In our outlook for 2022, we noted that the macroeconomic backdrop was becoming more challenging.
A combination of monetary tightening and stubbornly high inflation would mean returns on developed government bonds were likely to be flat to slightly negative. We anticipated that equities and commercial property returns would be higher than government bonds but that high valuations and weaker growth would cause them to fall well short of returns in 2021. While many analysts were forecasting the start of a new commodities supercycle, we expected most commodity prices to fall by 2023. We expected that growth in 2022 would be weaker than most currently anticipate. Likewise, we believed that inflation would fall back next year in most countries, albeit at a slower pace than consensus expectations.
“…Russia’s invasion of Ukraine has impacted our international equity allocation and increased the market risks and obstacles that investors will face in 2022 and beyond.”
As a result of these expectations, we lowered our fixed-income duration across our portfolios, slightly reduced our equity overweight and brought our small-cap overweight back to neutral. We did slightly increase our international equity, and Canadian equity exposure as our expectations were that these markets would do better in 2022 as a result of their more attractive valuations and cyclical exposure. On the whole, the fixed income and equity asset mix changes have benefited our portfolios in Q1, however Russia’s invasion of Ukraine has impacted our international equity allocation and increased the market risks and obstacles that investors will face in 2022 and beyond. Further, the war has caused us to re-evaluate some of our expectations for 2022.
“..we now expect global inflation to be one percentage point higher on average this year than we previously envisioned.”
Price pressures have intensified again, and we now expect global inflation to be one percentage point higher on average this year than we previously envisioned. As of February, global inflation rose to a 13-year high of 5.3%, and it appears that it will rise further in March and April as the surge in energy prices related to the Ukraine war takes effect. There is also the risk that the war will exacerbate supply shortages. We did see improvements in the supply of goods in services in the first two months of the year, but the reduced supply of Russian and Ukrainian exports of key goods, including metals and wheat, threatens to worsen the supply challenges. Further exacerbating the issue is that shipping costs have risen further, not just because of the war but also due to renewed virus-related shutdowns in China.
Given all the headlines, it may not feel like it, but now is probably the point of maximum pain as fading energy and supply chain re-openings should bring inflation down as the year goes on. Labour markets are still very tight, and there is a risk that transient pressures morph into more sustained ones as wages are bid up, causing core inflation to settle at uncomfortably higher rates. The one reassuring sign is that there is early evidence of an easing in the cyclical price pressures in the U.S., which led to the upward charge in inflation last year. Nonetheless, we think that central banks are right to be laying the groundwork for a marked rise in interest rates in the year ahead. What is for certain is that rate increases will not solve supply-related issues unless central banks move far enough and fast enough to collapse demand. However, that may make things worse in the short run if increased financing costs inhibit economic growth.
“Given the upside surprises to inflation and the hawkishness of policymakers, we believe there is more monetary tightening in the pipeline than we thought likely three months ago.”
Provided that financial risks do not crystalize as monetary policy is tightened, we suspect a further inflation overshoot would cause policymakers to err on the side of acting even more decisively. Given the upside surprises to inflation and the hawkishness of policymakers, we believe there is more monetary tightening in the pipeline than we thought likely three months ago. As noted in my previous commentaries, central banks are stuck between a rock and a hard place. They need to rein in inflation, a large portion which is out of their control, while supporting economic growth and the financial markets. I expect that central banks may be willing to sacrifice financial markets in order to keep the economic growth momentum positive. This would be painful and should be a concern for investors and cause them to re-evaluate the risks in their portfolios. From my team’s perspective, the range of outcomes has widened, and we are re-evaluating those risks and the market response to the next set of rate increases. At the moment, the market is vacillating on a daily basis as to whom it believes will be the winners and losers. I am happy with our current positioning, as our factor diversification is immunizing these vacillations. However, further changes to our portfolios may become necessary in the near future, should conditions worsen.
As an investment team, we think a lot about risk exposures: which ones we want to take on because we believe there is a risk-adjusted opportunity and those that we want to avoid or minimize. I have noted that many investors, in their search for yield and avoidance of inflation risks, have gravitated heavily to floating rate/leveraged loan funds. We have seen the quality of the leveraged loan market depreciate significantly over the last couple of years as the lowest quality issuers have moved from the traditional high yield bond market into syndicated leveraged loans. A recent report from the Federal Reserve Bank of New York confirms our observations.
I’ll save you the trouble of reading all 55 pages and highlight the following observation by the Federal Reserve Bank staff:
“Our research suggests that much of this lending is, in fact, riskier than high-yield bond lending, despite being senior secured. A rule to remember in lending is that the best borrowers borrow long, fixed, and unsecured. The worst borrowers borrow short, floating rate, and secured. And in this case, the main driver of leveraged loan growth is private equity using loans to fund buyouts. Senior secured leveraged loans help private equity firms maximize the amount of leverage for the lowest cost.”
I would caution investors who are seeking income and to minimize the effects of inflation to size their positions in leveraged loan funds appropriately for their risk level. We do have exposure to loans mixed in with our high yield bond exposure, and we’re satisfied that it’s appropriately sized for the risks inherent in the position. A considerable amount of money has flowed into private equity over the last few years and leveraged loans have been the security of choice to fund acquisitions. As a result, if we have a recession that lasts longer than three months, I expect that credit quality will be problematic and the outcome may not be pretty for investors who have taken on outsized risk should defaults spike.
Until next time, stay safe and be well.
Chief Investment Officer