Source: Bloomberg Finance, LP
Another reason for volatility was change in the tone from central banks. Investors were concerned that tighter monetary conditions would cause a recession. U.S. inflation, as measured by Consumer Price Index, gained 7.0% in 2021 (4.8% for Canada). Inflation reduces the purchasing power of our income and decreases the real return of our investments. For central banks, it is generally a mandate to keep inflation low. With economies performing strongly, unemployment rates returning to pre-pandemic levels, it is time for monetary policy to change. Both the U.S. Federal Reserve and the Bank of Canada have hinted that rate hikes will start in March 2022. The timing has been moved up versus the consensus of just a few months ago. Currently, we anticipate four to five hikes for both the U.S. and Canada. This will take policy rates from 0.25% to 1.25% to 1.50% in Canada, and from 0.10% to 1.10% to 1.35% in the U.S. These rates are higher but still substantially lower compared to normal. This means accommodating policy will continue in 2022. What scares investors the most is that hikes will go so far that they eventually trigger a recession, like some of the previous cycles. Central banks have said their path is data dependent – data including inflation, economic growth and employment. We expect the first couple of hikes to have very little impact to all of the above. However, the annual inflation rate should moderate as we enter the second half of this year. Why are we so confident? This is because some of the data points – monthly inflation for April, May, June and July – were substantially higher than trends due to supply shocks that are continuing to ease. The bad news is anything labour-driven is getting more expensive as wages are increasing to attract workers to return and as oil prices rise. With all of this considered, inflation for the U.S. and Canada this year will probably be close to 4%, which is still a relief. We expect economies to reach equilibrium at 3% inflation and 2% central bank rates. To get to lower than 3% inflation, bank rates have to rise, which increases the likelihood of a recession. We will probably get to the equilibrium sometime in 2023.
Aside from collapse in the speculative segment of the markets – which we do not participate in – and the change in central bank tone reacting to very strong economic conditions, not much is different this year. There is chance our life will be returning to normal as the pandemic turns into an endemic. People are getting hired, paid growing wages and spending. Investors are seeking opportunities to invest; even if we do not care about growth, we need to grow our assets to preserve purchasing power. Our portfolios have held up very well during this correction as we underweight bonds and avoided speculative investments. We will continue to actively manage the portfolios to navigate change in policies and investor sentiments. We are finding opportunities outside of the U.S. and have been trimming U.S. equity and adding to emerging markets and Japan – both would be considered laggards that offer better value. In addition, many countries in emerging markets are either at the middle or end of a tightening monetary cycle. Japan, which suffered decades of disinflation, is unlikely to see rate hikes. These countries offer better value and shelter from the North American rate hike cycle. We recognize there is a growing trend of artificial intelligence, virtual reality and electric vehicles. The common denominators of all these technologies are demand for high-performance semiconductor chips. Even though some of the semiconductor manufacturers may be domiciled in the U.S., which are subject to higher interest rates, their growth is unlikely to change regardless of the timing and size of these rate hikes. It is also important that they are not “new kids in the block”, as they have been around for years with solid balance sheets and cash flows. Their products have been enhanced and use has been changed, allowing their revenue and margins to grow significantly. We are expecting the sector to benefit and have established a significant position to capture this growth.