Oversight

The recent market cycle can be characterized by numerous unusual aspects. Many of these relate to being in a highly inflationary environment for the first time in more than 40 years, a climate that predates the majority of today’s market participants. This month’s Outlook highlights some of the effects of inflation that are offering perplexing signals as investors navigate through this inflationary environment.

We recently published our 2023 Financial Markets Forecast, which presents a comprehensive review of our investment thinking for the year to come. Therefore, as in years past, we devote the February edition of Outlook to providing an annual update on organizational developments at Connor, Clark & Lunn Investment Management (CC&L). The one overriding mission for our firm is to ensure that we put the necessary amount of time, energy and resources into managing mandates and meeting the performance objectives of our clients, accompanied by industry-leading standard of service. In this edition of Outlook, we provide an update on our business and our commitment to reinvesting in the company to ensure future success both for our clients and the organization.

This year’s Forecast looks at the secular themes that underpin our outlook, and then considers the shorter-term cyclical factors influencing the outlook for the economy, inflation, and monetary policy. We examine market valuations and taking into account all these factors, we set the framework for our portfolio strategy. Throughout the next year, updates to our Forecast will be highlighted in our monthly newsletter – Outlook.

The nearterm economic deterioration fable for Canada has been well told. Canada’s citizenry is engaged in a love affair with real estate. Not needing, yet still benefiting from the global drop to near-zero interest rates we embraced home ownership, taking on massive mortgage debt to pay for increasingly expensive homes.

We discuss the approach to delivering returns from fixed income by using alternative tools.

The global economy is heading for a slowdown in economic activity. Central banks, after having pushed through a series of rapid increases in policy rates, have begun to slow down the pace of rate hikes. The Bank of Canada, a global leader in policy tightening, put forward a smaller than expected rate hike late in the month, which was especially noted. This had asset markets closing the month higher. Against this backdrop, we ask whether it now time to dive back into risk assets. We think that it is still too early.

Financial market volatility picked up in September as a result of diminished liquidity globally, which can set the stage for unexpected shocks. In September, the BoE came to the aid of the UK government bond market amid financial instability due to a sharp rise in gilt yields. This had ripple effects through UK pension funds and triggered selling in an already difficult market. It is evident there is a distinction between risks related to financial instability and day-to-day financial volatility, and when policymakers may step in with support. With inflation above target, and absent financial stability concerns, we believe they will remain resolute in their battle. We are watchful over unforeseen instability, but focused on the fundamental outlook.

Equity markets rebounded in the summer months, rallying when inflation edged off its highs or when Fed Chair Powell raised the possibility of a slowing in the pace of rate hikes. Throughout this period, earnings forecasts have remained resilient. One of the biggest hazards to risk assets is that we have not yet seen downgrades to earnings estimates that typically accompany a recession, suggesting the potential for considerable weakness should earnings begin to reflect slowing activity. Most countries continue to combat higher inflation, which we believe remains the singular focus for central banks and tilts the balance of risks towards a worsening economic outlook.

Risk assets have rebound since mid-June, as investors expect economic weakness to alter central bank tightening course. Last month, we explored the greatest risk to our near term view, which is a sustained upside surprise in inflation. This month, we assess what is needed to see to bring inflation down by the end of the year, from a top down basis, as well as decomposing inflation into its components. In aggregate, it looks to us like inflation is not so much peaking and turning lower as it is likely to stay elevated for some time.

Market returns have been dismal this year, reflecting tightening cycles that will take monetary policy into restrictive territory. More recently however, markets rallied on the expectation that a recession would curtail central bank tightening. Investors appear to be interpreting a recession as “good news” in that the policy moves currently outlined by central banks will break the uptrend in inflation, and that will allow a return to a low growth, low rates environment. But what happens if these actions are not enough to slow inflation? Monetary policymakers would be faced with some undesirable scenarios. We discuss these scenarios in more detail and determine that, while they are not likely, they are also not implausible.

We are approaching the halfway point of 2022, a year that has proven to be a challenge for nearly all asset classes. In many ways, given the macro backdrop, the market moves have been understandable as central bank tightening cycles, resulting slowdowns (and potential recessions), as well as high inflation are all negative for markets. However, markets are not yet fully pricing in a recession. There are some indications, including resilient earnings forecasts and only a brief yield curve inversion so far, that are not yet suggesting an imminent recession. As we look ahead to the balance of the year, we are also not expecting a recession, but we remain cautious with risks tilted toward slowing economic activity and the related outcomes for risk assets.

From the end of the last recession, we are inevitably moving towards the next one. The only question is when it will occur. Economic indicators suggest solid underlying conditions, and that a recession is not imminent. However, with inflation expectations hovering around concerning levels for central banks, the Fed is clearly demonstrating a willingness to forego economic growth in order to achieve price stability. While in previous circumstances, the Fed has come to the rescue when financial markets have tumbled, this assumption is likely gone for now as the Fed’s focus is clearly centered around fighting inflation. As a result, market risks lie ahead, a sentiment to which we remain attuned.

The moves this cycle have been happening faster than usual. The US yield curve, measured by the spread between 10-year and 2-year yields has turned negative in a record short period following the Fed’s first interest rate increase. While each recession since the late 1960s has been preceded by this inversion, there are several key differences this time. Notably, the Fed’s preferred yield curve recession indicator is still quite steep, it is not yet clear how quantitative tightening will impact yield curves, Canada’s 10-year less 2-year yield curve is not yet inverted, and corporate sector profitability as well as consumer savings remain high. While we don’t believe a recession is imminent, we are closely monitoring developments.

This violation of the sovereignty of a neighbouring country and indeed the attack on democracy is difficult to fathom. As we consider the consequences of this shock, we can learn from financial history that the economic backdrop heading into a shock is critical. Markets were already on shaky footing this year in response to increasingly assertive central banks. Strong commodity prices stemming from the crisis are likely to weigh on growth, pressure inflation higher, and complicate central banks’ decisions. We discuss the adjustments we have made to the portfolios as a result, that reflect both direct and indirect impacts.

We recently published our 2022 Financial Markets Forecast, which presents a comprehensive review of our investment thinking for the year to come. Therefore, as in years past, we devote the February edition of Outlook to providing an annual update on organizational developments at Connor, Clark & Lunn Investment Management (CC&L).

The one overriding mission for our firm is to ensure that we put the necessary amount of time, energy and resources into managing mandates and meeting the performance objectives of our clients, accompanied by industry-leading standard of service. In this edition of Outlook, we provide an update on our business and our commitment to reinvesting in the company to ensure future success both for our clients and the organization.