Q4 2021 | Market Update

Note: Due to January market volatility and key rate announcements, we have updated our Q4 commentary with additional market data to Jan. 26.

Additional links: CIO Chhad Aul speaks about market volatility

Article on understanding market volatility

Highlights

• After hitting record highs in Q4, markets declined in the new year: S&P 500 down 7.2%, NASDAQ down 11.4% and S&P/TSX Composite down 1.9% for the month to January 26.
• On Jan. 26, the U.S. Federal Reserve did not increase its benchmark rate but signalled it would “soon” be appropriate to raise rates. The Fed moved to end its QE program in March and signalled it was ready to reduce its balance sheet once rates begin to rise.
• On Jan. 26, the Bank of Canada kept its key target interest rate steady at 0.25%. The BOC governor Tiff Macklem stated that Canadians should expect a rising path for interest rates in order to control inflation.
• As of Jan. 26 benchmark oil prices moved higher to US$87.52-a-barrel, with uncertainty over the Russia/Ukraine border dispute.
•  In Q4 into January, the Omicron variant continued to spread, slowing global economic growth, and clouding the earnings outlook.

How we view the selloff

• We anticipated increased volatility and moved to a neutral equity weighting last fall.
• Market corrections are a normal occurrence in a bull market, and by some measures this one was somewhat overdue.
•  At this point in the market cycle we don’t expect a bear market to emerge.
• Worries about elevated inflation added fuel to the selloff. However, many of the indicators we watch suggest that certain drivers of inflation could moderate in the latter half of the year.
• Central banks may not be as aggressive as is priced into markets if inflation cools as the year progresses.
• We expect yields to slowly move higher as we move closer to rate increases.
• Speculative companies with high-price-to-sales multiples were hit the hardest in the correction.
• We prefer high-quality companies with sustainable earnings potential. These should potentially recover and could do well at this point in the earnings cycle.

To rescue the economy from COVID-19, in March 2020 the U.S. Federal Reserve unleashed a flood of liquidity by slashing interest rates to effectively zero. The market rallied to record highs. But the question of when the Fed would begin turning off the tap has hung over the market for months. In mid-December, investors finally got part of the answer when the Fed set the stage for rate increases by announcing that it would end its bond-buying program. Then, when the minutes of that meeting were released on January 4, the Fed confirmed it would tighten, possibly in three, quarter-point hikes this year. In response, the yield on U.S. ten-year Treasuries immediately spiked, triggering a selloff in the bond and equity markets, with high-multiple tech companies hit the hardest.

The Fed also appeared more aggressive when it indicated that after it ends its bond-buying program, it would begin to reduce the size of its balance sheet. It has grown from about US$4.5 trillion to over US$8 trillion through bond purchases during the pandemic. And reducing it could drain even more liquidity from the market.

With the S&P 500 more than doubling off its pandemic low, it remains to be seen how equity markets will adapt to this changing rate environment. So far, markets have been resilient. Indeed, despite the emergence and global spread of the Omicron variant of COVID-19, the S&P 500 was up 27% in 2021 – racking up double-digit returns for the third year in a row. Both the S&P 500 and the Dow also hit new highs on January 3, just prior to the release of the Fed minutes.

We expect increased market volatility as rates begin to rise. However, even if the Fed rate was at 1% by the end of 2022, that would still be quite low by historic standards. As well, for now with inflation running at close to 7%, real bond yields are deeply negative, with equity markets continuing to attract investors looking for an alternative.

Equity markets also continue to be supported by massive fiscal stimulus (estimated at US$20 trillion worldwide), including the recent passage of a US$1-trillion infrastructure bill. If President Joe Biden is also able to pass a version of his Build Back Better Act, it could add even more stimulus. In the meantime, the European Union is rolling out its €2.018-trillion European Recovery Plan.

Staying neutral in an uncertain market  

Still, even with ongoing fiscal and monetary support there are reasons to be cautious. With a forward PE ratio of close to 29, the S&P 500 is trending well above its long-term average of 15.5. And with Omicron triggering economic lockdowns, it has the potential to slow the economy and dint earnings growth, which was estimated at nearly 22% for S&P 500 companies in Q4. It also remains to be seen how stubborn inflation will be and how aggressive the Fed will ultimately become in fighting it.

With that uncertainty in the market, we ended the quarter broadly neutral on equities in the Sun Life Granite Managed Solutions. However, we expect the economy to continue to recover throughout 2022 and have positioned the portfolios for a continued rotation into high-quality U.S. and global, value and cyclical stocks. As part of our value play, as we entered the New Year our largest equity overweight was in global mid-caps and small-caps. This should give us broad exposure if the global economy further recovers.

Energy and financials (a beneficiary of rising interest rates) were two of the top-performing sectors in Q4. To participate in that trade, we had an overweight exposure to financials. We have also owned the XLE in the past. We did not have a direct play on oil in Q4, which climbed from around US$20 a barrel in April 2020 to US$72 a barrel at the end of December 2021. However, we have exposure through the geographic weightings in specific underlying funds and the S&P/TSX Composite Index, which has a heavy weighting in energy. 

Growth stocks led value stocks for most of the last 13 years, including in much of the market’s recovery off the 2020 bottom. In Q4, technology stocks (particularly those with high price-to-earnings ratios) sold off in anticipation of a more hawkish Fed. However, led by the so-called FAANG stocks, many quality names in the sector later rallied as investors sought stability in strong balance sheets. Hence, as a counter to our overweight in cyclicals and value stocks, we largely maintained our position (as we have throughout the market’s rally) in high-quality growth.

With U.S. equities continuing to push higher throughout Q4, we purchased out-of-the-money equity put options to hedge potential tail risks from an over-extended market and Omicron’s spread.

Fixed income: Prefer cash to government bonds

Despite the Fed’s decision to taper back its bond-buying program and looming interest rate increases, the yield on U.S. 10-year Treasuries ended the year at 1.52%, down from its March high of 1.74%, but still up 63% on the year. At the same time shorter term yields, which are more sensitive to expected central bank tightening, moved sharply higher as two-year Treasuries climbed from 0.11% to 0.73% on the year. However, in January, following the release of the minutes of the Fed’s December meeting, the yield on 10-year Treasuries surged above 1.7%, triggering a major bond selloff on the prospect of higher interest rates.

We believe yields could potentially grind higher still in 2022. Given this, we continued to be underweight duration-sensitive issues. We also remained overweight cash at year end and could eventually use some of that to increase our bond holdings if yields become more predictable.

Alternatively, we remained overweight credit with a focus on high quality corporate bonds. And within our weighting, we held a specific allocation to intermediate-term corporates.

Chart 1: High-yield bonds outperform