By clicking "Accept", you agree to the storage of cookies on your device to improve your browsing experience on our site, analyze the use of our site and analyze our marketing activities. See our Digital Data Policy for more information.

War and inflation

Quarterly review

Richard Morin

Update :
Update :
April 24, 2022

The financial markets are currently affected by 2 major events.

On the one hand, inflation is proving to be more persistent and higher than previously thought, forcing the U.S. central bank to tighten monetary policy more quickly than expected, starting with a first increase in its key rate (the rate at which it lends to U.S. banks) of 0.25% in March. More hikes will follow by the end of the year.

Sooner or later, other central banks will have to react and raise their policy rates as well. These increases will affect borrowers, especially households that will face higher mortgage payments. However, they will only have a direct impact on the portfolio if they result in higher interest rates on longer-term bonds.

This is indeed what we are seeing: the rate (yield to maturity) on U.S. government bonds maturing in 10 years rose from 1.5% to nearly 2.5% during the quarter. The same is true in Canada. Based on past experience, however, the worst of the rise in 10-year rates (and hence the fall in bonds) may be behind us. This is discussed in more detail in the "Bonds" section below.

The other major event of course is Vladimir Putin's invasion of Ukraine. In addition to the horrors it is inflicting on the Ukrainian people, this aggression risks disrupting international trade and fuelling inflation. The price of a barrel of oil - of which Russia is the world's2nd largest exporter - rose to more than $110 during the quarter and finally closed at $100. In addition, Russia and Ukraine account for a quarter of the world's wheat exports, and are among the largest producers and exporters of nickel, copper and steel.

In the short term, rising rates are a blow to bondholders - whose market value falls when rates rise. On the flip side, however, it allows interest payments to be reinvested at higher rates. And since rising rate cycles have the unfortunate tendency to cause a recession, bonds can serve as an insurance policy in the portfolio.

Rising rates and the invasion of Ukraine have also created winners and losers on the equity side. Canadian investors are among the winners: stocks are up nearly 4% since the beginning of the year, buoyed by the rising price of oil and natural resources, of which Canada is rich in.

Table Asset Classes Returns

Because of its greater concentration in technology and growth stocks, the U.S. stock market did less well during the quarter. In mid-March, the S&P 500 Index was down nearly 13% and the NASDAQ Index was flirting with the bear market (down 20%). However, the U.S. stock markets rebounded strongly from mid-March onwards, with the S&P 500 and NASDAQ ending the quarter down 5.0% and 9.1% respectively in USD.

Market Review

Canadian equities: a hedge against inflation

Up 3.8%, Canadian equities offered thesecond best performance (behind Australia) of all developed markets in thefirst quarter. The Canadian stock market has been outperforming its U.S. counterpart for quite some time now and this outperformance seems to be confirmed since the invasion of Ukraine.

There is no need to look for a reason to explain this outperformance: Canada is full of natural resources - oil and materials - that the whole planet is currently snapping up. The CRB All Commodities Index is up 27% since the beginning of the year and 60% over one year.

The interest in Canadian equities extends far beyond our borders: Americans have injected approximately $1 billion into Canadian equity ETFs, almost as much as Canadians themselves.

While strategists at major U.S. and foreign firms recommend investing in commodities to protect the portfolio from the ravages of inflation, Canadians who are passively invested in their stock index have this protection right from the start.

Table Sector yields

US equities: first negative quarter in 2 years

Pointing inflation has a very different effect on the US stock market, which is boosted by technology. Despite a rebound in March, U.S. equities are down 5.9% (in CAD terms) for the quarter, their first negative quarter since the spring of 2020.

U.S. stocks are clearly more affected by rising inflation and interest rates than by the situation in Ukraine. In fact, they are up 5% since the invasion began. Apart from a few initial jolts, wars generally do not have a noticeable effect on returns. Despite the horrors of war, it seems that "business is business".

The NASDAQ index fell by more than 20% from its peak before rebounding in mid-March and ending the quarter down 9.1%.

International equities: resources and oil are the sinews of war

Only two international stock exchanges resisted the downward trend in thefirst quarter.

Australia - like Canada - is well endowed with natural resources, which explains why its stock market is up 6.1% (in CAD) over the quarter.

The other exception is the United Kingdom, which imports only 8% of its oil and gas from Russia and is therefore spared the risks of shortages that are currently affecting continental Europe.

The MSCI International Stock Index was down 7.1% (in CAD) for the quarter.

Emerging markets: the decline continues in China

The very severe correction in Chinese equities continued in the first quarter and they are now down about 50% from their peak in February 2021. After the Chinese government's assault on monopolists under its "common prosperity" policy and the crisis in the real estate sector, the stock market is now suffering from the drastic containment of some of the country's largest cities in the face of a new wave of Covid-19.

The other countries in the MSCI Emerging Markets Index experienced declines similar to those in the developed markets inQ1. The only notable exception was Brazil, up 34% for the quarter. This country - mismanaged by a populist - still has a lot of catching up to do, however, as its stock market has still not recovered its 2008 level!

The MSCI Emerging Markets Index returned -7.7% for the quarter.

Bonds: The Federal Reserve takes action

After telegraphing its intentions since the end of 2021, the U.S. central bank - Federal Reserve Bank - began tightening monetary policy to combat inflation.

Some say that the Fed took too long to act and allowed inflation to take hold. As if to prove them right, in the face of more persistent and higher than expected inflation, the Fed is now being forced to accelerate the rate hike. It announced a 0.25% increase in the Fed Funds rate (the rate at which US banks can borrow from the Fed) in March, the first since December 2018. A total increase of more than 2% is expected in 2022, followed by further increases in 2023.

The Fed also signaled that it would soon begin reducing the size of its bond and mortgage-backed securities portfolio. These 2 measures represent a major tightening of monetary policy in an effort to prevent inflation from getting out of control.

As we saw above, a rise in the central bank's policy rate (which is a short-term interest rate) does not necessarily lead to an equivalent rise in long-term interest rates, those that really affect investors.

The Fed has in fact undertaken four cycles of monetary policy tightening - rate hikes - over the past 30 years. As Table 1 shows, although the average Fed Funds rate increase has been 2.81%, 10-year bond yields have only increased by 0.34%. In 2004-2006, 10-year yields actually fell by 0.77% as investors anticipated a recession. History has proven them right.

Table Rate Increase Cycle
Table 1

It is this fear that tightening monetary policy will cause a recession that is causing 10-year rates to rise less quickly than short-term rates: many investors are buying bonds as an insurance policy.

For our part, we are keeping the bonds we hold in our portfolio. While their market value has declined, the interest payments remain unchanged. In addition, we can reinvest these interest payments as well as the capital from bonds maturing at higher rates.