We’ve seen a tumultuous year so far both in terms of world events and stock market performance. Stock and bond markets in particular are experiencing an uptick in volatility, which might feel more magnified given the long period of low volatility over the last decade. There are various causes for this increase in volatility, such as the recent invasion of Ukraine, higher inflation, and the noise around central banks increasing interest rates. 

Given what’s happening in the world and markets, investors are understandably concerned, which is why we continue to issue regular updates starting with our January update that featured an article about market volatility and geopolitical tension. At the time, the threat of invasion from Russia was heightened, but not a certainty. The bigger worry was inflation, and the likelihood that central banks would soon be raising interest rates. We issued another update when Russia invaded Ukraine to share commentary from our portfolio managers and sub-advisors. 

Fast forward to mid-March, and neither the prospect of increasing rates nor the situation in Ukraine has abated. Let’s explore what’s happened in markets year-to-date, and the impact of recent volatility on our funds. 

Central banks, rising rates, and inflation

The time of increasing interest rates has arrived. Labour markets are near pre-pandemic levels of employment, or even better in the case of Canada. As central banks typically have a dual mandate to strive for full employment and price stability, they can finally turn their attention to the latter—CPI in Canada was 5.7% year-over-year as of February. The Bank of Canada raised interest rates for the first time since 2019 on March 2, and the Federal Reserve in the US followed with its first hike on March 16. This was the first of many raises earmarked for the year from both central banks, with another five to seven quarter point hikes expected by year end.

The net result of this has been interest rates rising at a pace not seen for a number of years. We mentioned in the year-end portfolio managers’ commentary that 2021 was the worst year for overall bonds in Canada since 1994, down about 3% as yields rose 0.72% for the year. So far in 2022, the overall yield on the FTSE Canada Bond Universe has risen an additional 0.92%, driving bond returns further into the red by another 6.7%. Despite some increase in credit spreads due to risks over Russia, corporate bonds have performed on par with broader investment grade bonds, down about 6.4% year-to-date. 

For the Compass^TM Portfolios and ATBIS Pools (the funds), the fixed income represented by the ATBIS Fixed Income pool—which holds the same components at similar weights to the other funds—is fairing a little better on a relative basis, losing 5.2%. We have anticipated the possibility of rising interest rates for a number of years, and have positioned the funds by holding shorter maturity bonds on average, which are less sensitive to interest rate fluctuations. This has not been enough to overcome the pace at which yields have risen so far this year, which is still leading to negative performance on an absolute basis. The good news is that rising yields lead to better expected future returns for bonds. We left 2021 with the fixed-income holdings within the funds averaging a roughly 3% yield to maturity. At this point, that figure is closer to 4%.

The impact of the Russian invasion and interest rates on equity markets

Equity markets overall unfortunately haven’t done much to balance out the losses from bonds this year. Global equities as represented by the MSCI All Country World Index in Canadian dollar terms are down about -8.7%, but there are significant regional differences. A multitude of factors are at play here, so let’s explore a few of the largest possible contributors.

Canadian equities have fared better on average thanks to a large exposure to commodities—particularly energy. The sector represents about 15% of the Canadian market and is up over 24% so far this year. While the price of oil has forged a tumultuous path over the last few weeks, Canadian equities continue to stay afloat, up about 1.7% for the S&P/TSX Composite. Our funds have benefitted from this energy exposure, and also hold a relatively higher weight in financials, which have also done well. Canadian equities within the funds as a result have performed slightly better than the S&P/TSX Composite benchmark, up roughly 2.4% so far year-to-date¹.

US and international equities have not benefited as much from the rise in oil and gas. Energy stocks only make up about 4% of the market outside of Canada across developed markets—not enough to offset the poor performance from the other sectors in aggregate. US stocks are down roughly 7.7%, and international down 8.9% year-to-date. 

So what has been impacting other sectors? 

The increased earnings that some companies saw as a result of the pandemic and lockdowns seem to have been temporary for some. Companies like Netflix saw increased subscribership through 2020 and 2021, but are expecting muted growth for 2022. As a result, its stock is down more than 40% since the start of the year. 

Just like bonds, higher interest rates can also put pressure on stocks, especially higher valuation companies. We mentioned in the January update that “higher interest rates—not to mention high levels of inflation—put a higher cost on waiting for future cash flows, so these growth companies, in-turn, will be less attractive.” Shopify, a Canadian company trading at lofty valuations based on future expectations, was used as the example—down a staggering 54% year-to-date as of the time of this writing—but there are many similar companies that have taken it on the nose this year in the face of higher interest rates and inflation. Investors have shifted to valuing what a company can do for a shareholder today, not tomorrow. 

Finally, Russia’s invasion of Ukraine has also thrown the proverbial “spanner (or wrench) in the works” for markets around the world. Geopolitical tensions can be hard to predict, not only in terms of the ultimate outcome, but also the length of time an event plays out. Items at play in Ukraine include not only political and military conflict, but also, of importance to economies and capital markets, the supply of energy, given Russia is one of the largest exporters of oil and gas (especially to Europe). Given the region’s dependence on Russia, European equity markets have certainly not escaped the volatility. Indeed, the volatility in European equities so far in 2022 (as of March 15) is almost double what was experienced in all of 2021. 

The international equity component within the funds continue to lag the MSCI EAFE benchmark year-to-date, but the relative gap has closed slightly since our January update. As we said then, the performance differential can be attributed to an underweight in energy, as well as some of the higher valuation companies held through Mawer dropping with the broader sell-off in growth stocks.

Overall, the Compass funds are well positioned to weather the recent volatility in equity markets. Our allocation to Canadian equities and relative strength in our fixed-income holdings have allowed us to take advantage of the weakness overseas, buying companies at valuations not seen since the depths of the initial pandemic sell-off². Across the funds, we continue to actively rebalance trimming our Canadian equities and fixed-income holdings, re-deploying the proceeds into US and International equities. The funds have been rebalanced into international equities three times this year, with the latest round of buying on March 7.