Financial markets remained turbulent throughout the second quarter of 2022, as inflationary pressures (the highest in 40 years) and the prospect for more aggressive interest rate hikes continued to weigh on investor sentiment. Monetary policymakers aggressively stepped up their tightening measures in an attempt to prevent inflation (thought of as “transitory” just six months earlier) from becoming entrenched in the economy. The Bank of Canada and the U.S. Federal Reserve raised their target interest rates by 100 and 125 basis points (bps), respectively, during the second quarter.
The tightening in financial conditions was the key driver in leading to both the bond and equity markets tumbling. Commodity prices trended higher early in the year, but concern about demand destruction associated with the increasing probability of a recession caused a sharp pullback near the end of the quarter.
The FTSE Canada Universe Bond Index posted a quarterly loss of 5.66% over the second quarter. Bond yields continued their ascent, with two-year yields rising 83 bps in Canada and 63 bps in the U.S., and 10-year yields up 82 bps in Canada and 68 bps in the U.S. Although the widening of Corporate and provincial bond spreads is noteworthy as a sign of increasing risk aversion, it is the inverted nature of the U.S. yield curve that should be top of mind. In the U.S., mid- and longer-term yields are below shorter terms yields – and significantly so – which has been a very reliable indicator of a pending economic recession.
The MSCI All Country World Index declined 13.5% in local-currency terms (-12.8% in Canadian dollar terms) over the second quarter. The Canadian equity market declined a similar amount, dropping 13.2%. Emerging markets equities outperformed their developed market peers, with the MSCI Emerging Markets Index posting a -8.0% return (in local-currency terms).
Looking deeper within equity market trends, we see that returns from so-called “growth” funds have been the weakest. These types of companies are often less profitable and have future cash flows further out in the future, a profile that gets hit harder when interest rates rise. This investment style has also had the longest run of strength, raising valuations to unsustainable levels.
Europe is a region to watch, and for all the wrong reasons. Europeans are likely to be facing a challenging winter with respect to affordable energy, and periods of economic stress highlight the difficulties in adopting a one-size-fits-all set of monetary policies across the Eurozone. Many European equity indices were down over 20% in the first half of the year.
Beginning mid-July, it seems market participants have transitioned from fears of inflation and rate hikes to anticipating better times ahead. Inflation may have indeed peaked in July; in the U.S., CPI decreased fractionally, raising hopes of Central Banks easing back on their rate-hiking plans. Post-quarter end, equity markets, and risk assets in general, have rallied significantly.
But will it last? There are a number of economists and research services suggesting a continued decline in economic growth for multiple quarters. The reasons for this are beyond the scope of this update, but there are many given. Historically, environments of declining inflation and economic growth have been very bad for equities, but have all included breathtaking bear-market rallies popping up occasionally to trap the unwary. Being “macro aware” and diversified, with a long-term disciplined plan, is the best defense to get through these periods of market volatility.