The World Bank and the OECD have slashed their global growth expectations, citing the surge in energy and food prices, along with disruptions from the Ukrainian war and ongoing pandemic restrictions in China.1 While businesses are grappling with labor shortages and surging wage growth, consumer demand remains strong, and the persistence of very high price growth has been pushing longer run inflation expectations higher. The rising risk of stagflation in the world economy is tipping toward risk of recession as Central Banks have turned increasingly hawkish to counter elevated inflationary pressures. Energy and food price shocks are leading many countries into slowing growth, tighter living standards, and a deteriorating political climate. The extent of the inflation spiral and a rising probability of a recession are, together, acting as a headwind to finding a true market equilibrium. In July, we maintained our outlook for three months of Recession followed by nine months of Inflation for the U.S. economy.
The Chinese economy advanced 0.4% in Q2 of 2022, amid the lingering impact of outbreaks and “shrinking demand” at home.2 China’s annual inflation rate climbed to 2.5% in June 2022, with food prices rising the most in 21 months.3 China’s surveyed urban unemployment declined to 5.5% in June.4 The annual inflation rate in the Euro Area increased to a new record high of 8.6% in June of 2022, strengthening the case for the ECB’s first rate hike in 11 years in July.5 The unemployment rate in the Euro Area edged lower to a fresh record low of 6.6% in May.6
The American economy contracted an annualized 1.6% in Q1 2022.7 Expectations are for a second negative quarter in Q2. The trade deficit narrowed in May, as exports hit a record high while soaring prices and slowing domestic demand weighed on imports. The goods deficit widened with China, the EU, and Canada, but narrowed with Mexico and Russia.8 The annual inflation rate in the U.S. accelerated to 9.1% in June of 2022, the highest since November of 1981.9 Canada’s trade surplus broadened to CAD 5.3 billion in May of 2022. It was the largest monthly trade surplus since August of 2008, as exports rose 4.1%, largely driven by high prices of energy products.10 Canada’s annual inflation rate rose to 8.1% in June, the highest since January 1983.11
Equities and bonds have seen sharp selloffs this year. The drawdown in equities reflects the difficult tradeoff confronting central banks on growth and inflation. U.S. equities posted their worst first half performance since 1970. The S&P 500 posted a loss of 19.96%, while the S&P Mid Cap 400 and S&P Small Cap 600 performed marginally better, down 19.5% and 18.94%, respectively. Canadian equities experienced a dismal first half of the year, with the S&P/TSX Composite down 9.9%. In Europe, Portugal was the only country that made a positive contribution to the S&P Europe 350 this quarter, while the trio of Germany, Switzerland, and France weight heavily on the pan-European benchmark, pulling it to a loss of 8.7% in Q2. U.K. equities significantly outperformed their Eurozone peers, dropping just 3.0% in Q2. The S&P Pan Asia BMI lost 6.4% in June to complete its worst quarter since Q1 2020 and its fourth consecutive losing quarter.
The near-term risk of a renewed repricing in markets amid persistent inflation pressures caused us to adjust our asset allocation in May. In July we maintained the defensive asset allocation that was set at that time. Cash remains at 10% across all models. U.S. earnings are beginning to show signs of stress in industries where inflation is impacting consumption. The safe haven status of gold in times of uncertainty, including war and inflation, is central in our asset allocation. Canadian oil and liquid natural gas directed through the U.S. pipeline system for export to Europe is benefiting Canada. Volatility is expected to continue in the fixed income arena. While we monitor events, we have noted that some of the global price pressures have shown signs of easing. Global shipping costs (and times) have been declining and wheat prices have reversed their surge on the initial Russian invasion of Ukraine. Oil prices have fallen from early June, pushing gasoline prices lower into July. In many countries, higher house prices have also shifted into reverse as early interest rate hikes cool housing markets.
The probability of a “soft landing” is becoming less likely. Poor consumer sentiment in reaction to rapidly rising prices is at odds with strong household balance sheets, leading to an uncertain path for discretionary spending. The current environment reinforces the importance of distinguishing investment views on tactical (6-12 months) and strategic (five years and beyond) horizons. Our approach to portfolio management is nimble, opportunistic, and deliberate in identifying asset classes that are best placed to generate returns in a new world order. Our focus is on protecting portfolios from downside risk, and we believe that our investment process is working to achieve that goal.
Deborah Frame, President and CIO
1 OECD Economic Outlook. June 8, 2022.
2 Trading Economics. China GDP Growth. July 15, 2022.
3 Trading Economics. China Inflation. July 9, 2022.
4 Trading Economics. China Unemployment. July 15, 2022.
5 Trading Economics. Europe Inflation. July 1, 2022.
6 Trading Economics. Europe Unemployment Rate: Eurostat. June 1, 2022.
7 Trading Economics. U.S. GDP Growth. May 26, 2022.
8 Trading Economics. U.S. Trade Gap: Bureau of Economic Analysis. July 7, 2022.
9 Trading Economics. U.S. Inflation. July 13, 2022.
10 Trading Economics. Canada Trade Surplus. July 7, 2022.
11 Trading Economics. Canada Inflation. July 20, 2022.
Index return data from Bloomberg and S&P Dow Jones Indices Index Dashboard: U.S., Canada, Europe, Asia, Fixed Income. June 30, 2022. Index performance is based on total returns and expressed in the local currency of the index.