The past year witnessed very strong performance in North America’s equity markets. As measured in Canadian dollars, the S&P 500 delivered a 28% total return in the United States while the S&P/TSX generated a return of 25% in Canada. These were extraordinary returns, but they were not evenly distributed. In the U.S., just five technology-related companies generated over 50% of the S&P 500’s performance from April onwards. Furthermore, the top performing individual sector was oil and gas, which also helped propel the strong performance in Canada.
Equity markets are bifurcated. Strong recent performance has been driven by a limited number of large companies and one or two sectors. For most public companies, share price performance has been comparatively pedestrian.
As the COVID-19 pandemic continues to hit society in successive waves, governments in the developed world continue to deficit spend at record levels while their central banks maintain interest rates near zero. These two macro economic factors have created over-stimulated economies. With demand for goods at record level highs, a shortage of qualified labour, and supply chains pushed beyond their design capacity, the world has entered a serious inflationary period for the first time in four decades.
Interest rates have been at record low levels since the financial crisis began in late 2008. Over these past 13 years, cheap money has inflated the valuation of virtually everything. While equity markets performed well over this period, so has the residential housing market as well as most other types of assets. However, excessive inflation generally has a negative impact on both debt and equity markets. Central banks have arguably waited too long to tighten the money supply. While political leaders would prefer not to see any rate increases before 2023, this seems highly unlikely. We expect that central banks will reduce quantitative easing early this year, followed by a series of measured but modest interest rate increases over the next 24 months. The days of free money appear to be ending.
A rising interest rate environment is sure to cool off an overheated economy and certain overheated sectors of the market. It could mean that the strong returns witnessed in the equity markets in 2021 will not be repeated. This is not necessarily a bad thing, even if it could result in some additional volatility. A return to some higher level of interest rates signals a return to economic normality. A cooled off but still growing economy gives supply a chance to catch up with demand, reducing the current stress on global supply chains.
Our objective is to provide you with steady performance returns over the medium and long run. A lower pace of sustained growth, with some normalization of interest rates, will create an environment that best suits our investment style and approach. Inevitably, fund flows will shift away from the small number of companies that have benefitted from momentum, in search of more reasonable valuations supported by strong fundamentals. This should in turn result in a larger number of companies contributing to overall performance, a sign of a healthier market.
Our society remains in a difficult period, particularly with regards to public health and psychological well being. Despite these challenges, we remain constructive for the investment horizon ahead of us. We wish you all the best for a happy and healthy 2022.