Markets and investors certainly experienced a rough ride in the first half of 2022.
Sudden shifts in perspectives on demand-supply imbalances for commodities, goods and services, and even labour forced a reconsideration of inflation’s stickiness. Rising consumer price inflation and inflation expectations forced the U.S. Federal Reserve and the Bank of Canada into the most aggressive rate hike cycle in more than four decades. With many of the supply imbalances unresolved, markets began to embrace North American central banks’ resolve in the inflation fight.
And then came the June to July equity and bond market rebounds, which included widespread optimism that central banks would end their hiking cycles in early 2023 and reverse the current monetary policy by cutting rates. Fed chair Jerome Powell dashed those hopes with his brief, pointed speech at Jackson Hole in August, which pushed equity markets down and bond yields back up.
Inflation, meanwhile, looks like it peaked in the summer, at least in North America. The U.S. Personal Consumption Expenditures Index (PCE), the Fed’s preferred measure, hit almost 7% in June, falling to 6.2% in August, year over year. Other evidence indicates that tighter monetary policy is slowing economies as intended. Commodities broadly, with the notable exception of energy in Europe, have seen prices come down, and inventories of many previously scarce durable goods have risen.
The unfolding energy crisis in Europe and the now very familiar “dynamic zero-Covid policy” in China may continue to wreak havoc with global supply chains. The high price of energy and the possible rationing of power in Europe could cause significant hardships for households and businesses throughout the winter.
Market expectations of a potential recession have risen, but they’re not definitive. However, a growth slowdown leading to a borderline recession has been mostly priced in. Earnings expectations overall have fallen slightly quarter over quarter, and the Canadian three-month Treasury Bill versus the 10-year bond yield curve has inverted. A continuation of reduced earnings expectations and prolonged curve inversion increases the odds of a further economic slowdown. And bond market volatility remains quite high, which has elevated the cost of hedging risks across many markets.
Credit spreads have widened but are not yet signalling the expectation of the credit market issues that usually accompany recessions. Much like households, businesses came into 2022 in pretty good shape from a profitability and debt-service coverage standpoint. The higher yield curves that businesses now face will test these fundamentals in the year ahead as existing debts roll over and coupons reset higher. For investors, higher government yields and wider spreads are together offering some of the best absolute returns on investment-grade corporate bonds since 2009.
Considering how the first half of the year unfolded, financial advisors should ensure their clients’ portfolios are well diversified and reconstructed to focus on the long term to absorb ongoing volatility. Here’s how advisors can prepare their clients for the end of the year.
Focus on the long term. While it’s easy to get swept up in the panic caused by current market conditions, advisors should remind their clients not to overreact to short-term bouts of volatility by making drastic decisions. Instead, they should remain focused on their long- or medium-term time horizons, which should allow them to absorb volatility as long as they’re sticking to the right risk level in their portfolios.
Don’t give up on bonds. For perhaps the first time in their lifetimes, investors may be seeing red in the bond portion of their portfolios and be tempted to move their money into savings products. As mentioned above, advisors should steer their clients away from this kind of overreaction. Savings products tend to have very short time horizons and lower available yields, while investment products have a longer lifespan and a wider range of yields. Furthermore, investors may open themselves up to more total portfolio risk by losing the offsetting diversity that bonds provide in their portfolios, which absorbs market volatility in the long term.
Inflation: the end is in sight. While many have felt the immediate effects of inflation in Canada, the good news is that it’s starting to roll over. As such, investors should avoid any drastic moves in their portfolios in reaction to pricing that has already happened. That’s not to say, however, that investors shouldn’t look for ways to build in some inflation-aligned components to their portfolios. For example, investors with too much growth equity exposure can rebalance by adding a value equity strategy or a small amount of commodity exposure for diversification to help with future inflationary periods.
Consider rebalancing. As fairly large geopolitical and policy-driven event risks continue to play out in the markets, there is the potential for tail risk scenarios ahead. Even with inflation rolling over, there are still tight financial conditions, supply chain interruptions, the European energy crisis and the war in Ukraine, which means we can expect volatility to continue. Clients shouldn’t be afraid to rebalance their portfolios. The main thing they should consider is the amount of risk they want in the portfolio. This type of market does provide extra incentive to think about their risk tolerances, and to reconstruct portfolios around emerging risks and new return opportunities.
Steve Locke is chief investment officer, fixed income and multi-asset strategies, with Mackenzie Investments.