Canadian Markets in Uncharted Waters

We’ve just come through a tough year when high inflation and rising interest rates dominated market discussions, along with Russia’s invasion of Ukraine.

Here’s a quick review of the Canadian market in 2022 as we embark on a new year, hoping for a return to normalcy in the global markets.

Fixed Income

The Bank of Canada (BoC) raised the overnight lending rate from 0.25% to 4.25% during 2022 through a number of outsized rate hikes meant to combat high inflation. This rate hike cycle was one of the most aggressive tightening efforts by the Bank of Canada, and even led to a super-sized rate hike of 100-bps rate at the July meeting.

For bonds, 2022 was the worst calendar year for the FTSE Canada Universe Bond Index (Broad Composite) since 1980. In the 40+ years of calendar-year returns, there were only five down years, and only one back-to-back negative year for the Index (2021 & 2022):

During 2022, short maturity bonds broadly led performance in the Broad Composite, with Short AA+ Corporates leading major segments with a loss of 3.5%, while longer maturity bonds broadly lagged in the Index. Long Federals performed the worst in the Index with a loss of 24.0% as duration was a major detractor to the performance:

FTSE Canada Universe Bond Index 2022 Return (%)

Bonds in the Broad Composite on average were trading at a premium heading into 2022, and with the plunge in bond prices during the year, they were on average trading at a discount with a much higher yield by the end of 2022. Yield-to-Maturity reached 4.3% in comparison to 1.9% at the end of 2021 for the Broad Composite, after seven rate hikes by the Bank of Canada during the year.

At its most recent meeting in December, BoC made a significant change to the language of the statement: “Looking ahead, Governing Council will be considering whether the policy interest rate needs to rise further to bring supply and demand back into balance and return inflation to target.” An indication of a potential pause in rate increases.

We could see less negative pressure on bond prices in 2023 with a potential pause or a slowdown to rate hikes, which would put bond yields in focus this year. Bonds, on average, are also trading below the par value in the Index with bond yields back to the late 2008 levels.

Equities

The S&P/TSX Composite Index (TSX) finished the year with a loss of 5.8%, which was the 13th?worst calendar year return of the Index since 1957 (see table). Royal Bank of Canada regained the top market cap spot in the Index, reclaiming it from Shopify as it plunged 73.0% during 2022, detracting 4.5% of the TSX’s performance.

Energy was the best performing sector in the S&P/TSX Composite Index, with a gain of 30.3%, followed by consumer staples (10.1%), materials (1.8%) and industrials (1.4%) during 2022 (All the returns referenced are in total returns in CAD derived from Bloomberg L.P.).

Health care finished at the bottom with a decline of 61.6%, but only represented a small average weight of 0.5% during 2022, which had a minimal impact to the overall performance of the Index.

Financials, which represents the largest sector weight in the S&P/TSX Composite Index, declined 9.4% last year.?Among the big six banks in Canada, National Bank led with a loss of 1.4%, closely followed by RBC (-1.5%). TD and BMO both declined by single digits, -6.0% and -6.2%, respectively. Bank of Nova Scotia finished at the bottom with a loss of 22.9%, followed by CIBC (-21.7%).?

Rapid increase in interest rates, high inflation levels, and uncertainty derived from macroeconomic and geopolitical factors have reduced risk appetite for investors, negatively impacting valuation multiples like Price-To-Earnings ratio during 2022.

Looking ahead, the S&P/TSX Composite Index is trading at similar valuations during March 2020, October - November 2011, and the Global Financial Crisis (October 2008-June 2009) based on Price-to-Earnings multiple in recent periods:

The TSX is already trading at levels during a typical slowdown or a recession, hence, earnings will be in the spotlight for 2023.

Dividend yields are attractive at 3.5% for the Index, providing investors with a source of income.

New year, fresh start

During 2022, we saw the status quo put to the challenge for both fixed income and equity markets, as we entered an uncharted territory that looked very different from the past decade.

The Canadian fixed income market experienced double-digit declines during 2022 and caught many by surprise on the magnitude of that decline. We have also seen value stocks broadly lead performance in major markets by a large margin, as multiples on some of the growth stocks contracted significantly during 2022.

I think there are opportunities in parts of the market, specifically in fixed income as we start the year with a much more attractive yield compared to the start of 2022. Also, some of dividend paying stocks provide an attractive income with modest growth potential for long-term investors.

As I start my second year at Franklin Templeton, I’m looking forward to connecting with more colleagues in the industry and sharing ideas and insights as we start a fresh year.

Happy New Year!

Disclaimers

FTSE Global Debt Capital Markets Inc. (“FTDCM”), FTSE International Limited (“FTSE”), or the London Stock Exchange Group companies (the “Exchange”) (together, the “Licensor Parties”). The Index is compiled and calculated by FTDCM and all copyright in the Index values and constituent lists vests in FTDCM. The Licensor Parties shall not be liable (whether in negligence or otherwise) to any person for any error in the Index and the Licensor Parties shall not be under any obligation to advise any person of any error therein.

“FTSE?” is a trademark of FTSE International Limited in Canada and Taiwan, and “FTSE?” is a trademark of the London Stock Exchange Group companies in the rest of the world and is used by FTDCM under license. Broad Composite is represented by the FTSE Canada Universe Bond Index; Long Composite is represented by the FTSE Canada Long Term Overall Bond Index; Mid Composite is represented by the FTSE Canada Mid Term Overall Bond Index; and Short Composite is represented by the FTSE Canada Short Term Overall Bond Index.

Broad All Government is represented by the FTSE Canada All Government Bond Index; Long Government is represented by the FTSE Canada Long Term Government Bond Index; Mid Government is represented by the FTSE Canada Mid Term Government Bond Index; and Short Government is represented by the FTSE Canada Short Term Government Bond Index. Broad All Corporates is represented by the FTSE Canada All Corporate Bond Index; Long Corporates is represented by the FTSE Canada Long Term Corporate Bond Index; Mid Corporates is represented by the FTSE Canada Mid Term Corporate Bond Index; and Short Corporates is represented by the FTSE Canada Short Term Corporate Bond Index.

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