Since the beginning of the year, we have been enduring a punishing correction in the financial markets. In Canada, the decline may not be enough to fit the textbook definition of a “bear” market, but by all other factors we’ve been experiencing a “bear at work”.
CORRECTIONS AND BEAR MARKETS ARE NORMAL
A market correction is defined as a decline of more than 10% from peak to trough and it happens every couple of years.
A bear market is defined as a decline of 20% or more from peak to trough and it typically occurs every 8 or 10 years. The average length of a bear market is 6 to 9 months.
Corrections and bear markets are a normal part of the investment landscape. When it happens it’s disconcerting for investors since there are few places to hide. Bonds usually act as a buffer when equity prices are falling. Not this time. Since the beginning of the year, both the bond and equity markets have moved in the same direction – down.
“SHORT-TERMISM” CAN HIJACK A DISCIPLINED INVESTMENT STRATEGY
To avoid overreacting in the face of dramatic world events, investors need to cut through the noise. And today the noise is deafening!
It’s hard to stay focused on your longer-term investment objectives when you see the world struggling with a global pandemic, housing prices at record-breaking levels, out-of-control food and gas prices, the war in Ukraine, and even the risk of a third world war. When “short-termism” sets in, it is difficult to stay the course and prevent the fear and uncertainty from hijacking your commitment to a disciplined investment strategy.
Fear and uncertainty lead to volatility in the financial markets. So far this year the Volatility Index (VIX), a measure of short-term volatility (for the next 30 days), has been above its long-term average. On Friday it closed high at 26.09 compared to the long-term average of 19.09. Monday It jumped to 27.75. Markets are going to continue to be choppy. This is good news for seasoned investors who understand that volatility spells opportunity, but it is not the only
consideration. Today’s geopolitical risks are extremely high and need to be factored more heavily into investment decisions.
TO STAY FOCUSED, CONSIDER THESE FACTS.
First the good news.
Canada’s unemployment rate is at a record low – at 5.1%, the lowest in 45 years.
Wages are increasing – up 3.9% in May for hourly wage earners, up from 3.3% in April, and hitting 4.5% for permanent workers, up from 3.4% in April.
Job growth is strong. In the last 12 months, the Canadian economy created over 1 million jobs – there are 500,000 more jobs than pre-pandemic.
Interest rates are normalizing. When interest rates are abnormally low and credit is easily obtained, the lines between investment, entertainment, and gambling become blurred. Investors start putting money into speculative ventures and “get rich quick” schemes.
Canadian commodities are commanding high prices on world markets.
The Bank of Canada recently cancelled its ultra-long (50-year) bond auction that had been scheduled for this month. The Canadian economy is surprisingly resilient and does not need to add more debt to the balance sheet.
And now the bad news:
Inflation is surging. The April 2022 inflation rate for Canada was 6.77%, up from 4.80% at the end of last December. Core inflation, which excludes the volatile prices of food and energy, was at 4.62%, up from 3.40% in December 2021.
There are many reasons why inflation has increased so much in such a short time.
- The strength of the Canadian economy means we have a tight labour market. Employers must be more competitive on wages, benefits, working conditions, and other perks. This is inflationary.
- Supply chain disruptions persist due to Covid-related shutdowns and the war in Ukraine.
- Extreme weather conditions have affected food sources around the world. The fear of a food shortage is prompting higher demand and higher prices.
- The war in Ukraine is stoking fear of out-of-control inflation because of high food and energy prices.
- Ukraine, the “breadbasket of the world”, is the 4th largest exporter of grain globally. Many developing nations in Africa and Asia rely on the wheat from Ukraine. Russia is blocking the grain exports, using this as leverage to get the West to remove sanctions placed on Russia.
- The war in Ukraine is driving the shortage of oil and gas in a world still reliant on fossil fuels. We feel the impact of the higher gas prices at the pumps.
Inflation is rising around the world. If it persists, it will slow global economic growth and possibly lead to a global recession.
Interest rates are rising. After decades of declining bond yields and even negative real interest rates, the tide has turned. A major transition is underway as central banks increase rates to curb inflationary pressures. Over 60 central banks around the world have increased their interest rates since the beginning of the year.
The Bank of Canada has been aggressive, raising the overnight rate from 0.25% at the start of the year to 1.50% as of June 1. This in turn has prompted the chartered banks to increase their prime lending rate from 2.45% on January 1, 2022, to an average of 3.70% on June 1.
In its analysis of US stock performance in the early phases of Fed tightening cycles, BCA Research concluded that typically stocks “wobble” in the first few months following the initial rate hike, but they end higher over a 12-month horizon. So far, it’s been quite the wobble, but if this post-Fed Reserve tightening pattern also applies to Canada, it fits with expectations that the second half of this year will see more resilient markets.
Rising interest rates do not mean that equity markets can’t function. Historically they have performed well when interest rates were in the 3.5% to 5% range.
Canadian household debt is high. Data released last week by the Bank of Canada in their annual Financial System Review – 2022 indicate that:
- the share of Canadian households with a debt-to-income ratio of 350% or more increased from 16% to 19%; one in 5 households are heavily indebted and vulnerable to interest rate increases.
- about a third of Canadian households have a mortgage – 15% of them have a debt-to-income ratio of 450% or more, a variable rate, and an amortization period greater than 25 years. Looking forward housing prices are expected to fall. This will put more pressure on these Canadians.
The market correction has been deep. Spurred by the prospect of rising interest rates, the decline started in technology and innovation stocks, then spread to other sectors. There has been a rotation out of growth stocks and into value.
The volatility in the bond markets has been more dramatic than expected, but it hasn’t come as a total surprise. We’ve been preparing for it for the last few years by moving to Aligned Capital Partners to have greater access to private equity and credit, reducing allocations to fixed income, and increasing your cash holdings and/or adding real/tangible assets and alternative asset strategies.
Economic growth is slowing, not just in Canada and the US but also globally. The US is very close to being in a recession according to the definition of two consecutive quarters of negative GDP growth – the first quarter of 2022 was negative. Although possible, it is unlikely that Canada will slip into a recession over the next 12-months. If it does, it will be shallow and short-lived. Because of our size and proximity to the US, Canadian markets usually follow trends in the US. This time the strength of our commodities markets may enable us to avoid a recession. What happens in Ukraine is an important factor.
WHAT DOES THIS MEAN IN TERMS OF YOUR INVESTMENT PORTFOLIO?
If your portfolio is well-diversified, especially if it has been enhanced with real estate and infrastructure, resources, and other commodities, it will stand the test of any bear market.
In an interview at the Davos World Economic Summit in May of this year, Goldman Sachs strategist Vicki Chang suggested that the correction in the equity markets has created some of the best long-term opportunities ever. With the extreme geopolitical events of our time, the challenge is in finding how best to capitalize on such opportunities.
The investments that offer relative value are becoming easier to identify but when will the trend turn more positive? When will the selling frenzy end? It will require signs of inflation moderating. This could come quickly. Much depends on the war in Ukraine.
Equities are seen as a store of value in the face of inflation. In our next portfolio rebalancing, we’ll be increasing allocations to equities that rank high on the “Quality” factor. Global small-cap value funds will be of interest, as will healthcare, infrastructure, technology, and commodities.
Fixed-income assets, such as short-term government and corporate bonds, floating-rate loans, and GICs provide some security in uncertain times. We’ll be increasing allocations to bonds or bond funds/ETFs as the interest rate increases plateau. If you want to hold GICs, the rates are higher than they have been for many years. We don’t tend to recommend them because they do not keep up with inflation, but if you want to check out the rates, give us a call.
Continue to be defensive for now but stay primed and ready to act as soon as the short-term market indicators stop trending downward. If you have any questions about the contents of this commentary or how your portfolio is performing, let us know.
The information in this commentary is for informational purposes only and is not meant to be personalized investment advice. The content has been prepared by Jan Fraser, Fraser & Partners Investment Services of Aligned Capital Partners Inc. (ACPI) from sources believed to be accurate. The opinions expressed are those of the author and do not necessarily represent those of ACPI.