It is halftime for 2022, and if this were a football match, the markets are in dire need of a great inspiration speech before retaking the pitch. The 1st half really had no place to hide, as both bonds and equities declined. Some markets breached the -20% threshold, commonly referred to as a bear market, while many others were down less but still materially. At the same time, bond yields have been rising, weighing heavily on bonds. And with recession risks rising, credit spreads have widened, providing another headwind for corporate bonds. There were a few bright spots; energy did well, along with a handful of commodities. The U.S. dollar was strong, and gold was flat. Beyond these pockets, the 1st half was largely in the red.
The magnitude of the wealth decline cannot be overstated. After adding $33 trillion compared to levels before the pandemic started, equities have given most of this back. Adding $33 trillion in less than two years is unheard of historically. Markets took over a decade to add that amount from the recession in 2008 till 2020. And then to give most of it back in a mere six months? Incredible. Even more incredible is the wealth drawdown in the bond world, which is much larger than equities. The global bond market rose in value to $550 trillion, which is over half a quadrillion. But with yields rising, and now credit spreads, this amount has fallen by $102 trillion. Add them up, global wealth has been reduced by $120 trillion this year.
Many factors have contributed to this resetting of prices. Central banks and government spending has pivoted from being supportive of markets to restrictive. Partly as pandemic support was no longer needed and more so to combat the high global inflation levels. Globally, people moved from spending more on goods to services. These kinds of sea changes really mess with the economy and add uncertainty. Add the war in Ukraine to the mix. Plus, we have slowing global economic growth and rising recession risk.
But let us not forget asset prices, from stocks and bonds to real estate, were very elevated due to a confluence of factors at the start of the year. And those factors have all reversed direction creating a great re-pricing of assets. Global equities were trading at about 20x earnings on Jan 1, a good measure higher than the long-term average of about 15x. Meanwhile, global bonds carried a yield of 1.3%, historically very much on the low side, implying bonds are expensive. Fast forward six months, with global equities down 18% and global bonds down 14%, valuations for both are at or below historical averages. Equity valuations have fallen to 15.7x, and bond yields have climbed to 3.0%.
What We Got Right and Wrong So Far This Year
While we all knew this would be a challenging year, the magnitude of the drawdown in asset prices is likely the expected surprise. Our outlook for 2022 ended with the following statement, correct in tone but, in hindsight, an understatement in magnitude:
“Overall, this year will likely prove more challenging given central bank pivots, continued inflation issues, and the slowing pace of growth. We suggest that it may prove inopportune to expel defensive components of your portfolio and chase upside as we head into the new year.”
– Investor Strategy investment implications from December 2021
Below we go through our portfolio construction recommended tilts published in December of 2021, along with an indication of whether it was the correct tilt or not, given how this year has progressed.
Overall Asset Allocation – An overweight in equities was clearly the wrong call, given how equity markets have corrected. However, underweight bonds was correct, as was overweight cash, which was the best performing asset class.
Global Equities – On a relative basis, the TSX has been one of the better-performing markets year-to-date, while the U.S. has been near the other end of the spectrum. However, the overweight international did not work out well depending on the geographic mix. Europe, dragged down more by the war, has performed as poorly as the U.S. market. However, Asia has helped.
We got the style tilt right, as value indeed outperformed growth by a material margin. Size was a tie, with small- and mid-cap performing inline with large-cap.
Fixed Income – While it has been nearly impossible to make money in fixed income this year, all our tilts helped mitigate the damage. Underweight the asset class helped, as did remaining lower on duration and higher on credit.
Currencies – It may come as a surprise, but the CAD to USD is roughly where it was to start the year, around 78-79 cents.
Alternatives – Overweight alternatives as an asset class certainly helped, given how poorly equities and bonds performed. Plus, leaning more towards diversifiers and real assets helped mitigate portfolio damage.
Overall certainly more positives than negatives on our portfolio construction tilts so far in 2022. Acknowledging it is always bittersweet celebrating relative wins. Now let’s see what we can do for the back half.
The 3 Stages of a
Maybe it is a bear. Maybe it is a corrective phase of pandemic-induced excesses. Then again, these are just labels. Regardless of what you would like to call this current market, we believe there are 3 phases given the unique nuances of how we reached this point – valuation reset, revisions, and recovery.
Stage 1 – Valuation Reset
Valuations of any asset are based on its forecasted future cash flow or earnings, discounted into today’s dollars. The discount rate depends on the risk-free rate and a premium for the uncertainty of future earnings or cash flow. This premium tends to be smaller for bonds but rises if default risk or a recession looms. For equities, which enjoy the potential of upside earnings surprises, the premium is much higher as the future is much more unknown. Again, if a recession looms, the discount rate goes way up.
But in today’s world, we don’t even have much clarity on the risk-free rate as central banks embark on a rate-hiking program to combat inflation. Is it 1.5%, 2.5% or 4%? Depends on the path of inflation. And there is a rising recession risk. Simply put, the discount rate has gone way up given the high level of uncertainty over the coming quarters and years.
This is the crux of the valuation reset, and make no mistake, valuations have reset materially. On average, the price-to-earnings ratio of equity markets has fallen about 24%. That is a pretty big reset and does bring valuations from being somewhat elevated to below average. Not a screaming buy from a valuation perspective on equities, especially if you view the ‘earnings’ as at risk of revisions (next stage). Still, the froth has been taken out of the equity market.
Bonds, too, have gone through a valuation reset. Yields were ridiculously low a couple of years ago during the pandemic uncertainly and monetary stimulus. However, yields started to rise all the way back at the beginning of 2021; they just accelerated in 2022. So, the bond market has been in a ‘bear’ market for 18 months now (higher yield = lower price, of course). Yields are no longer ridiculously low – they are not even low. They are normal again, or dare we say juicy.
From a valuation reset, the bond market may be the relatively more attractive asset class. But this really comes down to what will be the longer recurring threat: inflation or a recession. If inflation continues, bonds are still at risk. But if a recession is quickly becoming the path ahead, bonds should outdo equities. It is a tough one, but the good news is that valuations in both asset classes are much improved, which improves future expected returns even in an uncertain world.
We believe the valuation reset is largely done... but revisions are up next.
Stage 2 – Revisions
The economy is slowing down. Tightening financial conditions are taking their toll across many industries, as are consumer behaviours changing back towards pre-pandemic patterns. Consumer confidence is in the dumps due to the market drop and inflation. Plus, high energy prices are not helping.
Take your pick for signs of slowing global economic activity. Copper prices, which have an honorary degree in economics, have been falling fast. Housing activity in Canada and the U.S. has started to slow materially, mainly due to higher mortgage costs. This is now beginning to show up in prices.
From Credit Suisse June monthly survey of real estate agents – ‘The adjustment to higher rates appears to be happening more rapidly than in prior cycles as the change in traffic was more abrupt and we’re now already seeing a reaction on pricing.’
Based on PMI surveys, manufacturing activity is slowing after running really hot to catch up and alleviate many backlogs. Meanwhile, leading indicators are certainly not going up anymore, and some are starting to decline. The data has been softening.
Let's not forget the U.S. economy contracted in Q1, and based on the Atlanta Fed's GDP Now measure, Q2 is looking pretty close to zero growth. GDP Now is a bit skewed on the data but attempts to capture how the economy is doing in almost real-time. If Q2 comes in below zero, that would be a technical recession for the U.S. economy, two consecutive quarters of negative GDP growth.
If you believe we are in a recession today, you have not been in enough recessions. A spike in imports, which reduces GDP, occurred in Q1 as port bottlenecks eased. And while the economy is slowing, too early to say it is heading into a contraction.
But make no mistake, forecasts are being revised lower. The chart below shows the economists' consensus expectations for developed economies and emerging/developing. As you can see, 2022 growth has been trending lower, especially in emerging economies, given the events in Eastern Europe. These trends in economic expectations are likely going to continue to come down as we move through the 2nd half.
The good news is few market participants lament over economist forecasts, perhaps due to a patchy success rate at forecasting turning points. However, many more investors focus on company earnings and may be set to see downward revisions as well.
Let’s start with margins, which we did get wrong as we thought cost pressures would crimp margins near the end of 2021. There is no denying that corporate costs are on the rise. Shipping costs, wages due to a tight labour market, commodity prices – the list goes on. However, we underestimated the ability of companies to pass this on very quickly into higher prices, which most of us consumers have become keenly aware. For example, a sandwich cost me $18 last week in the Toronto Path.
The problem now is consumer prices (CPI) have come back in a little, and producer prices (PPI) are still rising. CPI is starting to come down, fingers crossed, as the efforts to combat inflation are working. Namely, economic demand is softening. Using our proxy of PPI finished goods, costs will come down too, but it lags. And during this lag, margins are at risk.
It does get a bit more concerning since margins are sitting at all-time highs (as far back as our data goes). Sales growth is the lifeblood of margins. Now, this can come in the form of greater output in units or rising prices, or both simultaneously, as has been the norm over the past few years. The risk now is based on current consensus analyst estimates; sales growth is poised to decelerate in the 2nd half of 2022 and into 2023.
Ok, so that probably makes sense – slowing economic growth begets slowing sales growth, leading to margin compression. The only piece missing is what this means for earnings forecasts. This analysis may be too optimistic. Current forecasts have S&P 500 operating earnings growing on average 12.5% across the 2nd half of 2022 and the 1st half of 2023. However, we believe earnings forecasts will come under downward revision pressure in the months ahead, or even in Q2 earnings season in July. Expectations are simply too high.
Stage 3 – Recovery
Stage 1 and Stage 2 look a bit doom and gloom but don’t forget how far markets have already fallen. Has much of this been priced in? Probably a good amount but not all. And remember, much of this is by design. Markets went too far, inflation got too hot, and now the central banks of the world are tightening to slow economic growth and alleviate the inflation pressure. What is happening right now – recession talk and markets reacting negatively – is precisely what is supposed to happen.
As the economic data cools, it will increasingly show up in the inflation data. The bond market is keenly aware of this, and break-evens have started to come down. The amount of inflation priced into the bond market in the 2–5-year tenor is now back down to early 2021 levels.
We are not saying that inflation risk is gone; the future path of rents and wages remains uncertain and could accelerate. And even if inflation comes back down, it will likely not get all the way back down to the pre-pandemic norms to which the markets had become so accustomed. The inflation risk is starting to decline, though, and that is good news.
If inflation begins its long journey back down in the 2nd half of 2022, that will be partly because economic growth is cooling, opening the door for central banks to slow or cease their rate hiking paths, notably into 2023. This has already shown up in the Fed Funds futures market. At the moment, the futures have the U.S. Federal Reserve moving their rate from the current 1.5% to 3.5% in Q1 of 2023 but then cutting rates back down to 3.0% by the end of 2023.
Whatever the path, as soon as inflation pressures ease, financial conditions should begin to ease as well. Whether we can avoid a recession during this adjustment will be the talk of the town in the 2nd half.
Market Cycle & Risk
While we do believe the 2nd half of 2022 will be much better than the 1st half, it will not be smooth sailing. Below are three key aspects that could surprise the market – the 3rd is the big one:
Summer of Discontent – Most often quoted in U.S. dollars, food and energy prices are very high. They are even higher if using pesos or lira. As the summer drags on, this could lead to increased political unrest in developing countries, where food and energy make up a big portion of the consumer basket.
Wages & Rents – The path over the coming quarters is very sensitive to the path of inflation. Wages, which impacts the services categories of CPI, have been rising. Now there are some signs employment is cooling, which is good. But wage pressures remain a risk, as does rent. The CPI rent component often trails housing prices by a year or so. Given home prices had been going up until a few months back, this CPI component may have further to run to the upside, lifting headline CPI.
Recession – No doubt this is the BIGGIE. Markets continue to struggle with what to worry about more, inflation or recession. We believe as the 2nd half drags on, recession talk will grow louder and louder. So let’s dive into this one much more.
Central bankers have a relatively poor track record of using monetary policy to successfully pull off an economic soft landing when the winds are calm and the economy is on its normal flight path. That is not today. The global economy grew by 5.8% in 2021, which is well above normal. And inflation became a significant problem, let’s call this wind. So the runway is a mile off, and we are still at 10,000 feet with a strong crosswind. If Fed Chair Jerome Powell and peers can pull off a soft landing, we should give him the call sign Maverick. In other words, at best, we are looking at a bumpy landing; at worst, there is a recession pending.
That being said, the timing of the next recession remains very uncertain. The old adage is a recession is when your neighbour loses their job, and a depression is when you lose yours. At the moment, just about everyone has a job, and we just are complaining about high gas prices. Even the timelier Indeed total job postings index is still rather elevated.
Beyond employment, the economic momentum is clearly on the softer side. The Market Cycle indicators, which capture rates, economic, sentiment, and fundamental forward-looking indicators, have been falling fast. Still above the danger zone but not by too much.
I'm going to end this section on a positive note. The U.S. consumer, which makes up about 20% of the world's economy, is in very good shape. China and other parts of Asia, which had been on stricter Covid lockdowns due to less effective vaccines and higher population density, are now coming out of lockdown. When this happened in North America and Europe, we enjoyed one of the strongest economic bounces in years.
It's going to be an exciting 2nd half, so what to do now?
With so much movement in asset prices from stocks to bonds, changes in economic trajectory, and sentiment, it should be no surprise that we have made several changes for positioning into the 2nd half. Within the ‘Portfolio Tilts’ table, a solid turquoise square is our tilt for the 2nd half, while a shaded box denotes the previous positioning. Lots of changes, so here goes:
Overall Asset Allocation
While the overweight equities has clearly been the wrong tilt year-to-date, given valuations and how far the market has come down, we do feel more comfortable with this tilt going forward. Bond yields have risen considerably this year, so we have upgraded bonds to market weight. Yields in government and investment grades have risen to much more attractive levels. Inflation remains a risk, but given rising recession fears, a more neutral bond allocation is more prudent today. The overweight in alternatives, which has helped shield value year-to-date, is moving to underweight. It has become easier to find yield from traditional sources, and given the market decline, the need for diversifiers has diminished.
Question: what would it take to move the overweight equities to a strong overweight?
Global equities are in a bear market and off to one of their worst starts to a year since the 1970s. But in times like this, it's important to remember that you don't want to be selling at the low and locking in the losses. The important question everyone will be asking is when to be a contrarian and go the other way by adding to positions – the always risky 'buying the dip.'
Timing the market has always been a mug's game and virtually impossible to do. To some extent, the best strategy will be to take advantage of these pullbacks and average into oversold positions on an opportunistic basis; it is not an all-in or all-out decision.
Most market observers have blamed the recent selling pressure on central banks, which in their battle against inflation, are willing to accept a recession and higher interest rates. In that regard, the information everyone should be looking for is the fabled 'peak in inflation' and once we see that, it will be time to jump in to add to risk assets such as equities. This could take the form of CPI rolling over or even gasoline prices coming down.
This is the definition of a stock picker's market, as various companies and sectors will turn at different times. If inflation does show signs of peaking and recession risk is likely to remain elevated, this may also trigger a reversal in market leadership. So far in 2022, Value has been dramatically outperforming Growth. High multiple stocks and sectors, such as technology, see their valuations compress during times of rising rates. But the opposite is also true; if yields peak and overall earnings growth slows, the Growth style should once again perform better than Value.
For the biggest bounce on inflation risks fading, hopefully soon, growth equities may benefit the most. Be ready.
There are several changes to our recommended equity tilts. Reducing Canada, which has been a relative winner this year, as recessionary risk rise. Plus, upgrading U.S. equities on the -20% price drop year-to-date provides a better risk/return balance. International equities, also down similar to the U.S., remains overweight given an improved view of Asia and elevated relative value of the Canadian dollar to yen and euro. We continue to favour developed markets strongly and shy away from emerging markets. Financial conditions are tightening, and we have some fears of political instability in developing economies, given high energy and food prices. Below are a few deeper dives into equity categories.
Cooling on Canada – A strong home country bias has benefited Canadians this year, with the TSX outperforming the S&P 500 by around 10% so far, making it one of the smaller losers. Occasionally, behavioural biases can work in your favour. Benefiting from strong performance in energy and agriculture stocks, Canada is one of the few developed markets that has been a relative winner in this inflationary environment. Based on recent forecast revisions from the IMF, Canada is one of only a few economies that avoided a GDP trim, expecting to grow by 2.8% this year. Recent outperformance has emboldened many strategists to continue recommending overweighting Canada; however, we have grown more cautious. With recessionary winds blowing, we fear that the Canadian economy is more vulnerable to an economic slowdown and higher yields than the United States.
Central to our point of view is the excessive leverage within the financial system. The Canadian economy is far more rate-sensitive than the U.S., given the frothy housing market and high household debt. With high debt levels, there is a distinct possibility that the next Canadian recession will be more severe than the one in the United States. While the composition of the U.S. market makes it more vulnerable to rising rates given its large technology and consumer discretionary models, the Canadian economy is more reliant on housing and access to cheap capital.
Despite recent strength in the energy patch, and rosy sentiment, the sector is the definition of cyclical, and we would not expect it to hold up should recession fears continue to grow. Volatility remains high, and we’d note that the sector already fell 20% from its peak in May. The best time to buy commodities was when inflation was not on anyone’s radar, not when it’s making multi-decade highs. If we extend this logic to Canada as a whole, this is not the ideal time to be overweighting an index with heavy commodity and housing exposure.
There has also been a significant cooling on Canadian banks, which have struggled the past few months. Though they benefit from rising rates in some aspects, housing exposure and credit risks are becoming a growing concern. Canadian banks’ short position on the New York Stock Exchange have surged recently. This echoes our concern over Canada in general, centring around Canadian housing.
Given these risks, our overweight Canada allocation has been reduced to neutral. Recession odds are elevated but not a certainty, and Canada is uniquely positioned with both energy and food security, as well as relative political stability. Compared with many countries, these factors help explain how the Canadian dollar has held up as well as it has so far this year. Compared with other G10 currencies, it has held up the best against the surging U.S. dollar. The TSX is also still trading at attractive valuations with the blended 12m forward P/E ratio at just 11.5. Balancing out these elements, a neutral weighting is warranted.
Tipping Back to Market Weight U.S. – From our asset allocation view, moving from overweight in Canadian equities to market weight coincides with an inverse move south of the border. The Canadian market, while recently has been challenged, has held up much better than the United States. Allowing us to shift our Canadian allocation downward and our underweight in U.S. equities to market weight. While our conviction is not extreme, due to various reasons such as heightened recession risk and challenges ahead for the Fed to orchestrate a soft landing. There are cases to be made that allow for a modest change of our American weight in our view.
From a valuation standpoint, the S&P 500 just crossed below the 15-year median of 17x price-to-earnings. Equities in the U.S. continue to become more attractive as we continue to progress through this part of the cycle. While the valuation compared to a 15-year median does not look ‘cheap’, it has returned to normalcy, at least a ‘normal’ level we have seen for the last 8+ years. This valuation compression was large and happened swiftly, as one would expect when yields on the U.S. 10-year go from 0.6% to 3.2% in two years. Yes, there is an argument to be made for margins tightening if inflation stays higher for longer, but hey, we never said investing comes without risk. Again, valuations shifting back to normal calls for a modest shift to market weight, and we would likely need to see a larger compression to warrant a move to overweight.
From a currency standpoint, after the recent run of the U.S. dollar, the best way to implement a U.S. market trade would be to hedge the USD. The risk-off trade has propped up the safe-haven currency. If we get a rise in U.S. equities, the risk-off trade will subside, and the dollar may fall alongside it. Canada has their own currency challenges ahead due to our housing market and debt ratios, but this strategy is weighed more heavily on a pullback in the U.S. dollar.
Overall, the long duration of the U.S. market has been punished during this rising rate environment. U.S. Growth is down -26% year to date while value has only pulled back -10%. However, future recession aside, if inflation begins to subside and we begin to see a change in investor sentiment, the growth in the U.S. is set up for a larger bounce back than other global indexes.
International, Gut-Check Time for Japan – Looking globally, Asian markets are becoming increasingly interesting. Emerging market equities appear extra risky at the moment given the recession risk, the geopolitical risk with high food and energy prices, and tightening global financial conditions. They are no place to be if we are going into a recession due to the overarching effects of high food inflation and elevated energy prices. There is a solution, and oh yeah, it’s the second-largest developed economy in the world. If the title didn’t give it away, yes, we are talking about Japan. While China still holds the title of the largest economy (developed and developing) in the region, Japan remains a major player on a global scale. The Asia Pacific region will certainly benefit from the reopening tailwinds of China. The country is a dominant player, and the first signs of reopening have been positive for the market. However, China does continue to carry significant risk due to political actions towards public companies. As China opens up, the market reaction may be more swift than other members in the region, but a less volatile and longer-term play may just be Japan.
While most global economies enact a hawkish policy, Japan remains on the dovish side of things, but it has not come without a cost. Most notably has been the historic fall of the yen against global currencies. At the most recent policy meeting, the BOJ maintained its target short-term rate of -0.1% and the 10-year yield around 0%. Much different than our North American economies that continue to raise targets by historical levels. Thus, the obvious weakness in the yen stems from widening interest rate differentials between Japan and other economies. When talking yen falling, we aren’t talking about small moves in the currency. From January 2021, the yen has fallen (higher is weaker) 30%+ against both the U.S. Dollar and the Loonie. There is a strong belief that the BOJ will have to abandon its 0.25% cap on benchmark bond yields and let them rise to recuperate the yen loss. If this does happen, it sets up a strong scenario for international investors to benefit. However, the longer Japan stays accommodative, and if inflation continues to pick up, the yen could break these levels. But from our view, a rapid move like this warrants a deeper look at the potential for portfolios.
Shifting away from policy and diving into the Japanese equity market, the year-to-date performance of the Nikkei has seen an identical drop to the S&P 500 of -20% in U.S. dollar terms. However, this selloff has been detailed prior that a large percentage of it is due to currency. The Nikkei in Japanese yen has held up relatively well. At the same time, Japan is still experiencing growing profitability due to the advent of Abenomics. A set of policies laid out by former prime minister Shinzo Abe through increasing money supply and government spending to make the Japanese economy more competitive. After sustaining some compelling earnings growth, the valuations are signalling a convincing buying opportunity. Not to mention, Japanese exports are increasingly competitive given the weak yen. Looking across other regions in Asia, the gap between current forward P/E and the 15- year median is persuasive, especially since outlining prior to that, we want to be underweight emerging markets at the risk of a recession.
To cap it all off and solidify Japan as a potential ‘longer-term’ play for portfolios, look at the makeup of their index. The economy is riddled with some of the most exciting future global trends, such as robotics, electric vehicles, semiconductors, and many other innovation opportunities. The government is not holding them back either. Current Prime Minister Kishida supports innovation and wants to see Japan thrive in the long term. While the weakness in the yen due to accommodative policy is a setback, any slight tightening in the future may help tame inflation and reverse the fall of the yen. On the other side, perhaps they simply ride out inflation and wait for a global recession and rate-cutting elsewhere without having to change their dovish attitude. Regardless, Japan's recent economic and market activity has opened the door for investors to consider a place for it in their portfolios.
Bonds have become bonds again. With the worst selloff in decades, the one positive is that the yields currently available in the market are certainly attractive in absolute, relative and historical measures. And you don't need to go down the credit spectrum to find yield. Add the uncertainty of a potential recession, and it's time to go market weight bonds once again.
Within bonds, the need to remain low duration is also fading. It was an easy call when 10-year yields were below 1% to stick with low duration and lean on credit for cash flow. Today, with 10-year yields over 3%, time to dial those back. On the credit front, there is good news and bad news. If there is a pending recession, we do not believe it will be deep, given the lack of excesses built up in the economy. And many corporate balance sheets are strong. This is good news for credit. However, many high-yield companies have significantly increased their financial leverage to get through the pandemic. With the market awash in yield across different risk levels, is the extra yield worth it? At the very least, go active to try and avoid some of the potential defaults.
Alternatives certainly helped in the 1st half of the year. Leaning on diversifiers and real assets were the places to be. For the 2nd half, given bonds are bonds again and we believe equities will enjoy a rebound on fading inflation, we find less need to be overweight alternatives.
The only change among alternative strategy buckets is cooling our strong overweight in real assets down to overweight. The strong overweight tilt was before inflation and commodity prices spiked. As inflation cools, real assets will likely follow. But we remain overweight as the longer-term prospects remain very compelling.
Real Assets: Still Like Them, Just Not as Much – One area of strength in markets this year has been in Real Assets. Energy has been the group that has experienced the strongest returns and continues to show promise going forward. Over the last few years, as ESG investing has gained popularity, there has been a lack of capital deployed towards the resource sectors. The lasting impact of this shift in investing dollars is that there are no readily available sources of new supply in energy and materials.
Everyone wants to move to a more sustainable and greener future, but it's not that easy and will take time. Investors should consider the theme of energy transition for the next few years – which requires natural gas, nuclear, and renewables. Energy companies that survived the years of $20 WTI have become incredibly profitable in an environment of over $100 prices. What is different in this cycle vs others is that this free cash flow is being returned to shareholders instead of wasted on acquisitions or risky growth projects. Energy stocks should continue to act well, and selloffs in which they participate with the broader market should be looked at as buying opportunities.
The one commodity that has frustrated investors for the past two years is gold. In many textbooks, you can see model portfolios that would show a 5% weight in precious metals to have an uncorrelated asset that will protect against inflation. Well, we are in an environment where all these themes are occurring, but gold isn't really working as expected.
Maybe last year some of the demand for gold was diverted to new areas such as cryptocurrency, but that should have reversed this year. What may be the main culprit for the lack of performance is the strength of the U.S. dollar? In a risk-off world, global investors tend to turn to U.S. Treasury bonds to protect value; this increases the price of the U.S. dollar and has weighed on the price of gold in U.S. dollar terms. Investors in Asia and Europe are having a very different experience with their gold holdings, as in local currencies, it has acted very well.
There is still time for gold to work in this cycle, and by the end of the year, it may be one of the top-performing asset classes. But for this to happen, we need to see the U.S. dollar peak vs other currencies. If inflation levels off in the 5% range and the FOMC becomes more balanced, we may see the U.S. dollar pause and gold move higher.
2022 has started off as a bear, and the risks remain, including inflation and recession. And while we are not uber bullish, given the declines and valuations, the 2nd half certainly looks like it should be better than the 1st half.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
— Greg Taylor is the Chief Investment Officer at Purpose Investments
— Derek Benedet is a Portfolio Manager at Purpose Investments
— Brett Gustafson is a Portfolio Analyst at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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