Escalating geopolitical tensions related to uncertainty around the war in Ukraine and prolonged supply chain disruptions have shifted stagflation concerns towards recession, as the first quarter of 2022 in in U.S. experienced negative growth. The emergence of highly transmissible COVID-19 variants also continues to risk derailing the global economic recovery. Central banks are weighing aggressive monetary tightening, in response to the current high inflation against recession risks. The inflation that we are experiencing today is less a ‘monetary phenomenon’ and more the result of adverse supply shocks, coupled with large fiscal injections that occurred during the pandemic. Any restrictive Fed hikes will coincide with a tightening of fiscal policy, economic weakness abroad, and war on Europe’s doorstep, fueling further commodity dislocation. In June, we maintained our outlook for three months of Recession followed by nine months of Inflation for the U.S. economy.

China is currently experiencing an Omicron outbreak that has prompted lockdowns and a prolonged downturn in the property sector. The Chinese economy expanded 4.8% year over year in Q1 of 2022, slowing from an 8.1% expansion last year, which was the steepest pace in nearly a decade. Retail sales fell 3.5%, down for the first time since July 2020.1 China’s annual inflation rate was at 2.1% in May 2022.2 The Euro Area economy expanded 5.4% year-on-year in the first three months of 2022, the biggest annual gain in three quarters.3 Annual inflation rate in the Euro Area increased to 8.1% in May of 2022, a fresh record high, from 7.4% in each of the previous two months.4 The unemployment rate in the Euro Area was unchanged at a record low of 6.8%.5

The U.S. economy contracted an annualized 1.5% on quarter in the first three months of 2022. Imports surged and exports dropped slightly less.6 The annual inflation rate in the U.S. unexpectedly accelerated to 8.6% in May of 2022, the highest since December of 1981. Energy prices rose 34.6%, due to gasoline (48.7%), fuel oil (106.7%, the largest increase on record), electricity (12%), and natural gas (30.2%).7 The trade deficit in the U.S. narrowed to a four-month low of $87.1 billion in April of 2022. Exports were up 3.5% to a record high. The deficit with China decreased $8.5 billion to $34.9 billion, with imports falling by $10.1 billion, the most in seven years.8 GDP in Canada expanded 0.8% on quarter in the first three months of 2022, the weakest performance in three quarters, due to a 2.4% drop in international exports volumes, mostly energy products.9 Canada’s annual inflation rate increased to 6.8% in April of 2022, the highest since January of 1991.10 The unemployment rate in Canada fell to 5.1% in May of 2022.11 Canada posted a trade surplus of CAD 1.5 billion in April of 2022, narrowing from a downwardly revised 2.3 billion surplus in the prior month.12 The Canadian central bank hiked the overnight rate by 50 basis points to 1.5% in early June.13

Equity market risk has shifted from interest rates (and the discount rate) to earnings. U.S. equities suffered in May, as inflation concerns along with Fed rate hikes weighed on markets. As a result of a comeback in the final week of the month, the S&P 500 posted a slight gain of 0.2%, while the S&P Mid Cap 400 and S&P SmallCap 600 were up 0.8% and 1.9%, respectively. U.S. fixed income performance was mostly positive while gains in commodities continued, particularly in the Energy sector. Canadian equities were flat for the month, with the S&P/TSX Composite up 0.1%. Switzerland and Denmark weighed heavily on the S&P Europe 350, pulling the benchmark to a loss of 0.6% in May. Among S&P Europe 350 sectors, Energy took the top spot with an 11% gain, extending its year-to-date advance to 36%. U.K. inflation-linked bonds were hit particularly hard, off 9%, extending its decline for a sixth straight months. The S&P China 500 and S&P Hong Kong BMI both gained 3%.

In June we maintained the defensive asset allocation that was set in May. Cash remains at 10% across all models. U.S. earnings are beginning to show signs of stress in industries where inflation is impacting consumption. The safe haven status of gold in times of uncertainty, including war and inflation, is central in our asset allocation. Canadian oil and liquid natural gas directed through the U.S. pipeline system for export to Europe is benefiting Canada.

June has witnessed financial market volatility and uncertainty. The war in Ukraine and sanctions on Russia continue to push prices of commodities higher. The current positively correlated bond and equity markets have created an investment environment where opportunities are rare and fluid. Our outlook reflects these developments. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP. April 18, 2022.

2 Trading Economics. China Inflation. June 10, 2022.

3 Trading Economics. Europe GDP Growth. June 6, 2022.

4 Trading Economics. Europe Inflation. May 31, 2022.

5 Trading Economics. Europe Unemployment Rate: Eurostat. June 1, 2022.

6 Trading Economics. U.S. GDP Growth. May 26, 2022.

7 Trading Economics. U.S. Inflation. June 10, 2022.

8 Trading Economics. U.S. Trade Gap: Bureau of Economic Analysis. June 7, 2022.

9 Trading Economics. Canada GDP. May 31, 2022.

10 Trading Economics. Canada Inflation. May 18, 2022.

11 Trading Economics. Canada Unemployment: Statistics Canada. June 10, 2022.

12 Trading Economics. Canada Trade. June 7, 2022.

13 Trading Economics. Canada Central Bank Rate Decision. June 1, 2022.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. May 31, 2022. Index performance is based on total returns and expressed in the local currency of the index.

The economic recovery from the downturn caused by the coronavirus pandemic continues and multiple macro risks persist. Inflation due to supply shortages as well as fiscal spending, government debt, more hawkish central banks, and an uncertain labour market are afflicting developed economies around the world. The risk of a sharp slowdown in the coming months has heightened. Concerns over recession are starting to outweigh those of inflation. In May, we pushed out our Inflation outlook and updated our current outlook to three months of Recession followed by nine months of Inflation for the U.S. economy.

The Chinese economy expanded 4.8% year over year in Q1 of 2022. March activity showed retail sales fell 3.5%.1 China’s annual inflation rate accelerated to 2.1% in April 2022 from 1.5% in March, the highest reading since last November.2 The Gross Domestic Product in the Euro Area expanded 5.1% in the first quarter of 2022.3 The economic outlook for the Euro Area is subdued as the war in Ukraine continues, exerting upward pressures on commodity prices. The annual inflation rate in the Euro Area rose to a record high of 7.5%.4 The unemployment rate in the Euro Area fell to a record low of 6.8% in March. Among the biggest economies in the Eurozone, declines in the jobless rate were seen in Germany (2.9% vs 3%) and Italy (8.3% vs 8.5%).5

The American economy contracted at an annualized 1.4% in the first three months of 2022, following 6.9% growth in Q4 2021. Gross private domestic investment slowed sharply (2.3% vs 36.7%).6 Annual inflation slowed to 8.3% in April from a 41-year high of 8.5%.7 The U.S. trade deficit widened sharply to a record high in March. Exports dropped 5.9%, while imports surged 17.7%. The trade deficit with China increased to $34 billion from $30.7 billion in February.8 Canada’s annual inflation rate rose to 6.7% in March, against the backdrop of sustained housing prices, substantial supply constraints, and geopolitical conflict that lifted prices for energy and agricultural markets.9 The unemployment rate in Canada fell to 5.2% in April.10 Canada posted a trade surplus in March, largely due to crude oil and bitumen, as the war in Ukraine lifted energy prices worldwide.11

U.S. equities continued to face obstacles in April, as poorly received earnings, especially from Big Tech, inflation fears, and looming Fed rate hikes were reflected in the markets. The S&P 500 posted a loss of 8.7%, logging its worst monthly performance since March 2020. The S&P MidCap 400 and S&P SmallCap 600 were down 7.1% and 7.8%, respectively. U.S. fixed income was weak across the board. The S&P/TSX Composite was down 4.9% in April. International equities also disappointed in April, with the S&P Developed Ex-U.S. BMI down 7% and the S&P Emerging BMI down 5%. The Netherlands and Germany weighed heavily on the S&P Europe 350, pulling the benchmark to a loss of 0.4% in April. U.K. equities bucked the trend, rising 0.9% and moving up to 6% year-to-date. Among S&P Europe 350 sectors, Consumer Staples took the top spot with a 5% gain, while Information Technology fell a full 7%. The S&P Pan Asia BMI extended its losses into April, plunging 6.4% and posting a fourth consecutive month of declines. Japan dragged the index down the most. Bonds moved in tandem with equities, with both local currency and USD-denominated debt edging lower across Asia, declining 4% and 3%, respectively.

In response to the inability of our optimizer to find a solution for our most conservative model in May, we updated our asset allocation, increasing cash to 10% in all models and reducing exposure to large-cap U.S. equities by the same amount. We continue to see U.S. earnings as strong, but inflation is beginning to hit consumption in many industries. The safe haven status of gold in times of uncertainty, including war and inflation, is central in our asset allocation. Canadian oil and liquid natural gas directed through the U.S. pipeline system for export to Europe will benefit Canada.

As the war in Ukraine and sanctions on Russia continue to push prices of commodities higher, high inflation readings and hawkish messaging from Central Banks have caused sovereign bond yields to continue their ascent. The current positively correlated bond and equity markets have created an investment environment where opportunities are rare and fluid. Our outlook reflects these developments. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP. April 18, 2022.

2 Trading Economics. China Inflation. May 11, 2022.

3 Trading Economics. Europe GDP Growth. May 17, 2022.

4 Trading Economics. Europe Inflation. April 29, 2022.

5 Trading Economics. Europe Unemployment Rate: Eurostat. May 3, 2022.

6 Trading Economics. U.S. GDP Growth. April 28, 2022.

7 Trading Economics. U.S. Inflation. May 1, 2022.

8 Trading Economics. U.S. Trade Gap: Bureau of Economic Analysis. May 4, 2022.

9 Trading Economics. Canada Inflation. April 20, 2022.

10 Trading Economics. Canada Unemployment: Statistics Canada. May 6, 2022.

11 Trading Economics. Canada Trade. May 4, 2022.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. April 30, 2022. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The recent inflation surge is generating two challenges to the global expansion. The immediate one comes from a squeeze in household purchasing power, concentrated in Europe and low-income commodity importing nations. If growth stalls in the second half of the year, it will likely have negative repercussions for both growth and inflation. If growth proves resilient, then risks rise that the inflation surge passes through to price and wage setting, requiring tight monetary stances. In April, we updated our current outlook to three months of inflation followed by nine months of stagnation for the U.S. economy.

The Chinese economy expanded 4.8% year over year in Q1 of 2022.1 China policymakers are dealing with a significant weakening amid lockdowns to bring the Omicron wave under control. China’s surveyed urban unemployment increased to 5.8% in March 2022 from 5.5% in the previous month. The latest figure marked the highest jobless rate since May 2020, amid re-imposing COVID-19 restrictions following widespread outbreaks.2 The annual inflation rate in the Euro Area surged to an all-time high of 7.5% in March, compared to 5.9% in February, as the war in Ukraine and sanctions on Russia pushed fuel and natural gas prices to record high levels. Energy recorded the highest annual rate, with prices of other items, including food rising also.3 The unemployment rate in the Euro Area fell to a record low of 6.8% in February of 2022. Among the biggest economies in the Eurozone, declines in the jobless rate were seen in Spain, Italy, and France.4

The American economy expanded an annualized 6.9% annualized in the last three months of 2021.5 The U.S. unemployment rate declined to 3.6% in March from 3.8% in the previous month.6 The annual inflation rate in the U.S. accelerated to 8.5% in March of 2022, the highest since December of 1981. Energy prices increased 32%, as gasoline and fuel oil were impacted by Russia’s invasion of Ukraine. Food prices jumped 8.8%, the most since May 1981.7 The trade deficit in the U.S. remained near record levels of $89.18 billion in February, as imports continue to rise amid robust demand and rising oil prices. Imports were up 1.3%, on higher shipments of crude oil, other chemicals and petroleum products, fuel oil, and capital goods. Trade deficits were recorded with China, the EU, Mexico, and Canada. The goods gap with Russia widened to $2.1 from $1.6 billion.8

The unemployment rate in Canada fell to 5.3% in March from 5.5% in February. It was the lowest rate on record since comparable data became available in 1976, marking a robust recovery for the labor market from the Covid-19 pandemic.9 Canada posted a trade surplus in February, narrowing from an upwardly revised 13-year high surplus in the previous month. Imports rose by 3.9%, due to uncertainty about the future supply of metals from Russia. Exports rose by 2.8% to a record-high, led by sales of energy products (up 7.8%), largely due to soaring prices because of the war in Ukraine.10

The U.S. S&P Large Cap 500 faced a turbulent quarter, down 4.6%. Smaller caps underperformed, with the S&P MidCap 400 and S&P SmallCap 600 down 4.9% and 5.6% for the quarter, respectively.  An inverted yield curve signaled concerns of an impending recession. U.S. fixed income performance was weak across the board. Gains in commodities continued, driven by Energy’s outperformance. Canadian equities outperformed the U.S. in Q1, with the S&P/TSX Composite up 3.8%. Energy posted a 29% gain. The S&P Europe 350 rebounded from losses suffered in the first two months of the year, resulting in a negative 4.9% in the first quarter. Most sectors and countries represented in the benchmark declined in Q1 2022. Energy was the best performing sector, up 18%. The United Kingdom and Norway contributed positively to the region’s returns in the quarter, while German equities were the most negative. The S&P Pan Asia BMI posted three consecutive months of declines, down 6.2% for the quarter. Amongst local market gauges, the S&P China 500 sank 14.3% in the first three months of 2022.

We have maintained our asset allocation across all models in April. Last month’s move to reduce exposure to the 3-to-7-year U.S. Treasury bond and add to Gold and Canadian Equities has had a positive impact on the portfolio. We continue to rely on the safe haven status of gold in times of uncertainty, including war and inflation. Canadian oil and liquid natural gas directed through the U.S. pipeline system for export to Europe along with their higher prices will benefit Canada. We are monitoring large cap U.S. equity exposure.

The Russian-Ukraine conflict, surging inflation, and concerns about the Fed’s rate hike plan have led to the S&P 500’s worst quarter in two years. Real interest rates remain low and private sector balance sheets are healthy. Our outlook reflects these developments. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP Growth. April 18, 2022.

2 Trading Economics. China Unemployment. April 18, 2022.

3 Trading Economics. Europe Inflation. April 1, 2022.

4 Trading Economics. Europe Unemployment Rate: Eurostat. March 31, 2022.

5 Trading Economics. U.S. GDP Growth. March 30, 2022.

6 Trading Economics. U.S. Unemployment: U.S. Bureau of Labor Statistics. April 1, 2022.

7 Trading Economics. U.S. Inflation. April 12, 2022.

8 Trading Economics. U.S. Trade Gap: Bureau of Economic Analysis. April 5, 2022.

9 Trading Economics. Canada Unemployment: Statistics Canada. April 8, 2022.

10 Trading Economics. Canada Trade Surplus. April 5, 2022.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. March 31, 2022. Index performance is based on total returns and expressed in the local currency of the index.

 

 

We have lowered our 2022 global GDP growth outlook following the invasion of Ukraine by Russia, one month ago. A commodity supply shock has pushed up CPI inflation expectations and contributed to a shift in our expectations regarding the timing and size central bank rate hikes. Our outlook focuses on the reflationary consequences of strong underlying demand and rapidly tightening supply as well as the commodity and financial market response to the Russian invasion of Ukraine. Against the backdrop, in March, we maintained our current outlook of three months of inflation followed by nine months of growth for the U.S. economy.

The Chinese economy faces elevated risks due to their somewhat less effective vaccines and the zero-tolerance policy on Covid infections. China’s annual inflation rate stood at 0.9% in February 2022.1 China’s surveyed urban unemployment was at 5.5% in February, up from 5.3% in January.2 GDP in the Euro Area expanded 4.6% year-on-year in the fourth quarter of 2021.3 The annual inflation rate in the Euro Area rose to a record high of 5.9% in February from 5.1% in January.4 Russian energy became a pressure point in the war in Ukraine, with the U.S. banning oil and gas imports, the U.K. banning oil imports, and the European Commission aiming to cut gas imports by two-thirds.

Given the combination of an aggressively tight labor market and significantly above-target inflation, the Fed has waited much longer to start raising rates than at any point over the last 30 years. The U.S. unemployment rate edged down to 3.8% in February from 4% in the previous month, a new pandemic low.5 Annual inflation rate in the U.S. accelerated to 7.9% in February, the highest since January of 1982.6 The U.S. trade deficit widened to a record high of $89.7 billion in January from an upwardly revised $82 billion in the previous month. It reflects an increase in the goods deficit of $7.1 billion to $108.9 billion, as soaring energy costs pushed imports to a record high while the services surplus narrowed by $0.6 billion to $19.2 billion.7 The Canadian economy grew by 1.6% in the fourth quarter of 2021, the most in 4 quarters and following a 1.3% expansion in the third quarter.8 Canada’s annual inflation rate quickened to 5.7% in February, the highest since August of 1991.9 The unemployment rate in Canada fell to 5.5% in February from 6.5% in January. It was the lowest jobless rate since January of 2020, officially reaching pre-pandemic levels after 25 months.10 Canada posted a trade surplus of CAD $2.62 billion in January of 2022, compared with a downwardly revised deficit of CAD $1.58 billion in December. It was the widest trade surplus since September of 2008.11

The Federal Reserve is now challenged to balance increasing inflation expectations with the risk of a slowdown caused by the war in Europe, approving a 1/4 percentage point increase in the primary credit rate to 0.5%, effective March 17, 2022. Over 99% of S&P 500 companies have reported fourth-quarter earnings with earnings per share growth of 32%. First-quarter estimates are much lower at 5%. U.S. equities faced a challenging February, with the S&P 500 declining 3.0%. Smaller caps outperformed, with the S&P MidCap 400 and S&P SmallCap 600 up 1.1% and 1.4%, respectively. Energy continued its position as the best-performing sector in the S&P 500, up 7.1%, and was the only sector to post a gain.  Canadian equities were flat in February, with the S&P/TSX Composite up 0.3%. The S&P Europe 350 extended its January losses in February with another 3.0% decline, leaving it down 5.9% year-to-date.  The U.K. was up 0.8% in February. The S&P Pan Asia BMI declined 0.9%, weighed down by the S&P China 500, down 1.7%. Australia and New Zealand helped with gains.

We adjusted our Asset Allocation across all models in March. We reduced exposure to the 3-to-7-year U.S. Treasury bond by 15% and added 5% to the current gold exposure and 10% to Canada equities. We continue to rely on the safe haven status of gold in times of uncertainty, including war and inflation. Canadian oil and liquid natural gas directed through the U.S. pipeline system for export to Europe along with their higher prices will benefit Canada. We are monitoring large cap U.S. equity exposure. U.S. fiscal spending that will fund local governments supports our exposure to short-term treasuries and municipal bonds in the U.S. We believe that U.S. rate increases in 2022 will be done cautiously so as not to risk causing a recession.

Our expected lower GDP growth forecast is driven by higher commodity prices and tightening global financial conditions as shifting expectations for central banks and inflation risks push global interest rates higher. Meanwhile, real interest rates remain low, private sector balance sheets are healthy, and the impact of the global commodity shock is for now, limited. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China Inflation. March 16, 2022.

2 Trading Economics. China Unemployment. March 16, 2022.

3 Trading Economics. Europe GDP Growth. March 8, 2022.

4 Trading Economics. Europe Inflation. March 17, 2022.

5 Trading Economics. U.S. Unemployment: U.S. Bureau of Labor Statistics. March 4, 2022.

6 Trading Economics. U.S. Inflation. March 10, 2022.

7 Trading Economics. U.S. Trade Gap: Bureau of Economic Analysis. March 8, 2022.

8 Trading Economics. Canada GDP Growth. March 1, 2022.

9 Trading Economics. Canada Inflation. March 16, 2022.

10 Trading Economics. Canada Unemployment: Statistics Canada. March 11, 2022.

11 Trading Economics. Canada Trade Surplus. March 8, 2022.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. February 28, 2022. Index performance is based on total returns and expressed in the local currency of the index.

Geopolitical escalation in February has materially increased the risk of further aggravating the energy and commodity crisis developing over the past 2 years. After weeks of rising tensions, Russia launched a full-scale invasion of Ukraine on February 24th. The U.S., in cooperation with its Western allies, has responded by imposing sanctions against Russia, prompting significant shifts in global markets. Resulting higher commodity prices, especially in food and energy, will exacerbate inflation in the U.S. and other developed economies, slowing economic growth, and leading to stagflation. In February, we have maintained out current outlook of three months of inflation followed by 9 months of growth for the U.S. economy. We will revisit this outlook as events evolve.

China’s annual inflation rate fell to 0.9% in January 2022 from 1.5% a month earlier. This was the lowest reading since last September, as the cost of food dropped the most in four months.1 The Euro Area economy expanded 4.6% year-on-year in the last three months of 2021.2 The annual inflation rate in the Euro Area edged higher to a fresh record high of 5.1% in January of 2022. Energy continues to record the biggest price increase.3 The unemployment rate in the Euro Area fell to 7% in December of 2021. Among the biggest economies in the Eurozone, declines in the jobless rate were seen in Spain (13% vs 13.4% in November), Italy (9% vs 9.1%) and France (7.4% vs 7.5%).4

The American economy expanded an annualized 6.9% in Q4 2021, higher than the 2.3% in Q3.5 The annual inflation rate in the U.S. accelerated to 7.5% in January of 2022, the highest since February of 1982, as soaring energy costs, labour shortages, and supply disruptions coupled with strong demand weighed on the number.6 The U.S. unemployment rate edged up to 4.0% in January of 2022, little changed from December’s new pandemic low.7 The U.S. trade gap in both goods and services rose 27% to hit $859 billion in 2021, an annual record as imports grew faster than exports. The imports surged 20.5% or $576.5 billion last year, as Americans purchased more foreign products and strong demand pushed up the prices. Exports were up 18.5% or $394.1 billion.8 Canada’s headline inflation rate accelerated to 5.1% in January of 2022, remaining the highest since September 1991. COVID-19 pandemic-related challenges continued to weigh on supply chains, and energy prices remained elevated.9 The unemployment rate in Canada rose to 6.5% in January of 2022 from an upwardly revised 6% in December of 2021.10

Anxiety about impending rate hikes as well as a tapering in asset purchases by the Fed to combat inflation led to the worst monthly performance for U.S. equities since March 2020, with the S&P 500 down 5.2% in January. Smaller caps performed even worse, with the S&P MidCap 400 down 7.2% and the S&P SmallCap 600 down 7.3%. Energy was the only sector to post a gain in January, up a staggering 19.1%, boosted by the continued rise in oil prices. In Canada, The S&P/TSX Composite was down 0.4%. Energy posted a 12.5% gain. The S&P Europe 350 started 2022 on the back foot, finishing January down 3.0% and giving back its gains since the end of November 2021. The U.K. was the sole country to make a significant positive contribution, while the Netherlands and Switzerland were the largest detractors; each pulled back the overall return by -1%. Energy and Financials stood out among pan-European sectors, rising 13.5% and 4.4%, respectively, while consistent with global trends, Information Technology was the main laggard, plunging 12.9%.

In February, we adjusted our Asset Allocation across all models. Total exposure to small and mid-cap equities was replaced with exposure to gold. This reflects the safe haven status of gold in times of uncertainty, including war and inflation. We are monitoring large cap U.S. equity exposure as we weigh the impact of multiple factors including Fed tightening, the impact of the pandemic, and geopolitics involving Russia-Ukraine against a strong earnings season. U.S. fiscal spending that will fund local governments in the pending infrastructure bill supports our exposure to short-term treasuries and municipal bond exposure in the U.S. We believe that U.S. rate increases in 2022 will be done cautiously so as not to risk causing a recession.

The reality of what could turn out to be the biggest conflagration in Europe since the Second World War has been reflected immediately in global equity markets and pressures have broadened across sectors. The base effects and volatility generated by the pandemic are still affecting the data, and additional supply side issues that had begun to normalize are reversing. From U.S.–China decoupling to the shift to a low-carbon economy to the rise of technologies, we are not going back to the 1990s, when cheap goods were the zero-inflation offset for the rising cost of housing, as well as education and healthcare. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China Inflation. February 16, 2022.

2 Trading Economics. Europe GDP Growth. February 15, 2022.

3 Trading Economics. Europe Inflation. February 2, 2022.

4 Trading Economics. Europe Unemployment Rate: Eurostat. February 1, 2022.

5 Trading Economics. U.S. GDP Growth. January 27, 2022.

6 Trading Economics. U.S. Inflation. February 10, 2022.

7 Trading Economics. U.S. Unemployment: U.S. Bureau of Labor Statistics. February 4, 2022.

8 Trading Economics. U.S. Trade Gap: Bureau of Economic Analysis. February 8, 2022.

9 Trading Economics. Canada Inflation. February 16, 2022.

10 Trading Economics. Canada Unemployment: Statistics Canada. February 4, 2022.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. January 31, 2022. Index performance is based on total returns and expressed in the local currency of the index.

 

 

The International Monetary Fund cut its world economic growth forecast for 2022 as the Covid-19 pandemic enters its third year, citing weaker prospects for the U.S. and China along with persistent inflation. Concerns over the stalled talks between Russia and NATO allies have added a layer of geopolitical risk to the heightened uncertainty. The IMF has estimated that the world economy expanded 5.9% last year, the most in four decades. That followed a 3.1% contraction in 2020 that was the worst peacetime decline in broader figures since the Great Depression.1

The IMF has indicated that inflation is expected to remain elevated in the near term, averaging 3.9% in advanced economies and 5.9% in emerging market and developing economies in 2022, before subsiding in 2023.2 A big part of the inflation story involves trade decoupling and increased support for domestic labor. Central banks that slashed interest rates to soften the economic decline caused by the pandemic face pressure to tighten policy to confront surging consumer prices, threatening to curtail the growth rebound. Governments also have less fiscal space for spending to address health needs and buoy their economies after piling up record debt. In January, we revised forecast of Growth (U.S. GDP greater than 2.5%) to an Inflation Outlook (U.S. CPI greater than 3.5%) for the first three months and Growth for the remaining nine months of the twelve -month forecast horizon.

China’s economic growth slowed during the fourth quarter of 2021. The economy expanded by 4.0% year-on-year in October-December, as multiple headwinds including a property downturn, supply chain issues, and COVID-19 outbreaks occurred. In the full year of 2021, the economy grew 8.1%, the fastest expansion in nearly a decade.3 China’s trade surplus in 2021 widened to USD 676.4 billion, the highest on record, from USD 524 billion in 2020, as exports surged 29.9% and imports 30.1%. China’s trade surplus with the U.S. was USD 396.58 billion for the whole of 2021, 25% higher than in 2020.4

The Eurozone economy expanded 3.9% year-on-year in the third quarter of 2021.5 Annual inflation in the Euro Area accelerated for the sixth straight month to a record high of 5% in December of 2021 from 4.9% in November.6 Annual inflation in the U.K. increased to 5.4% in December of 2021 from 5.1% in November. This is the highest reading since March 1992.7

The U.S. economy grew by an annualized 2.3% on quarter in Q3 2021. A resurgence of COVID-19 cases resulted in new restrictions and delays in the reopening of establishments in some parts of the country.8 Government assistance payments in the form of forgivable loans to businesses, grants to state and local governments, and social benefits to households all decreased in the third quarter. The annual inflation rate accelerated to 7% in the last month of 2021, a fresh high since June of 1982.9 Energy was the biggest contributor to the gain. Inflation spiked in 2021 due to soaring energy costs, pandemic-induced supply constraints, labour shortages, increasing demand, and a low base effect from 2020. In the United States, a sharp decline in unemployment has been accompanied by nominal wage growth, a degree of tightening in U.S. labor markets that is not occurring in other economies. Tighter labor markets may feed through to higher prices. As a result, the Federal Reserve communicated in December 2021 that it will taper asset purchases at a faster pace and signaled that the federal funds rate will be raised in 2022.

Despite the ongoing pandemic, U.S. equities had a banner year in 2021, with the S&P 500 reaching 70 closing highs on its way to a 28.7% return. Mega-caps outperformed, with the S&P 500 Top 50 up 30.8%. Small-Caps outperformed Mid-Caps in 2021, with the S&P Small Cap 600 up 26.8% while the S&P Mid Cap 400 was up 24.8%. Canadian equities had a strong year, with the S&P/TSX Composite up 25.1%, the best performance since 2009. The S&P Europe 350 set several new records, adding 5.6% in the final month to finish 2021 with a 26.1% total return. The Netherlands, Austria, Sweden, Italy, and France all had positive contributions. The S&P Pan Asia BMI gained 2.1% in December, narrowly moving into the black for 2021 with a gain of 0.9%. The market standard commodities benchmark, the S&P GSCI, rose 40.4% in 2021, as high and rising inflation provided a backdrop for this inflation-sensitive asset class. Commodities finished strong in December, rising 7.6% over the month as energy bounced back.

In January, we maintained our Asset Allocation across all models. We are monitoring U.S. equity exposure as we gauge the impact of multiple factors including Fed tightening, the impact of the pandemic, and geopolitics involving Russia-Ukraine. The high multiples and ‘intentional plan to lose money now because the future is huge’ business models have led to volatility and corrections in January. Corporate earnings across all market caps were solid in Q3 and are being monitored as reporting begins for Q4. U.S. fiscal spending that will fund local governments in the pending infrastructure bill supports our exposure to short-term treasuries and municipal bond exposure in the U.S. We believe that U.S. rate increases in 2022 will be done cautiously so as not to risk causing a recession.

The changing picture of the economy comes with structural challenges but eventually leads to improved liquidity, healthy consumer balance sheets, and a healing labor market. From U.S.–China decoupling to the shift to a low-carbon economy to the rise of technologies, we are not going back to the 1990s, when cheap goods were the zero-inflation offset for the rising cost of housing, as well as education and healthcare. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 International Monetary Fund. World Economic Outlook. January 2022.

2 International Monetary Fund. World Economic Outlook. January 2022.

3 Trading Economics. China GDP Growth. January 17, 2022.

4 Trading Economics. China Trade. January 14, 2022.

5 Trading Economics. Eurozone GDP Growth. December 7, 2021.

6 Trading Economics. Europe Inflation. January 7, 2022.

7 Trading Economics. U.K. Inflation. January 19, 2022.

8 Trading Economics. U.S. GDP Growth. December 22, 2021.

9 Trading Economics. U.S. Inflation. January 12, 2022.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. December 31, 2021. Index performance is based on total returns and expressed in the local currency of the index.

Section 1: Q1 2022 Outlook

 

Global Consumer Prices are Approaching their Fastest Increase of the Past Quarter Century

The COVID-19 pandemic has generated unprecedented macroeconomic volatility and its reverberations will be felt for some years to come. 2020’s lockdowns resulted in the largest drop in global GDP in modern history, which was followed by a re-opening bounce producing the strongest recovery in 50 years.i

Setbacks due to the COVID-19 Delta and Omicron variants have been met by higher natural and vaccine-acquired immunity, significantly lower mortality, and new antiviral treatments. This has occurred in an environment of record corporate liquidity and strong fundamentals that have continued to drive capital investment, inventory re-stocking, shareholder return, and merger and acquisitions activity. Global consumer prices are approaching their fastest increase of the past quarter century.

As economies recover, the stimulus that has been provided by policymakers has led to concerns that a rise in inflation is now embedded. Two unique facts about the nature of the recent stimulus led to inflationary potential. The first is that it has combined fiscal stimulus with central bank asset purchases. The second is the large scale of the two interventions.

 

Measuring Inflation and its Impact on the Pandemic Economy

The break¬even inflation rate is recognized as the difference in yield between a nominal Treasury bond and the real yield on a TIPS bond of equal maturity. Historically, this difference has also been considered a market measure of expected inflation.

More recently, following the Great Recession of 2008-2010, the information content of the breakeven inflation rate as a measure of expected inflation has been impaired. Unprecedented Quantitative Easing (QE) has been implemented to increase the money supply and encourage lending and investment, through controlled asset purchases by the Fed and other central banks. The action has resulted in engineered low rates that are intended to stimulate demand and consumer price inflation via the traditional channels. Recently, around the globe, in Switzerland, Germany, the Netherlands, Denmark, and Finland, nominal rates have been negative all the way out to 30 years due to the impact of versions of QE in those countries.ii Evidence has shown that quantitative easing, especially in Europe and Japan, has not resulted in the desired economic outcomes or a rise in consumer price inflation to target levels.

One offshoot of the low rate of inflation in advanced economies over the past two decades has been for policymakers to accept greater risks of overshooting their targets. The Fed and Bank of Japan have made this most explicit by setting an average inflation target and an “overshooting commitment”, while the ECB has said its new mandate may imply a period of inflation being “moderately above target”.iii

The level of real rates that keeps an economy growing in line with potential growth and inflation at target, is defined as the neutral real interest rate or r*.iv This neutral real interest rate has been declining across advanced economies over the past 50 years, driven by factors that have increased retirement savings in an aging population and enabled higher savings rates flowing to the wealthy due to inequality (the wealthy tend to have higher savings rates). This has occurred while there has also been a fall in desired investment, driven by the rising importance of less capital-intensive services and, the slowdown in potential GDP growth across advanced economies.

Before the pandemic, r* was far lower than in the past. We saw this during the Fed’s tightening cycle in 2016-18, when the fed funds rate rose to between 2.25% and 2.5% – implying a peak in real rates of only about 0.4% – was enough to engineer a slowdown in economic growth, led by rate-sensitive sectors like residential investment and durables consumption.v

We have observed that when inflation does not rise above a trigger level, real interest rates will not likely rise as high as they have in the past in order to bring inflation back down. There are three key reasons for this.

First, real equilibrium interest rates are currently close to zero across advanced economies, which is much lower than they were before the Global Financial Crisis.

Second, the structural factors that have prevented inflationary pressures from becoming embedded in the system remain at play, including flexible labor markets, labor-saving technological progress, and globalization (even if it is partly rolled back).

Third, policymakers’ new mandates recognize these factors and are less concerned than in the past to bring inflation down.

In a scenario of inflation rising to 3-4%, real interest rates need to rise to 1%. That would imply increases in nominal policy rates to between 4% and 5% if central banks decide they want to return inflation to 2%. In a “worse” scenario in which the inflation rate rises to 5% or more on a sustained basis, real interest rates may need to rise to 2-3%. This would give rise to nominal rates of somewhere in the region of 7% to 9% – levels not seen since the early 1990s.vi And as higher inflation may become more ingrained, they may need to stay there for longer. This scenario would be likely to cause a more significant global downturn, much higher unemployment and pose a risk to the property sector.

 

Will Inflation be Persistent Post Pandemic?

Potential parallels have been drawn between the current recovery and the so-called “roaring 20s” after the First World War and the Spanish Flu Pandemic. The 1920s was a decade of strong economic growth, with demand fed by loose policy, financial liberalization, and a surge in demand for consumer appliances related to more homes getting electricity. This strong growth was not accompanied by any pick-up in inflation, partly because the 1920s were also notable for their range of productivity-enhancing innovations.

The current environment may be more like the 1960s and early 1970s, when a rise in demand was backed by strong bank lending that led to money growth and to overheating and a rise in inflation. By the mid-1980s, real interest rates in the U.S. were around 4.5% on average in the G7. At the same time, the prevailing level of r* was considered to be about 3%. At that time, real rates were around 150bp above r*.vii

 

The Fed, Employment, and Inflation

The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. In spite of the failure of the relationship to hold true in recent years, the Philips Curve remains the primary model through which the Fed understands inflation. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.

The Fed has a dual mandate by which it aims for full employment as well as price stability, and it now aims to minimize “shortfalls” from its employment goal. The Fed could keep monetary policy loose even if inflation is slightly above target if it judged that it has not reached full employment.

For much of 2021, the Fed was content to view inflation developments as transitory. If post-pandemic dislocations such as further delays in China’s reopening, supply chain issues and labor shortages persist, inflation may become persistent.

In the U.S., the labor market has tightened faster than expected. This is occurring as the Fed’s full employment goal—the last remaining condition for liftoff—is in sight. Support to pricing may now be pivoting to a tightening labor market that is pushing up wages, business costs, and business output prices.

 

Global Balance Sheets and Combined Fiscal and Monetary Stimulus

Has the pandemic shown inflation to be a fiscal phenomenon?

A decade of QE did not cause much inflation. Fiscal stimulus has sent it soaring. While central banks, not governments, are charged with hitting inflation targets, does the experience of the pandemic show that current inflation is fiscal spending induced?

Aggressive fiscal policy stimulus was a key catalyst of the recovery. The rise in fiscal deficits has dwarfed the size of those seen after the global financial crisis. In the U.S., this has resulted in the biggest ever peacetime deficit.viii This was particularly the case in 2021, when cash injections from central banks were at record monthly levels. After consistently dismissing the threat of inflation, the Fed’s “better late than never” pivot on the issue is part of a general shift in global central banking towards less monetary policy stimulus.

In the 2010s, central banks created vast amounts of money through their QE schemes, while governments enacted fiscal austerity. Inflation in the rich world was mostly too low, undershooting central banks’ targets.

Then the pandemic struck and there was plenty more QE. In combination, economic policy stepped up with the $10.8 trillion in fiscal stimulus implemented worldwide, equivalent to 10% of global GDP.ix The result has been high inflation. The tsunami of fiscal stimulus was accompanied by bond-buying of almost equal magnitude: central banks in America, Britain, the Eurozone, and Japan have together bought more than $9trn in assets. The result has been a surge in deposits at commercial banks.

Our view is that this version of fiscal stimulus leads to more spending. In combination with QE, the central bank creates new money with which it buys the bonds that the government has given out. When everything is netted, the government is not giving out bonds. It is giving out cash. Is this version of expanding combined supply proving to be inflationary?

In the U.S., the rich country that has splurged the most, deposits have risen from around $13.5trn in early 2020 to around $18trn today.x Not by coincidence, the U.S. has also had the most inflation. With consumer prices rising at an annual pace of 7.0% in December, the Federal Reserve on December 15th was forced to acknowledge that inflation had become a serious threat.xi

The current approach that combines monetary and fiscal stimulus is unique in history. One way in which fiscal stimulus boosts inflation is by strengthening households’ and firms’ balance-sheets, making them more likely to spend. When the government raises cash from investors, they receive bonds in exchange. The government then hands out the money to households, returning it into circulation. Netting off, it is as if the government has just given out new bonds. Whether those bonds constitute new wealth for the private sector is the subject of a theoretical debate. When the government runs up debts the public could also expect to pay higher taxes in the future—a liability that offsets their newly created assets.

Investors value government debt, especially America’s, for its liquidity, meaning they are willing to hold it at a lower interest rate than other investments—much like the public is willing to accept a low yield on bank deposits. But, while its policy stance will remain accommodative for quite a while, the world’s most powerful central bank is now set to completely stop its asset purchases by the end of the first quarter of 2022. An increasing number of other central banks (not only in the emerging world but also in some advanced economies such as Norway and the U.K.) have already embarked on interest rate hiking cycles.

If money and debt are substitutes, their combined supply can be powerfully inflationary. David Andolfatto of the Federal Reserve Bank of St. Louis wrote in December 2020, “it seems more accurate to view the national debt less as a form of debt and more as a form of money in circulation.” He also warned Americans to “prepare themselves for a temporary burst of inflation” in light of the one-off increase in national debt during the pandemic.xii

 

2022 Global Inflation Outlook

A sustained surge in inflation has not been experienced across advanced economies during the past three decades. As the inflation risk increases in the post-pandemic world, investors have little practical experience of how to position their portfolios during such times. A critical element in the inflation outlook will be the confidence among consumers and investors that inflation will be managed and controlled successfully as we move out of the pandemic environment.

Risk of a demand-induced inflation looks greatest in the U.S. The policy stimulus there has been especially large, fiscal policy remains loose and output is already much closer to its pre-crisis trend than in other countries. There is less chance of strong demand fueling inflation in Japan and the Eurozone, where the economic recovery is likely to remain slower and the relationship between demand and inflation is weaker.

The 2022 global economic recovery is moving forward with limited slack, particularly in the Developed Markets. Less than three years into the expansion, the global output gap is likely to close in early 2023. While December’s 2021’s 7.0% surge in consumer prices is not expected to be sustained, the combination of limited slack, above-potential growth, and gradual monetary policy normalization points to Developed Markets core inflation settling higher than its pre- pandemic norm.

Markets will no longer have liquidity injections to power them through uncharted and choppy economic waters. Investors will have to take a view on the durability and impact of the inflation surge, including the drivers of its eventual demise. For more than a decade, large-scale central bank purchases of assets boosted not just those being bought in markets but also virtually all other assets, including financial and physical (such as housing, art, and other collectibles).

Tighter financial conditions will continue to feed a combination of financial instability and lower private demand. In its extreme, stagflation policies become a lot less effective at a time when markets are dealing with underpriced liquidity, credit, and solvency risk. Inflation would eventually come down in this scenario through a process that leads to a drop in economic activity.

The combination of strong economic growth, aggressive fiscal and monetary stimulus (comparable only to the post-WWII accommodation), pent-up demand, and supply-chain bottlenecks have triggered an inflation pick-up to levels not experienced for decades. We will monitor key inflation indicators and consumer and investor sentiment.

 

U.S. Inflation Hit Another ~40-Year High

U.S. Consumer Price Index: Year-over-Year Change (%)

SOURCES: S&P DOW JONES INDICES, U.S. BUREAU OF LABOUR STATISTICS, BLS DATA AS OF JANUARY 12, 2022.

 

U.S. Inflation Indicators

SOURCE: AMUNDI RESEARCH AS OF DECEMBER 2021. TIPS: TREASURY INFLATION PROTECTED SECURITY.

 

 

Section 2. Four Themes

 

Theme 1: Energy Prices Drive Global Inflation

There are symptoms of dysfunction in global energy markets. Early in 2022, oil prices in the U.S. have hovered above $80 a barrel, their highest level since late 2014. Natural-gas prices in Europe tripled in 2021. Demand for coal has surged. Power cuts in China, coal shortages in India, and spikes in electricity prices across Europe are the collateral damage.

A few years ago, producers of fossil fuels would have responded to such price signals by swiftly ramping up output and investment. In 2014, with crude above $100 a barrel, Royal Dutch Shell, a European supermajor, put more than $30 billion of capital expenditure into upstream oil and gas projects.

Not this time. Climate change has led to unprecedented pressure on oil and gas firms, especially European ones, to shift away from fossil fuels. As part of Shell’s long-term shift towards markets for lower-carbon gas and power, its upstream capital spending this year has shrunk to about $8 billion.xiii

As the pandemic eases, the oil market could reach a point of lacking any spare capacity, according to Goehring & Rozencwajg, a commodity-investing firm.xiv That might be only a temporary state of affairs; Aramco and ADNOC could respond rapidly. But temporarily at least it would push prices of crude sharply higher, adding further strains to economies already suffering from soaring costs of natural gas for homes and energy-intensive activities, from steelmaking and fertilizer production to blowing glass for wine bottles.

 

Theme 2: Labour Shortages Begin to Drive U.S. Inflation

Labour markets have continued to recover as economies have reopened.

There is mounting evidence of labour shortages intensifying across Developed Markets with the most acute shortages in the U.S. and the U.K. Job vacancies have also increased, and are now well above pre-pandemic levels in Australia, the U.S., and U.K. And while the rise in vacancies is good news to the extent that it reflects strong demand for labour as economies recover, it also suggests that firms are finding it hard to fill positions and could lead to some upward pressure on wages.

Unlike in the U.S., the Eurozone labour market has some spare capacity. And in the U.K., the fact that sectors with the most vacancies are those with the highest share of workers previously on furlough, suggests that there should be less labour market friction as those workers seek employment. A rate hike in the back half of 2022 may be confirmed at the next month’s FOMC meeting.

 

Theme 3: China Growth Restrained

China’s relationship with the United States and the global economy is a critical factor that has the potential to dramatically shape economic growth and investment opportunities, not only in China but globally. While China’s economy managed to outperform its peers during the early months of the pandemic, it now faces major challenges over the near term as deleveraging and policy tightening restrain growth.

While the government has made some progress in controlling shadow banking, it is aware of additional work needed to properly address financial stability risks, especially amid mounting bankruptcies, including state-owned enterprises. Ultra-loose lending facilities of earlier years, coupled with large government deficits and borrowing during the pandemic, caused debt to explode. According to the Bank for International Settlements, non-financial sector domestic debt rose from 239% of GDP in 2015 to reach 290% of GDP at the end of 2020, the increase driven in large part by corporations (which includes state-owned enterprises).xv Deleveraging has become a priority. The government is now willing to accept slower but more sustainable growth. Real estate property developers, for instance, are facing more stringent borrowing conditions, and that has already led to a significant slowdown in loan growth in the construction sector.

Over the longer term, the alteration of global value chains in the aftermath of the pandemic, geopolitical tensions with Western democracies, the relationship with Hong Kong and Taiwan, carrying the Belt and Road Initiative to fruition, an aging workforce, and declining productivity all represent serious challenges for China. The central government is hoping to address some of those with the implementation of its five-year plan, a focus on supporting “home grown” domestic demand. U.S. concerns about China’s respect for intellectual property and other international trade laws, as well as concerns about China’s increasingly aggressive foreign policy, have been escalating since Xi Jinping became president in 2012. Viewing China’s recent actions as a response to actions initiated by the Trump administration seems to overlook the larger context.

 

Theme 4: Fed Policy Support for Risky Assets Ends

The Fed has supported keeping “risk-free” rates low, while also continuing to provide direct support to competing risky assets. These purchases are intended to lower long term interest rates and prod investors into investments that would spur growth.

The original policy began on March 23rd, 2020, when the central bank announced that two corporate bond facilities would be established – a Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuance, and a Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity for outstanding corporate bonds.xvi

The facilities were enhanced on April 9th, 2020. Changes included i) increases in the Treasury’s equity investments, to $50bn for the PMCCF and $25bn for the SMCCF; ii) a broadening of participation to include “fallen angels” that had been investment-grade on March 22nd; iii) a clarification of the maximum leverage ratios of the SPV: 10:1 for investment-grade and 7:1 for sub-investment-grade bonds; and iv) the inclusion of some high-yield bonds in the SMCCF’s purchases of ETFs. Finally, the SMCCF was tweaked again in June 2020. That facility is now also able to purchase in the secondary market eligible corporate bond portfolios that track a broad market index.xvii

In June of 2020, the Fed announced its decision to tweak its policy again, to provide support to the corporate bond market following the outbreak of COVID-19, buying corporate bonds in the secondary market, and thus feeding further gains in the prices of equities.

In November 2021, fed officials laid out a plan to slow their $120 billion in monthly Treasury bond and mortgage-backed security purchases by $15 billion a month starting in November.xviii

 

 

Section 3. Investment Outlook

 

Global Pandemic Leads Us to a Growth Forecast for the Next Twelve Months while we Continue to Closely Monitor the Outlook for Inflation.

SOURCE: FRAME GLOBAL ASSET MANAGEMENT

 

Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.

 

 

Section 4. December 2021 Portfolio Models

One year after the launch of anti-Covid vaccines, financial markets have been willing to move beyond the pandemic while the economy has not. We see this with the disruptions among supply chains, particularity labor and commodity markets. The longest economic expansion in American history – 128 months – has been followed by the shortest recession – 2 months – and has registered the sharpest rebound ever measured. Inflation continues to be fed by supply shortages, labor costs, worker shortages, and consumers, who are responding to the changes imposed by the pandemic. In December, we maintained our twelve-month forecast of Growth (U.S. GDP greater than 2.5%) through the period while we continue to closely monitor the outlook for inflation.

We maintained our Asset Allocation across all models in December. Corporate earnings across all market caps were solid in Q3. U.S. fiscal spending that will fund local governments in the pending infrastructure bill supports our exposure to short-term treasuries and municipal bond exposure in the U.S. We believe that raising rates too early in 2022 during a transitory inflation environment will not occur for risk of causing a recession.

The global economic recovery is moving forward with limited slack. Against the backdrop of an incomplete recovery and a significant buildup of public sector debt, we have lowered our growth recovery expectations while maintaining our outlook to above 2.5% GDP growth in the U.S. over the next twelve-months.

 

Deborah Frame, CFA, MBA

President and Chief Investment Officer

January 14, 2022

 

iTrading Economics. U.S. Market Return. 2020 and 2021.
iiTrading Economics. Nominal Interest Rate by Country.
iiiTrading Economics. ECB Inflation Target. January 7, 2022.
ivBrookings/Hutchins Centre. Neutral Interest Rate. October 2018.
vFederal Reserve. Open Market Operations. 2016 to 2018.
viTrading Economics. Nominal Interest Rate by Country.
viiTrading Economics. Nominal Interest Rate by Country.
viiiTrading Economics. U.S. Budget. December 10, 2021.
ixInternational Monetary Fund. Covid-19 Global Fiscal Response. November 2021.
xInternational Monetary Fund. Covid-19 Global Fiscal Response. November 2021.
xiTrading Economics. U.S. Fed Funds Rate. December 15, 2021.
xiiDavid Andolfatto. Federal Bank of St. Louis. December 2020.
xiiiThe Energy Shock. The Economist. October 16, 2021.
xivThe Energy Shock. The Economist. October 16, 2021.
xvTrading Economics. China Non- Financial Debt. 2020.
xviU.S. Federal Reserve. March 23, 2020.
xviiU.S. Federal Reserve. June 2020.
xviiiiU.S. Federal Reserve. November 2021.

One year after the launch of anti-Covid vaccines, financial markets have been willing to move beyond the pandemic while the economy has not. We see this with the disruptions among supply chains, particularity labor and commodity markets. The longest economic expansion in American history – 128 months – has been followed by the shortest recession – 2 months – and has registered the sharpest rebound ever measured. Inflation continues to be fed by supply shortages, labor costs, worker shortages, and consumers, who are responding to the changes imposed by the pandemic. In December, we maintained our twelve-month forecast of Growth (U.S. GDP greater than 2.5%) through the period while we continue to closely monitor the outlook for inflation.

The Chinese economy expanded 4.9% year-on-year in Q3 2021, down from 7.9% growth in the previous quarter, amid several headwinds including power shortages and supply chain bottlenecks.1 China’s consumer price inflation accelerated to 2.3% in November from 1.5% a month earlier.2 Exports from China increased by 22% to a record high in November.3

The Euro Area economy advanced 2.2% in the three months to September 2021. Household consumption accelerated while government expenditure slowed.4 The British economy advanced 1.3% in Q3, lower than the 5.5% growth rate in Q2.5 The annual inflation rate in the Euro Area increased to 4.9% in November from 4.1% in October. The biggest increase was seen in cost of energy (27.5%).6 The Euro Area seasonally adjusted unemployment rate edged down to 7.3% in October. Amongst the largest Euro Area economies, the highest jobless rates were recorded in Spain (14.5%), Italy (9.4%) and France (7.6%).7

The U.S. economy expanded an annualized 2.1% in Q3 2021. Personal consumption increased, mainly boosted by international travel, transportation services, and healthcare.8 Monthly inflation in the U.S. came in at 6.8% annualized in November. The indexes for gasoline (6.1%), shelter (0.5%), and food (0.7%) were among the larger contributors.9 The U.S. trade deficit with China decreased $3.2 billion to $28.3 billion. The gap with the EU also narrowed $2.1 billion to $16.6 billion but the deficit with Mexico widened $0.8 billion to $9.7 billion.10 The Canadian economy rebounded by 1.3% in Q3, underpinned by household spending and exports as pandemic restrictions were phased out.11 Canada’s headline inflation rate remained at 4.7% in November, amid supply chain issues and low base year effects.12 The unemployment rate in Canada fell to a new pandemic-low of 6.0% in November.13

It was not smooth sailing for U.S. equities in November, as concerns about the Omicron strain coupled with less-than-transitory inflation and accelerated tapering by the Fed upset markets during the last three days of the month. The S&P 500 posted a loss of 0.7%, outperforming the S&P Midcap 400 and the S&P Small Cap 600, which declined 2.9% and 2.3%, respectively. Canadian equities posted moderate losses with the S&P/TSX Composite down 1.6%. The European markets began November positively, but lockdowns and rising COVID caseloads spread across the continent towards the end of the month, before the twin challenges of a new virus strain and soaring core inflation pushed equities firmly into the red. The S&P Europe 350 finished with a loss of 2.5%. Nearly every country represented in the pan-continental benchmark contributed to the declines, except Switzerland. The S&P U.K. (GBP) was down 1.9%. The broad-based S&P Pan Asia BMI was down 3.8%. Most Asian regional fixed income indices advanced this month, led by the S&P/ASX Australian Government Bond Index, which gained 3% as investors steered towards the relative safety of government securities. Commodities fell heavily, led by a 20% decline in S&P GSCI Crude Oil on the back of fears that new restrictions on global travel may sap demand.

In December, we maintained our Asset Allocation across all models. Corporate earnings across all market caps were solid in Q3. U.S. fiscal spending that will fund local governments in the pending infrastructure bill supports our exposure to short-term treasuries and municipal bond exposure in the U.S. We believe that raising rates too early in 2022 during a transitory inflation environment will not occur for risk of causing a recession.

The global economic recovery is moving forward with limited slack. Against the backdrop of an incomplete recovery and a significant buildup of public sector debt, we have lowered our growth recovery expectations while maintaining our outlook to above 2.5% GDP growth in the U.S. over the next twelve-months. The changing picture of the economy comes with structural challenges to some sectors but eventually expects to lead to improved liquidity, healthy consumer balance sheets, and a healing labor market. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP Growth. October 18, 2021.

2 Trading Economics. China Inflation. December 9, 2021.

3 Trading Economics. China Exports. December 9, 2021.

4 Trading Economics. Europe GDP. December 7, 2021.

5 Trading Economics. U.K. GDP. November 11, 2021.

6 Trading Economics. Europe Inflation. December 17, 2021.

7 Trading Economics. Europe Unemployment. December 2, 2021.

8 Trading Economics. U.S. GDP. November 24, 2021.

9 Trading Economics. U.S. Inflation. December 10, 2021.

10 Trading Economics. U.S. Trade. December 7, 2021.

11 Trading Economics. Canada GDP. November 30, 2021.

12 Trading Economics. Canada Inflation. December 15, 2021.

13 Trading Economics. Canada Unemployment. December 12, 2021.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. November 30, 2021. Index performance is based on total returns and expressed in the local currency of the index.

The demand recovery following 2020’s historic pandemic recession has been concentrated in goods and has pushed supply chains to their limits, extending delivery times to records and boosting prices and volatility in growth and inflation. Supply shortages are raising current inflation, while secular forces that alter the balance of supply and demand and sustain high inflation are also in play. Global growth is tilting in a reflationary direction as a result of the interaction among policy preferences, the recurring waves of the pandemic, and underlying structural change. In November we maintained our twelve-month forward forecast of Growth (U.S. GDP greater than 2.5%) through the period but we are closely monitoring the outlook for inflation.

In contrast to growth elsewhere, China’s current policy is focused on deleveraging, de-carbonization, and a reduction in income inequality. Actions to deliver long-term gains come at the expense of weaker near-term growth. Significant overhangs exist in China’s real estate sector and corporate balance sheets. The Chinese economy grew by a seasonally adjusted 0.2% in the three months to September 2021.1 China’s annual inflation rate accelerated sharply to 1.5% in October 2021 from 0.7% a month earlier.2 China’s surveyed urban unemployment stood at 4.9% in October 2021, unchanged from the previous month, which was the lowest level since December 2018.3

The Euro Area economy advanced 2.2% in the three months to September 30 2021, following 2.1% growth in the previous period. The economy continued to recover from the coronavirus hit with Austria (3.3%), France (3%) and Portugal (2.9%) recording the biggest expansions.4 The British economy advanced 1.3% in Q3 2021, lower than 5.5% in Q2.5 Annual inflation in the Euro Area jumped to 4.1% in October from 3.4% in September.6 This was the highest reading since July of 2008, as the bloc battled surging energy costs due to supply shortages. The annual inflation rate in the U.K. edged down to 3.1% in September from a 9-year high of 3.2% in August. The Euro Area seasonally adjusted unemployment rate edged down to 7.4%.7

As expected, the Fed announced that it will reduce the pace of its asset purchases beginning this month. While manufacturing supply constraints and U.S. labor market dislocations can be linked to pandemic dynamics, the slow supply improvement in recent months raises concerns that global slack is less than previously assumed. The American economy expanded by an annualized 2% in Q3 2021, slowing sharply from 6.7% in Q2.8 This is the weakest quarter of pandemic recovery, as government stimulus declined while a surge in COVID-19 cases and global supply constraints weighed on consumption and production. The annual inflation rate in the U.S. surged to 6.2% in October of 2021, the highest since November of 1990. Upward pressure was broad-based, with energy costs recording the biggest gain (30% vs 24.8% in September).9 The U.S. unemployment rate fell to 4.6% in October 2021, the lowest since March 2020.10 The annual inflation rate in Canada went up to 4.4% in September of 2021 from 4.1% in August.11 The unemployment rate in Canada declined for the fifth straight month to 6.7% in October of 2021 from 6.9% in September.12

Despite lingering inflation concerns, U.S. equities recovered strongly in October, thanks to robust corporate earnings. The S&P 500 posted a gain of 7.0%, outperforming mid and small caps, as the S&P MidCap 400 and the S&P SmallCap 600 rose 5.9% and 3.4%, respectively. Canadian equities posted strong gains in October, with the S&P/TSX Composite up 5.0%. The S&P Europe 350 strengthened 4.7% in October. The U.K. and Switzerland were the top contributors, adding 1% each to the large-cap European benchmark’s performance. The large cap S&P Southeast Asia 40 and S&P Asia 50 outperformed, adding 5.1% and 2.6%, respectively. Commodities run continued in October with the main S&P GSCI Index gaining 5.8%, as S&P GSCI Crude Oil and S&P GCI Silver jumped 12.2% and 8.6%, respectively.

In November, we eliminated our gold exposure and replaced it with exposure to U.S. small caps across all portfolio models. Corporate earnings across all market caps are solid in the third quarter. U.S. fiscal spending that will fund local governments in the pending infrastructure bill supports our exposure to short-term treasuries and municipal bond exposure in the U.S.

The global economic recovery is moving forward with limited slack. Against the backdrop of an incomplete recovery and a significant buildup of public sector debt, we have lowered our growth recovery expectations while maintaining our outlook to above 2.5% GDP growth in the U.S. over the next twelve-month period. The changing picture of the economy comes with structural challenges to some sectors but eventually leads to improved liquidity, healthy consumer balance sheets, and a healing labor market. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP Growth. October 18, 2021.

2 Trading Economics. China Inflation. November 10, 2021.

3 Trading Economics. China Unemployment. November 10, 2021.

4 Trading Economics. Europe GDP Growth. November 16, 2021.

5 Trading Economics. U.K. GDP Growth. November 11, 2021.

6 Trading Economics. Europe Inflation. October 29, 2021.

7 Trading Economics. Europe Unemployment. November 3, 2021.

8 Trading Economics. U.S. GDP Growth. October 28, 2021.

9 Trading Economics. U.S. Inflation. November 10, 2021.

10 Trading Economics. U.S. Unemployment. November 5, 2021.

11 Trading Economics. Canada Inflation. October 20, 2021.

12 Trading Economics. Canada Unemployment. November 5, 2021.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. October 31, 2021. Index performance is based on total returns and expressed in the local currency of the index.

 

 

There has been mounting evidence that the pace of the global recovery has slowed. In many economies, it reflects increased consumer caution about high virus cases and shortages limiting how fast economies can grow. The shortage of semiconductors and the current logjam that is taking place at ports along the west coast of the U.S. has had a big impact on the recovery in the U.S. and their trading partners. The root of the issue boils down to the pandemic disrupting the “traditional” flow of activity — causing a supply and demand imbalance. The most likely outcome is a weakening macro backdrop that will weigh on the longer-end of the yield curve. In September we maintained our twelve-month forward forecast of Growth (U.S. GDP greater than 2.5%) through the period.

The Chinese economy expanded 4.9% year-on-year in the third quarter of 2021, easing sharply from a 7.9% growth in the previous period.1 It was the slowest pace of expansion since the third quarter last year. China’s corporate debt has risen to US$27 trillion, nearly one third of the world’s total corporate debt and 159% of China’s GDP. The construction and engineering sectors (around 45% of the debt) could trigger contagion effects on the global economy.2 The European economy expanded 2.2% in the second quarter of 2021 while the British economy expanded 5.5%.3 The Eurozone annual inflation rate was confirmed at 3.4% in September 2021, the highest rate since before the global financial crisis in September 2008. Energy prices were responsible for almost half of the overall year-on-year inflation reading, rising by 17.6% in September after a 15.4% advance in August.4 Unemployment in Europe held at 7.5% while in the U.K. it was 4.5% in August, the last reported month.5

The final U.S. Q2 GDP growth rate came in at 6.7%. The annual inflation rate in the U.S. edged up to a 13-year high of 5.4% in September from 5.3% in August.6 The U.S. unemployment rate dropped to 4.8% in September 2021, from 5.2% in the previous month. It was the lowest rate since March 2020, as many people left the labor force and the negative effects of Hurricane Ida and the Delta variant’s summer spike started to fade. The jobless rate remained well above the pre-crisis level of about 3.5% due to ongoing labor shortages.7  The Canadian economy unexpectedly shrank 0.3% in Q2 2021, ending three straight quarters of expansion mostly due to a decline in home resale activities and exports.8 The annual inflation rate in Canada went up to 4.4% in September of 2021 from 4.1% in August.9 The unemployment rate in Canada declined for the fourth straight month to 6.9% in September of 2021 from 7.1% in August.10

Mounting fears of inflation, an ongoing Congressional budget impasse, and anticipation of a reduction in Fed liquidity provisions all weighed on U.S. equities in September. For the third quarter, the S&P 500 posted a gain of 0.6%, while the S&P MidCap 400 and the S&P SmallCap 600 fell 1.8% and 2.8%, respectively. Despite losses in September of 2.2%, Canadian equities managed to post slight gains in Q3, with the S&P/TSX Composite up 0.2%. The blue-chip S&P Europe 350 managed a 0.9% gain for the third quarter after declining 2.9% in September. U.K. equities bucked the trend, escaping September’s downturn and rising 2.1% in Q3. The Netherlands had the largest contribution (48bps) to the benchmark while Germany hurt the composite due to an uncertain outcome in government elections at the end of the quarter. The broad-based S&P Pan Asia BMI shed 1.4% in September, leaving it with a loss of 3.0% for the quarter. Japan was the top-performing Asian index in September, with the S&P/TOPIX 150 up 4.7% for the month. Hong Kong and Korea lagged, as an ongoing regulatory crackdown in China and Evergrande’s widely publicized troubles soured investors.

In October we maintained our asset allocation for all portfolio models. The added exposure to Canadian equities in September worked well as the Canadian market, led by higher energy prices, experienced a strong month. U.S. fiscal spending that will fund local governments in the pending infrastructure bill supports our exposure to short-term treasuries and municipal bond exposure in the U.S. We continue to include gold in the asset allocation as a portfolio stabilizer during volatile equity markets.

Our outlook hinges on whether the sources of recent disappointment are transitory amid several headwinds including power shortages, supply chain bottlenecks, a persistent property bubble in China, and COVID-19 outbreaks. Shortages of workers in many economies are also weighing on the growth for the rest of the year. The changing picture of the economy comes with structural changes that will challenge some sectors while at the same time, the reopening is expected to lead to improved liquidity, healthy consumer balance sheets, and a healing labor market. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.

 

Deborah Frame, President and CIO

 

1 Trading Economics. China GDP. October 18, 2021.

2 S&P DJ. “Can China Escape Its Corporate Debt Trap?”. October 19, 2021.

3 Trading Economics. Europe GDP. September 7, 2021.

4 Trading Economics. Europe Inflation Rate. October 20, 2021.

5 Trading Economics. Europe Unemployment Rate. September 30, 2021.

6 Trading Economics. U.S. Inflation Rate. October 13, 2021.

7 Trading Economics. U.S. Unemployment Rate. October 8, 2021.

8 Trading Economics. Canada GDP. August 31, 2021.

9 Trading Economics. Canada Inflation Rate. October 20, 2021.

10 Trading Economics. Canada Unemployment Rate. October 8, 2021.

 

Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. September 30, 2021. Index performance is based on total returns and expressed in the local currency of the index.