Q1 2022 - Market Review

ECONOMIC COMMENTARY

Until the release of their eponymous album in 1991[1], Metallica had been a fringe thrash metal group. One of the most popular singles of that recording was the power ballad Nothing Else Matters. Two events left their mark during the first quarter. First, the sharp hawkish turn by the Federal Reserve and other central banks, and second, Russia’s unprovoked military assault of Ukraine. Besides that, channelling our inner Metallica… nothing else matters. At the very least, these two events, combined with the prevailing stress in supply chains globally instantaneously increased the risk of an economic slowdown, if not a recession.  As such, financial markets quickly adjusted in response to the new reality.

Most equity markets declined during the first quarter. Specifically, the MSCI All Countries World Index and S&P 500 Index fell -4.75% and -4.70%, respectively. Europe, due to its proximity to the epicenter of the Russia-Ukraine conflict, and Emerging Markets, because Russia is one its core constituents, fared worse with the MSCI Europe and the MSCI Emerging Markets declining -5.36% and -6.97%, respectively. However, there was a noteworthy exception in an otherwise see of red. In effect, Canada’s financials and materials heavy S&P TSX Composite recorded a gain of 3.84%. Canada’s equity market performance exceeded that of all other developed markets in local currency terms. Apart from Russia’s RTS which declined by over 35% in ruble terms and dramatically more in hard currency terms, the Shanghai SE Composite index declined in excess of 10% as omicron tested China’s zero-covid policy.

From a stylistic standpoint, ‘Value’ stocks significantly outperformed ‘Quality’ and ‘Growth’ as higher interest rates forced market participants to lift the discount rate used to calculate the present value of future cash flows. Specifically, the MSCI World Value Index was down -0.65% while the MSCI World Quality and MSCI World Growth indices were down, 8.39% and 9.64%, respectively.

Turning to fixed income, the rapidly changing consensus about the near term expected path of interest rates had devastating ramifications across the entire universe. To put things in perspective, on December 31, 2021, the consensus was calling for 3 interest rate hikes throughout 2022 in the United States. Three months later, the consensus was calling for 9 hikes in addition to the 0,25% hike that had already taken place in March with the terminal rate forecast exceeding 2,50%. If the current consensus were to materialize, it would be the most aggressive monetary tightening cycle since 1981. Interestingly, despite the negative impact that the Russia-Ukraine conflict is already causing on global growth, at least two Federal Reserve governors[2] publicly reiterated the central bank’s intention to deal with inflation. With that in mind, very few segments of the fixed income market apart from T-Bills posted positive returns. For instance, the ICE Bank of America Merrill Lynch Global Government Bond Index declined 4.74%, the worst quarterly performance posted by global government bonds since 1980. Corporate bonds fared slightly worse as modest credit spread widening compounded the woes brought about by higher interest rates. To this point, the ICE Bank of America Merrill Lynch Global Corporate Index and the ICE Bank of America Merrill Lynch Global High Yield Index declined 6,90% and 5,54%, respectively. Every other segment was also down from Mortgages to Preferred Shares. The best segment was the Bank Loan sector with the Credit Suisse Leveraged Loan Index losing only -0,10% during the quarter.

Commodities had a spectacular quarter with the S&P GSCI Commodities Index appreciating 33,13%, led by the oil and natural gas heavy weighted energy sub-index which jumped 46,10% on heightened supply crelated risks following Russia’s invasion of Ukraine. The Agricultural commodities sub-index and the industrial sub-index advanced 21,90% and 17,70%, respectively. Speaking of industrial metals, nickel prices more than doubled overnight at one point when one major participant who had overly large short positions could not face margin calls, which prompted its broker to liquidate the participant’s position. Strangely, the London Metals Exchange first halted and then decided to cancel seven hours of trading in the nickel contract. This is something that had never been seen in the futures markets. A notable laggard in this chaotic quarter was the Precious Metals sub-index which logged a mere 6,68% gain.

Finally, foreign exchange markets also witnessed a resurgence of volatility. While movements between the Canadian dollar and the Greenback were relatively contained, the Euro, due to its proximity to the epicenter of the Russia-Ukraine conflict was down nearly 5% against the Greenback at one point before recovering towards the end of the quarter. Oddly, the Japanese yen which has had a tendency to strengthen in prior risk off episodes was off over 5% during the first quarter and has continued to weaken afterwards.

GLOBAL FINANCE & GLOBAL TRADE GET WEAPONIZED

February 24th, 2022 will be remembered as the day when for the 1st time since 1945, a European country launched an unprovoqued attack on to another as Russia launched a military strike in Ukraine’s eastern provinces. While NATO has not done anything that would be perceived by Moscow as a direct military confrontation such as sending troops on Ukrainian soil, many global governments and corporations quickly imposed a series of dramatic financial sanctions on Russia that are set to have a more damaging impact on the daily lives of Russians than than a military conflict. Among some of the most significant measures, we can think of UPS and FedEx deciding to halt deliveries to Russian customers, a move that was copied by container shipping giants Maersk and MSC days later. Consumer product companies Apple and Nike also halted sales to Russia shortly after the beginning of the conflict while car manufacturing giant Volkswagen shut production in Russia. Closer to us, albeit on a smaller scale, the convenience store chain Alimentation Couche-Tard, which operates a few dozen stores in Russia under the Circle K brand also announced that it was shutting operations in Russia. In an even more surprising move, British Petroleum walked off its joint venture position in Russian gas exporter Rosneft, reportedly taking a 25 billion british pounds write down in the process. Additionally, Norges Bank Investment Management, the 1,3 trillion sovereign wealth fund operating inside Norway's central bank announced that it would dispose of all its Russian assets. While British Petroleum and Norges may have been pressured by their respective governments, we note that other measures were voluntarily. Interestingly, for many of the above mentioned actors, Moscow’s actions have provided a unique opportunity to showcase their ESG credentials with an emphasis on the “S”, or social pillar. In fact, we predict that both internal and external stakeholder pressure will be so high that those who have not acted yet will be prompted to jump on the financial sanction bandwagon.

Yet as if sanctions imposed by the private sector weren’t enough, governments globally were also quick to react. For instance, Germany, which had been reluctant to confront Moscow under Chancellor Merkel, agreed to exclude Russian banks from the SWIFT financial messaging system and announced an immediate increase in its defense spending to 2% of Gross Domestic Product. Berlin also suspended the Nord Stream 2 project[3] and reversed a policy of not supplying arms to conflict zones in order to send weapons to Ukraine.

Finally, while Ukraine will almost certainly never joined NATO, Moscow’s expansionist foreign policy has driven Finland and Sweden to announce that they would formally reconsider applications for NATO membership.

To summarize, the new international consensus is that Russia is a renegade state and its strongman’s medieval obsession to recreate Peter the Great’s Russia has induced far more domestic financial repression than could have been imagined. Sure Russia has impressive foreign currency reserves but as it is cutoff from the rest of the world, it will inevitably fall into a deep recession and burn through its reserves within 18 to 24 months at the current pace. At least, this is the signal that comes from Russian financial assets… those that can still be traded.

STRATEGY UPDATE

It is unusual to witness global equities outperform the fixed income market segments in a down market. Similarly, it can be unsettling for conservatively positioned families to experience losses that exceed the losses that would have been experienced had they held a more aggressive portfolio. Yet this is the type of results that financial markets delivered in the first quarter.

With that in mind, we suspect that many investors will be tempted to reduce fixed income exposure to the bare minimum. This would be a mistake. While the recent across the board decline in fixed income assets is shocking from a historical perspective, it should not be surprising in light of the on-going inflation surge which has just been made more complicated by the Kremlin’s decision to extend its territory to the west. More surprising to us is rather the relatively mild adjustment experienced by equities given the radical changes that are operating globally.

In fact we believe that broadly speaking, equities are vulnerable at this juncture, at least in comparison to certain fixed income markets segments. To this point, many of the arguments that prompted market participants to favor equities over fixed income no longer apply. Perhaps the most important one - as it relates to one of the two things that mattered during the first quarter – is that central banks have started to increase policy rates and that the Federal Reserve seems resolute in its efforts to fade its balance sheet. All else equals, the seemingly unlimited post Great Financial Crisis liquidity injections which benefited equities more than any other asset class is set to be reversed. Admitedly, numerous prior attempts by the Federal Reserve to curb its balance sheet have failed but we would point out that the Federal Reserve did not have to contend with inflation running upwards of 7% annualized until now. Another argument that is no longer valid is that the dividend yield on equities no longer exceeds the yield on ten year treasuries. For instance, the S&P 500 Index dividend yield was 1.27% on December 31, 2021 and increased to 1.37% on March 31, 2022[4]. By comparison, the yield to maturity on 10 year treasuries increased from 1.51% on December 31, 2021 to 2.34% on March 31, 2022. In other words, on an after-tax basis, fixed income looked compelling for the first time in a while. That does not mean that we are pessimistic about equities. In fact, even if global growth projections are being revised downward, earnings projections continue to be revised upwards, which may seem counterintuitive in a high inflation scenario but it is perfectly natural, as long as corporations are able to transfer their higher input cost to their customers. To date, corporations indeed seem to be able to do that. So equities could recover. We are just stating that they look less appealing relative to fixed income compared to just a few months ago.

As we wrote before, we do not believe in market timing and we very seldom make bold market calls which lead to significant portfolio adjustments. However, in our Q4-21 letter, we wrote:

 “…interest rates on government bond rates with maturities ranging between 2 to 7 years appear too low relative to inflation expectations over such horizons. Either nominal rates move higher or inflation expectations recede.”

In discretionary managed mandates where we had the flexibility to do so, we used this observation to de-emphasize fixed income in favor of hedge funds in late 2021, which helped as it was coincidentally the 2 to 7 years part of the interest rate curve that incurred the most violent adjustment during the first quarter.

While the derating of the short term portion of the interest rate curve may not be over, we do not have strong non consensual views remaining other than the belief that the low volatility regime that characterized the previous decade in the financial markets is unlikely to resurface.

[1] Also known as the Black Album, which debuted at number one in ten countries, selling 650,000 units in the U.S. during its first week.

[2] Governor William C. Dudley and Governor Lael Breinard

[3] A set of offshore natural gas pipelines in Europe, running under the Baltic Sea from Russia to Germany.

[4] Source: Bloomberg.