Q2 2022 Commentary

JCIConnection

It’s not over … yet.

With the first half of 2022 now in the books, what an unexpected and tumultuous ride it has been thus far. Six months ago, the S&P 500 reached all-time highs in a world where lingering supply chain pressures and potential COVID-19 outbreaks seemed to be equities’ most pressing risks. While those two risks have largely abated throughout the year, the bitter war in Ukraine and elevated levels of inflation around the world suggest the refreshed slate of macro-overhang may be more daunting than ever.

An important market development to note, especially going into the back half of the year, is the balance of performance between U.S. treasuries and equities. Given the ~17% drawdown in the S&P 500 resulting from numerous macro risks, one might think that traditional safe-haven assets such as bonds might have been the proper place to hide. However, through 1H/22, the U.S. 10-year Treasury yield rallied from 1.52% at the start of the year to 3.47% at its peak at the beginning of June, leading to substantial price declines as inflation concerns gained steam in parallel with economic growth risks. It has been interesting to see the recent and swift fall of U.S. 10-Year Treasury yield from a peak of 3.49% to 2.82% in less than a month as the search for better returns and mounting recession concerns take more of a front foot in investors’ minds.

As those concerns grow, it is worth noting that the 10-year US Treasury yield fell more than 30 basis points this past week, settling at near parity with the 5-year Treasury yield. Markets are now pricing in ~7 more 25 basis point hikes by the Federal Reserve by the end of this year but have also recently begun to reflect expectations for rate cuts coming in early 2023. Whether it is a lack of conviction, a broader state of confusion, or general exhaustion that has taken hold across market participants, this has become a market that does not seem to know what it wants amid a flurry of crosscurrents.

The next few months will be pivotal in deciding where we will land at year-end. As 2Q22 earnings are quickly approaching, this could finally be the inflection point for a market that has been overwhelmed as of late. Earnings revisions breadth across the S&P has now been firmly negative for weeks (currently -1.9%), but at the same time, we have yet to see earnings cuts from companies broadly rollover.

The market needs to re-calibrate economic risks fully. So, this becomes a matter of not just if we get a soft patch for growth, but when and for how long? Growth risks are becoming more front-loaded, and with the Fed staying restrictive as inflation remains persistent, we may stay with weak growth for longer.

Based on the data we track, significant parts of the economy (the consumer) and corporate profitability remain solid and will support stocks from current levels. According to research from BMO, U.S. stocks typically bottom not long after reaching the 20% decline mark. The recent S&P 500 Bull market (March 2020 to January 2022) was one of the shortest in history, lasting just under 22 months. Yet it doubled prices in only 17 months, which marked the fastest 100% gain during a Bull market ever. This serves as a reminder to investors that stocks can experience sharp and swift moves in both directions, a trend we have been seeing since the onset of the pandemic and one that may very well continue in the months ahead.

During non-recessionary bear markets, U.S. stocks typically bottom not long after hitting a 20% decline threshold

Despite all of the tea leaves we have seen across companies delaying/slowing hiring plans, the economic data continues to suggest a far more robust landscape for companies hiring.

We even saw job gains in goods-producing sectors, which are generally more sensitive to interest rates. It is also worth highlighting that manufacturing and construction jobs continued to increase, another positive signal for the economy. It was a bit concerning to see prime-age participation fall 30 basis points to its lowest level since March, adding tension to an already tight labour market.

What happened during the Second Quarter?

The second quarter of 2022 was challenging. After a resilient performance in Q1, the TSX Composite total return declined 13.2% during Q2. The S&P 500 total return dropped 13.5% in Canadian dollar terms. The MSCI EAFE (non-North American developed markets) descended 11.6% as well. The fixed income market also provided losses of 5.7%.

When we look at global sector performance during the quarter, out-performance was from some of the most defensive sectors, including Consumer Staples, Utilities, and Healthcare. These are sectors that should have more resilient earnings during a recessionary environment. Energy remained the strongest sector during the quarter, but it has pulled back significantly from peak levels seen on June 8th (down 17% in CAD$). Despite the resiliency, these defensive sectors are still down mid-single digits for Q2. All other sectors declined from 14% to 23%, with Consumer Discretionary and Information Technology performing the worst.

During the first quarter, inflation expectations rose significantly, with actual inflation data repeatedly reported as higher than expected. We can see in Figure 1. that inflation expectations implied in the futures market ramped up considerably in the first few months of 2022. In turn, this has moved up expected rate increases from various central banks globally. Figure 2. demonstrates how much central bank rates for December 2022 have risen since the start of the year. Rate increase expectations continued to rise during the quarter as inflation continued to show no slowing down, as in Figure 3.

There has been a tug of war between inflation fears and recession fears. Figure 1. shows that inflation expectations in the futures market peaked at the end of March and have been on a downward trend since. Looking at the CRB All Commodities Index (Figure 4.), we can see prices have already peaked back in early May this year. This helps to explain the peak in inflation expectations even though actual reported inflation has not demonstrated a peak (Figure 3.).

As inflation has remained stronger than expected and rate increases are going to be greater than initially anticipated earlier this year, the market is now concerned over recession risk. Figure 2. shows that December 2022 central bank rate expectations have been coming down since mid-June on these recession fears. Figure 5. confirms this fear as Corporate High Yield credit spreads have widened.

Inflation has remained persistently high. At first, it resulted from pent-up demand coming out of COVID-19 lockdowns. There were significant savings during COVID-19, which continues to be deployed. COVID also had a significant negative impact on global supply chains. Then the Russia-Ukraine war further put pressure on energy, commodity, and agricultural prices. In addition, wage growth has been coming in above trend with labour coming back into the workforce (Figure 6. Unemployment Rate) and a tight labour market.

Ultimately, a recession is becoming a more likely scenario with high food prices, high energy prices, and rising interest rates all going to impact growth. However, we are not of the view that we will have a deep recession. We expect rising rates to have the desired effect on inflation, and we have already seen many input costs peaking. We also believe that the labour market will remain strong enough to prevent a more material recession.

With this backdrop in mind, we have made some portfolio changes. Within Fixed Income, exposure has been on the lower end of its historical range as our long-term view for Fixed Income returns has been negative. We also kept the duration (time to maturity) shorter than the overall bond market, and our corporate bond exposure has been similar to our government bond exposure.

Overall, our Fixed Income positioning has helped the portfolio’s relative performance. Over the short- to medium-term, we believe the outlook within fixed income has improved and may look to change positioning. We have also reduced our exposure to equities across Canada, the U.S. and internationally and raised cash positions. As we get closer to more visibility on the earnings outlook (estimates are likely to decline during the year’s second half), we will look to deploy some cash into compelling opportunities in the equity market. We reduced exposure to information technology, communication services, and interest-rate-sensitive financials during the quarter.

The current market valuation looks compelling (Figure 7.), with Canadian and international markets trading well below one standard deviation below their 10-year average.

The U.S. market is trading below average levels. However, earnings estimates have yet to show weakness and should be coming down soon. It is unclear how much they will be cut, but this will be key in determining how cheap the market is.

Over the long term, the biggest driver of equity market performance is ultimately determined by earnings growth and cash flow generation through recessions and economic expansion. Our Canadian equity exposure has proven the most resilient against other markets and has declined less than the Canadian equity market. The most significant contributor has been the energy exposure which we increased in the latter part of 2021. We did sell some exposure earlier this year to lock-in some of the strong performance.

Our exposure in U.S. and International Equity has not performed as well. In the U.S., exposure to large-cap technology like AMD, Microsoft, and Apple has hurt, although these have been solid long-term performers, and we continue to see them as core positions.

Within international equities, our exposure to consumer discretionary and industrials was a drag as these sectors have declined on recessionary fears. But ultimately, as we take a three- to five-year view on our positions, we see very compelling investment opportunities within our portfolios.

Investments with a future.

Within our current portfolios, we see a few companies, which have underperformed in their markets recently, but we think there is a strong outlook going forward.

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