The past year proved challenging for financial markets, ending in losses for both equities and bonds.
The U.S. equity market (S&P 500) declined by 18.1% (12.2% in Canadian dollar terms), while Canada did relatively better with the TSX declining 5.8% for the year. Further, the Canadian bond universe lost over 11% during this period, reflecting the rapid rise in lending rates by the Bank of Canada.
These poor results were impacted by three major events which contributed to lower valuations and increasing concerns of recession. First was the high rate of sustained inflation, leading most central banks to tighten money supply and increase interest rates. Second was the invasion of Ukraine by Russia. Third was China’s comprehensive lockdown and economic slowdown as it continued to battle COVID-19.
The U.S. Federal Reserve led the developed world’s central banks by increasing its prime lending rate from near zero to a range of 4.25 – 4.50%. While inflation has been moderating, it remains stubbornly high, inviting further rate hikes. The challenge is to reduce inflation without driving the economy into a recession. We believe this is wishful thinking given the blunt nature of monetary policy and are anticipating a mild recession in 2023.
Confounding this economic landscape is the continuing tight labour market and net job creation. This is usually not part of a recessionary scenario and does point to a degree of resilience within the economy. While the recent layoff of 150,000 tech workers attracted headlines, the U.S. economy added a stunning 4.5 million new jobs over the past year, the second largest gain on record.
The invasion of Ukraine by Russia, and its obvious lack of success, portends an extended conflict. Commodity prices for energy, food and minerals have increased as a result, and will remain elevated if this war is prolonged. The lengthy lockdown in China, suddenly reversed in recent weeks, has revealed cracks in the world’s second largest economy. An overly levered property market is a major concern, as real estate development represents 25% of China’s GDP.
As dismal a year as 2022 was, there is room for optimism in the year ahead. Inflation will continue to decline with time. Further, the era of cheap money of the past 15 years is over for the foreseeable future. As witnessed this past year, the return to more normal interest rate levels tends to reverse the excesses building in financial markets, whether it is speculation in momentum stocks, the overextension of private equity and other alternative asset valuations, or the frenzy in cryptocurrencies. In addition, the recent rise in interest rates is returning the global economy to a more “normal” footing. Equity markets tend to look forward, and will begin to anticipate the next up cycle, as the global economy returns to growth in late 2023 and into 2024.
Our focus on owning quality investments and maintaining elevated levels of cash has helped protect the value of your portfolio over the past year. We remain disciplined in this approach as we head into 2023.