Last year was a tumultuous one, with economies ravaged by successive waves of coronavirus pandemic-related stresses and closures.
Despite the negative impact these forces had on the economy, the stock market continued to rebound from the March 2020 correction and performed well. And in the face of higher volatility, U.S. stock exchanges were the highest performing market with returns averaging at 27 per cent. It was followed by Canadian exchanges, which saw returns of 25 per cent and lagged by international stocks, with returns of 10 per cent. Bond returns were negative as mid- and long-term rates began to normalize following the rate cuts in early 2020.
Entering 2022, the pandemic continues to be the dominant theme for capital markets in the midst of a fifth wave. Despite the fast spread of the Omicron variant, governments, particularly ones in North America, seem resolved to avoid a full economic shutdown. We’ve also witnessed the impact of expansive monetary policies in the form of growing inflation levels.
With the U.S. Federal Reserve already planning three rate increases this year, the Bank of Canada is expected to follow suit. With increases in the overnight rates, we can also expect a parallel shift up in rates across the bond yield curve. Accordingly, North American bonds will likely come under pressure, regardless of the term, and a decline in bond prices is expected in 2022. For institutional investors, an allocation to variable rate bonds and real return bonds would help to enhance fixed income performance in the year ahead.
In addition, we can anticipate that stocks will continue to outpace bonds, with returns in the six to nine per cent range. Moreover, rising interest rates will create some extreme winners and losers.
More defensive stocks are likely to lead the market. Sectors, such as consumer staples, that can more easily pass on cost increases, should perform well in this economy. Banks should benefit from higher interest rates, which should improve their net interest margins. As well, the resources sector is expected to continue to benefit from increased infrastructure and housing spending. Even the battered energy sector should continue to perform well in 2022, with global supply remaining at depressed levels and demand slowly normalizing with the curtailment of closures. Given the strength in the financial and resources sectors, we can expect Canadian stocks to outpace U.S. and international stocks.
In an inflationary market with rising interest rates, cyclical stocks will presumably come under pressure. Stocks in the consumer discretionary and leisure sectors, which have a harder time passing along cost increases, will likely underperform the market. In this type of environment, speculative companies with high long-term growth expectations and little or no present earnings will be particularly disadvantaged.
Stocks in the airline and travel sectors, which have been battered by the pandemic, will continue to struggle as travel volumes remain low and cancellations remain prevalent. These stocks will remain depressed until restrictions are lifted and travel behaviour returns to normal, after which the stocks are likely to rebound — and rebound strongly. At this point, it’s difficult to predict when this will happen.
Technology stocks will continue to drive economic growth. Some of the hottest trends will relate to the growth of cloud computing, the continued rollout of 5G technology, the growing impact of artificial intelligence, the refinement of autonomous vehicles and the growth of e-commerce and e-commerce platforms.
In terms of alternative asset classes, infrastructure demand is expected to continue to grow, with an increase in infrastructure spending initiated in the U.S. and elsewhere around the world to stimulate economic growth during the pandemic. Demand growth for this asset class should continue to drive prices up and cap rates down on infrastructure projects.
We also expect a continued bifurcation of the commercial real estate market. Offices, particularly ones in the downtown segment, as well as the retail sector, will continue to suffer because of pandemic-related reductions in demand. This should lead to downward pricing pressures. However, these trends may not reverse, even following the end of the pandemic, due to fundamental shifts, which may result in a permanent increase in remote employment and online shopping. Demand in the industrial and multi-family residential sectors should remain robust.
In this environment, commercial mortgages may present a better way to leverage the real estate market, as they allow investors to avoid direct real estate exposure. Underlying real estate is used only as collateral to the mortgages and normally includes a considerable cushion in the form of a lower loan-to-value ratio to protect investors in the event of a default. Like traditional bonds, an allocation to variable rate mortgages should help enhance returns.
Unfortunately, 2022 promises to continue to hold institutional investors in the grip of the pandemic. However, by evaluating the market and portfolio positioning, investors may be able to better position their portfolios to weather the continuing storm.