David's Weekly Review - May 28 - June 3, 2022

Good afternoon, clients, partners, and colleagues.?War, inflation, central bank moves, and COVID lockdowns remain ongoing themes, while fund flows indicate some positive investor sentiment towards China.?

Overall, markets chopped into a positive week by yesterday afternoon while economists look for a strong, albeit slowing US labor market.?We saw another 50 bps hike in Canada with more expected to arrive, to tame inflation, with a terminal rate roughly in the 3% range.?

As I continually emphasize with clients, although governments are behind the inflation curve, we recommend sitting tight, not making any large moves in your portfolios while considering minor strategic asset allocation changes but not ignoring some shorter-term tactical opportunities, particularly in short-duration bonds, as I’ll review below.

This week, we’ll look at the war in Ukraine, particularly from the economic viewpoint.?We’ll follow up with a few interesting charts covering interest rate expectations, market performance, and the ongoing short-duration bond trade.?We'll take a peek at consumer inflation expectations and then wind up with RBC PAG’s Global Insight Weekly.?Enjoy.

Ukraine War

Three important events occurred or are developing this week:?two that directly impact inflation-fighting and two that adjust the balance of power in Ukraine’s favour.

For the former, after some vacillating, the US has decided to 4 HIMARS multiple launch rocket systems which have a range of roughly 45 miles, compared to about 20 miles for the current artillery systems.?These new heavy weapons would allow the Ukrainians to hit Russian supply and logistic lines and possibly out-of-reach Russian artillery that is currently causing massive damage in the theatre in Donbas.

Testing of the US HIMARS System

Germany Steps Up

German Chancellor, Olaf Scholz, in his piecemeal fashion, has agreed to send about 50 of their modern IRIS-T air-defense system to Ukraine, after much pressure from the opposition.?These defensive systems have the ability to protect the skies above cities, thereby, dampening the effectiveness of the Russian strategy to simply rubble, and depopulate cities by way of long-range weapons.?Think Mariupol and Severodonetsk which have both been almost completed destroyed.

Inflation Mitigation and Exacerbation

On the inflation front, May 30 marked the beginning of a special European summit on collective defense, aid for Ukraine, and energy security, which brought policymakers from the EU to agree on a late-night deal that would partially ban Russian energy imports, alongside an upcoming 6th wave of sanctions from the EU.?This move away from Russian oil will likely exacerbate inflation but longer term will create more energy safety for Europe which is also committed to spending $200B EUR on sea-based wind power over the next decades.

Allies “Grainularly” Increasing Efforts in the Black Sea

World grain prices are on the march due in part to the cutting off of the significant supplies normally provided by Ukraine.?Earlier this week, John Stavridis – former Supreme Allied Commander of NATO forces in Europe noted that the black sea is effectively under Russian control but that NATO allies Romania, Bulgaria, and Turkey all have warships in the area, while the US has warships in the Mediterranean that can flow towards the Black Sea.??

Stavridis says the international community will need to consider escorting grain from Odessa which is choked off now. We’ll need to open up the seas to Ukraine and this action will be “the next big muscle movement in the war”, with the intent of getting food to countries including in Africa and re-opening Ukraine's economy to the world.

Markets and Charts

The biggest news this week was the rate hikes.?As we can see below, the red line indicates where markets are expecting the policy rate to end the year as the BoC and Tiff Macklem try to combat multi-decade high CPI prints.

Source: Bloomberg

Historically speaking, a 3% terminal rate would still be considered accommodative to the economy, while effects on the housing market would be negative overall on price, with longer-term commodity inflation (lumber, steel) shoring up price support.?The BoC statement was quite hawkish, indicating that the Governing Council was prepared to operate more forcefully if needed”, indicating a 75bps hike is a possibility in the future.

The S&P for the Technically-Oriented

For those chartists out there, the figure below shows some key technical levels, Fibonacci levels to be specific, the latter of Sanskrit origin, that are considered to be natural retracement levels for markets.?Having followed technical analysis for a number of years in my previous decades as a professional trader, I look at Fibonacci as somewhat unscientific, but useful to get a basic idea of how far markets are moved.?With so many trading systems based on these numbers, they can be a self-fulfilling prophecy.?That aside, the next levels down at the classic 23.6%, 38.2%, and 50% retracements show some expected support/resistance areas as the market sells off.

Short-Duration Bond Trade – Still Good?

With so much action on the monetary policy front, we can confirm that the pricing at the front end of the yield curve (from 2-4 years, more or less), has already fully priced in all of the upcoming rate hikes.?That is, even as overnight rates are raised, the bond market has thought way ahead and adjusted as if the rate cycle will happen with 100% certainty.?The longer-end of the curve – 5+ years – is still subject to speculation on the future of inflation, but the flatness indicates that expectations of lower inflation over the next couple of years are the current outlook.?In the chart below, we can still see the outperformance at the short end of the curve, indicating that this trade is available.?However, there’s no assurance that it won’t disappear if either inflation numbers turn over quickly, setting back rate hike expectations, if bond liquidity dries up, or if market confidence ends up squeezing credit spreads down to less attractive levels once again.

The chart below demonstrates the performance of the RBC Discount Bond ETF (a government/IG corporate short-duration portfolio), vs the VAB aggregate bond Index ETF, the iShares Core Canadian Short Term Corporate Bond Index, and XSB, the iShares Canadian Short Term Bond Index.?Although the yield to maturity of RDCB is below that of a bespoke selection of short-duration investment-grade corporates, it’s clear that this ETF has far outperformed VAB and XSH.

Are Inflation Expectations Entrenched?

I’m sharing a statistically insignificant poll I posted on LinkedIn this week, asking about consumer behavior.?The chart is self-explanatory.?The result of this very small data set indicates that inflation expectations are impacting consumption with the majority of respondents stating that they will wait until inflation cools before making any major purchases.

TIP OF THE WEEK:

Volatility is the Accumulator’s Best Friend

When you forget about timing the market and just invest the same amount every month, you end up optimizing your average price.?Why is this??Because the crowd is usually wrong and emotional.?Most investors buy markets aggressively on greed on the way up, spending a lot of money on a few shares, while selling aggressively on the way down, on fear, selling a lot of shares at a lower price.?However, if you invest regularly when the market is down, you buy a higher number of shares at a below-average price. When the market is higher, you buy fewer shares at a higher price.?Taking it a step further, if you follow the doctrine of rebalancing your portfolio regularly, you will find yourself selling your shares at higher prices and buying them back at lower prices.?BUY LOW/SELL HIGH.?See my five-step investing plan to learn more.

Finally, I’d like to share this week’s Global Insight Weekly.?Enjoy

In this week’s issue…

• Opportunities amidst volatility -?Uncertainty about the economy, inflation, and monetary policy have supercharged volatility in financial markets and, correspondingly, a repricing in valuations. Further downside cannot be ruled out until greater visibility arrives, but we believe valuations across a number of assets are starting to look relatively more enticing.
• Regional developments:?Additional rate hikes expected to benefit Canadian banks; U.S. stocks seek direction; Euro-area inflation accelerated to an all-time high; A sign of pressure for Japan’s economic rebound

Please find the report here: Global Insight Weekly

If you have any questions or concerns about your own portfolio or would just like to discuss some ideas, please get in touch.

Have a great weekend,

David

[email protected]

416 720-9097