December 13, 2022

Financial letter, Fall 2022, 61^th edition

Patience is in order

Investors are concerned by persistent signs of stubbornly high inflation, which is causing significant losses in the major stock markets. This year, the S&P 500, Nasdaq and Dow Jones had their worst start since 2002! The rally that began in June, spurred on by hopes that inflation would cool and allow the Fed to adopt a friendlier stance, did not last.

Index		Level	3 months	6 months	1 year
S&P/TSX		18 444.22	-1.35%	-14.36%	-5.28%
S&P 500 (USD)		3 585.62	-4.89%	-20.21%	-15.50%
MSCI Emerging Markets (USD)		875.79	-11.46%	-21.53%	-27.86%
MSCI World (USD)		2 378.65	-6.07%	-21.16%	-19.23%
CAD/USD Exchange Rate		0.72	0.78	0.80	-7.78%
Bond yield Canada 2-year		3.79%	3.10%	2.29%	0.53%
Bond yield Canada 10-year		3.17%	3.22%	2.41%	1.51%
Oil (US$)		74.49$	105.76$	100.28$	6.23%
Gold (US$))		1 660.61$	1 807.27$	1 937.44$	-3.81%

 

When will inflation ease?

A return to normal inflation will take time. If inflation stops increasing month-over-month, levels will return to nearly 3.0% by March 2023. However, if inflation keeps rising at a monthly rate of 0.2%, it would still sit above 4.5% next spring, which would likely require further monetary tightening.

There are several factors that show a little hope of respite. With the exception of natural gas prices, most commodities have trended downwards amid fears of recession. After exploding early in the pandemic, lumber prices are back to pre-pandemic levels and Canfor has resorted to temporary rotating production shutdowns due to a lack of demand. Despite ongoing pressure in some segments, supply chains have seen a general easing. In fact, the Federal Reserve Bank of New York and CBRE supply chain index has dropped from its highs and is maintaining a strong downward trend.

On September 21, the Fed released its inflation and prime rate projections. Its projected rate of inflation for the personal spending index is 2.8% in 2023, 2.3% in 2024 and 2% in 2025. As a result, the key rate will be 4.4% at year end, 4.6% in 2023, 3.9% in 2024 and 2.9% in 2025. The direction of the key rate will be tied to inflation, which hinges on geopolitical and structural realities (including demographics), a supply shock, the price of raw materials and the environment. Desjardins Economic Studies projects a key rate of 4.50% in December 2022 and 4.00% in December 2023.

Persistent inflation remains the main risk to the global economy, as it would force many central banks to raise their interest rates more aggressively. If central banks don't respond forcefully enough, high inflation may become even more entrenched and difficult to control in the medium term. In our base scenario, economic activity will contract in Canada, the US and other countries, notably in Europe. High inflation and rising borrowing costs could further slow consumer and business demand. Canada would be particularly vulnerable to a sharper global economic slowdown, which would negatively impact its exports and terms of trade. Furthermore, bigger increases in unemployment and interest rates could exacerbate Canada's housing market slowdown. The European economy is especially vulnerable due to soaring energy prices and potential shortages caused by the war in Ukraine. Although prices for oil, some foods and other commodities have fallen, the war in Ukraine remains a major source of uncertainty in our forecast. That means further turbulence in the months ahead, which should give the US dollar the upper hand against most currencies. We therefore expect the Canadian dollar to end the year around US$0.72 before losing a bit more ground in early 2023.

Asset allocation

Investors and savers will probably be happy to say goodbye to 2022. Among the asset classes considered, only cash and the US dollar will provide positive returns. Property value, one of the main sources of savings for many households, should also continue to correct itself.

After 2 years of strong asset growth, this is the price we must pay to rein in inflation. Returns could rebound in 2023, but only if we manage to avoid a severe recession.

As we enter the fourth quarter, we are maintaining a healthy dose of caution regarding the recommended allocation. We recommend an overweight position in cash level, an underweight position in the bond market, a neutral position in equities and an underweight position in alternative investments.

Bonds. Ever-rising inflation (excluding food and energy) and the central banks’ determination to combat a potential price-wage spiral suggest that interest rates may still not have peaked, hence the underweight asset class. Nevertheless, certain segments of the bond market are becoming increasingly attractive.

While rock-bottom interest rates at the beginning of the year dampened expected returns, rising rates have significantly improved the asset class outlook.
We prioritize direct holding with bonds so that investors can see the maturity dates and yields.

Equities. The recent stock market drop saw the S&P 500 fall nearly 20% from its peak. This decline in stock values, combined with strong corporate earnings growth, caused some stock valuations to fall dramatically.

25% drop. Since 1980, the S&P 500 has fallen by 25% or more 7 times. Following these drops, the index rose by an average of 24.9%, 40.4% and 111.0% after 1, 3 and 5 years respectively.

In light of the economic outlook, the geographic allocation is as follows:

• United States: overweighting
• Canada: overweighting
• Europe: underweighting
• Emerging markets: underweighting

Alternative investments. The chronic low interest rates and historically average stock market valuations of recent years have encouraged many investors to invest in new asset classes. Recent disruptions, along with higher interest rates and lower valuations, have reduced interest in alternative classes.

Conclusion

Although recent years have brought us their share of surprises, macroeconomic and financial contexts have rarely been so uncertain, making it more challenging than ever for forecasters to make predictions. This uncertainty justifies a very nuanced investment strategy. Now is not the time to take very firm positions. When in doubt, balance should always prevail.

While weathering a more volatile market, investors should keep a few fundamental points in mind:

• Remember why you invest
• Understand what you do control and what you don't
• Remain objective
• Set realistic expectations
• It's OK to ask for help

After all, it's during downturns that the value of good advice is worth its weight in gold!

We hope that this information helps you better understand the markets. Please don't hesitate to contact us if you'd like to discuss our investment strategies in more detail. We'd like to reiterate our commitment to keep working hard to help you meet your long-term financial goals by seizing the best opportunities on the markets.

 

Louis Vazzoler
Portfolio Manager