October 14, 2021

Financial letter, Fall 2021 – 57^th edition

After demand, Covid infects supply

To forestall a domino effect on supply and demand, governments opened the coffers of public finances and central banks deployed a bottomless monetary toolchest (interest rates, virtual balance sheets, quantitative purchasing).

So much so that demand will be a spark plug of the economic cycle in 2022 and 2023. In North America, households accumulated surplus savings estimated at close to $2.5 trillion in the U.S. and $200 billion in Canada – an average of about $5,300 per Canadian at the end of 2020. Never has a recession left households so well off. Domestic demand (including household consumption) will continue to buoy the expansion through adolescence and maturity to the cyclical peak, widening the imbalance of supply and demand. GDP growth in 2022 is projected at 3.8% in the U.S. and 4.1% in Canada, a normal deceleration following the vigour of the recovery to date.

Index		Level	3 months	6 months	1 year
S&P/TSX		20 070.25	0.18%	8.75%	28.05%
S&P 500 (USD)		4 307.54	0.58%	9.18%	29.98%
MSCI Emerging Markets (USD)		1 253.10	-8.03%	-3.32%	18.52%
MSCI World (USD)		3 006.60	-4.11%	7.98%	29.41%
CAD/USD Exchange Rate		0.79	0.81	0.80	5.04%
Canada 2-Year Bond Yield		0.53%	0.45%	0.23%	114.57%
Canada 10-Year Bond Yield		1.51%	1.39%	1.56%	168.98%
Oil (USD)		75.03$	73.47$	59.16$	86.55%
Gold (USD)		1 756.95$	1 770.71$	1 707.71$	-6.83%

RISK FACTORS

The financial markets have an optimistic view on the future of the economy. However, many risks are on the horizon which leaves us to have a prudent approach.

In the view of Desjardins Economic Studies: “The spread of the Delta variant confirms that the pandemic is not over and that its development remains the main risk factor for our economic scenarios. The slow pace of vaccination campaigns in some countries, lower-than-expected vaccine efficacy and the spread of new variants could affect the economic situation, forcing the extension or reintroduction of restrictive health measures. [These factors] would also affect financial markets by eroding profit outlooks and investor optimism. The many supply and demand imbalances, including new production constraints stemming from the pandemic and supply problems, could make inflation surge more than anticipated.

That said, economic growth, still supported by [fiscal] and monetary policies, could be stronger than expected. The surplus savings stockpiled during the pandemic could be spent rapidly, leading to robust demand and sustained growth in consumer prices. The improved economic outlook and rapid rise of prices are making things harder for the central banks. Maintaining overly stimulating monetary policies or other highly aggressive [fiscal] measures could lead to a much bigger surge in inflation expectations and make bond yields rise. On the other hand, tightening monetary policies too abruptly could also trigger a negative reaction from markets.

All those risks will continue to be present in the near future and we continue to put emphasis on positioning your portfolio for the long term. Companies and the global economy are in an expansion period.

FIXED INCOME

At this stage of the economic cycle and pandemic management, central banks are justified in beginning to reduce the degree of monetary accommodation. Desjardins Group economists see the Fed making a first quarter-point hike, to 0.50%, in Q3 next year (July), followed by four more quarter-point hikes in 2023. In Canada, Desjardins Group economists see a first quarter-point hike, to 0.50%, next summer and a second hike in Q4 of next year followed by three more in 2023.

We will be watching the reaction of the bond market. From September lows, the yield of 10-year federal bonds has risen 25 basis points to 1.54% for U.S. Treasuries and 36 basis points to 1.51% for Canadas. For the end of next year, 10 years Canada bonds could hit 2.25%.

Even if we continue to underweight bonds in a portfolio, we think it is still important to continue to hold them because they improve the overall portfolio diversification and gives a good downside protection.

INFLATION: TEMPORARY, OCCASIONAL PART-TIME, PERMA¬NENT OR PERMANENT PART-TIME?

Is that not the essence of the question? When inflation rose above its targeted bounds last April, May and June, central banks, economists and investors declared its movement to be temporary. After all, the data of last spring were comparable to those of the deflationary moment of 2020. But forces both cyclical (scarcity of electronic parts and containers; tangled chains of supply, production and delivery; low inventories), and structural (scarcity of labour power; rising wages; matured containers) have kept inflation above the speed limit. The BoC’s expectations are 3.0% in 2021 and 2.4% respectively in 2022. Like the bond market, the central banks could be underestimating inflation and be obliged to revise up their outlooks. In that case they could move their first rate hikes a few months closer. For the moment, the Fed, the ECB and the BoC are confident that inflation will slow. Stay tuned …

FOREIGN EXCHANGE

The Canadian dollar lost 4% of it s value since the month of June. However, the vaccination success, labor market growth, possible rate hike before our southern neighbor and many other developed countries and massive infrastructures spending plan would benefit our currency. The Canadian dollar presently at 1.25$ versus the USD could trade around 1.20$.

PORTFOLIO STRATEGIES

With a recession hard to imagine over the next 12 to 24 months, asset allocators will do better leaning to equities rather than bonds. Moreover, an expected rise of interest rates like that of the first quarter of this year could be temporarily constraining for growth styles and their markets. So out to a three- to six-month horizon, under conditions of rising rates, equities of the financial, energy and base metal sectors could do well, fuelling outperformance by value-style stocks and the Canadian market generally. In September we rebalanced our portfolios on their target, and this generated liquidity to be reinvested adequately in the market when opportunities will present themselves.

Tactically, our investment strategy overweight equities and cash and underweights fixed income and duration.

Selecting the right asset allocation based on your personal and financial situation, your risk tolerance and investing time horizon is a golden rule when investing.

CONCLUSION

We hope this provides you with additional market insight. We’re always available to discuss our investment strategies with you at greater length. We remain committed to working even harder to identify promising market opportunities to help you achieve your long-term goals.