Invasion, inflation, recession? A look back at 2022 in 10 charts

CIO Office National Bank Investments

National Bank Investments

Market Update │ January 2023

Highlights

• The Russian invasion of Ukraine, record inflation, potential recession on the horizon – it's fair to say that 2022 has proven to be challenging on many fronts. For investors, this context has resulted in pullbacks for stocks and bonds in the first half of the year, followed by a six-month period of ups and downs with no clear direction.

• In sum, the vast majority of market segments showed losses in 2022, with record declines for bonds. In terms of leadership, we note the best performance by assets more closely linked to commodity prices, including the Canadian stock market. Conversely, the bottom of the list belongs to stocks that are more sensitive to interest rate movements, such as the U.S. technology giants.

• We take this January edition to look back at the major events of 2022 through 10 key charts. In a nutshell, the story of 2022 revolves around (1) the perfect inflationary storm, (2) a true global phenomenon driven in part by (3) rising energy prices stemming from the war in Ukraine. But also, and, more importantly, by (4) potentially the tightest job market ever. Seeing the risk of persistent inflation taking shape, (5) central banks quickly shifted into catch-up mode, dragging stocks into a bear market – (6) sometimes too quickly – (7) along with bonds. On the economic front, the rate hikes served as a real (8) cold shower on an overheated real-estate sector, in addition to (9) triggering several early signs of a recession that would make it (10) the most anticipated recession in history, if it were to materialize.

• Happy reading and best wishes for the New Year!

Market Review

Fixed Income

• Canadian bonds posted losses in December as medium and long-term yields rose in the face of hawkish Central Bank discourse.

• As a whole, 2022 is actually the worst year in history for Canadian bonds (-11.5%). This loss is in addition to the decline seen in 2021 (-2.7%), marking the first time the Canadian bond universe has experienced two consecutive annual declines.

Equities

• The dramatic stock market rebound of the fourth quarter ran out of steam in December, particularly in North America. The S&P/TSX (-4.9%) and S&P 500 (-5.8%) underperformed the EAFE region (+0.1%) and emerging markets (-1.4%).

• However, for the full year, the S&P/TSX (-5.8%) was an impressive outperformer, benefitting from strong exposure to commodities. It was a much more challenging period for the MSCI EAFE (-14.0%), the S&P 500 (-18.1%) and MSCI Emerging Markets (-19.7%), all of which posted their worst annual performances since 2008.

FX & Commodities

• In December, the price of oil declined for the sixth time in seven months. Thus, despite the Russian invasion of Ukraine and the dramatic rebound that followed, oil prices end the year with a relatively modest gain of 6.7%.

• On the currency front, the U.S. dollar declined in December, particularly against the euro. It was a different story for the year as a whole, as the Greenback appreciated significantly amid aggressive monetary tightening by the Federal Reserve.

A challenging year for investors

The Russian invasion of Ukraine, record inflation, potential recession on the horizon – it's fair to say that 2022 has proven to be challenging on many fronts. For investors, this context has resulted in pullbacks for stocks and bonds in the first half of the year, followed by a six-month period of ups and downs with no clear direction (Chart 1).

That said, the losses in global equities in 2022 (-12% in C$) may not be so dramatic considering that they followed solid gains in 2021 (+18%). In Canada, a second consecutive year of outperformance (+25% in 2021, -6% in 2022) even leaves the S&P/TSX with sizable gains over the entire period. Exceptional market movements were instead observed on the fixed-income side, with the Canadian benchmark recording its worst year ever in 2022 (-11%), a loss that followed the 3% decline seen in 2021.

To put this in perspective, these performances mean that a benchmark balanced portfolio (60% equities, 40% bonds) has an annual return that is similar to those recorded during the financial crisis and the bursting of the tech bubble, although the recent rebound in Q4 has helped limit the damage (Chart 2).

Finally, in terms of leadership, it is generally the commodity-related segments of the equity market that have outperformed their category; think of energy within sectors, value and dividend styles within factors, and Latin America and Canada within regions. Conversely, the bottom of the list belongs to the assets most sensitive to interest-rate movements, which naturally include long-term bonds, but also the equity sectors of technology (Apple, Microsoft), consumer discretionary (Amazon, Tesla), communication services (Google, Facebook, Netflix), and growth stocks, in general (Chart 3). In sum, this is essentially a sharp reversal of the major leadership trends seen over the past decade.

A look back at 2022 in 10 key charts

The year 2022 will have been marked, above all, by the wave of inflation that hit the economy with full force. While this perfect storm actually originated in 2021 when major disruptions in global supply chains led to a dramatic rise in the price of goods, the Russian invasion of Ukraine that began on February 24 quickly pushed food and energy prices to record highs early in the year. Ultimately, as a symptom of an overheating economy, inf lationary pressures shifted to services over the course of the year, with their contribution to total inflation now more than twice the 2% target of central banks (Chart 4).

This global phenomenon was not limited to North America, as Europe was also strongly affected. For example, while price growth in both Canada and the U.S. reached their highest levels in nearly 40 years, Germany has never experienced such inflation since data became available (Chart 5).

In this regard, much of the blame falls on the advent of the most significant armed conflict in Europe since the Second World War and on its consequences for global commodity markets. As Russia is the world's second largest producer of crude oil and of natural gas, the disruptions have been particularly severe in the energy sector. Specifically, the price of a barrel of WTI oil climbed to $124 in March, a level that has only been exceeded once before in history, in the summer of 2008. This is quite a rebound since the negative prices of April 2020 (Chart 6).

At the same time, economic overheating was quietly but surely developing, stemming from a strained labour market. In fact, we may have even seen the tightest labour market in history, with the ratio of job openings per unemployed worker reaching an all-time high while the unemployment rate remained near its historic low (Chart 7). While a strong labour market is generally good news, it becomes a problem when it leads to significant acceleration in services inflation – which is closely tied to wage growth – and that is exactly what has happened.

For central banks, this turn of events ended hopes that the inflationary wave would only be "transitory". With the risk of more persistent inflation now a reality, policymakers quickly went into catch-up mode. As such, while markets initially expected only three 25 bps hikes from the Federal Reserve in 2022, investors were instead treated to a sizeable 425 bps of tightening of the federal funds rate. It was the same story on our side of the border, where the Bank of Canada also surprised markets with aggressive rate hikes. As a result, North American policy rates are now about twice as high as they were before the pandemic (Chart 8).

In the stock market, this monetary equivalent of “slamming on the brakes” was reflected in a downward trend, with the S&P 500 officially crossing into bear market territory (-20% since the last peak) in June. This was followed by a period of strong moves, both up and down, with our market sentiment indicator hitting the extreme pessimism threshold three times, which this year has proven to be quite effective in signaling a potential short-term rebound (Chart 9).

On the fixed-income side, policy rate hikes led to a dramatic rise in bond yields. Although movements of a similar magnitude have been observed in the past, notably during the 1980s, the particularity this time was the extremely-low initial level of rates (around 0.50% in 2020). Thus, with record duration risk and no coupon to cover losses, the shock to the bond market was brutal, with U.S. Treasury bonds posting unprecedented losses (Chart 10).

Beyond financial markets, the impact of monetary tightening is also being felt in the real economy, particularly in those sectors most sensitive to interest-rate movements. The most striking case is certainly real estate, which, after starting the year in overheating, is now operating at a much slower pace, as illustrated by the decline in existing home sales on both sides of the border (Chart 11).

In the end, 2022 concluded with increased recession risks, as the list of leading indicators pointing to a sharp economic downturn on the horizon continues to grow. Among these, the inversion of the yield curve (in the form of the 10-year rate minus the 2-year rate) has a track record that commands respect, having predicted the last six U.S. recessions. Inverted for nearly six months, this yield curve is showing its deepest inversion since 1981 (Chart 12).

Notably, the accumulation of early warning signals implies that the coming recession would, if it were to materialize, be the most discounted recession in history, according to the Survey of Professional Forecasters conducted by the Federal Reserve Bank of Philadelphia since the 1970s (Chart 13).

Are these concerns exaggerated? Or, conversely, are there previously-unsuspected financial vulnerabilities that only a recession can reveal? No one knows for sure. One thing is certain though, 2023 is shaping up to be (another) eventful year as central banks begin the most difficult part of their fight against inflation: assessing when they should stop – or even reverse – their cycle of rate hikes to ensure a definitive victory against inflation without triggering an unnecessarily severe recession. Not an easy task, but not impossible either. To be continued!