April 15, 2022

Financial letter, Spring 2022, 59^th edition

The geopolitical backdrop is changing.

Prior to the invasion of Ukraine, the financial markets projected that such an invasion would not trigger a world war and global recession. Although the economic sanctions against Russia are targeted, they're disrupting the supply chain (including oil, natural gas, neon, krypton, xenon, microprocessors) and driving up inflation. In the United States, inflation reached 7.9% in February, the highest rate since 1981. In Canada, it rose to 5.7%, a level not seen since the early 1990s.

China's zero-COVID policy, the pandemic's sixth wave, the war in Ukraine, economic sanctions against Russia, the scarcity of certain parts to make electronic components, the production, processing and delivery capacity of businesses, demographics and labour shortages are disrupting the supply chain. Unless there is structural dysfunction, capitalism will adjust and evolve to optimize profitability. According to Adam Smith, the “invisible hand” will allow supply and demand to find their natural equilibrium, but it will take time.

Indexes		Level	3 months	6 months	1 yr
S&P/TSX		21 890.16	3.84%	10.60%	20.27%
S&P 500 (US$)		4 530.41	-4.60%	5.91%	15.63%
MSCI Emerging Markets (US$)		1 141.79	-6.99%	-8.11%	-11.13%
MSCI World (US$)		3 053.07	-5.04%	2.43%	10.62%
C$/US$ exchange rate		0.80	0.79	0.78	0.43%
FTSE/TMX Short Term bond index		741.12	-2.98%	-3.45%	-3.31%
FTSE/TMX Mid Term bond index		1 204.27	-6.83%	-6.53%	-5.04%
Gold (US$)		1 937.44	1 829.20	1 726.37	13.45%

Inflation

Overall, supply chain disruptions, the impact of expansionary monetary and fiscal policies, and wage and resource price pressures will drive inflation above the major central banks' targets in 2022. Between now and the summer, the ripple effect of sanctions against Russia and the surge in resource prices will temporarily push annual inflation close to 7% in Canada and 10% in the United States.

Money policy

Already underway in several countries (including Australia, Canada, the United States and the United Kingdom), the monetary normalization cycle will accelerate in the coming months, surpassing bond market expectations.

Desjardins Group expects 6 hikes in its key rate in 2022, followed by 3 hikes in 2023; respectively 2% and 2.75% at the end of the year. The US Federal Reserve (Fed) may have to do more if price growth continues to exceed its expectations.

The Bank of Canada (BoC) raised its key rate from half a percentage point to 1% on April 13. BoC Governor Tiff Macklem pointed out that the economy is strong and that inflation has far exceeded its target range of 1% to 3% since the spring.

He said inflation has three key elements: “The first is the global shift toward goods and away from services during the pandemic, combined with pandemic-related disruptions to the production and delivery of goods. The second is a broadening of price increases to everyday items like food and energy, making it more difficult for consumers to avoid paying higher prices. And the third is the strength of the Canadian recovery and the overall balance between demand and supply in our economy.” He added that this broadening in price pressures is a “big concern.”

According to the Bank of America, the BoC will hike its rate by half a percentage point 3 times, in April, June and July, and then adjust its key rate by a quarter point until it reaches 3.25% in March 2023. At this pace, Canada's economy could tip into recession before the end of the year. The overblown forecasts seem disproportionate and unrealistic.

The household debt rate alone calls for gradual movement in the key rate and acceptance by those controlling it that monetary governance is an inexact science. While inflation is high, the labour shortage is driving wages up and the supply chain bottlenecks are undermining supply and demand, yet tightening monetary conditions to tip the economy into recession after all the efforts made by public authorities to keep it afloat since 2020 is not a realistic scenario.

Desjardins Group expects the key rate to be 1.50% at the end of 2022 and 2.00% at the end of 2023.

The Fed is predicting nominal GDP growth of 7.1% in 2022 and 4.6% in 2023. The New York and Cleveland Fed models show a 6.1% and 4.7% probability of recession in the next 12 months. However, in mid-March, one-third of respondents to a CNBC survey were expecting a recession. The war in Ukraine, rising resource prices and inflation and the yield curve may have played a part.

Unless the Fed slams on the brakes, a recession is unlikely in the next 12 to 18 months. Desjardins Group is predicting real GDP growth of 3% in 2021 and 2.4% in 2022.

In Canada, real GDP rose 0.2% in January and 3.5% over one year, surpassing the pre-pandemic peak in February 2020. Goods-producing industries grew significantly, with construction in the lead, followed closely by utilities. Desjardins Group expects GDP growth of 3.5% in 2022 and 2.5% in 2023.

Interest rate outlook

Globally, the bond market wiped out about $2.6 trillion in valuation in the first quarter. This kind of decline has not been observed since the Bloomberg Global Aggregate Index began compiling data in 1990. In 2008, the decline was around $2 trillion. The persistent strength of inflation and the shift in direction by the major central banks to get inflation to its target are the main reasons for the interest rate hike.

In the United States, the Bloomberg US Aggregate Bond Index posted a 5.93% decline in the first quarter. In Canada, the FTSE Canada Universe Bond Index fell 6.97% in first 3 months.

Inflation's unrelenting rate and the action by the central banks will continue to weigh on the bond sector in 2022. Desjardins Group predicts that the rate for federal bonds maturing in 2 and 10 years will be 2.70% and 2.80% in the United States and 2.35% and 2.55% in Canada. It is interesting to note that the yield curve will have a positive slope.

For these reasons, our strategy is to underweight the bond asset class based on our targets and to have a short average duration (2.25 years), because the shorter the duration, the lesser the volatility.

Asset allocation

After the first quarter of 2022, we are maintaining a neutral bias for cash, an underweighting in the bond market and a slight overweighting in the share market. While this positioning may seem optimistic, it's primarily a relative positioning, as several asset classes are currently overpriced and deals are scarce. Humility and the management of expectations remain essential at this time, especially given the many areas of concerns these days.

While interest rate hikes will unquestionably affect bond values, the relationship with stock prices needs more nuance. For starters, companies don't report revenues in real (inflation-adjusted) dollars, but in nominal terms. A world where the economy is characterized by sustained, but not excessive, inflation could therefore be good for future corporate earnings.

What's more, over the past 10 years, expected earnings for the following 12 months have correlated very strongly with inflation figures. In that case, should investors really be worried about inflation?

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

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

Conclusion

We're maintaining a marginally pro‐risk positioning without any significant deviations from our targets. To get a total projected return of 5%, the investment strategy for a balanced portfolio (cash, 10%, fixed income, 35%, shares, 55%).

While current inflation accounts for a large part of investor concerns, it goes beyond that. Accelerated monetary policy normalization, although the slowdown in economic growth is overdue, must continue. How will the markets react to rising rates? Could this upward pressure on inflation and downward pressure on economic activity lead to a stagflation scenario? Will China succeed in taming its tech giants with a view to shared prosperity while allowing securities to rebound? Will OPEC+ be able to maintain its exemplary discipline and ignore repeated demands for increased production? And Russia… While a ceasefire agreement or an end to the conflict would be very good news, the sanctions imposed on Russia should certainly remain in place for much longer!

Lastly, in the face of much uncertainty, a focused, measured and balanced approach is needed. Amid multiple challenges and more volatile times, investors can fully appreciate the value of advice.

We readily recognize that the answers to these interesting circumstances will be imperfect and incomplete. To stay focused on long-term objectives, the investment strategy is based on the following core pillars: rigorous analysis, risk management, diversification, optimization of the risk-adjusted return and accuracy of execution. Staying focused also means ignoring headlines and emotions.

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 are committed to working ever harder to find solid opportunities in the financial markets, so as to help you reach your long-term goals.