This article is , provided by Canso Investment Counsel Ltd.

Market must-reads: Highlights from Canso’s Market Observer for April 2022

War in Europe. Inflation at levels not seen in decades. Central bankers talking tough – and raising rates. Bond prices tumbling. In short, a lot is going on in the world, and none of it seems to augur well for financial markets. In its spring Market Observer newsletter, leading Canadian institutional investment management firm Canso Investment Counsel Ltd. discussed the rapidly evolving policy and economic landscape – how it came to be here – and shared their insights on the impact for investors. To read the full report, please click here.

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This is not good

Inflation was already running high to start 2022, but Vladimir Putin’s aggressive and violent invasion of Russia’s democratic neighbour Ukraine in February created a strong tailwind for further global price increases. “There are few things more inflationary than war and defence spending, as neither creates productive capital or consumer goods,” the Canso team noted in the newsletter.

An end to inflationary pressures is nowhere in sight. Even if Russia and Ukraine come to some sort of peaceful resolution, war in Europe has undermined economic globalization. The integration of former Warsaw Pact countries and of Communist China into the global economy – which benefited the West with lower price inflation – “has all evaporated in the face of raw military power, applied brutally by Vladimir Putin to achieve his vision of restoring Russia’s stature as a great power,” Canso wrote. If the longer-term outcome of the Ukraine conflict is that the West weans itself off cheap Russian oil and cheap Chinese manufactured goods, then inflation will only continue to rise.

Central banks’ wake-up call

For years now, major central banks’ mantra has been to do “whatever it takes” (to repeat former European Central Bank head Mario Draghi’s famous declaration) to prop up economic growth in the face of – and even long after – black swan events like the Great Financial Crisis of 2007-2008. As the Canso newsletter noted, they got away with it for a long time, at least insofar as the spectre of inflation remained muted for much of the millennium. “The problem for central bankers now is that they started to drink their own monetary policy Kool-Aid,” the team wrote. “They too came to believe that money didn’t matter after all the years of Milton Friedman’s ‘Only Money Matters’ being proved wrong.” But when the COVID-19 pandemic hit, extraordinarily easy money was met with extraordinarily generous spending by governments – including “$1 trillion in pandemic ‘Trump Bucks,’ given to all U.S. citizens for nothing in return.”

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The resulting inflation is proving to be persistent – and highly unpopular with voters – and so image-conscious central bankers are being forced to change their tune. Now, the newsletter pointed out, they are pledging to do “whatever it takes” to contain higher prices. But the Canso team questioned whether monetary policymakers – or financial markets, for that matter – fully appreciate how difficult that might be. Looking back at historical periods when CPI inflation was higher than the yield on 10-year Canada bonds (that is, when real benchmark bond yields were sharply negative, as they are now), they found that rate hikes were far more dramatic than the ones currently being priced into bond markets. “Clearly, there is quite an increase waiting if history is our guide, with the increase in historical 10-year Canada yields rising between .5 per cent and 1.9 per cent,” they concluded. “Will this time be different? We’re about to find out!”

Bond market bloodbath

During a globally-relevant conflict like the war in Ukraine, investors would normally “flee” to the relative safety of bonds, but the opposite happened in this case, Canso pointed out. Instead, markets (rightly) see the war as inflationary, and so bond yields have gone through the roof as “central banks recognized they had overcorrected with their ultra-loose monetary policy response to the COVID pandemic.” Short-duration bonds, which historically are more attractive when rates are expected to rise, have provided no protection from the bond selloff. As the Canso team noted, the yield on U.S. two-year Treasuries is now above pre-pandemic levels, and Q1 2022 marked the worst quarter for the FTSE Canada Short Universe Bond Index since the first quarter of 1994. “The bad news,” they added, “is that more negative bond market returns seem to us to be ahead.” And the stock market is likely to be affected eventually.

With the potential for further dramatic rate hikes so high, the Canso team said they continue to favour “very short, safe and liquid securities”. “When liquidity wanes with the monetary tightening and prices fall substantially, we will be ready to buy,” they concluded. “Until then, we are still happy to watch from the sidelines.”

For more insights and analysis, see the full April 2022 Canso Market Observer by clicking here.

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The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.

This story was created by Canadian Family Offices’ commercial content division, on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.