Q1 | 22
No doubt, war is a human tragedy.
There are no winners. In the investment world. The Ukraine/Russian conflict has certainly heightened uncertainties. Geopolitical conflict in Eastern Europe remains fluid. As investors, we need to study the war’s implications and impacts on our investments.
We believe the COVID-19 pandemic started structural shifts and the Russian war has now accelerated those trends. For starters, inflation proved not to be transitory. Supply chain issues from COVID-19 created sticky inflation. Now, the Russia/Ukraine war, as well as the recent surge in Omicron cases in China, has inflation surging in many areas. Inflation is being driven by wages, housing and commodities.
Longer term, we believe the Russian invasion has reinforced the importance of National Security. This will result in de-Globalization and permanently higher input costs. As low-income families see their purchasing power declining amidst higher prices, the health of the consumer and pricing power of corporations have become important factors impacting future cash flows and margins.
The first quarter 2022 returns can be summarized as “Energy Up, Bonds Down”. The S&P 500 fell 4.6% in U.S. dollars. The heavy energy-weighted Canadian stock market outperformed the U.S. market in Q1, climbing 3.8% in Canadian dollars. In fixed income, after posting a negative return in 2021, U.S. and Canadian bonds posted a negative Q1 return. The U.S. 10-year Treasury Bond closed at 2.3% up from 1.5% at year-end 2021. Canadian and U.S. interest rates are now above pre-pandemic yields. In the quarter, this interest rate increase is reflected in the Canadian Bond Universe falling 7.2%. The currencies were stable in Q1, as the Canadian dollar was up 1% versus the U.S. dollar.
Although Covid-19 continues to be part of our lives, the stock market was dominated with news of inflation, Central Bank tightening and the Russian/Ukraine war. In Q1 2022, all S&P 500 sectors were negative except Energy and Utilities, and even that was not close. Energy was up 37%, far ahead of Utilities which were up only 4%. The same story in Canada. Energy was up 29%.
Given a more challenging macroeconomic environment, uncertainty remains high for 2022. We entered this acceleration in inflation with interest rates near historical lows. Given the backdrop of central bank tightening to fight inflation and ongoing supply chain disruptions, we expect Central Bankers to hike rates at a fairly consistent pace throughout 2022.
The greatest challenge to growth will be in Europe but economic activity in the U.S. and Canada will also be negatively impacted into 2023. A tight labour market, strong home price appreciation and an ongoing inventory restocking cycle remain bright spots for the economy. The strong labour market should not be understated. The U.S. unemployment rate fell to 3.6%, lower than it has been in all but 5 months since 1969.
Higher for longer is likely to persist across the commodity arena. The war has turbo-charged what was already an unsettled back-drop for commodities. The reality is that both a lack of investment in the old economy and natural resources (like oil and natural gas) and a surge in interest in renewable platforms – many of which require hard to find commodities like nickel, lithium, etc. – were already an issue.
Equities are a good inflation hedge, and companies with high cash flows and rising dividend yields should outperform in the environment we envision. As we look ahead, we think we are stuck between three forces: war in Ukraine, supply chain issues in China (driven by rising Omicron cases), and above average inflation in North America. These forces are not likely to get ‘fixed’ overnight. The offsets are that productivity is booming, consumer savings is high, and unemployment is low.
On economic growth, it still seems likely that strong demand will cause the economy to grow above its potential in 2022. Consumer spending should remain strong, reflecting solid income growth, strong balance sheets and pent-up demand. It is hard to see how even 7 more rate hikes the Federal Reserve projects for 2022 will derail this growth. The most interest sensitive sectors of the economy, home-building, capital spending and, to a lesser extent, auto sales, are all experiencing massive pent-up demand which is unlikely to be reduced significantly by modest increases in very low interest rates.
On the flip side, the challenge for the Central Bankers is to orchestrate a soft landing. Historically, this has been difficult to do. There is a chance that we get a tradeable 10% or more correction in 2022. This would represent a major break from the 2021 near-nirvana backdrop, would not be unexpected. We have raised cash to be redeployed when market opportunities arise. In fixed income, we are holding minimum fixed income allocations, high quality Investment Grade bonds and short duration.
In summary, we are in a period of uncertainty. We are about to reverse an unprecedented 13-year period of Global Co-ordinated Accommodative Central Bank Policy. On the flip side, yields are low and investors need exposure to real assets whose cash flows can grow with inflation. Now more than ever, it is time to hold Quality. As we navigate the expected volatility in 2022, LDIC will seek strong management teams, reasonable valuations, strong balance sheets and cash flow generators.
If you have any questions, please contact us at 416-362-4141.