indicatorMarket Commentary

Market volatility, central bank meetings, and… Ukraine?

By ATB Investment Management Inc. 27 January 2022 6 min read

We’ve seen a busy start to the year for capital markets, from expected and unexpected sources. Volatility has returned to equities after a relatively quiet finish to 2021. Intraday sell-offs and rallies captured attention on Monday and Tuesday this week, as participants awaited the results of central bank meetings in Canada and the US. Meanwhile, tensions between Russia and the US over Ukraine contributed to increased geopolitical concerns, while COVID-19, for once, was relegated to the background.

The good news is that we expect this latest equity sell-off to be fleeting, despite the expectation that markets will be more volatile this year compared to last. We’ll explain why, but first, let’s explore some of the reasons it might be happening.

If we take a step back, last year was relatively calm, historically speaking, for equities with the worst declines being around 5%. The average annual decline over the last 50 years is around  14%1. So far this year, the US equity market is down about 9% while Canadian and international equity markets are down a more modest 3% and 5% respectively2. The recovery from the pandemic is much further along than this time last year, so there are questions around whether economic growth will still be supportive, what impact inflation will have on the economy, and how much central banks might pull back on stimulus. Couple that with the Ukraine tensions, and all these question marks have led to higher volatility in the first few weeks of 2022. Of all of these, we believe that central bank policy action—in the form of anticipated higher interest rates this year—is having the biggest impact. We support this with two broad market themes. 

The first argument in support of this is the observed difference in performance between “growth” and “value” stocks this year. The theory goes that rising interest will impact growth stocks to a larger degree since their cash flows supporting company valuations are further out into the future. Higher interest rates—not to mention high levels of inflation—put a higher cost on waiting for those future cash flows, so these growth companies, in-turn, will be less attractive. Value stocks, on the other hand, tend to see less earnings growth, but provide an investor with cash flows today. Rising interest rates and inflation are less impactful when value stocks give tangible cash in hand today to support valuations. Regardless of whether this theory is true or not, growth stocks year-to-date have taken it on the chin and are down about 12%—far more than companies classified as value, which are down about 2%3. Shopify in Canada has been a relatively well known poster child for this. Trading at high valuations underpinned by earnings expected many years from now, the stock is down roughly a third in price from the start of the year.

Value outperforming growth

Source: MSCI, Bloomberg

The second argument is that the sell-off in equities has not had much of an impact on the corporate bond market. Rising corporate bond yields compared to similar term government bonds, known as credit spreads, can often be a good indication of deteriorating business conditions. These spreads can reflect the fear that a company will have a harder time paying its debts in the future. Corporate bonds year-to-date have not seen a comparable sell-off, and movement in credit spreads have been relatively subdued. In fact, year-to-date, corporate bonds protected value when compared to higher-quality government bonds. Instead, what we have seen is an increase in interest rates impacting bond prices; a move in interest rates likely pre-empting the targeted move up from central banks this year. Long-term government bonds, much like equities, have cash flows that stretch far into the future. Coincidentally, long-term government bonds have almost mirrored equity returns this year, down about 7%4.

US corporate bond spreads in context

Source: ICE BofA US Corporate Index spread vs. government via Bloomberg

From the beginning of the year through to Jan. 26, the CompassTM Portfolios and ATBIS Pools have been mixed compared to overall markets. 

Fixed income within the funds continues to benefit from shorter overall duration, so while down in absolute terms by around 1.7%, it has performed better than the overall bond universe, which has longer duration and is down 3.4%. Canadian equity is also faring better with one of the biggest differences being a far lower weight in Shopify. Of the TSX Composite’s 2.8% decline, about 2.3% is because of Shopify. This is a stock that was the largest in the TSX Composite at the start of the year, but one that the funds hold very little of. As a result, the Canadian equity portion is down less, at roughly 0.9%.

The US and international equity components are down compared to their respective S&P 500 and MSCI EAFE benchmarks. Much of this international equity is also behind the broader EAFE index. A detractor in these regions has been less energy weight overall (the best performing sector YTD). Some of the higher valuation cash-flow compounders that are held through the Mawer mandates have sold off with the broader growth market. Stocks that may be familiar such as tax and accounting software provider Intuit, and insurance broker Aon, are two examples of larger weights that have been hit this year with no underlying fundamental reason. Within the funds, we took the opportunity to sell some of the bond holdings and rebalance into international equities on Jan. 24, believing that equities are still poised to do better than bonds in the coming years.

ATBIS Pools series F performance vs. benchmark
year-to-date to Jan 26, 2022

Source: ATB Investment Management 
*Please see important portfolio disclosure information at the end of this document

Compass series A performance vs. benchmark
year-to-date to Jan 26, 2022

Source: ATB Investment Management Inc. 
*Please see important portfolio disclosure information at the end of this document

Equity markets have experienced a downturn since the start of the year, and with it an increase in volatility. A factor behind the sell-off is the concern over the impact of higher interest rates, which, when coupled with elevated inflation, may erode the value of future long-term earnings. Indications from the Bank of Canada and the US Federal Reserve suggest hikes will likely start in March. While the market has been primed for this, and likely priced in the prospect of several rate hikes this year, jitters about the timing have likely contributed to the volatility. As an analogy, consider the preparation and work required for an upcoming exam, and when the day arrives, there are still additional nerves.

Within the more conservative portfolios, the Compass Portfolios and ATBIS Pools have performed well, and met our expectations. The equity-centric portfolios have missed the mark, especially in international equities. This has been unexpected given our tilt toward quality companies, but the move was not due to any change in process or deteriorating fundamentals. For comparison, we can look back at historical equity performance, using the 100%-equity Compass Maximum Growth Portfolio for reference. The track record shows the fund performing better than the benchmark about two-thirds of the time on a monthly basis in down markets. So while the start of the year hasn’t been ideal, markets are unpredictable in the short-term, and this type of deviation is not abnormal for our equity holdings overall. 

Our view as we head into a rate hiking cycle is that economic conditions and equity fundamentals such as earnings remain supportive, and our portfolios are well-positioned over the medium-to-longer term. Brief bouts of high volatility are not unusual in equity markets, and we expect this current spell to be fleeting or, in other words, transitory.

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