Central banks battle stubbornly high inflation
By ATB Investment Management Inc. 17 June 2022 4 min read
2022 has certainly been a volatile year so far for both equity and bond markets. While the COVID-19 omicron variant in January and the Russian invasion of Ukraine in February were contributing factors in the first quarter, the most recent fluctuations are mostly due to uncertainty surrounding: continued high inflation; the efforts of central banks to tame this inflation via interest rate hikes; and whether the economy itself will have a “soft landing” or experience a recession as a result of this policy.
The market selloff this past week was initially triggered by the US May inflation (CPI) report released on June 9, showing that inflation had continued to rise, primarily from higher energy prices. Markets sold off sharply as forecasters were now expecting a 0.75% rate increase at the next Federal Reserve (Fed) meeting, and more subsequent aggressive action to quell inflation.
With a strong labour market that hasn’t shown signs of easing, and a higher-than-expected CPI report, the Fed had the latitude to bump interest rates higher than initially anticipated on June 15. The Fed’s messaging in May pointed to further hikes of 0.5%, subject to economic conditions. With the CPI staying elevated, the decision was made to bump rates up by 0.75%. A hike of this magnitude hasn’t been seen from the Fed since 1994, which was also implemented to curb inflation. The 0.75% hike this week underlines the Fed’s commitment to achieving price stability again.
How higher interest rates impact asset prices
As volatile as this year has been, we believe much of the decline to date has resulted from repricing assets to the now higher risk-free rate. Whether we’re looking at a bond or a company stock, the price for that security is ultimately determined by the expected future cash flows (dividends, coupons, etc.), discounted to the present time, at the appropriate rate. When that rate moves higher, the present value falls. This is what we’re seeing in both equity and bond markets.
Using fixed income as an example and the bond holdings within the Compass Portfolios, and ATBIS Fixed Income pool, the holdings overall were yielding 3% as of the start of the year. At the time of this writing, the yield on the bond holdings is just over 5%. The roughly 10% price decline year-to-date was an impact of yields moving higher. Without a doubt, for conservative investors, the price decline has been painful with most investors having never experienced these kinds of declines in an asset class like bonds, which are typically associated with low risk. As we stated in our article comparing bonds and GICs last month, the losses to date have not been permanent due to defaults but instead due to bonds repricing lower to reflect the now higher yield to maturity. The fixed income holdings within the funds as of mid-June have a yield to maturity of just over 5% per year—far higher than at the start of the year.
For stocks, higher risk free rates have a similar impact. Global stocks at the end of 2021 traded at roughly 21 times the current annual earnings.1 Looked at another way, paying $21 for an annual expected income of $1 is an earnings yield of 4.75%. Today, thanks to stocks declining in price, you can buy that same dollar of earnings for $16 indicating a yield of 6.25%, higher by 1.5%, nearly mirroring the rise in government yields. Unlike bonds, stocks also tend to grow earnings over the longer term on average by an inflation adjusted 2 to 3% given an overall longer-term expected return closer to 8 to 9%. The expected return on stocks is therefore higher than the bonds held in the portfolios, and certainly much higher than government bonds or GICs at 3 to 4%. These return expectations still hold commensurate with the level of risk taken in each type of asset.
How the funds have performed through this period and forward expectations
Using the ATBIS asset class pooled funds as a proxy (which hold much of the same underlying assets as the Compass Portfolios), relative returns for the month have been positive. Within fixed income, the focus on shorter-duration bonds continues to pay off compared to the broader bond market with better performance through June 16 month-to-date by about 1.1%. Equities have also shown some resiliency within the funds. Canadian, US, and international stocks have outpaced benchmarks month-to-date on a relative basis by 0.2%, 0.9%, and 0.1% respectively.
What does all this volatility and asset repricings mean for our portfolios? It’s been a challenging year, for sure, with both bonds and equities having experienced negative returns. However, it’s important to remember that our portfolios are designed for a longer-term horizon, whereas this current period of market activity has been in existence for about six months, which is relatively short when considering a horizon of 10 years or more. While it’s difficult to forecast the length of this downturn, the current economic and company fundamentals remain sound. It’s prudent to stay the course and remain invested rather than reacting to volatility over the short term.
The MSCI world index representing global developed country equities had a trailing P/E of 21.48 at the end of 2021 compared to 16.34 on June 17,2022. Source, Bloomberg.
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