Economic and Financial Markets Commentary – January 2022


The economy

The COVID-19 pandemic’s impact on economic activity receded in the fourth quarter of 2021, due to rising vaccination levels and general adaptation. Advanced countries are back into the mature phase of the economic cycle, where they were in February 2020, prior to the pandemic induced recession.

Inflation moved up steadily last year, well above expectations. This surge has been caused by supply chain disruptions, governments' fiscal generosity towards households, and the shift in consumption patterns away from services and into goods. The consensus remains for the current inflation spike to be transitory, but more enduring than expected.

Central bankers in Canada and the United States have acknowledged the strength of the economic recovery since the pandemic trough of the second quarter of 2020 and began tapering their super accommodative monetary policies in recent months, mainly by progressively buying less Federal and Treasury bonds respectively. Hikes in the discount and Fed fund rates are now expected for 2022.

Untoward developments for 2022 growth include lingering labour scarcity in some service industries, increasing wages in low-paying jobs, tapering of expansionary monetary policies, and the Chinese economic growth slowdown and real estate overbuilding in that country. The main geopolitical concerns involve Russia invading Eastern Ukraine and the Chinese rhetoric over Taiwan.

The markets

The Canadian yield curve flattened considerably in the fourth quarter of 2021. Short- and mid-term interest rates moved up, spurred by Bank of Canada tapering talk, while longer-term rates beyond the 8-year maturity moved down, likely due to lower economic growth expectations.

The yield-to-maturity of the FTSE Canada Universe Bond Index settled at a meagre 1.9%, up 0.11% from three months earlier. This index posted losses of 0.5% for the fourth quarter and 0.9% for the year.

The S&P/TSX Composite Index for Canadian equities was up 6.5% in the last quarter of 2021 and 25.1% for the year. The strong quarterly performance came from sectors or industries poised to gain from inflation or higher long-term interest rates: Materials and Real Estate companies, oil and gas producers, and banks. Lagging were defensive or growth-oriented industries and sectors. Health Care (-19%) was dragged down again by the poor performance of the cannabis stocks.

For American equities, the S&P 500 Index was up 11.1% in the quarter, a high result fuelled by steady profits growth. Mega-cap companies, perceived as safer provider of high-quality growth, led the market. The full-year market advance is exceptional at 27.6%; the consequence of an improving economy and the Fed’s accommodative monetary policy.

As for International equities, the MSCI EAFE trailed at 2.9% in the last quarter of 2021, and was up 10.8% for the year.

Overall, the elevated annual and quarterly market performances were driven by tremendous profit growth for most companies, made possible by the strength of the economy and fuelled by inflationary pressures.


Inflation has emerged as the dominant topic as we entered the new year. The main question is whether it will remain elevated or will gradually, or rapidly, subside.

The current combination of robust economic activity, central banks tapering, and high inflation is pushing up interest rates, as illustrated in the early days of 2022. Higher rates raise borrowing costs and discount factors used to value future cash flows. These conditions lead to an asset-price deflation and a slower economic growth.

Higher rates are the main downside risk to equity markets in 2022.

Compounding the risk, if inflation remains elevated, central bankers may accelerate their move away from their very easy monetary policies adopted at the onset of the pandemic in April 2020.

Another danger to the equity market is labour cost increases due to labour scarcity and higher inflation. This trend is already in place in the United States, but only nascent in Canada. A sustained rise in unit labour costs will depress corporate profit margins and may potentially trigger an inflation spiral. Such a scenario, although possible, remains unlikely, however, due to the high rate of productivity advances.

Finally, another possibility is weakening economies caused by the higher interest rates and labour costs and goods scarcity, but with elevated inflation enduring, nonetheless. This is the stagflation scenario, which may yet develop as 2022 unfolds.

…and the equity market

High or rising interest rates are unequivocally negative for equity markets. However, the current uptrend for rates may well reverse later in 2022.

Unlike interest rates, high inflation is not necessarily bad for equity markets. Asset values increase with inflation, and many companies can pass on their higher prices to their customers. We are currently witnessing this in the United States where the Producer Price Index rose by 9.7 % in 2021 and the Consumer Price Index by 7.0%.

A stagflation situation is also ambiguous for equity markets. Stock prices may lift alongside inflation such as in the last stagflation period from 1976 to 1980. During those years, using Canadian and American averages, CPI inflation accelerated from 5.3% to 11.8% while the stock market had a 22.2% annualized return. (Canadian bonds returned an annualized 3.0%, far below inflation.)

Unfortunately, cycles of accelerating inflation always end up badly, which we saw in 1981 when inflation peaked, and the bond and equity markets pulled back.

Expectations for 2022

We anticipate equity markets will generate positive returns in 2022. But nothing comparable to 2021, which was an extraordinary year.

Economic progress will carry on and profits will grow. Assuming a modest rise in interest rates, we expect the Canadian and American equity markets to provide a return in line with historical averages: between 6% to 12%.

Canada may outperform the United States if interest rates increase, given the higher value and cyclical factors content in the S&P/TSX Composite Index relative to the S&P 500 Index.

As for inflation, the topic of the moment, we are assuming the CPI will stabilize in the early months of 2022 and begin a gradual descent in the second half. From 4.8% in Canada and 7.0% in the United States in 2021, annual CPI could decline to 4% in Canada and to 5% in the United States by the end of 2022. Further out, CPI could ease off to 3%. Such a level is manageable by the financial markets and central bankers could normalize monetary policy, while still allowing the massive accumulated federal debt to be slowly deflated down. Equity markets would undoubtedly continue to climb under such circumstances.

We fear, however, that “greenflation” and the disappearance of the deflationary forces that emanated from China over the last 20 years will keep inflation above the low levels of recent years.

Unless otherwise specified, financial information presented is in Canadian dollars.