Tapping the Brakes

Navigating the start of 2022 has required the investment community to keep a calm head and two hands on the wheel.  Three risks dominated the markets: the Omicron wave, a spike in commodity prices and an attendant jump in borrowing rates as central banks move to keep inflation in check, and the war in Ukraine.  This caused some outsized moves in commodities, currencies, and interest rates, and more modest declines in global stock markets, as you can see below.

There’s an old bond market saying that when the Fed taps the brakes, someone goes through the windshield.  Central banks have been doing a lot of brake tapping in recent weeks, with the Bank of Canada raising their benchmark borrowing rate 0.5% last week and the U.S. Federal Reserve increasing rates by 0.25% in March and strongly hinting they will take more aggressive action at their upcoming meeting in May.  As we highlighted in our year in review in January, central banks have a dual mandate: full employment and price stability.  Having achieved the former (Canada’s unemployment sits at 5.3%, its lowest rate on record, and U.S. unemployment sits at 3.5%, a 50-year low), they are now laser focused on the latter.  With core inflation climbing at the fastest rates since the early 1980s, central banks needed to tamp down demand by increasing borrowing costs, or they risked facilitating the wage/price spiral that led to the stagflation of the 1970s. 

So far, they have succeeded.  Admittedly, it has been no Sunday drive, to continue the analogy, as both bonds and stocks have experienced declines since the beginning of the year.  But the car hasn’t veered off the road, and no one has gone through the windshield, except perhaps the Russian ruble. 

While there has been a huge jump in grain and energy prices resulting from Putin’s invasion of Ukraine, and the lockdowns in Shanghai which will inevitably result in further supply chain disruptions; long term consumer inflation expectations remain firmly anchored near long-term averages.  Unlike the 1970s, very few are rushing out to buy used cars or rent an apartment because they think it will be meaningfully more expensive to do so in 5 years.  This is essential to keep the wage/price spiral in check, which would risk a repeat of the 1970s, which was very damaging to businesses and the economy alike.

We would be remiss if we didn’t point out that the yield curve inverted briefly a few weeks ago, as the yield on 2-year U.S. Government Bonds briefly moved higher than 10-year U.S. Government Bonds before steepening back out the following week. For some context, yield curve inversions have pre-dated every U.S. recession since the early 1970s, though its predictive capabilities are mixed and markets can rally substantially after they invert. Our view is that a diversified, balanced approach to investing should soften the blow of any slowdown, and the inversion should be viewed as an advance warning rather than a call for dramatic action. And unlike earlier inversions, financial conditions aren’t precarious and real rates remain in negative territory.  In short, while ominous, this is occurring against a relatively strong economic and financial backdrop.

While growth prospects have fallen over the past few months, there are several tailwinds that should support the markets going forward.  Labour markets remain very strong, and, while confidence has taken a hit, consumers and corporations alike have very strong balance sheets with limited debts and excess cash to spend.  Investor positioning remains defensive, and sentiment is washed out, with recent institutional surveys showing an even more bearish outlook than in March of 2020.  With expectations set low, companies have a low hurdle to clear at a time when valuations have already moved lower, creating a positive set up going forward.  Finally, not all central banks are increasing borrowing costs or removing policy supports.  One notable exception is China, which is cutting rates and easing regulatory burdens to offset the drag created by Omicron. 

As mentioned, a diversified approach with a mix of bonds, credit and GICs to hedge against the risks of a slowdown, and inflation hedges like stocks, infrastructure and real assets is the right vehicle for long-term success as it positions investment portfolios to weather various market conditions.  As always, you can expect us to keep our eyes on the road and two hands on the wheel.   

 

 

 

 

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