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Markets finish on a high note despite central bank pivot

January 11, 2022
clock 5 MIN READ
  • U.S. stocks were the top-performing major market for the fourth quarter and the full calendar year. Canada, the U.K. and Europe also performed quite well over both time frames, while China was down steeply for the quarter and year.
  • In our view, ultra-low interest rates in the face of higher inflation and above-average growth may force central banks to adopt more aggressive policies than they and market participants currently envision.

SEI’s Domestic View

Like the rest of the world, Canada has been on an economic rollercoaster for two years running. Rising rates of COVID-19 infections have led to restrictions on mobility and periodic lockdowns, which then ease as caseloads crest and begin to fall. In the past year, real gross domestic product (GDP) contracted in April and May as the COVID-19 wave caused by the Delta variant washed over the country. The economy bounced back in the months thereafter; growth for the year as a whole is expected to reach 4.5%, with a similar gain in 2022.

While GDP growth appears to have ended 2021 on a strong note, the New Year will likely begin on a distinctly weaker one. The country was in the midst of a violent spike in new COVID-19 cases during December as the Omicron variant began to rip through the population. Fortunately, this contagious new version of the virus has so far proven to be generally less severe than previous variants.

Among currently infected patients in the country, only 0.2% are considered as seriously or critically ill. It surely helps that residents have been diligent in getting their vaccinations. As of December 24, 77% of the population is fully vaccinated (this does not account for booster shots) and 6% is partially vaccinated. In the U.S., only 61% is fully vaccinated; 12% is partially vaccinated. (Source: Worldometer.com)
High vaccination rates and a low percentage of serious cases notwithstanding, the federal and provincial governments are again imposing restrictions on mobility and activities in order to limit the virus’ spread. Germany, Italy and China are more restrictive, but Canada may well see limits increase in the weeks ahead. Stringency levels in the U.S. and U.K. remain comparatively low.

The notable differences in approach used to combat the virus are reflected in varying rates of economic growth. Between 2010 and 2019, inflation-adjusted GDP in Canada tended to track (and often exceed) the pace of its southern neighbour. Yet Canada was starting to lag the U.S. even before the pandemic hit. During the worst part of the lockdown period in the first half of 2020, the Canadian economy suffered a sharper peak-to-trough decline. The subsequent recovery also has not been quite as strong. As of the third quarter, Canada’s economy was still below its fourth-quarter 2019 GDP peak, while the U.S. already was in new-high territory and almost back to its pre-pandemic growth trend. Still, compared to the other large economies, Canada continues to benefit from its proximity to the U.S. The North American neighbours remain joined at the hip, which is a good thing for Canada.

Like the U.S., Canadian businesses are facing labour-market pressures and rising input costs. The price pressures are not as severe, but they are worrisome. The Bank of Canada (BoC) has pulled back on quantitative easing; the consensus view calls for a series of policy-rate hikes in 2022, leaving the overnight rate at least a full percentage point higher than it is currently. At SEI, we do not expect the BoC to be so aggressive. Rather, like the last rising interest rate cycle in 2017 and 2018, we suspect the central bank will follow the U.S. Federal Reserve’s (Fed) lead. While policy divergences do occur, coordination is the norm—especially when Canada and the U.S. face similar economic challenges.

The Canada-U.S. rate differential on 2-year Treasury notes surged in October as investors anticipated that the BoC would hike interest rates sooner and more aggressively than the Fed. The spike did not last, but Canada’s 2-year note is still about 0.2% higher than it was at the end of 2020. The exchange rate, meanwhile, is almost exactly the same as it was this time last year; although the loonie has slipped by more than 7% from its May and June peak levels. A rising interest-rate differential in favour of Canadian 2-year yields tends to be associated with the Canadian dollar appreciating versus the U.S. dollar. 

At this point, it is unclear which way the spread will go from here. The exchange rate may be stuck in a narrow trading range, at least for the next few months. From a longer-term perspective, the Canadian dollar is considerably below the levels it reached during the 2010-to-2012 period. The country’s exporters have since become far more competitive. Exports of goods climbed sharply in 2015 and 2016, thanks to this currency depreciation and the improving strength of the U.S. economy. More recently, the surge in oil prices has led to a sharp gain in energy exports. In 2021, Canada reported the first surplus on its current-account balance since 2008. The improvement in trade balance should provide additional support for the currency.

The economic outlook in 2022 for Canada remains upbeat. Elevated commodity prices, improving supply-chain conditions for motor vehicles and parts, and a competitive currency all bode well for growth. Of course, there are also challenges in the form of rising cost pressures, labour shortages, and the uncertainty surrounding the impact of the latest COVID-19 wave and others that may follow. A turn toward monetary tightening also is concerning, but we suspect that the BoC will raise interest rates in a cautious fashion, mimicking the U.S. Fed’s approach.

In 2021, the MSCI Canada Index (total return) rose by more than 25%, nearly matching the performance of the MSCI USA Index (total return). Earnings were exceptionally strong last year, and analysts’ estimates of 12-month forward earnings climbed about 35% over the period. The Canadian stock market’s valuation, as measured by the forward price-to-earnings (P/E) ratio, became cheaper as a result. The market currently trades at a forward P/E of less than 15 times, a substantial 33% discount to the U.S. stock market. On an absolute basis, this earnings multiple is somewhat elevated versus history, but hardly in bubble territory. We believe investors can look forward to another solid performance for the Canadian stock market in 2022 as the economy continues its recovery from the stresses of the past two years.

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