The stock market is a curious thing. With both stocks and bond prices down this year, investors may wonder whether the principles of a diversified portfolio can still hold up. The first six months of 2022 saw the TSX down 18%, the S&P dropped 24% and Canadian bonds were down by 14%. It’s worth mentioning that stock and bond prices falling in tandem and so aggressively is a very unusual dynamic in history. So, how close during the first half of 2022 did you come to changing your investment strategy? That real life experience likely tells you much more about your risk tolerance than any hypothetical scenario on paper.
In our view, the Bank of Canada (BOC) is bringing investors back down to earth with the reality of the economic situation that the central bank faces today. Simply, to quell record-high inflation, the BOC will likely need to raise its target rate well into the so called “restrictive zone” above 3.50%, which could erode demand enough to cause a recession. Including the past BOC interest rate increases this year, the current policy rate sits at 2.50%. While that’s certainly not new news to most of us, that statement helps reground expectations, which appear to have been lost on some investors over the summer months amid the strong equity market rally since mid-June. To be clear, the BOC is not readying a position to slow its interest tightening policy any time soon. On the contrary, rates are likely to climb higher from here.
Historically, September is the weakest month for the equity markets and investors should prepare for increased equity market volatility, lower economic growth trends and continued geo-political uncertainty heading into the fall. While the equity markets may muddle through until the next earnings season in October but obvious near-term catalysts to drive markets higher appear lacking at the moment.
Are recent indicators of slowing growth a warning sign of impending recession or perhaps something less ominous? We believe it is too early to price in an imminent recession. More likely, we’ll see “stagflation”, where growth slows but is nominally positive, inflation stays higher for longer and financial markets continue to face volatility. At the same time, we believe investors should not overreact and conclude that a recession is inevitable.
One other thing to note: recessions are usually characterized by excesses. Excesses in areas like inventory, manufacturing capacity or credit that need to be wrung out of the system. We’re not seeing those types of overhangs this time. Excesses in this economic cycle have instead built up in financial markets and asset prices themselves, like housing.
We see at least three areas of uncertainty that may continue to weigh on equity markets.
- the move towards tighter monetary policy is accelerating.
- the corporate profit outlook is dimming.
- geopolitical uncertainty remains high.
Today’s economic fundamentals are different from the prior cycles and portfolios should change too. With uncertainty high, investors should practice discipline, even “buying the dip” may seem attractive but remaining patient until there is some clarity around inflation, central bank monetary policy, corporate earnings, and international events, may be prudent.
The peak inflation scenario dynamics that drove the markets higher this summer are likely a fading tailwind for a higher market moving into the fall. Wait for confirming evidence of a new bull market before adding aggressively to portfolio risk.
Its an opportunistic time to buy into the market buy emotionally one of the hardest. With the vast majority of portfolios down so far this year, it might not be a great year from a performance perspective but given the number of twists and turns, it is a good year to get to know your risk levels.