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May 12, 2022|Market Commentary|
As emphasized in The Year in Review: 2021, we believe in passive investment management and therefore don’t spend a lot of our time analyzing the economic cycle, worrying about current capital market valuations relative to our own estimates, or forecasting short-term returns for individual securities, sectors, or countries. Instead, we focus on establishing long-term (i.e. 10+ years) return assumptions for broad asset classes and constructing model portfolios that we expect will provide our clients with efficient returns over that time frame.
While it has only been a few months since publishing our 2021 update, the significantly negative year-to-date performance of capital markets in 2022 has received a lot of media attention and we feel it deserves a special commentary. As your portfolio manager, we have a responsibility to keep you informed about the performance of your investments, but we believe it is equally important for us to discuss recent capital markets performance in a broader context and to remind you about the importance of sticking to your long-term investment strategy during times of volatility and uncertainty when fear might tempt you to do otherwise.
Year-to-Date Performance Overview
To begin, let’s review year-to-date performance for individual asset classes (Chart 1) and how those returns interact when combined in different proportions within our model portfolios (Chart 2):
Ugly would be an appropriate word to describe the year-to-date performance figures outlined in Charts 1 and 2. Due to a confluence of factors – the Russian invasion of Ukraine, ongoing pandemic impacts on supply chains, and shifting monetary policy in response to rising inflation – returns have been significantly negative across most asset classes, leaving investors few places to hide. After reviewing these results, six topics are worth highlighting (click/tap a topic to expand):
Gold has provided diversification benefits
While most asset classes have declined in lockstep, gold (+4.1%) has been a notable exception. Gold is an optional component available in some of our model portfolios, included for its potential diversification benefits. It has been working as intended thus far in 2022, cushioning model portfolio returns by 0.5% to 0.7%, although this may be little consolation when a portfolio is still down double digits.
Foreign currency exposures have provided mixed benefits
When we invest in foreign assets (e.g. U.S., International, Emerging Markets, and Global Low Volatility equities) we do not hedge the foreign currency exposure. Foreign asset class returns in Canadian dollar terms are therefore a combination of the return on foreign equities themselves and the gain/loss of foreign currencies relative to the Canadian dollar. Historically, leaving foreign currency exposures unhedged has reduced the overall volatility of a Canadian investor’s portfolio.
This historical relationship has held in 2022 for U.S. equity, with the unhedged exposure to the U.S. dollar (+2.3%) somewhat cushioning the negative U.S. equity market results. However, due in part to the Russian invasion of Ukraine, the unhedged exposure to other foreign currencies (-2.9% on a representative basket of international currencies) has detracted from the returns for International, Emerging Markets, and Global Low Volatility equity in 2022.
Canadian equity has outperformed
While still negative year-to-date, Canadian equity (-5.7%) has significantly outperformed other equity asset classes. Much of this is a result of the Russian invasion of Ukraine and the resulting increases to global energy and agricultural products, things that Canadian companies sell a lot of.
Global Low Volatility equity has outperformed
Some of our model portfolios include an allocation to Global Low Volatility equity. As the name implies, this asset class seeks to invest in equities that have lower volatility characteristics (i.e. experience smaller price increases/decreases) relative to the broader equity market. While this could be considered a type of active investment management – something we generally eschew – there is historical evidence supporting the strategy, and it has performed as expected thus far in 2022, with a year-to-date decline (-8.5%) that is about half that of other equity asset classes.
Equity returns are not out of the ordinary (at least so far)
Some equity asset class returns are approaching the 20% decline threshold that would categorize a bear market, and the results for some individual stocks have been much worse. However, we don’t view these year-to-date results as out of the ordinary (at least so far). By their nature equities are risky – this is why they have historically compensated long-term investors with higher returns than bonds or cash – and it is quite common for equity returns to fall double-digits within a year before recovering to finish the year in positive territory. As a recent example, recall that U.S. equities fell almost 30% in early 2020 at the start of the pandemic before finishing the year up almost 20%. We can’t say whether that will be the case in 2022, but we believe that medium- and long-term returns will continue to reward equity investors for the risks they undertake.
Fixed Income returns are uncharacteristically poor
While we just argued that year-to-date equity returns do not seem out of the ordinary, the same cannot be said for fixed income. Universe Bonds (which includes short-, medium-, and long-term bonds issued by Canadian governments and large corporations) have historically experienced negative returns in about 1/10th of years, and when negative results do occur they are typically moderate (e.g. -2.5% in 2021, -1.2% in 2013).
By contrast, Universe Bonds (-10.5%) have experienced a dramatic decline year-to-date. This uncharacteristically poor performance warrants further discussion, which continues in the next section of this article.
Among the six topics we’ve highlighted, the uncharacteristically poor performance of Fixed Income stands out to us as the most important and warrants further discussion. In the next section we’ll discuss why bond returns have been negative this year and what that means for bond investing going forward.
What Happened to “The Safety of Bonds?”
The start of 2022 has been characterized by the simultaneous decline of fixed income (bonds) and equities (stocks). Historically, these two investment categories have moved up and down in response to different economic forces, with their prices often moving in opposite directions. Investors refer to “the safety of bonds” because bonds generally perform well when there is a significant sell-off in the stock market, providing much needed diversification to an investment portfolio. The cushioning effect occurs because a falling stock market is often accompanied by an expectation of declining interest rates and bond prices increase when interest rates decrease.
Year-to-date, bonds have performed poorly for the opposite reason: rising interest rates. Longer-term interest rates have increased as investors began factoring in a series of aggressive rate hikes from the Bank of Canada intended to combat rising inflation. While these rate hikes will likely be implemented over the course of several years, bond investors don’t wait for each rate hike announcement to actually occur; instead they factor all future rate hike expectations into their decision-making immediately, as demonstrated in Chart 3:
Much of the pain for bond returns may now be factored in
The poor year-to-date performance of Universe bonds (-10.5%) may have you wondering if it makes sense to hold bonds at all, especially if the Bank of Canada is expected to keep hiking short-term interest rates. In response to this question, keep in mind that bond investors have already factored future rate hike expectations into their decision-making and prevailing interest rates have therefore adjusted to incorporate the “bad news.” This is well demonstrated by the wide gap that currently exists between the Canada 10 Year Bond Yield and the Target for Overnight Rate (Chart 3).
Investors’ reaction to the prospect of more Bank of Canada rate hikes over the coming years led to an immediate adjustment to bond interest rates and concentrated the long-term impact of those rate hikes (i.e. negative bond returns) into just a few months in early 2022. At this point, additional negative bond returns should only occur if investors begin to expect that even more Bank of Canada rate hikes (above the ones that are already anticipated) will be necessary.
The prospect for future bond returns is drastically improved
The higher interest rates in early 2022 that are responsible for the poor year-to-date performance of Universe bonds also provide a silver lining. With higher prevailing rates, bond investors will now earn a higher rate of return going forward – assuming interest rates do not continue increasing from here.
As outlined in Chart 3, the Canada 10 Year Bond now yields about 3% which is 6 times higher than the 0.5% yield that investors received from a similar bond in mid-2020. Furthermore, the yield to maturity on a typical Universe Bond fund now exceeds 3.5%, substantially higher than our most recent long-term capital market assumption of 1.9% for the asset class. While the events of early 2022 resulted in a one-time performance hit to bonds, an investor selling bonds today would miss out on the ability to earn back that lost performance at a much faster rate going forward.
Consider Short-term Performance in a Broader Context
While immersed in a downturn it can be difficult to step back to consider the big picture. Uncertainty often leads to fear, which leads to irrational behaviour. As your portfolio manager, one of our most important jobs is to help you identify irrational behaviours and overcome the urge to act on them. There are a variety of ways we can help with this, but one technique is to simply show you a chart of long-term investment performance that puts the scale of recent market performance into perspective (Chart 4):
Other things to keep in mind:
- We’ve worked together to create your financial plan. The return assumptions in your plan incorporate periods of poor performance so it is unlikely that any of your financial goals have been derailed by recent capital markets performance.
- If you are currently a net saver (i.e. you are making regular contributions to your investment accounts or you let distributions within your accounts be reinvested) the recent decline in capital markets means that your future contributions will be able to buy more than they did at the start of the year.
- While the world seems particularly uncertain and fragile these days, it has actually been a pretty uncertain place for many centuries. Financial markets, while potentially volatile, have generally been quite resilient and the long-term trend thoughout history has been up.
If you have any questions or comments about this article, or would like to discuss your investments, please reach out to your advisor. We are always happy to chat.
Footnotes
- Chart 1
- Chart 2
- Chart 3
- Chart 4
- Chart 1
Data sources:
Inflation & Currency
Inflation: Canada All-Items CPI (March 2022 vs. November 2021)
U.S. Dollar: Bank of Canada CAD/USD Daily Rate
International Currencies: Bank of Canada Daily Nominal Canada Effective Exchange Rate excluding the U.S. Dollar (Inverted)
Fixed Income
Cash: S&P Canada Treasury Bill Index
Short-term Bonds: Solactive Broad Canadian Short Term Bond Universe Index
Universe Bonds: Solactive Broad Canadian Bond Universe Index
Equity
Canada: S&P/TSX Capped Composite Index
U.S.: CRSP US Total Market Index (CAD)
International: MSCI EAFE Investable Market Index (CAD, net of withholding taxes)
Emerging Markets: MSCI Emerging Markets Index (CAD, net of withholding taxes)
Global Low Volatility: MSCI All Country World Minimum Volatility Index (CAD, net of withholding taxes)
Alternatives
Gold: LBMA Gold Price (CAD, AM Price)
Disclaimer:
It is not possible to invest in a benchmark or index directly and returns do not reflect the transaction costs or management fees that an investor would incur when investing in a financial product, such as an exchange-traded fund, that attempts to track the performance of a benchmark or index.
- Chart 2
Disclaimer:
Model portfolio returns are an average of the asset class returns from Chart 1 weighted by each model portfolio’s target asset allocations. Returns presented are hypothetical because it is not possible to invest in a benchmark or asset class index directly and the returns from Chart 1 do not reflect the transaction costs or management fees that an investor would incur when investing in a financial product, such as an exchange-traded fund, that attempts to track the performance of a benchmark or asset class index.
Clients’ actual returns will vary based on their management fees and the timing of cash flows into and out of their respective accounts. Model portfolio performance presented in Chart 2 also assumes that asset class weightings are held constant while in practice an account’s asset allocation may deviate from targets within a reasonable range.
- Chart 3
Data sources:
Canada 10 Year Bond Yield: Bank of Canada Daily Government of Canada 10 year benchmark bond yield (V39055)
Bank of Canada Target Rate: Bank of Canada Daily Target for the overnight rate (V39079)
- Chart 4
Data sources:
CRSP US Total Market Index (CAD)
Disclaimer:
It is not possible to invest in a benchmark or index directly and returns do not reflect the transaction costs or management fees that an investor would incur when investing in a financial product, such as an exchange-traded fund, that attempts to track the performance of a benchmark or index.
