The first-half of 2022 proved to be a challenging time for global financial markets. High inflation, rising interest rates, the ongoing conflict in Ukraine and persistent supply-chain challenges have acted as a myriad of headwinds for financial markets. Notable indexes for both risky assets (stocks) and less-risky assets (bonds) have suffered double-digit losses since the start of the year. On a relative basis, client portfolios have performed well and have continued to protect capital during the market weakness.
Much of the weakness seen thus far has come from stock market valuations being reset. The high-flying growth (ie. technology) stocks that reached unprecedented valuations during the pandemic were the first to fall near the start of the year. Notable U.S. indexes, including the technology-heavy Nasdaq index and the S&P 500 index (500 largest publicly-traded companies in the U.S.), have seen significant losses, declining 21% and 30% respectively from the start of the year to the end of June. Since the end of March, other sectors have started to follow-suit. The Canadian TSX Composite index (~250 largest publicly-traded companies in Canada), which consists of more financial and commodity stocks, was a standout performer until April but has now declined 11% from the start of the year to the end of June.
Many higher risk and speculative assets have suffered even larger losses. The euphoria that encapsulated cryptocurrencies for the better part of the past two years has largely faded. The total market value of cryptocurrencies has fallen from over $3 trillion to less than $1 trillion. The price of Bitcoin has declined more than 50% since the start of the year while many other “Altcoins” have suffered even larger losses.
One of the challenges investors have faced is that this market weakness has come during a period of rising bond yields. Historically, high-quality bonds have tended to perform well during periods of market weakness as many investors would typically undertake a flight-to-safety by buying high-quality bonds, thus raising bond prices. However, bond yields have shifted upwards with rising interest rates. Bond prices fall as bond yields rise and this has created a rare situation where bond prices have fallen alongside stock prices. The FTSE Canada Mid Term Corporate Bond Index, which consists of Canadian bonds with a maturity of 5 to 10 years, has declined 12% since the start of the year through June 30.
Now that stock valuation have reset, we expect that company earnings may continue to suffer as high inflation and rising interest rates continue to take hold. Inflation has a tendency to propagate quickly throughout industries as rising input costs lead to higher prices and pressure household incomes. Workers must then seek higher wages to offset higher household expenses which further drives up labour input costs. This can cause a wage-price spiral to take hold as the cycle repeats and company margins are squeezed. Higher interest rates serve as an attempt to avoid this spiral by reducing consumer demand to drive down prices. With higher interest rates, consumers will need to prioritize core monthly expenses over discretionary spending. This is ultimately a lose-lose situation as rising input costs followed by lower demand leads to lower earnings.
During these uncertain times, we continue to emphasize the benefit of a conservative approach and investing with a margin of safety. Over the long-term, valuations have shown to be a reliable indicator of expected returns and the potential for losses during periods of weakness. They should therefore be considered fundamental to any investment decision. We continue to remain focused on owning good companies with strong pricing power to combat margin compression, but at fair or discounted valuations. We view the current weakness as an opportunity to evaluate some of these companies that did not previously trade at fair valuations. From a fixed income standpoint, although rising yields continue to pressure bond prices, they have presented an opportunity in shorter-term fixed income investments as short-term yields have risen significantly over the past year.
Disclaimer: This information is not intended to be comprehensive investment, tax or legal advice applicable to the individual circumstances of a potential investor and should not be considered as personal investment advice, an offer, or solicitation to buy and/or sell investment products. Every effort has been made to ensure accurate information has been provided at the time of publication, however accuracy cannot be guaranteed. Interest rates, market conditions, tax rules and other factors change frequently and past investment performance does not guarantee future results. The manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein. Please consult an investment manager prior to making any investment decisions.