“It’s a victory when the weapons fall silent and people speak up.”
Ukrainian President Volodymyr Zelensky
Rain is a normal part of any spring, but spring 2022 feels like a torrential downpour. The relentless shelling of Ukraine offers no end in sight (along with a 16-month-long, bloody civil war in Ethiopia and numerous other conflicts). Inflation marches stubbornly upward, hitting the most vulnerable consumers hardest. Meanwhile, COVID-19 fires are still burning brightly; BA.2, a sub-variant of Omicron, dominates globally. In Shanghai, 26 million people are under lockdown among soaring infections. Dr. Peter Jüni, head of Ontario’s COVID-19 Science Advisory Table, said “it is very clear” that the province is in the middle of a sixth pandemic wave. Case numbers in Canada continue to rise.
Russia’s brutal assault on Ukraine threatens to spark a massive humanitarian crisis. Ukraine is known as Europe’s bread basket. Both countries are vital suppliers of food, energy and other commodities to the world. Prices have surged for wheat, fertilizer, oil, gas and nickel, to give just a few examples. Wheat farmers plant their spring seeds in March and are highly reliant on Russian fertilizer. Their ability to seed and fertilize, not to mention export, are in question while tanks instead of tractors plough through the fields. Higher prices could jeopardize food security, especially in Africa, Asia and the Middle East.
Central banks are now aggressively taking aim at inflation, which is at a generational high. In March, the Bank of Canada (BoC) and the U.S. Federal Reserve raised interest rates by 25 basis points (bps). Both are signalling they will increase rates another 50 bps and are discussing quantitative tightening, which would reduce the size of each bank’s government bond holdings. Volatility roiled equity markets and bond prices cratered. Canada’s bond market is down 7.03% for 2022.
Despite a brisk upward move in bond rates, the rate curve flattened and even inverted briefly, indicating doubt about the economy’s long-term growth trajectory. While there’s no imminent threat, markets are concerned that central banks could over-react and spin rates too high, too fast. Markets are starting to worry that efforts to conquer inflation could hammer the economy into a recession.
Equity markets were in a slightly better mood in March and were largely positive for the month, recouping some of their losses for this year.
Canada – Taming inflation
Inflation climbed to 5.7% in February, a 30-year high. It was up from 5.1% in January, and was also higher than the 5.5% predicted by a Bloomberg economist survey. Consumer demand remains strong and labour markets tight, putting upward pressure on inflation. Speaking to a business audience, BoC Governor Tiff Macklem confirmed the bank’s commitment to a 2% inflation target and said it would act “with determination” to rein in soaring prices.
The BoC increased its policy rate by 25 bps in March. BMO Economics is now calling for a 50 bps increase at each of the bank’s next two meetings (April and June) followed by a 25 bps increase in July. That would bring rates to 1.75%, a sharp 1.50% increase from where they sat at the beginning of March. Real estate watchers say rising rates are already beginning to cool Canada’s hot housing market, a trend that may continue as more hikes loom.
On the business front, capital investment remained resilient. Growth in core durable goods orders has been positive since the beginning of the year. However, ongoing uncertainty over the war in Ukraine and surging inflation have dampened consumer confidence.
The S&P/TSX outperformed other major markets up until the last few days of the quarter as risk appetite recovered. The index returned 4.0% for March and 3.8% for the quarter. Despite global efforts to stabilize key commodity supplies, prices continued to experience intense volatility in March. West Texas Intermediate crude, the U.S. benchmark, peaked at over US$123 per barrel before retreating to US$100 on optimism about peace talks between Russia and Ukraine. Gold, often regarded as a safe haven and inflation hedge, surged to US$2,050 before it settled around US$1,938 per ounce. The 10-year government bond yield increased from 1.84% to 2.41%, while the 2-year yield increased from 1.45% to 2.29%. As a result, the yield spread compressed from 39 bps to 12 bps. The 10-year yield is up 82 bps this year.
U.S. – Scaling up a European presence
President Joe Biden travelled to Europe to rally global democracies, shore up Western alliances in support of Ukraine and levy more sanctions against Russia in retaliation for invading its neighbour. He also announced that the U.S. will take in up to 100,000 Ukrainian refugees. The final words of his Warsaw speech echoed around the world. “For God’s sake, this man cannot remain in power,” he said of Russian President Vladimir Putin. Afterward, the White House was quick to downplay the statement’s significance, saying that the Biden administration was in no way pushing for regime change in Russia.
In March, President Biden also announced a US$5.8 trillion budget proposal for the fiscal year 2023 that begins October 1. His blueprint would reduce the deficit by US$1 trillion in a decade and calls for higher taxes on the wealthy, more funding for defence, education, public health, housing and the police. Under the proposed new tax, the 0.01% of households worth more than US$100 million would pay a minimum 20% tax rate, including unrealized capital gains. This would reduce the government deficit by approximately US$360 billion over the next decade. Mr. Biden’s budget would also have a substantially lower deficit than last year’s in part because of the expiration of coronavirus relief measures.
While broader indices continue to experience volatility, it’s important to note that the fundamentals of U.S. companies remain strong. In the final quarter of 2021, an impressive 77% of firms in the S&P 500 reported earnings per share above expectations, one of the best quarters on record. These strong earnings helped lift the S&P 500 by 3.7% during March, paring back losses to 4.6% for 2022. The tech-heavy Nasdaq Composite rebounded by 3.5%, and is now down 8.9% for the year, despite the Fed’s March stated intention to be more aggressive. BMO Economics expects 50 bps hikes at the next two Federal Open Market Committee meetings, with the midpoint reaching 2.35% by the end of 2022.
Europe – Fuel conundrum
In March, the European Central Bank (ECB) said it would stop injecting capital into financial markets this summer, which would open the door to interest rate hikes. S&P Global’s chief economist Chris Williamson said, “businesses are bracing for weaker economic growth, with expectations of future output collapsing in March as firms grow increasingly concerned about the impact of the war on an economy that is still struggling to find its feet from the pandemic.” Inflation was 5.8% in February and is expected to climb higher; the ECB would prefer 2.0%.
European economies could see a diesel shortage as the European Union assesses a ban on Russian oil imports. Russia is Europe’s largest supplier of diesel, accounting for about 50% of Europe’s supply. The second largest supplier, Saudi Arabia, accounts for approximately 12% of imports. Replacement supply, if available, comes with higher prices. Alternatives could come from the U.S. (which is expected to have a net surplus of 1.1 million barrels per day), or the Middle East. However, increased flows from these locations would take time.
March saw the Euro Stoxx 50, FTSE 100, and DAX return 0.4%, 1.4%, and -0.3%, respectively. For the quarter, they returned -8.9%, 2.9%, and -9.3%, respectively.
China – Lockdowns return
In the first half of February, Lunar New Year festivities closed many factories and, as a result, energy demands decreased. But the Ukrainian conflict and subsequent supply shortages have caused commodity prices to soar. China imports 70% of its oil and 40% of its gas from overseas. The consumer price index (CPI) was up 0.9% in February; the government has left its 2022 CPI target at around 3.0%. China’s central bank plans to pay more than 1 trillion yuan in profit to the central government this year to help support fiscal spending.
Beijing’s determination to contain Omicron outbreaks indicates a willingness to make growth a secondary priority. Shanghai, China’s financial hub and largest city, has been under strict lockdown to contain a coronavirus outbreak, sticking to the country’s “dynamic zero-COVID” policy. President Xi Jinping aims to minimize the impact of COVID-19 controls on businesses and residents.
China’s manufacturing and services activity both contracted in March compared to February, the first such tandem shrinkage since the country’s major COVID-19 outbreak in 2020. Official readings were below 50, a level that indicates contraction.
For March, the Hang Seng and Shanghai Composite posted negative returns of 2.8% and 6.1%, respectively. For the quarter, they declined 5.7% and 10.7%, respectively.
Japan – Efforts to revive the economy
Japan’s Prime Minister Fumio Kishida ordered his ministers to develop a fresh spending package by late April to cushion the economic blow of rising commodity, energy, and grain prices impacting households after Russia invaded Ukraine. Mr. Kishida told reporters, “The government must carry out solid counter measures for rising prices of oil, raw materials and (other) goods, to revive Japan's economy.”
War in Ukraine and a weak yen have increased Japan’s cost of importing goods. The Prime Minister’s ruling coalition partner, the Komeito party, proposed a package that expanded subsidies to industries affected by rising fuel costs, cutting the gasoline tax and countering rising grain prices. Additional spending will add to Japan’s already massive public debt and will mean the economy will lag other developed countries in moving on from pandemic-related stimulus.
The yen sunk to a six-year low relative to the U.S. dollar thanks to a dovish Bank of Japan.
The Nikkei rose 5.8% in March and returned 2.5% for the quarter.
Our strategy
With no shortage of geopolitical and economic risk, uncertainty is currently the most prevalent theme. In an environment like this, diversified portfolios and a long-term perspective are vital for staying the course.
Within this broader framework, we make tactical adjustments to portfolios to position for the current market context. Given the ambiguity of the war in Ukraine, inflation and next moves by central banks, we believe it’s appropriate to modestly reduce portfolio risk, in particular from equities since they have enjoyed a bit of a bounce-back. We will be adjusting client portfolios to remove our explicit overweight to U.S. equities, preferring a modest overweight to North American equities, with appropriate underweights to fixed income. While we continue to favour equities overall, we believe it’s prudent to modestly scale back our conviction.
As the BoC and Fed are starting down the path of tightening, bonds will likely remain challenged. Therefore, we prefer to tilt toward cash, short-duration fixed income or alternative funds exposure in the near term.
The last word
Spring is traditionally a time for hope and renewal. While we certainly face significant challenges, there is reason to be optimistic. The Ukrainian people have been valiant in defending their homeland under the shadow of war and Western sanctions will continue to drain Russian resources. Economic and job growth remain strong, as do corporate earnings – which put some wind back in equity market sails. Most significantly, after two full years of COVID-19, we can cautiously move forward, transitioning from pandemic to endemic, and perhaps toward life as we once knew it.
Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe are reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change. BMO Private Wealth accepts no liability whatsoever for any loss arising from any use of this commentary or its contents. The information, opinions, estimates, projections and other materials contained herein are not to be construed as an offer to sell, a solicitation for or an offer to buy, any products or services referenced herein (including, without limitation, any commodities, securities or other financial instruments), nor shall such information, opinions, estimates, projections and other materials be considered as investment advice, tax advice, a recommendation to enter into any transaction or an assurance or guarantee as to the expected results of any transaction.
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