is still on strong footing and growing, albeit at a slower pace. We believe the direction of economic growth and corporate earnings growth will remain strong and positive through 2022. It is the direction of these items that have the strongest correlation to the direction of the stock market over the longer-term. Although short-term interest rates are rapidly on the rise this year, rates still remain relatively low historically. Credit stress indices remain modestly low, showing that that money availability is still strong and supportive of markets.

In addition, unemployment is at historically low levels, and U.S. households’ financial positions are significantly improved today relative to 2019. Savings held in deposits and other financial accounts have increased dramatically, real estate and stock market wealth has increased, and borrower distress has decreased. That improvement in financial strength will be a support to the aggregate economic recovery in coming quarters. According to the Brookings Institute, they estimate that U.S. households accumulate $2.5 Trillion in excess savings (inflation adjusted to 2020 dollars) between March 2020 and January 2022. This is a clear and notable difference between now and the Great Recession.

We want to clarify why the yield curve has been a recession indicator in the past, and which part of the curve we believe is the most important. The yield curve measures the spread between what an institution pays compared to what it can make by lending it out or investing it. When short-term interest rates rise above longer-term ones (inversion), it disincentivizes lending, and therefore restricts the supply of money. This is the beginning of a cycle that can lead to recession, but not always. When the supply of money is restricted, it reduces the availability of money, which slows economic activity and thus corporate earnings, which drives the correlation to the stock market we discussed above. Recently, the 2-year and 10-year U.S. treasury curve inverted. Although this is heavily scrutinized, we believe the 3-month and 10-year curve, and even more specific, the 3-month and 5-year curve should be favored and watched closely. We find this to be especially true this time with the historic level of money put into depository institutions over the last two years. Since February 2020, according to Bloomberg’s Fed data, commercial bank deposits have surged by $4.75 trillion to an astonishing $18 trillion. You can see the 10-week rate of change in U.S. commercial bank deposits below, the largest deposit ramp in a generation.

Source: Tony Dwyer, Canaccord Genuity

We know that this excess capital went into the banking system that pays, up to this point, nearly a zero deposit rate, yet has been lending it out or investing it at much higher rates around the middle of the yield curve. In other words, the 3-mth and 5- or 10-year yield curve has been steep for quite some time and remains steep today. This favored part of the yield curve is not signaling a recession. For those who hang their hats on the 2-year and 10-year yield curve, it still has never served well as a short-term indicator. After this part of the yield curve has inverted in the past, U.S. equity markets have continued to move much higher on average for 18 months with a median gain of 17.7%. In addition, although this inversion has preceded every past recession, it has also been a false alarm before as well, so as with any indicator it needs to be analyzed with others and in context of the environment we are in. It is important to note that in the past, when inverted yield curves preceded recessions, real rates of return (interest rates minus inflation) were positive, not negative like they are at present.

Our view remains that the first half of this year will likely continue to be bumpy, and that we see more potential upside in the second half of the year and into 2023, as the year-over-year slowing in positive economic and earnings growth ease, and inflation begins to come down from elevated levels. Our fundamental core thesis we have discussed in past missives still points to a positive economic growth picture that is driven primarily by continued liquidity as the economy transitions back from a goods to services post-Covid, and continues to fully reopen. Clearly there are risks to this forecast; inflation and higher interest rates, the Russian invasion of Ukraine, and the transition from goods to services could dampen the growth outlook, but ultimately the balance of probabilities currently points to growth staying positive. It remains to be seen if central banks can help navigate this transition for markets, but as noted above, households are currently in a much better financial position to help support the still strong economic backdrop.

Within the context of economic growth staying positive, the significant global equity declines and severely oversold conditions we witnessed in early March, followed by an historically strong four-day rally, suggests using further bouts of weakness as an opportunity to add exposure to risk assets. We posted this chart in our Weekly Insights, showing what happened in past occurrences where we have seen the S&P 500 post four consecutive 1% or more gains. In March, this happened for just the fifth time, and the forward-looking results have been extremely positive. As always, past performance is no guarantee of future results.

Source: Grant Hawkridge, Optuma

Regardless of where we are in the market cycle, it is important to take a disciplined approach and follow a rigorous process 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. Currently, due to higher market volatility, our cash levels remain elevated. We will continue to monitor our Milestone Recession Risk Composite and make further adjustments as our process dictates.
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 March 31st, 2022: (click image for PDF version)

Sources: BNN Bloomberg, Thomson Reuters, Refinitv, CI Global Asset Management, Teranet & National Bank of Canada, CNBC, Globe & Mail, National Post, MarketWatch, Bank of Canada, Statistics Canada, The Economist, Wall Street Journal, Canaccord Genuity, BCA Research, Bespoke Investment Group, CI Financial, Optuma