Uncertainty abounded at the start of 2022. Just as the pandemic started to recede from headlines, it was quickly replaced with stories about continued high inflation, rising interest rates, and geopolitical risks. While we’re used to seeing equity markets bear the brunt of volatility, bonds were down significantly as well. Bonds are supposed to be the stabilizer for choppy equity markets, and typically are. Quarters where bonds and global stocks are both down at the same time have only happened about 10% of the time since the mid-1970s. This is only the second time it’s happened in the last 10 years. Q2 2015 also experienced this aberration, which was far more mild with both equities and bonds only down 1 to 2%, which is why this quarter made investors more uncomfortable than they otherwise might be in times of volatility. 

The funds have been holding less interest-rate-sensitive (shorter maturity) bonds in anticipation of higher interest rates. It paid off last year in the funds, which was already a poor year for bonds. For the start of this year, we don’t believe many, including us, expected the speed and magnitude of rate increases. Rates moved up about 1.14%, and we were happy to have less duration at roughly five years compared to the broader universe at eight years. It paid off with fixed income in the funds, down around 5%¹ compared to the FTSE Canada Universe Bond Index, down 7% for the quarter. 

As for the cause of the swift interest rate rise, central banks earmarked raising rates at a faster pace to combat inflation in the January meeting. Russia’s invasion of Ukraine gave temporary pause to rates—yields typically come down in periods of uncertainty, and interest rates actually did by nearly .5%²—but the impacts to energy prices from supply disruptions over Russian exports put inflation back in focus driving nominal rates higher. Projections today call for as much as 2.25%, or nine quarter point hikes to the Bank of Canada’s target overnight rate by year-end in Canada. That’s up significantly from the 1.25% in hikes expected for 2022 at the end of 2021. 

The +1% difference in expectations has materialized by hitting Canadian bond holders with the worst quarter since at least prior to 1980 (which is as far back as records go for the FTSE Canada Universe Bond Index). Part of the problem in comparing this past quarter to many decades ago is that we never had a high starting yield to begin with to cushion the blow. This not only gives an investor less carry in the form of periodic interest, but also increases the interest rate sensitivity of the average bond (duration) with the bulk of the cash flows returned at maturity through principal, rather than spread out through higher interest payments over the whole period.

That brings us to the good news. Looking forward, yields for the FTSE Canada Universe Investment grade bond index topped 3.17% near the end of March, the highest yield seen since 2011. The fixed income within the funds, holding a higher weight in credit, has an even higher expected return with an average yield of just over 4%. Despite the uptick in volatility from Russia’s actions, credit spread movement has been relatively subdued over the quarter. The funds continued improving bond credit quality, adding to high quality liquid positions so that we have the ability to be opportunistic again should a larger credit event occur.

In anticipation of rising interest rates, equity markets were already off to a poor start during the first half of the quarter. US equity markets, with larger weights in higher valuation sectors most sensitive to interest rates, were hit harder than other markets in early January. The funds held less in some notable names such as Meta (Facebook) and Netflix, which both continue to be down 30 to 40%. Overall, US equities in the funds lagged. However, through the quarter the fund experienced positive attribution in technology, communication, and consumer discretionary sectors, and was offset negatively by selection in commodity-focused cyclicals, which were among the best performers—namely energy and materials. 

Within international stocks, Russia’s invasion of Ukraine late in February fanned the flames of an already volatile market. As sanctions were applied to Russia, commodity prices sharply rose to multi-decade highs, leading to further inflation and concerns around energy prices stifling economic growth. As mentioned in communications earlier this year from the ATBIM team, exposure to Russian stocks within the funds was minimal. Relative performance compared to the MSCI EAFE Index was still negative though for reasons similar to the US. The funds have less exposure to cyclicals, like energy, which did well, and lagged from selection in a few higher valuation companies. Companies like professional publisher Wolters Kluwer, and specialty chemicals manufacturer Sika, for example, have performed very well over recent years, but moved down in tandem with the broader growth sell-off in January. We continue to position the funds with a slight overweight to international stocks, as valuations remain attractive. Regional performance differences are very difficult to forecast, so we have always prioritized diversification. That said, the valuation gap to other regions for international stocks is starting to be material. Should it continue, a further overweight could be warranted. 

Canadian equities have weathered the turbulent markets well this year, being one of the only developed markets that is positive year to date. This is largely due to prominent financial, energy and materials sectors, which saw positive performance. The funds’ relative higher weight—when compared to the S&P/TSX Composite Index—in financials coupled with an on par energy exposure, helped cushion negative returns from the other parts of the funds. Taking advantage of the relative strength, we trimmed Canadian equities and bonds in favour of international equities at the beginning of March. We subsequently rebalanced back into bonds later in the month as international markets rebounded after digesting the situation in eastern Europe. 

Interest rates have moved up considerably in anticipation of swift rate hikes. Where we go from here is a question mark—higher rates are not a given. The central banks do not have an easy path ahead as they aim to tame inflation without (hopefully) pulling the economy into a recession. Our longer-term view continues to favor equities compared to bonds, which reflects our current positioning. This was due largely to our view that fixed-income returns would be poor in the coming years as rates normalize, and equity valuations by comparison still looked attractive. A lot has happened in three months though. In the near term, should yields rise further supporting the case for bonds, and as risks mount for a higher probability of recession, we will shift towards less equity exposure as we last did in 2018.