March 2022 – Economic and Financial Markets Commentary

2022-03-08

The economy

Worldwide, economic activity fell precipitously in the second quarter of 2020, due to widespread lockdown measures in an effort to ward off the then-developing COVID-19 pandemic.

The deep and short recession was followed by a strong recovery from mid-2020 to mid-2021. By the last quarter of 2021, most countries were back to the mature phase of the economic cycle, where they were in February 2020, prior to the pandemic.

Headwinds to growth became more important. Labour scarcity, higher wages, and the tapering of expansionary monetary policies all emerged as new issues. Most importantly, inflation had moved up to concerning levels, well above early expectations. The strength of the rebound, supply chain disruptions, governments' fiscal generosity towards households, and the shift in consumption patterns away from services and into goods were primary causes.

No longer making up lost ground, growth in advanced countries began to slow down, from the previous elevated levels.  

The combination of a mature cycle, central banks tapering, and high inflation began pushing up interest rates. By the beginning of 2022, higher expected interest rates and slowing growth had become important risks for the equity markets.

Russia and Ukraine

We wrote this past January that the main geopolitical concerns involved Russia invading Eastern Ukraine and the Chinese rhetoric over Taiwan.

Unfortunately, the first concern has happened.

Without being predictable, it was not unexpected. In 2007, Russian president Vladimir Putin, in a speech to the Munich Security Conference, repudiated the post-1989 settlements following the fall of the Berlin Wall, whereby many countries formerly under the Soviet Union sphere of influence moved towards the West. True to form, Putin invaded Georgia in 2008, and occupied Crimea and the Donbas region in Eastern Ukraine in 2014. Recently, he made it clear Ukraine should not exist as a fully separate country but be subsumed within Russia.

The devastating set of legal, financial, and economic sanctions and the heightened uncertainty due to the Russian invasion of Ukraine are amplifying the existing strains to the world economy, exacerbating the decelerating growth trend. Inflation will rise further and remain elevated longer.

The equity markets

Higher uncertainty, economic dislocations, rising interest rates, and higher inflation are all negative factors for equity markets.

Historically, equity markets initially pull back at the onset of military actions and rebound later when the initial uncertainty spike recedes. This is what occurred at the onset of the Vietnam War (August 1964), the Gulf War (January 1991), the Afghanistan war (October 2001), the Iraq war (March 2003), and the Crimean crisis (February 2014). The saying “Buy the dips” identifies this equity market behaviour.

However, we think the traditional rebound following the onset of a war or crisis may be much delayed this time around for four reasons: (i) the armed conflict is large, the crisis extreme, and uncertainty will remain elevated, (ii) economic growth was already slowing down, (iii) inflation is high and interest rates are moving up, and (iv) the extraordinary set of sanctions initiated by advanced countries will depress growth. 

If slow growth and high inflation persist, it will usher in a stagflation period. As we wrote two months ago, equity markets may be able to navigate well such circumstances.

Portfolio management

In light of the high inflation (including high energy prices) and rising interest rates, which both act as strong headwinds to growth, and of the growth slowdown, we began shifting portfolios towards a different structure in November 2021.

In a nutshell, portfolios advised by Triasima have seen a combination of additions to the Energy and Materials sectors and reductions to cyclical holdings from the Industrials and Consumer Discretionary sectors. We also moved portfolios away from the growth factor by decreasing the Technology sector weightings. In some instances, we recently began to introduce names from defensive and stable industries as well.

Furthermore, in the case of balanced mandates, Triasima added to the bond asset class, reducing its underweight, while reducing equities.

These movements, having begun in November 2021, accelerated in January and February 2022, when the impediments to growth became more visible. As such, it has not been necessary to aggressively modify portfolios due to the Ukraine invasion. Rather, we carried on with the evolution already in place.

Notwithstanding, a new development caused by the invasion is larger cash reserves, a result of the added uncertainty and as we find more names to sell than to buy.

Finally, client portfolios held no Russian stock prior to the invasion.

Expectations for 2022

Our expectations at the beginning of the year were for the Canadian equity market to outperform the American market in 2022. A key justification is the higher weighting of natural resources industries in the S&P/TSX Composite Index relative to the S&P 500 Index, and its lower exposure to the growth factor, whose performance is inversely correlated with the direction of interest rates. This view is unchanged.

While slowing, economies progress nonetheless, and profits are growing. We anticipated equity markets would generate positive returns in 2022, in line with historical averages of 6% to 12%, provided long-term interest rates do not rise beyond the 2.5% to 3.0% range.

We must now ratchet down this view. The war and the sanctions will keep inflation high for a longer period, depress sentiment, and further slow economic growth. The expected dip in the equity markets will be more pronounced and last longer.

Equity markets will eventually rebound and move to all-time highs, but a new bull market has now been pushed further out. Our expectation for equity returns in 2022 is still positive and relies on a rally later in the year.

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

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