October 06, 2022
After a challenging start to the year, market volatility continued in the third quarter. The summer started with a rally in stocks as inflation declined from peak levels. With peak inflation likely behind us there was a possibility that central banks would soften their aggressive interest rate hikes. However, the rebound in equities was short lived as central banks reaffirmed their commitment to fighting inflation. While higher rates are necessary to create a better balance between inflation and growth, this dynamic increases the risk of a recession and further declines in markets.
Equity returns reflect a deteriorating outlook
The downward pressure on bonds subsided this quarter as they posted a modestly positive return. Yet on the year, bonds have offered very little protection from equity market declines. This is an inconvenient result of the high inflation and higher rate environment. Bonds have declined as their yields rise and stocks have fallen as the economy slows.
Bonds up in Q3 after a terrible start to the year
Looking forward there is a cloudier picture for markets. It is clear that the labour market is strong and inflation remains too hot. However, due to the lagged effect of policy, central bank efforts have not fully begun to affect the economy. What is not clear is how this tighter policy will affect the economy in the quarters ahead. The future path for markets is heavily dependent on what happens with labour, wages, inflation and growth. As such, we expect a continued high level of volatility around each economic data release as so much is riding on their outcomes.
We have been defensively positioned within portfolios which has helped protect capital in a challenging period. Strategically, we have been recommending an allocation to alternatives for many years. These include our private market alternatives as well as multi-strategy hedge. These strategies have performed well and have been more resilient than the public markets. While it will take time for these asset classes to fully reflect current conditions, they continue to generate strong income and protect capital as rates have moved higher and inflation has been persistent.
Our tactical allocation process has been flagging tighter financial conditions and slowing growth. This environment is likely to lead to market volatility and continued deterioration in the outlook for markets. As such, when stocks moved higher this summer, we took the opportunity to sell some equities to buy bonds. Within the bond allocation we have been reducing risk by adding to core bonds. This move should protect capital if the economic slowdown becomes more severe. Within equities we have been underweight global large-cap stocks. This includes US companies which have seen a large decline in valuation and European companies which have been hit hardest by the war in Ukraine.
Our portfolio management teams have been defensively positioned. We believe slowing growth will lead to weakening company earnings and have added to stocks which are more resilient to this decline. In some areas of the portfolio we are beginning to see opportunities to buy companies that already reflect an overly pessimistic view. If markets fall further, we will capitalize by selectively buying more quality companies at attractive prices. Within bonds we believe yields on corporate and provincial credit will move higher. We have reduced this exposure in our core bond portfolio and remain defensively positioned within high yield. We believe this positioning will serve clients well through this period of heightened uncertainty and set us up well for the eventual recovery.
From the desk of Jeff Guise, Managing Director, Chief Investment Officer, CC&L Private Capital.