Persistent inflation, hawkish central banks, and strained supply chains continued to sway global markets in May. While several equity markets stumbled through the month, a late rally in asset prices helped markets find their footing to end the month flat. The S&P500, MSCI EAFE and MSCI Emerging Markets indices were down less than 1%, measured in Canadian dollars. The 10-Year U.S. Treasury Note which began the month with a yield of 2.94%, posted marginally higher returns, ending the month with a yield of 2.84%.
While worries over inflation and tight labor conditions continued to grip markets, we believe we are seeing very early signs of easing from both. The U.S. Fed’s preferred inflation measure, Core PCE, cooled down for the second month in a row and the list of U.S. corporations slowing hiring plans is on the rise. Additionally, manufacturing PMI data is moderating. Nonetheless, central banks remain hawkish. While we believe central banks will be more aggressive in the near term, we expect them to be more data dependent later this year and the focus to shift from price pressures to slowing growth.
Given this backdrop, our equity exposure favors factors such as high quality and low volatility. We are cautious on international developed markets and cyclical equities. In addition, we view recessionary risks to be higher for Europe than for the U.S. In line with these views, we reduced our exposure to international mid-cap stocks that we believe are most sensitive to slowing growth and are tactically overweight U.S. equities that we believe can perform better across diverse scenarios.
We are neutral on both Canadian and emerging market equities. Canadian equities have held up better than most other markets thus far this year, thanks to a strong rally in energy stocks. However, Canadian markets’ concentration in materials, energy and other cyclical sectors could pose a challenge going into the second half of the year. While emerging market equities led by China could get a lift from a raft of easing measures targeted at growth, we are staying neutral towards the asset class on concerns over stringent lockdowns, disrupted supply chains and slowing trade.
In fixed income, we remain slightly underweight duration and we trimmed our exposure to corporate bonds. Given the rise in borrowing costs and higher spreads, we see downside to global high yields. Additionally, a stronger U.S. dollar could lead to tightening financial conditions for emerging markets and we remain tactically underweight emerging markets investment grade bonds.
We increased our exposure to Canadian bonds. The near-term stance of Bank of Canada towards inflation has been quite hawkish and the central bank raised interest rates by 50 bps in each of its past two policy meetings. Consequently, the yields on the 2-year bond jumped to 2.8%, the highest since 2008. We see these levels of yields to be attractive and used the opportunity to increase our Canadian fixed income exposure.
