January 21, 2022

Financial letter, Winter 2021, 58^th edition

Groundhog Day…

The pandemic isn't over, as shown by the onset of the Omicron variant and the rise in cases, hospitalizations and deaths in several countries. COVID‑19 therefore remains an important risk factor that can still affect our forecasts. Another wave of the pandemic and spread of the new variant (vaccine efficacy against it is not yet known) could hurt economic conditions, making it necessary to prolong or bring back restrictive public health measures This would also affect the financial markets by eroding profit outlooks and investor optimism. The many supply and demand imbalances, including production constraints stemming from the pandemic and supply problems, have accelerated inflation, and this could persist, particularly if the pressures on wages and housing costs strengthen.

Indexes		Level	3 months	6 months	1 yr
S&P/TSX		21 222.84	6.50%	6.70%	25.15%
S&P 500 (US$)		4 766.18	11.02%	11.66%	28.68%
MSCI Emerging Markets (US$)		1 232.01	-1.36%	-9.25%	-2.47%
MSCI World (US$)		3 231.73	7.86%	7.98%	22.38%
C$/US$ exchange rate		0.79	0.79	0.81	0.75%
FTSE/TMX Short Term bond index		763.85	-0.49%	-0.42%	-0.93%
FTSE/TMX Mid Term bond index		1 292.61	0.33%	0.32%	-2.69%
Gold (US$)		1 829.20$	1 756.95$	1 770.11$	-3.64%

However, still buoyed by fiscal and monetary policies, economic growth could be stronger than expected. The excess savings stockpiled during the pandemic could be spent rapidly, triggering robust demand and sustained growth in consumer prices. In the United States, the passing and implementation of President Joe Biden's ambitious infrastructure and family assistance plans could lead to stronger economic growth in the medium term. However, the political uncertainty fed by partisan divisions in Congress may affect the economy and the markets.

Risks of more lasting acceleration in price growth are making things hard for central banks. Maintaining overly stimulating monetary policies or fiscal stimulus to drive demand could spark a much bigger surge in inflation expectations and push bond yields higher. On the other hand, tightening monetary policies too abruptly could also trigger a negative reaction from the markets.

Beyond the erratic stock market movements after Omicron invaded the headlines, the economists polled by Bloomberg are also optimistic about 2022 and 2023.

Overall, global economic growth will reach 3.9% in 2022, with 3.3% in advanced countries and 4.3% in emerging countries according to Desjardins Group forecasts.

A word about inflation…

Globally, prices will climb 3.6% in 2022, 0.1% higher than in 2021. In advanced economies, inflation will be comparable to 2021 in 2022 (3.1%). In Canada and the United States, price growth overshoot central bank targets of 3.3% and 4.1%, respectively, in 2022. The pandemic, supply and demand imbalances, labour shortages, and rising labour, supply, production and delivery costs account were the key price growth drivers.

However, according to Desjardins Group, growth is expected to level off in next few months, followed by a gradual slowdown, with some imbalances expected to wane in 2022.  

A word about interest rates…

Interest rates will climb gradually in 2022 and 2023. Desjardins Group forecasts show 10‑year rates rising from 1.60% at the end of 2021 to 2.40% at the end of 2022 and 2.80% at the end of 2023 in the United States, with respective year‑end readings of 1.65%, 2.30% and 3.20% in Canada. In comparison with other periods with high inflation, the anticipated interest rate increases remain small.

A word about currencies…

According to Desjardins Group, changes in monetary policy should continue to have major influence on currencies. It remains to be seen whether the Fed will manage to significantly accelerate the tapering of asset purchases, which would pave the way for an earlier rise in interest rates. The recent appreciation in the U.S. dollar may have been too swift. An easing of risks in the coming months, particularly on the pandemic front, may also drag it lower.

In the very short term, the loonie may have more troubled skies ahead than expected. Tactically, it may trade between 80¢ and 83¢ U.S. in the first half of the year and between 78¢ and 82¢ U.S. in the second half. That being said, optimism about Canada's economic growth next year will prompt the Bank of Canada to get a monetary head start on the Fed, which should give the loonie a temporary boost in the first and second quarters of 2022. By then, it may even hover around 82¢ U.S.

Investment strategies

Returns have been decent in recent years, helping fuel investor expectations. But as the fine print often reminds us, the past is no guarantee of the future … and current expectations of future returns must be managed with the utmost care and humility.

The first challenge for future returns arises from exposure to bonds. Over the past 20 years, the Canadian 10‑year bond rate has averaged 2.9%, compared with about 1.7% at present. As a result, any bond exposure is unlikely to rival past performance. That being said, they still have their place in the portfolio. However, instead of contributing to current returns as in the past, their greatest value could now be limited to the protection they provide. Government bonds still have the advantage of gaining value and remaining liquid during equity shocks, offering opportunities for beneficial rebalancing. They proved it once again in March 2020, and there is nothing to suggest that this is no longer the case.

What alternatives are still available to investors? Alas, there is nothing magical about the financial markets, and investors are limited to 2 options. They can either lower their expectations or add exposure to slightly more at‑risk assets. Note that the second option requires a higher risk tolerance, particularly in a bear market.

As we enter 2022, we are maintaining a cash neutral bias, an underweight to bonds and a slight overweight to equities (55% vs. 50% TARGET). Geographically speaking, Canada and the United States remain our prime targets with overweight positions. Despite recent inflationary pressures, companies have managed to protect their profit margins, and sustained economic growth should be sufficient to maintain them. While perhaps appearing highly optimistic, this is mostly a relative positioning at a time when a number of asset classes are currently overpriced and deals are scarce.

A word in closing…

After a few turbulent years with higher‑than‑expected returns, we're maintaining a marginally pro‑risk positioning without any significant deviations from our targets.

While current inflation remains investors' top concern, it does have company. Keeping close tabs on monetary policy normalization with slower economic growth already expected will be necessary. How will markets react to rate hikes? Will there be any spillover on the housing market? If winter is harsh, what would staunch the rise in European energy prices? Could the pressures pushing up inflation and throttling economic activity trigger stagflation? Will China manage the Evergrande implosion while bringing its tech giants to heel?

Ultimately, all these swirling uncertainties call for a marked, measured and balanced approach. Amid multiple challenges and more volatile times, investors can fully appreciate the value of advice.

We hope this information will help give you a better understanding of the markets. Feel free to contact us for a more in‑depth discussion of our investment strategies. 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.