Inflation remained elevated through most of the developed world in the second quarter staying above 8% in the US, and rising to 7.7% in Canada for May. Employment data, on the other hand, has remained strong. This has allowed the central banks to move more swiftly with rate hikes to slow demand for goods and services. The Bank of Canada’s target overnight rate has increased to 1.5% from 0.25% at the beginning of 2022 with more hikes expected, but the remaining anticipated moves have already been reflected with higher yields throughout the yield curve. 

If we dig a little deeper into the inflation numbers, there are some early signs, in the US at least, that the upward trend of inflation since March 2021 is turning. The core CPI in the US, which excludes the volatile sectors of energy and food, has reported year-over-year (YOY) changes of 6.2% in April, and 6.0% in May, after hitting a high of 6.5% in March this year. The core PCE (personal consumption expenditures) indicator, which the US Federal Reserve prefers to use to determine its interest rate policy (and which also excludes energy and food), has also been trending down after hitting a YOY high of 5.3% in February 2022, 5.2% in March, 4.9% in April and 4.7% in May.

Granted, annual inflation rates with a magnitude of 4.5% and above are still higher than what central banks like to see, no matter the indicator used, nor the sectors excluded. And to be sure, a downward trend of two or three months is not conclusive. Trimming excess demand from the economy will be needed for inflation to return to its target range of between 2 and 3%. Those indicators, however, are moving in the right direction and suggest that the rate hikes so far are having an impact.

The faster pace of rate hikes—just as in the first quarter of 2022—has moved interest rates up across the curve by roughly 0.75% to 1% depending on tenor. Interest rates in Q2 on average rose just as much as Q1. This has led to the yield on the broad Canadian bond index rising as high as 4.28%, the highest since November 2008.¹ Most of the dramatic increase in rates can be traced to government bond yields, and while corporate bond spreads have risen in tandem, they remain just slightly above their long-term averages, and have yet to signal any significant distress.

With central bank rate increases kicking off in high gear, inflation levels not seen since the 1980s, and continued pain at the pump, it’s no wonder that US and Canadian consumers are feeling the pinch, as showcased by significant drops in consumer sentiment over the quarter. The US reached a record low, and Canadian consumers haven't felt this pessimistic since 2008/2009. The pessimism is showing up in the data, with year-over-year US real personal spending growth returning to pre-pandemic levels, after coming in well above average since April 2021. Despite the general sour mood, consumers are well equipped to weather a recession. Savings are still well above historical norms in Canada and in the US, loan delinquencies are well below historical averages, and Canadian and US household debt service ratios continue to remain favourable compared to pre-pandemic levels despite the recent increase in rates. 

The rise in yields led to another quarter of negative returns for bond holders, down 5.7%, exacerbating feelings from an already tough first quarter. Bond holdings within the funds fared slightly better down 4.8%.² Similar to Q1, the shorter-duration bonds in the funds are less sensitive overall and returns have held up better in the environment of increasing rates. Bond quality has continued to improve and as of the end of the quarter, the fixed income held was priced to yield about 5% with a 3.8 year duration.

Within equities, Canadian, US, and international stocks all fell further for the quarter. Canadian equities, which were well insulated from declines early in the year thanks to the large energy sector performing so well, did not have the same buffer in the last quarter. The fund’s Canadian equity holdings protected some of the downside, up about 3% compared to the S&P TSX Composite Index. Holding far less Shopify, as well as little to no exposure to the poorly performing gold companies within the materials sector, helped limit downside. 

The funds also saw better relative performance within US equities by 1.6%. In a similar vein to Canada, having far less exposure to high valuation companies such as Tesla and Nvidia helped protect the downside. On the other hand, holding higher weights in familiar resilient names like Dollar General, Hershey, and Johnson & Johnson were additive, all seeing positive returns for the quarter. Lastly, small-cap and mid-cap stocks, which are overweight in the fund due to ongoing attractive valuations compared to large-cap, saw relatively less downside for the quarter.  

International equity was the one region this quarter where the funds saw negative absolute and relative performance, lagging the MSCI EAFE Index by about 0.3%. A lack of energy stocks accounted for about half of the relative underperformance. The energy sector is small at 5% of the index, but was the best performing sector over the period (down 1% in CAD terms), while the overall market was down 11.5%. Other detractors weren’t specific to any one sector or region, but were primarily due to individual security selection with higher-interest-rate sensitivity compared to the index. As an example, Taiwan Semiconductor (TSMC) has been a detractor this year. It may have been lumped in with the sell-off of other pandemic darling stocks that have been out of favour in 2022. Unlike some of those other stocks that saw a one-time lift from pandemic conditions, TSMC is the world's largest supplier of semiconductor chips, which continue to be in short supply. Its business model was proven long before the pandemic and at this point, the stock trades at a discount given the company’s past and forward-looking earnings growth trajectory.

This year has been difficult for investors, but for ATB Investment Management, these kinds of markets remind us why we have an investment philosophy that guides our decisions. We highlight some of the individual companies and fixed-income characteristics within this commentary because it’s a reminder that there is tangible value within the assets held by the funds. Contrast these assets with something we don’t hold, like a cryptocurrency, where it’s difficult to perceive any tangible value, and the price moves up and down based on supply/demand or sentiment. 

When markets inevitably become volatile, focusing on tangible value allows us to stay resolute on our long-term focus. Whether it’s a high-quality bond that now yields more than 5%, or a Canadian bank that we are holding at some of the best prices seen over the past decade, we know there is value in the cash flows these assets produce. Uncertainty drives market volatility in the short term, but valuations have a far better forecast of long-term performance. Valuations today are attractive, and leave us with greater conviction in our portfolio positioning.