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Reflections on Q2 2022 and What Lies Ahead

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By Joel Clark, CEO of KJ Harrison Investors

The first half of 2022 was one for the record books, and not in a good way. For investors, there was nowhere to hide. Not only were equity indices down significantly, but traditional fixed income, whether investment-grade, government or high-yield bonds, got hammered as well. The first half was all about inflation, and then about central banks’ aggressive policy response, including the Bank of Canada’s intentionally shocking full-percentage-point rate increase in June.

We would like to think that the second half of 2022 will be much better for investors than the first, but the global economy is very fragile. There are so many forces at play – war In in Ukraine, lack of investment in energy and food, tight labour markets, supply chain disruptions, rising rates – and they are all striking at once. It will take time for these inputs to play out and for markets to digest their impacts. That doesn’t mean, however, that retreating to a hidey-hole and waiting for the hurting to stop is a good idea.

In fact, the time to play defence is probably behind us. Valuations are down and they might well go lower, but the second half is when it makes sense to look for the beginning of a bottoming-out. Investors must be thinking about opportunity now.

We are looking in particular at three intimately connected macro themes: the U.S. dollar’s strength, the possibility that inflation is peaking, and a shift in market narrative from inflation to recession.

Rise of the greenback

When there is an economic downturn, money flees risk assets and goes to the safest place it can find. At the moment, that’s the U.S. dollar. Interest rates are increasing more quickly in the U.S. than elsewhere (one exception: Canada)

and the dollar is still the global economy’s reserve currency. The U.S. dollar index, which measures its performance against a basket of currencies, has risen more than 10% year-to-date and entered H2 at its highest level in 20 years. Great for the greenback, but bad for global borrowers whose liabilities are in U.S. dollars. They are stuck in a punitive cycle of inflation and tumbling currencies.

The cycle, however, will not last forever. That’s why we’re watching the U.S. dollar closely, looking for signs that it has peaked. If or when it does, it could coincide with central banks pivoting off their current aggressive stances. Which leads to Theme No. 2…

Peak inflation

Yes, the U.S. consumer price index increased by 9.1% in June, and that’s a scary big number.

But CPI is a rearview-mirror statistic. More forward-looking inflation indicators are starting to moderate. Commodities have begun to roll over. One-month copper prices are down more than 20% since June 1, and oil has seen similar or greater declines. Why? Because the global growth outlook is deteriorating rapidly. And that’s because central bankers are raising rates to destroy demand and, hopefully, contain inflation. Which leads to Theme No.3…

How deep is the recession going to be?

The signals suggest that tighter monetary policy is working, although it’s still too soon for central banks to do a victory lap. We shall see how the inflation numbers come in over the next few months, but the bigger risk with rates is perhaps on the too-much-too-fast side. When interest rates rise this quickly and aggressively, liquidity is driven out of the system at warp speed. So we are now moving into the big questions:

 

What will be the impact of this super-tightening on the economy? With abundant evidence that it is already slowing down, a recession looks likely, but will it be shallow or deep? Right now, equity markets seem to be discounting for a shallow recession. But what happens if things get worse?

There are no answers, of course, but the important takeaway is the shift in the narrative. The story for the second half of this year is all about a slowing economy and expectations of a policy pivot. Of course, there is a very real chance – we would say about 50% – that central banks go much too far in tightening and plunge the world into a deep and lasting recession. The other possibility, however, is that before that happens, and out of concern that it could happen, the U.S. Federal Reserve and other policymakers will pause rate hikes, perhaps as early as sometime in the second half. Then the narrative could shift again early next year as markets look ahead to falling rates, raising the potential for outsized equity returns in 2023-2024.

This is not to suggest that investors should attempt to time the markets. But if we assume a base case that is somewhat less dramatic than a complete global meltdown, the second half should provide at least a window through which we can see opportunities. Given the risks, we would prefer to err on the conservative side, looking for high-quality companies with the financial strength to ride out the economic storm and capitalize on long-term trends. In fixed income, meanwhile, we are beginning to see openings in investment-grade bonds, where yields for some very stable companies have become attractive.

When markets go down, everyone tends to shrink their time horizons and over-worry about next year, next month or next week. But as an investor, these are the times when you must extend your time horizons. As the market narrative switches from inflation worry to recession angst, the important questions will be whether and when central banks take their foot off the economic brakes. Right now is the time for investors to be thinking about how to position themselves for that pivot.

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