We started the year on a high note in the market, but within a few weeks saw the first of two key events:

1. A market pull back in mid-January led primarily in the growth/tech sector as inflation continued to increase stubbornly and was beginning to affect the economy. We had known that inflation was a problem, but the continued growth of the economy was keeping pace. When inflation started to outstrip growth it become more of a concern, especially for high cash companies like those in the tech and growth sector.
2. The invasion of Ukraine by Russia at the end of February threw gas on the fire for inflation, causing increased pressure on energy and food prices around the world.

    Inflation has been and continues to be the primary concern of the markets, and what we are experiencing is “Supply Side” inflation: lack of supply of goods, of energy, of food and services causing the increases in prices and cost of labour. Central banks main tool to combat inflation is to raise interest rates, which is a “demand side” tool- it decreases people’s and company’s ability to purchase goods and services. It is less effective against supply side inflation. Regardless, central banks continue to do what they can to raise interest rates in order to rein in inflation.

    The markets hit a low in mid-June, but then signs began to show that maybe inflation was letting up. Gas prices started to fall, which was a key variable. There was a glimmer of hope and the markets recovered, then when I came back to the office after labour day we started to see worrying signs that maybe things weren’t all that great. US consumer debt was rising faster than expected, and maybe inflation wasn’t done. If you combine this with a slowing economy, then this is not good, and what we hoped would be a short lived recession, could stall longer. The big kicker in all of this is unemployment. If a short recession turns into a longer recession, with stubborn inflation causing high interest rates with rising consumer debt AND unemployment rises, then it’s a big problem.

    I heard this same message from 3 separate firms in two days, and started making changes to the portfolios to shore them up and protect capital. Though there were some exceptions, we lowered our equity content, raised our fixed income, and made the portfolios more focused on Canadian content vs US. In the portfolios that I manage the holdings for I made changes to move from more growth oriented names to more stability. An example of this was the move from Disney to Enbridge. We like Disney. We feel the market is undervaluing it’s streaming services (among other things), and are waiting for that to reverse. However if we do enter a situation like what I described previously, then less people are going to be buying tickets to Disney World, and it will have continued head winds. Instead I move the money to Canada, to an energy company that pays a high dividend, and whose business looks healthy regardless of what point we are in the economy. It will be resistant to a declining economy.

    Sure enough, inflation turned out to be stubborn and remains high. As we entered this week, the TSX was down approx. 12% YTD and the S&P 500 was down approx. 25%.

 

Fixed income markets:

    Rising interest rates increase the yield of bonds that are being put out to market, they have the effect of lowering the value of current bond portfolios. A very important distinction is that it is the expectation of future interest rate increases that lowers bond prices, not necessarily the actual raising of rates.

    So though bond portfolios are now typically yielding 5%, where a year ago they were closer to 0.5%, the bond index is down approximately 12% YTD because of the forces at work I previously described.

This is an unusual situation to be in, where both stocks and bonds are in negative positions 10 months into a one year period. Looking back in the history of the stock and bond market, the analysis of rolling 12 month periods shows that this has only happened 1.8% of the time. There is a high likelihood of one if not both of these breaking that pattern soon.

    We are currently at a low point and a crossroads in the market. Inflation is at or near its high, and it is not coming into check as many hope which is particularly bad for fixed income. At the same time, the economic outlook continues to sour, which is generally bad for equity markets. That said, one of the best ways to curb inflation is to enter a recession, so it is very likely that if inflation does start slowing, the negative economic news may instead cause the stock market (and bond market) to go up. These first few trading days of this week are starting to show that something is giving.

    Looking forward, we are optimistic for the fixed income markets. We feel inflation will begin to lower, which puts less pressure on central banks for future interest rate hikes.

    For equity markets, all the negative news you are hearing is priced in, and we are sitting at a low in the markets that has significant support that will be tough to break through. The most likely scenario is that the coming recession will assist in easing the inflationary pressure on goods and services, and unemployment will not spike up more than expected.