An eventful first quarter
After a first-quarter marked by increasingly cautious central banks and the Russian invasion of Ukraine, Canadian equities are practically standing alone in positive territory, while other major equity markets and even bond markets are lower (Chart 1).
Though negative year to date, U.S. equities performed well during the month of March. In contrast, the situation remained challenging for emerging markets and bonds, both of which posted a third consecutive month of losses (Chart 2).
While moves of this magnitude are not unusual for stocks, bond declines are far less frequent. In fact, the retreat in U.S. Government Bond prices is the largest since 2000 (-15%). When considering total bond return (both prices of the bonds and interest received), this is the worst we’ve seen since 1981 (-12.5%) (Chart 3).
Under the circumstances, we’ve started to take advantage of the opportunity we see in depressed bond prices. I’ll come back to this in my conclusion, but for now, let's briefly review the two macroeconomic issues of the day: inflation and rising interest rates.
Food and Energy
One month into the Russian invasion, the atrocities from a human standpoint are clear, but the economic impact remains difficult to quantify given the wide range of scenarios to follow. What we do know, however, is that the importance of Russia and Ukraine in the production of many commodities will have an impact on inflation, particularly for food and energy (Chart 4).
Now, this doesn't mean inflation is running away. In fact, the pace of food price increases coming out of the pandemic is so blistering (+8%) that it is virtually guaranteed to slow over a 12-month horizon. Chart 5 below shows that food commodity price growth (agriculture, grain, and livestock) is expected to decline to a more reasonable +4% over the next six months.
Similar observations can be made for energy inflation (consisting mostly of gasoline prices) which predictably tends to follow the evolution of oil prices very closely. To achieve a pace of growth as high as what we have just experienced, oil prices would essentially have to reach $200 per barrel over the next 12 months (i.e. roughly double today's level). Nothing is impossible; recall that prices fell into negative territory in April 2020. However, judging from the price of oil futures, it seems more likely prices will be slightly lower a year from now (Chart 6).
For central banks, the eventual turnaround in annual inflation will certainly be welcome, but the situation is likely to remain uncomfortable for some time. Market expectations of medium-term inflation have recently reached an all-time high.
Fortunately, longer-term inflation expectations remain within the Fed's target range (Chart 8), suggesting that despite everything, markets haven't lost confidence in the Central Bank's ability to meet its price stability mandate. To ensure this remains the case, the Fed now believes it will need to quickly raise rates, and this is what is in store for the coming quarters.
No doubt about it: the Federal Reserve considers that the state of inflation and the job market no longer justify low-interest rates. Thus, in addition to delivering its first rate hike in March (unsurprisingly), the Fed is now projecting 6 more interest rate increases in 2022. While each increase is typically +0.25%, markets are even assuming that 2 of the 6 hikes will be of +0.50%, for a grand total of +2.25% in rate increases in 2022! This is slightly more than double what was expected in December (Chart 9).
These circumstances led to a meteoric rise in 2-year bond yields, which settled a few basis points below their 10-year counterpart, also up sharply (Chart 10).
At these levels, it wouldn't take much for the curve to invert (where the rate of interest is higher for short-term bonds than for longer-term bonds). Historically, such a signal has often been followed by a recession within a 6 to 24 month time frame, so it would likely cause concern for many investors. Yet, in reality, this phenomenon mostly indicates the market is already starting to anticipate the eventuality that Central Banks will be forced to backtrack on raising rates so quickly. This always heralds an economic slowdown, but not necessarily a recession.
Talks of a recession seem premature at this stage. After all, the Central Bank is just starting its ‘rate hike’ process because they are worried about the economy being too strong! The last few months have also shown that the Federal Reserves projections are anything but certain.
The Bottom Line
We continue to view the economic environment as supportive for risk assets. While the crisis in Ukraine will push up energy and food prices over the coming months, inflation should ultimately begin to moderate later this year.
Of course, the sustained rise in energy prices is a burden on consumers' spending capacity. Yet, a longer-term look at oil relative to disposable income indicates that, for now, prices may not be as constraining as one might think (Chart 14). The chart shows that while the cost at the pump is at an all time high, gas prices would have to move up to over $4 per litre to be as big a constraint on the economy as fuel was in 1979 and 2009.
Economic growth is bound to slow, but the strength of the manufacturing sector and the positive outlook for earnings growth should continue to be supportive for equities. Moreover, stocks seem to have already discounted a significant portion of the upcoming monetary tightening.
Nevertheless, the economic uncertainty has undeniably increased in recent weeks, as the knock-on effects from the situation in Ukraine and international sanctions against Russia remain hard to quantify.
And while I would not be surprised to see bond yields creep a bit higher (sending bonds prices a bit lower) over the coming years (Chart 18), the recent surge seems overdone. As mentioned earlier, bond returns have declined at a rate not seen since the 1980’s while bond volatility (Chart 19) is also at multi-decade highs.
In my experience, these extreme conditions typically suggest there will be a reversal in the near term. Add to this that bonds are precisely the type of investment typically sought during times of global uncertainty – makes them all the more attractive in my opinion.
Wishing everyone an enjoyable Easter Holiday – let’s celebrate and be grateful to be together again!
- Your Creed Capital Management Team