A tough start to the year for markets

It felt like the last renditions of “Auld Lang Syne” had barely finished being sung and the New Years Eve fireworks displays ended, when financial markets started 2022 with a loud “thud”!! And while risk assets have found a little footing of late, investors have certain been on the back foot to start the year. Chalk it up to increasing concerns that central banks are behind the inflation curve, ongoing uncertainty surrounding the Covid variants or pockets of elevated valuations – or likely all the above – but January was the worst month for financial markets since the start of the pandemic and the weakest start to a year since 2009. After hitting its record high on Dec. 29, the S&P500 fell 5.3% in January, while the more interest rate sensitive Nasdaq index dropped 9% after having tested bear-market territory intra-month. The S&P/TSX index, buoyed by heavyweight sectors like energy and financials, outperformed, falling only 0.6% on the month.  So, after two very strong years in equity markets here in North America, it is going to an uphill battle to this a repeat in 2022 – the good news however is that there are 11 months to go! The bell-weather UST 10-year yield Jumped 18 bps in January, eerily similar to the 17 bps increase we saw to start last year. Here at home the Canadian fixed income market has also struggled out of the gates this year, falling 3.4% - its largest monthly decline in over 15 years (Chart 1). 

Source: FTSE/Russell

Not surprisingly, the weak start to the year has seen volatility increase. It is interesting however, to see that while equity volatility has ebbed and flowed, bond market volatility has remained near its high of the past year (Chart2).

Chart 2:

Source: Bloomberg

Rates Markets

The benchmark UST 10-year yield ended last year at 1.51%, after having fallen as low as started 1.35% in early December. After the first day of trading in 2022, the yield stood at 1.63 – up 12 bps on the day (the Canadian market hadn’t even opened for trading yet and it felt like it was a long year already!). By the end of the first week of January, the yield was 1.76%, touched a high of 1.87%, before ending the month at 1.78% - up 27 bps MoM and 43 bps from its December low (Chart 3). As mentioned, 2022 has unfortunately started out much like 2021 in the Rates market, with yields moving sharply higher after breaking through key technical resistance levels. A potential silver lining is that the Q1 2021 peak in yields turned out to the highs for the year, and that scenario could certainly play out again this year. Domestically, the Canadian benchmark 10-year yield started the month at 1.43% and suffered a similar rise as witnessed in the US, ending the month at 1.77%.

Chart 3:

Source: Bloomberg

After two positive months of returns to end last year, Canadian Federal bonds returned -2.34% in January. This dragged down their 1-year return to -4.08%. Unlike in early 2021 when Corporate bonds were better able to weather the bond market’s weakness, credit underperformed (albeit modestly) their government counterparts for a third month in a row. Canadian IG corporate bonds finished January down 2.42%, trailing government bonds by 15 bps. Over the past quarter, corporates have underperformed by ~25 bps but on average generated ~109 bps of excess returns versus similar maturity government bonds for the past year.

With financial markets looking increasingly desensitized to the ongoing pandemic, it’s all about central banks! Even the most historically dovish central bankers, like the ECB, have recently signaled a more hawkish bias as persistently high inflation challenges their primary raison d’etre. Investors have been listening, repricing their expectations for policy tightening higher and with them, longer term bond yields. At the time of writing, markets had discounted almost 7, 25-bps rate hikes from the Federal Reserve (Chart 4), including a 50-bps start to the tightening cycle in March. Similarly, the Bank of Canada is expected to raise its overnight rate by almost 175-bps this year, with even the ECB, which many had questioned whether they would ever raise rates again, now discounted to hike a total of 50 bps point this year (forget Marty McFly, its “Back To Zero” for European monetary policy in 2022!).

Chart 4:

Source: Bloomberg

After having spent the vast majority of the post-GFC period at the zero lower-bound, only reaching a peak of 2.50% following the ill-fated, and ultimately shortened 2018 tightening cycle, the amount of rate hikes currently priced into markets is looking aggressive. Yet with measured headline inflation running north of 7%, it is hard to argue that the FED (along with other DM central banks) are not “behind the curve” and that they will be required to take relatively forceful action to ensure that inflation returns to their target level. Remember when central bankers were lamenting their inability to get prices up to target and now 2% seems like a distant memory! (clearly a case of “careful what you wish for”).

At risk of stating the obvious, the primary driver of policy expectations and in turn bond yields going forward will be the path of inflation. While we can no longer use the term “transitory” with respect to current pricing pressures, we still believe that there are several either pandemic-related or cyclical-factors that are partially responsible for the run up in inflation. Supply-chain disruptions, strong goods demand that has been “pulled forward” by the pandemic and left inventories at historically low levels, reopening demand for services we all craved while under lockdowns and the ability to pay for all those goods and services thanks to generous government support. These should all begin to moderate as we move through this year and will likely, along with simple base calculation effect, help to push inflation lower. But will it be enough to drive core pricing measures to a level low enough that the Federal Reserve might be comfortable tightening at a more modest pace then is currently in the markets? One of the key drivers of both the near-term and medium-term inflation outlook will be the labour market, and in particular wages & salaries. US Average Hourly Earnings have been rising steadily in recent quarters (Chart 5) and at last print were up 5.7% YoY.

Chart 5:

Source: Bloomberg

At current levels, wages are stoking fears of a classic “wage, price spiral” which could see longer term inflation expectations become unanchored – a major determinate of actual longer term inflation rates and a key risk for central banks. It is our view that a combination of higher participation rates, productivity improvements and moderating demand will help to elevate wage pressures in the second half of this year. 

Overall, we think that inflation will moderate throughout the course of 2022, and while it will remain higher than central bank targets, it will likely decline to lower levels (3-4%) and be on an improving trend, such that monetary policy makers will feel comfortable removing stimulus at a “measured pace”. This scenario would also provide central banks with the flexibility to adjust their tightening plans should risks to economic growth emerge.

Our outlook continues to expect that the rate of change for growth and the level of inflation will remain elevated, particularly over the first half of 2022. This will put upward pressure on bond yields through mid-year. Employment growth should continue to be strong as people re-enter the labour force, household balances remain very strong and income growth has been solid, providing tailwinds to consumption. That said, leading indicators such as PMIs have rolled over and point to a slowdown in growth and moderation in measured inflation rates in the second half of the year. This should help to cap the level of bond yields and could see a rally in bonds later in the year. This scenario should also see RRBs continue to be well supported in the early part of 2022 but with a more challenging environment for breakeven inflation levels in the second half of the year.

Rates positioning: (i) modest duration underweight; (ii) neutral yield curve exposures; (iii) overweight Cdn prime residential mortgages; (iv) overweight RRB’s; (v) overweight Canada

Credit Markets 

For most of the past year, Credit markets have weathered the volatility in the Rates market quite well, with corporate bonds generating significant excess return in a rising yield environment. This relative return paradigm has been put the test however during the early part of this year. The sharp rise in bond yields has unnerved risk assets, including corporate bonds. This has caused risk premiums to rise to levels not seen since late-2020. The significant shift higher in policy expectations and the corresponding flattening of the yield has raised concerns surrounding the outlook for growth. This has also coincided with heavy calendar of new issue supply as corporations look to raise funding before yields move higher. The overall result has been a soft market for credit and modest spread widening (Chart 6).

Chart 6:

Source: BAML/ICE; Bloomberg

As we have highlighted, central banks around the world are signalling a more aggressive approach to tightening monetary policy and the removal of liquidity from the financial system. This more forceful approach could present further headwinds to risk assets. In addition, it also increases the risks of a policy “mistake” whereby central banks tighten policy too much and too quickly. That is not our base-case scenario, however we do believe that the uncertainly associated with the removal of policy stimulus will result in greater volatility in risk premiums this year. Despite these risks and expectation for increased spread volatility, we believe that both macroeconomic and credit fundamentals will remain constructive over the next 2-3 quarters, with overall economic activity and earnings still well supported. As we move towards the end of the year however, growth is expected to moderate – leading indicators such as global PMIs have already rolled over, and margins and earnings will face greater headwinds in late 2022. Technical factors, such as supply/demand dynamics, in credit market are likely to be less of a tailwind as issuance remain historically high and there is the potential for fund flows out of the asset class. Given the credit spread widened over the past 3 months, valuations are looking more attractive. That said, they are still trading near the bottom of their historical range and therefore valuations are not yet a catalyst for more aggressive positioning. Overall, we view the balance of risks still screening reasonably constructive in near term and thus corporate bonds are expected to generate excess returns in coming 2-3 quarters thanks to their higher yield carry.

In terms of risk premiums, Cdn IG credit spreads were relative stable in January but have widened in early February, rising from 112 bps to 116 bps. This relationship touched a recent low of 99 bps in late November. US IG credit spreads improved slightly following their Omicron-induced widened in late November, narrowing 5 bps to 95 bps on the month. US IG credit spreads similarly widened from 95 bps at year-end to 107 bps in January, after reaching as tight as 82 bps in Q4. As a result, Cdn IG has outperformed slightly in the recent widening environment.

Canadian investment grade corporate bond fell 2.42% in January, slightly behind government bonds on the month, and have declined 3.21% over the past year. Overall Canadian corporate bonds delivered -15 bps in excess returns over government bonds in January. US IG corporates returned -3.13% on the month and -2.86% for the year. Over the last 12 months, both Cdn and US IG have generated strong excess returns of 109 bps and 39 bps, respectively. The US HY market, due to its higher credit risk but lower interest rate risk, outperformed the high-grade corporate segment on the month and has outperformed materially over a one-year period, declining 2.75% on the month and gaining 2.08% for the year – this equates to excess returns over governments of -1.52% and 4.38% for the month and year, respectively.

We remain optimistic and overweight on credit, particularly IG corporates, in the near-term. The economic recovery should continue to generate growth that is well above potential GDP in the first half of 2022. Later in the year however, growth is expected to moderate and will therefore provide less support for credit in the second half of 2022. Bottom-up credit fundamentals are improving but we will continue to watch Management behaviour closely for evidence of more shareholder-friendly activities such as M&A and share buybacks. We will also be monitoring pricing and margin pressures to access potential deterioration in the earnings outlook. In this environment excess returns will be driven primarily by yield carry and less by spread compression but should still be positive, at least over the next 2-3 quarters.

Credit positioning: (i) we remain overweight credit; (ii) maintain a quality bias in favour of IG over HY, and more defensive credits within IG; (iii) overweight Cdn corporates, underweight US