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The day after the night before

Quarterly review

Richard Morin

Update :
Update :
July 20, 2022

by Richard Morin
Published on July 14, 2022

The financial markets have had a challenging first half of the year. After spending the first few months of 2022 adjusting to the prospect of higher interest rates to curb inflation, it is now the fear of a recession caused by those same rate hikes that is causing volatility in the markets.

Ironically, it was in their desire to accelerate out of the short-lived Covid-19 recession of early 2020 that central banks and governments set the table for a possible recession in 2022. Indeed, government handouts and historically low interest rates have boosted consumer spending, just as the global supply chain has seized up.

This excess demand for goods of all kinds has led to a surge in inflation the likes of which has not been seen since the 1980s. So, like Mickey Mouse in The Sorcerer's Apprentice, central banks are overwhelmed by the results of their incantations. Having perhaps pressed the gas pedal too hard (lowering interest rates) and provoked persistent inflation, they now risk provoking a recession by applying the brakes too suddenly.

Governments, too, may find the day after they wake up unpleasant. After stimulating the economy - and going into debt - with hundreds of billions of dollars, they will sooner or later have to pass the bill on to taxpayers in the form of higher taxes and budget cuts.

So there is a lot of uncertainty for the next few months on the economic side. But what impact will this have on the stock and bond markets? The stock market is constantly trying to anticipate recessions, and it does a pretty good job of it. The market usually starts to decline a few months before the start of a recession and also begins its inevitable rally a few months before the economy recovers (see chart 1).

S&P 500 Index & Recessions Chart
Chart 1: Market declines and recessions
Source: Bloomberg

Even if the market correctly anticipates the next recession, there is no telling when it will bottom out, let alone start to rise. In fact, the rally will take just about everyone by surprise, as it will occur while bad news is still dominating the headlines.

Table Asset classes performance

Against this backdrop of uncertainty, however, there is some good news. After the rise in interest rates since the beginning of the year, not only are bonds now paying current interest of over 3.0%, they have also started to play their stabilizing role in the portfolio again. They tend to rise when stocks fall, and vice versa. Bonds are a hedge in case of a recession. So it's important to maintain the target allocation between stocks and bonds, no matter what the "experts" tell us.

Even without knowing if the bottom has been reached, the decline in stock prices is also a great buying opportunity for most investors saving for retirement.

Invest in a diversified portfolio of stocks today and you'll reap the dividends in retirement. Instead, give in to your instincts and sell your stocks and you'll bite your fingers off.

Have a great vacation!

Market Review

Canadian equities: resources down

Canadian equities had a more difficultsecond quarter than the previous one, falling 13.2%. Due to its abundant natural resources, the Canadian market had served as a safe haven for investors trying to shelter from the damage of inflation in thefirst quarter. However, the more aggressive than expected tightening of U.S. monetary policy has created a new risk of a recession.

The quarter started well, with the CRB All Commodities Index up 11.6% in early June. However, recession fears caused an abrupt downturn and the index ended the quarter down 0.9%. This sharp decline in resource prices ended the outperformance of Canadian stocks relative to U.S. stocks.

The TSX Global Base Metals Index fell 32.3% in thesecond quarter, the largest decline since the 2008 financial crisis. A decline in the price of industrial metals (e.g. aluminum, steel, copper) is often an indicator of recession as investors fear that an economic slowdown will affect demand for these metals.

The financial sector, which accounts for almost a third of the Canadian index, was not spared during the quarter, recording a 13.9% decline, with BMO leading the way (-16%) followed by TD Bank (-15%). A rise in the key interest rate would certainly be felt in borrowing rates, thus reducing investments by households and businesses. This explains the decline in the stock prices of Canadian banks despite better than expected financial results in the last quarter.

It was also a tough quarter for the cannabis sector, which saw its valuation go up in smoke with a 53.4% drop, stemming from the performance of two of the industry leaders, Aurora Cannabis (-66%) and Canopy Growth (-62.3%). The latter posted losses in the billions during the last quarter, caused by the depreciation of some of their facilities as well as acquisitions.

Table Sector yields

U.S. equities: the worst start to a year since 1970

The decline in U.S. equities that began inQ1 accelerated inQ2. In fact, the S&P 500 had its worstfirst half since 1970 with a decline of 18.5% (in CAD). In 1970, it was also due to high inflation that the index lost 21%. It remains to be seen if history will repeat itself since a gain of 27% during the last 6 months of 1970 had allowed to recover the entire losses.

The relative outperformance of the consumer staples and utilities sectors, combined with the underperformance of consumer discretionary companies, tells us that the gray clouds of recession are also looming over our southern neighbors. Moreover, the market is suggesting that the economic climate will not be favorable for the cruise industry, as Royal Caribbean's stock fell 58.3% in the quarter.

The rise in interest rates continues to affect technology stocks downwards as evidenced by the NASDAQ index down 22.4% inQ2. Streaming giant Netflix must still be envious of its Silicon Valley peers after a difficult quarter (-53.3%) due in particular to a first drop in their subscribers in over 10 years.

U.S. banks also had a difficult quarter as the financial sector experienced a 20.4% decline. The 30-year fixed rate for mortgages rising from 3% to almost 6%, coupled with home prices 40% higher than in early 2020, ultimately caused a slowdown in U.S. home sales.

The U.S. central bank's rate hikes have increased the demand for the USD as a safe haven. The U.S. dollar index is up 8.8% year-to-date and has appreciated 2.9% against the CAD, which has positively affected C$ returns for the quarter.

International actions: Europe hostage of Putin

As Vladimir Putin's aggression against Ukraine continues, European markets continue to suffer from soaring energy and food prices, forcing the European Central Bank (ECB) to announce an increase in the key interest rate for the first time in over 10 years.

The difficult year continues for German equities, down 15.5% for the quarter and 27.2% this year. There are fears that the decline in natural gas supplies from Russia will lead to a shortage when the cold weather returns.

The Yen continued to fall as the Japanese stock market's return of -4.4% translated into a return of -11.8% when adjusted for CAD.

Overall, international equities were down 12.2% (in CAD terms) during the quarter, outperforming both Canada and the U.S. This was due to central banks being less aggressive on interest rate hikes.

Emerging markets: China against the tide

Unlike other major global markets, Chinese equities had a positivesecond quarter, up 6.8%. Buoyed by the easing of sanitary measures and a growth in production activities, China helped the emerging market index outperform the developed world.

Like the U.S. stock market, the stock markets of South Korea (-18.3% for the quarter) and Taiwan (-17.2%) were affected by their concentration in technology stocks.

After soaring in thefirst quarter with a 34% increase, the Brazilian stock market has fallen to the bottom of the heap, erasing almost all of its gains due to the drop in metal prices and uncertainty about their monetary policy.

The MSCI Emerging Markets Index returned -9.2% for the quarter.

Bonds: back to normal?

Bond rates (Government of Canada 10-year bonds) peaked at nearly 3.5% in early June before falling back to 3.2% by the end of the quarter. This reversal of trend is explained by the increased risk of recession perceived by investors, particularly since mid-June.

As prices move inversely to rates, the bond portfolio offered a return of -5.7% during the quarter.

This increase in bond rates was bound to happen sooner or later. Although it has affected investor returns since the beginning of the year, it allows bonds to finally start playing their role in the portfolio again:

  1. They generate a current interest income between 3% and 4% (depending on the proportion of corporate bonds held);
  2. They stabilize the value of the portfolio since, since mid-June, they tend to rise when stocks fall and vice versa;
  3. They offer some protection in the event of a recession, as evidenced by their behavior since mid-June that the market is concerned about such a scenario.
Chart 10-year mandatory rates Canada
Chart 2: Canadian 10-year bond rates
Source: Bank of Canada

We can therefore say that we are seeing a certain return to normal in the bond market, which in itself is good news.

Have a great vacation!