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May 13

Justwealth May Market Update

  • May 13, 2022
  • Exchange Traded Funds, Investing, Portfolio Management, Robo-Advisor

It was about one year ago when inflationary pressures were being dismissed as “transitory”. Undoubtably, that was a terrible misjudgement by central bankers, but the logic used to make such an assessment was not incorrect. The most common definition of inflation is the year-over-year change in prices for goods and services. If inflation was abnormally low exactly one-year ago, then current inflation will be measured against a weak starting point which may make the current inflation number seem high. When historical inflation returned to more normal levels (say a few months later), that weak comparison goes away and should bring current inflation back down. That was the logic used to justify the transitory nature of inflation.

Fast forward to today and inflation is now being compared to levels one-year ago when it started escalating rapidly – first from March to June, and then ramping up again in the fall months. The same argument now applies, but in the opposite direction. Unless there is some kind of exponential inflationary spiral (which is very unlikely), the year-over-year comparisons are now starting with abnormally high numbers, putting downward pressure on current/future inflation numbers simply due to the math of it all! Of course, there are more complicating factors involved, but the basic methodology for calculating inflation will now be a headwind instead of a tailwind for future inflation numbers.

Aggressive interest rate hikes have already happened, and the current pace of tightening is expected to continue and has been effectively priced into both bond and equity markets. This explains the 10% negative return in the Canadian bond market year-to-date, with similar-sized drops in equity markets over the same period. Looking forward, these interest rate hikes will also put downward pressure on inflation, by reducing consumers’ disposable income and disincentivizing business investment, effectively slowing economic output. If central banks tighten too aggressively, they will put economies into recession which will put immediate downward pressure on wages – another major culprit in inflation.

It is safe to say, that in our opinion, the turn in interest rate pressure is nearing, or may have already passed. Central bank increases will still occur over the coming months, but in our opinion, stability in bond market prices (government and higher quality corporate issues) should happen in the near term. Furthermore, given the dramatic change in yields across the entire spectrum of bonds, it has raised our long-term expectation for bond returns for the first time in many years!

Losses in the equity markets have been felt more severely in the more speculative sectors, namely technology. Companies that were bid significantly higher on promise and a good sales pitch during a period of excessive liquidity have been hit hard. This is very reminiscent of the dot.com crash of the early 2000’s where self-directed traders suffered huge losses and left the markets in droves. Sometimes a humbling experience like losing wealth due to excessive speculation is healthy for markets overall as it purges out a source of unnecessary volatility and prevents bubbles from building. Eventually, we expect that equity markets will return to normal, like they always have.

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