Some thoughts on market’s behavior to start the year

 

2022 has been challenging out of the gate and that is the very topic I wanted to focus this update on.

 

First we need to start with the acknowledgement that 2022 is a transition year for both the bond and equity markets, as policy makers start to remove some of that stimulus from the economy that was injected during the onset of the Pandemic. The major change will be the eventual increase in central bank interest rates. The bond markets are currently pricing in the first rate hike from the Federal Reserve around the March/April time frame. Given the shifting monetary policy environment, paired with the fact that 2021 was an excellent year for stocks, it is not surprising to us to see some selling pressure on equities as we begin the year.

 

With that said, even when tightening begins, the policy backdrop will remain incredibly accommodative by historical standards. Consider that real interest rates – which is the current coupon, or yield, an investor would earn on a government bond, minus the current rate of inflation, is presently negative in Canada, the U.S., Europe, and most of Asia. In other words an investor buying a 10 year U.S. Treasury today (the gold standard for safe assets) is expected to earn roughly -1% in real terms annually. While we do not argue equities are more expensive today than they have been at other times historically, in an environment of low-to-negative interest rates, equities should continue to offer attractive value to long-term focused investors, which of course most of us are.

 

Despite the volatility we are currently experiencing, we remain optimistic on the outlook for equities in 2022, underpinned by our view that the global economy remains strong, and it is the economy typically sets the stage for stocks. In the coming weeks I will expand on this very premise in greater detail.

 

Turning to the fixed income markets, bonds have been weak to start the year as bond investors continue to reprice interest rate hike expectations from the Fed. To convey what is happening in simple terms, let us consider a U.S. government issued bond. The coupon or yield a government bond pays is a function of what the Fed Funds rate is at the time the bond was sold to the market. As such if bond investors believe that Fed funds rate is going higher sooner than later, investors will demand increased compensation to purchase the existing issues of U.S. government bonds. The “increased compensation” comes in the form of a higher yield, which is achieved through the price decline of the bond. The low interest rate environment continues to compressed fixed income returns, and yet we remain committed to a having a strategic allocation to fixed income in all portfolios as a diversifier to smooth the ebbs and flows of the global equity markets. Bonds carry the added benefit of a steady and reliable source of income for portfolios.

 

I will part with the reminder that the key to strong investment management is having a discipline that is adhered to in both good times and bad. We have always preached having a patient, long-term approach to investing. Attempting to figure out which groups of companies are in or out of favour on a three or twelve month basis is not a pursuit we seek. Time is our biggest ally as investors. It is the compounding of the earnings over 3, 5, and 10 year periods of time that drive long-run results. Successful investing is not about trying to figure out what the market is willing to pay for our shares of Home Depot or Costco at a given point in time. With that said, we will continue to focus on what we can control which is to build resiliency in your portfolios by prudently selecting high-quality investments.