SEI’s Domestic View

The Canadian economy has performed quite well for over a decade. Since the beginning of 2010, inflation-adjusted gross domestic product (GDP) has climbed a cumulative 24.2% through the end of March 2022. That gain in overall business activity was bested only by the U.S. among the top-seven industrial economies. The country re-attained its pre-COVID-19 peak at the end of last year, led by solid gains in household spending and business investments in physical assets (such as land and machinery).

Trade also has been a positive factor in the past year as Canada benefited from higher commodity prices and strong demand from the U.S., its largest trading partner. The merchandise trade balance has been consistently in the black since mid-2021. Prior to the global financial crisis of 2007 to 2008, the country also ran merchandise-trade surpluses. Yet from 2008 through the first half of 2021, Canada was usually in a deficit position. That has since reversed.

Canada now faces a serious inflation problem, however. Consumer prices, no matter how they are measured, are rising faster than anything experienced in a generation. The conventional measure, the total consumer-price index (CPI), advanced 7.7% over 12 months ended May. The core CPI—which excludes the more-volatile food and energy prices to better reflect underlying inflation trends—was up 6.1%. Even the Bank of Canada’s (BoC) preferred measure, the core CPI-common—which tracks common price changes across categories in the CPI basket—increased by 3.9% over the past year. We expect the core CPI-common to continue its climb in the months ahead given the spreading of inflation across categories.

As in the U.S. and the U.K., Canada’s economy looks to be overheating. Growth in hourly wages is accelerating but still lags the gains posted prior to the COVID-19 pandemic. Unit labour costs (the difference between total compensation and productivity growth) are far more concerning. They have jumped by 8.4% over the year ended March, a gain that is even higher than the inflation rate.

A sharp acceleration in unit-labour-cost inflation has often been associated with a sharp deceleration in corporate profits growth. The correlation broke down in the aftermath of the global financial crisis, and profits have risen quite sharply in recent years despite the upward pressure in costs. This reflects an ability to ultimately pass higher costs onto the consumer. We wonder how long this will last. There were big labour cost upswings during the late 1980s and the mid-2000s. Both ended in recessions, with major reversals in profit trends toward the downside.

Monetary policy has certainly turned from a tailwind to a headwind. The BoC is following the U.S. Federal Reserve (Fed) in lockstep. We expect a 75 basis-point increase in the BoC’s policy rate at its next meeting in July, followed by a 50-to-75 basis-point hike in September. While Canada’s economy benefits from its heavy exposure to commodities, the prospect of the sharpest interest-rate up-cycle in decades provides a challenging economic backdrop.

SEI’s Global View

It’s been our mantra for the past year that U.S. inflation would be higher for longer than most economists and investors appeared to expect. We believe this remains the case, although the gap between our expectations and those priced in U.S. markets has narrowed considerably and the pace of inflation’s increase is almost certainly close to a peak. Investors and the Fed still seem to be betting that inflation pressures will ebb significantly starting in the second half of this year and fall to 3% by the end of 2023.

Fed Chairman Jerome Powell continued to express hope that the Fed can achieve a “softish” landing, where inflation gradually decelerates back to the central bank’s 2% target without a recession. Unfortunately, there has been only one successful instance since the end of World War II (1951-to-1952) when inflation was running above 5%.

Federal funds-rate futures indicate that investors are anticipating a series of increases between now and year-end that would bring the funds rate to 3.4%. The peak is indicated to be between 3.75% and 4% a year from now. Markets are presumably pricing in a recession by the second half of 2023, considering the funds rate is projected to decline at that point.

We believe this to be a reasonable forecast, but the actual outcome will depend on how quickly the economy actually weakens and inflation ebbs. The evidence as of today suggests that the U.S. economy may continue to show a resilience that surprises both the Fed and investors.

There are signs of economic trouble ahead. The surge in U.S. mortgage rates is delivering a big blow to the housing market. Beyond real estate, economists have begun citing the big increase in retail inventories as a harbinger of recession. We are doubtful that the inventory problems of department stores and general merchandisers are serious enough to throw the economy into recession in the near term.

There is no denying that rising interest rates will slow economic growth. But changes in monetary policy affect the economy with a long and variable lag. While the financial strength of U.S. businesses and households is likely to ebb, the starting point is a very high one. The labour market, for instance, remains exceptionally tight. Until a better balance between the demand and supply of labour is achieved, one should expect further large wage gains at the lower end of the wage-income spectrum, where the job market is tightest.

American job switchers have enjoyed a sharper-than-average wage gain of 7.5% over the past 12 months. It should not be surprising that the U.S. quit rate is significantly higher than in 2019 or at the previous economic peak in 2007. Other major developed economies aren’t too far behind. The U.K. has an unemployment rate below 4%. Canada and Europe usually have unemployment rates that are considerably higher than the U.S. and the U.K. That remains the case, but both report jobless totals that are below previous cyclical lows.

All this suggests that workers are in a strong position to seek bigger wage gains in an effort to keep up with inflation. The possibility of a global wage-price spiral still cannot be dismissed out of hand. This could force central banks to raise interest rates more than they would prefer.

In Europe, the need to hike interest rates has once again raised the specter of another periphery debt crisis. Italian 10-year bonds are trading some 70 basis points higher against German bunds than they were at the start of the year. This is on top of the two percentage-point jump in German rates that has been logged over the same six-month stretch.

The stress has not reached the crisis levels of the 2010-to-2012 period. Given all the other problems facing Europe, the European Central Bank (ECB) has vowed to support the weaker members of the eurozone with continued bond purchases.

As was the case last time, the economic priorities of the strongest countries are diverging from their weaker neighbours. The German-led bloc needs a more aggressive policy tightening along the lines of what the Fed is expected to do. Meanwhile, the weaker countries, Italy and Greece especially, now bear an even heavier debt burden relative to the size of their economies than was the case a decade ago. The interest expense on that debt could get out of hand fairly quickly if the cost of capital continues its sharp upward trajectory.

The ECB is so concerned about the situation that it actually held an emergency meeting the same day as the Fed’s interest-rate announcement in order to assure markets that it is working on an “anti-fragmentation tool” that will keep spreads narrow while still allowing the central bank to fight inflation.

On a more positive note, China’s economy appears to be in recovery mode. COVID-19 lockdowns in Beijing, Shanghai and other parts of the country have eased. The zero-COVID policy pursued by the Chinese government has hurt the economy to an extent seldom seen in the past three decades.

Home sales have also plummeted, falling 34% over the 12 months ended May. Chinese authorities are now trying to revive the property market by lowering mortgage rates, cutting mortgage down payment requirements and encouraging banks to start lending again.

Economy-wide lending has picked up, finally turning positive for the first time in a year. If that trend continues in the months ahead, other measures of current economic health should begin to recover too. Whether that will be enough to stave off a global recession is doubtful, however, in view of the rising interest-rate trend in the advanced economies. It might even prove counterproductive if a revival in Chinese demand for energy and other raw materials exacerbates the commodity-price boom at a time when global supplies are still constrained.

The poor performance of financial markets this year suggests that investors have already discounted a lot of bad news. The price decline in the S&P 500 Index recorded in the year-to-date contrasts sharply with the ongoing increases in forward-earnings estimates. The result has been one of the sharpest reductions in stock multiples outside of a recession in the past 25 years.

The froth certainly appears to have been taken out of the markets by this year’s pullback. That’s the good news. The bad news is that an economic recession and a corresponding decline in earnings might not yet be fully reflected in stock prices. Multiples tend to slide as projected earnings estimates fall. Even if price-to-earnings ratios remain at current levels, there could be a decline in projected earnings—and a comparable drop in stock prices—as analysts incorporate a recession’s impact into their models. While the consensus view is that stock prices face rough seas ahead, it is possible that earnings multiples do not need to contract much further than they have already—with the caveat that bond yields stabilize near current levels and do not climb significantly higher.

Economic Backdrop

There was no safe harbour from choppy market cross currents during the second quarter. Equities and fixed-income asset classes alike capsized around the globe, and even commodity prices ran aground as the likelihood of recession increased.

Emerging-market equities fell by double digits during the quarter, although they still fared better than their developed-market counterparts, buoyed by a rebound in China. U.K. stocks posted significant losses, but they were not as steep as those of Japanese or European equities. U.S. stocks, meanwhile, had the sharpest drop among major markets as the U.S. dollar appreciated by 6.49% versus a trade-weighted basket of foreign currencies.

Value-oriented equities tended to fall by less than growth-oriented equities across both large- and small-cap markets, although the performance spread was much wider within larger companies. No sectors were spared from losses, but energy and consumer staples had the mildest declines, while information technology and consumer discretionary had the steepest.

Government-bond rates climbed throughout the second quarter as prices fell. U.S. Treasury yields increased across the yield curve, with shorter-term rates outpacing longer-term rates for the full quarter, flattening the curve. U.K. and eurozone government-bonds rates also rose across the curve, but longer-term rates increased by more than shorter-term rates.

Fixed-income performance ran the gamut of losses, moving from relatively modest declines for government bonds to more severe losses for emerging-market and high-yield bonds.

The tide began to turn on commodity markets, as prices began to recede in various commodities from mid-quarter onward. The Bloomberg Commodity Index fell by 5.92% during the second quarter, while Brent and West-Texas Intermediate crude-oil prices climbed by 4.13% and 5.46%, respectively. Natural gas prices fell by 4.43% and wheat prices tumbled by 12.13%. Energy commodity prices peaked in early June, while the high water mark for wheat prices came in mid-May.

OPEC+ (the Organization of the Petroleum Exporting Countries—plus Russia) agreed at the beginning of June to boost the size of an oil production increase by roughly 50% in July and August, totaling 648,000 new barrels per day.

The European Union (EU) imposed a partial ban on Russian crude oil and petroleum products in early June, blocking seaborne oil shipments but allowing Hungary, Slovakia and the Czech Republic to continue pipeline imports for domestic consumption. In a farther-reaching move, EU companies were banned from providing shipping insurance to transporters of Russian petroleum products—regardless of the destination country—depriving shippers of a critical market for insurers.

Russia began reducing natural gas pipeline supply to Europe in mid-June, limiting its ability to stockpile for winter, and driving prices in the region much higher.

The 27 members of the European Council agreed in late June to formally accept Ukraine and Moldova’s candidacies to join the EU, taking the first steps to expand the union since Croatia’s entrance in 2013.

Toward the end of the quarter, the North Atlantic Treaty Organization (NATO) announced a plan to increase its high-readiness Response Force (NRF) from 40,000 to 300,000 after activating NRF troops for the first time in its history following Russia’s attack on Ukraine. Sweden and Finland’s paths to join NATO brightened at the end of June. Turkey unblocked their applications and signed a trilateral memorandum of support for their memberships in exchange for weapons sales, and prioritization by the Scandinavian countries of Turkish extradition requests for purported Kurdish militants.

The U.S. followed NATO’s planned increases with its own European expansion announcement at the end of the quarter. The buildout will include a permanent Army base in Poland, rotations through Romania and the Baltics, more Navy ships in Spain, air defenses in Italy, and fighter jets in the U.K.

Central Banks

• The BoC raised the policy interest rate by 0.50% to 1.50% on June 1. This was the second consecutive 0.50% increase and was largely expected as inflation has been running higher than the BoC target, which the central bank reiterated was the mid-point of a range between 1% and 3%. The BoC also continued its policy of quantitative tightening (that is, when the BoC would allow its government bond holdings to decline). The BoC’s next scheduled meeting is on July 13.
   
• The Federal Open Market Committee (FOMC) increased the federal-funds rate by 0.50% (the first hike of its size since 2000) at its early-May meeting, and then by 0.75% (the first of its size since 1994) at its mid-June meeting, bringing the benchmark rate to a range between 1.50% and 1.75%. The central bank also announced plans to reduce its balance sheet in June, allowing Treasurys and mortgages to run off (that is, mature without being replaced) at maximum respective paces of $60 billion and $35 billion per month. Economic fundamentals deteriorated in the FOMC’s latest quarterly Summary of Economic Projections (SEP), released in June. Real GDP projections declined for 2022, 2023, and 2024 compared to the March SEP, while projections for the unemployment rate increased across all three years, and inflation expectations increased for 2022. Projections for the federal funds rate were higher across the board as well.
   
• The Bank of England’s (BoE) Monetary Policy Committee (MPC) voted to increase the bank rate by 0.25% at both its May and June meetings, increasing the benchmark rate to 1.25%. It also continued to reduce its balance sheet by ceasing to reinvest proceeds from its asset-purchase program, with an expected £3.2 billion (British pounds) in redemptions for July 2022.
   
• The ECB concluded new purchases in its Asset Purchase Programme (APP) with net purchases of €40 billion (euros) in April, €30 billion in May, and €20 billion in June. Following its early June meeting, the central bank announced it would cease new purchases in the APP and intended to increase benchmark rates in July and September. The specter of rising rates sent government bond spreads higher for economically weaker European countries—like Italy, Greece and Spain. The ECB convened an unscheduled meeting in mid-June to ensure markets it would intervene to avoid the fragmentation of the European government bond market.
   
• The Bank of Japan (BOJ) redoubled its commitment to loose policy at its April and June meetings. Its short-term interest rate remained at -0.1%, and the 10-year Japanese government-bond (JGB) yield target held near 0%. The central bank continued to offer unlimited purchases of 10-year JGBs at 0.25% in order to keep its yield within the BOJ’s acceptable range.

Economic Data (unless otherwise noted, data sourced to Bloomberg)

• According to Statistics Canada, the rate of inflation accelerated (as measured by the change in the Consumer Price Index (CPI)) to 1.4% for the month and 7.7% for the year ending May. This was the largest annual increase in prices since January 1983. Gasoline prices were up 48.0% over the past year, significantly contributing to the rise in inflation. Prices for other energy and groceries also continued to rise at a brisk pace. Producer prices were also up sharply. The Industrial Product Price Index (IPPI) rose 1.7% in May and the Raw Materials Price Index (RMPI) was up 2.5%, while on a year-over-year basis the IPPI rose 15.0% and the RMPI jumped 37.4%. Energy prices were dramatically higher in both the one-month and 12-month periods. The Labour Force Survey revealed a mixed bag—the unemployment rate dipped 0.2% to 4.9%, but only because fewer people were searching for work. Employment actually declined by 43,000 (a 0.2% drop) as there were 51,000 fewer jobs for the aged 55 and over cohort.
   
• U.S. manufacturing growth peaked in April after accelerating through early 2022, then cooled (slowly in May, and then sharply in June), leaving a soft expansion at the end of the second quarter. U.S. services-sector growth declined throughout the second quarter, moving from notably high levels in March to a weak expansion in June. The U.S. labour market remained quite healthy during the second quarter. New claims for unemployment benefits trended higher—from roughly 180,000 per week in April to about 230,000 per week in June—but remained low relative to history. The U.S. Consumer Price Index climbed to 8.6% year over year in May—the highest rate since December 1981—while the Personal Consumption Expenditures (PCE) Price Index (the Federal Reserve’s preferred inflation gauge) edged down to 6.3%. 
   
• U.K. manufacturing activity settled lower throughout the second quarter. Manufacturing growth in June was positive, but soft. Growth in the U.K. services sector cooled during the second quarter from a dizzying peak in March, ending in June at a moderately healthy pace of expansion. Inflation climbed to 9.1% in the U.K. for the 12-month period through May, the highest level in 40 years. The U.K. claimant count (which calculates the number of people claiming Jobseeker’s Allowance) continued to improve in recent months—declining by roughly 85,000 from March through May, with total claimants representing 4.0% of the population in May compared to 4.2% in March.
   
• The expansion in eurozone manufacturing continued to slow throughout the second quarter, ending in June with an anemic pace of growth. Activity in the eurozone services sector accelerated in April to strong growth territory, before softening to end the quarter with a modest but healthy expansion. The year-over-year rate of consumer price inflation in the eurozone climbed to 8.6% in June, hitting an all-time high. The eurozone unemployment rate held at 6.8% from February through April, before cracking through to 6.6% in May to set a new record low (since Eurostat began tracking the dataset in 1998).

Market Impact (Referenced Index Returns are in CAD)

Stubbornly high inflation, sharply higher rates, war in Ukraine, and lingering pandemic concerns combined to pummel capital markets during the quarter. Most developed markets were down double digits, with Canada and the U.S. both falling more than 13%. Canadian smaller companies fared even worse, dropping more than 20%. All domestic sectors were down with healthcare, information technology, and materials declining the most, while energy and utilities held up the best. Emerging-markets equities outperformed developed markets mainly due to a relief rally in China, which was one of few areas to post a positive return for the quarter.

Fixed-income markets continued to slog through one of their worst periods on record. Short-term treasury bonds had a miniscule gain, but short-term corporate bonds fell. Overall though, corporate bonds generally outperformed government debt, and real-return bonds continued to struggle. U.S. high-yield bonds, which are riskier, were among the worst performers. 

Index Data (Q2 2022)

• The S&P/TSX Composite Index fell 13.19%.
   
• The FTSE Canada Universe Bond Index returned -5.66%.
   
• The S&P 500 Index, which measures U.S. equities, slid 13.35%.
   
• The MSCI ACWI (Net) Index, used to gauge global equity performance, lost 12.90%.
   
• The ICE BofA U.S. High Yield Constrained Index, representing U.S. high-yield bond markets, declined 10.16% (currency hedged) and 7.04% (unhedged).
   
• The Chicago Board Options Exchange Volatility Index, a measure of implied volatility in the S&P 500 Index that is also known as the “fear index,” climbed from 20.56 to 28.71. Intra quarter, the VIX recorded a number of readings above 30, reaching a closing high of 34.75 on May 9.
   
• WTI Cushing crude-oil prices, a key indicator of movements in the oil market, moved from US$100.28 to US$105.76 a barrel to end the quarter. Prices were highly volatile, reaching a closing high of US$122.11 on June 8 and a low of 94.29 on April 11.
   
• The Canadian dollar weakened to C$1.29 per U.S. dollar. The U.S. dollar was considerably stronger versus the world’s other major currencies. It ended June at US$1.05 versus the euro, US$1.21 against sterling and at 135.86 yen.

Glossary of Financial Terms

• Anti-fragmentation tool: An anti-fragmentation tool refers to the ECB’s plans to mitigate widening spreads between German government bond yields and those of economically weaker EU members.
   
• Asset Purchase Programme (APP): The ECB’s APP is part of a package of non-standard monetary policy measures that also includes targeted longer-term refinancing operations, and which was initiated in mid-2014 to support the monetary policy transmission mechanism and provide the amount of policy accommodation needed to ensure price stability.
   
• Bull market: A bull market refers to a market environment in which prices are generally rising (or are expected to rise) and investor confidence is high.
   
• Commercial paper: Commercial paper is a type of short-term loan that is not backed by collateral and does not tend to pay interest.
   
• European Commission: The European Commission is the executive branch of the European Union. It operates as a cabinet government, with 27 members of the Commission headed by a President.
   
• Fiscal policy: Fiscal policy relates to decisions about government revenues and outlays, like taxation and economic stimulus.
   
• Group of 7 (G7): The G7 is an inter-governmental forum for the leaders of major advanced democratic nations that includes Canada, France, Germany, Italy, Japan, the U.K. and the U.S.
   
• Hawk: Hawk refers to a central-bank policy advisor who has a negative view of inflation and its economic impact, and thus tends to favor higher interest rates.
   
• Monetary policy: Monetary policy relates to decisions by central banks to influence the amount of money and credit in the economy by managing the level of benchmark interest rates and the purchase or sale of securities. Central banks typically make policy decisions based on their mandates to target specific levels or ranges for inflation and employment.
   
• Mortgage-Backed Securities: Mortgage-backed securities (MBS) are pools of mortgage loans packaged together and sold to the public. They are usually structured in tranches that vary by risk and expected return. 
   
• NATO: The North Atlantic Treaty Organization (NATO) is an intergovernmental military alliance among 28 European countries and 2 North American countries.
   
• Pandemic Emergency Purchase Programme (PEPP): PEPP is a temporary asset-purchase program of private and public sector securities established by the European Central Bank to counter the risks to monetary-policy transmission and the outlook for the euro area posed by the COVID-19 outbreak.
   
• Price-to-earnings (PE) ratio: The PE ratio is equal to the market capitalization of a share or index divided by trailing (over the prior 12 months) or forward (forecasted over the next 12 months) earnings. The higher the PE ratio, the more the market is willing to pay for each dollar of annual earnings.
   
• Quantitative easing: Quantitative easing refers to expansionary efforts by central banks to help increase the supply of money in the economy.
   
• Summary of Economic Projections: The Fed’s Summary of Economic Projections (SEP) is based on economic projections collected from each member of the Fed Board of Governors and each Fed Bank president on a quarterly basis.
   
• Yield: Yield is a general term for the expected return, in percentage or basis points (one basis point is 0.01%), of a fixed-income investment.
   
• Yield curve: The yield curve represents differences in yields across a range of maturities of bonds of the same issuer or credit rating (likelihood of default). A steeper yield curve represents a greater difference between the yields. A flatter curve indicates the yields are closer together.
   

 Index Definitions

The Bloomberg Commodity Index is composed of futures contracts and reflects the returns on a fully collateralized investment in the Index. This combines the returns of the Index with the returns on cash collateral invested in 13-week (3-month) U.S. Treasury bills.

The Bloomberg Global Aggregate Index is an unmanaged market-capitalization-weighted benchmark that tracks the performance of investment-grade fixed-income securities denominated in 13 currencies. The Index reflects reinvestment of all distributions and changes in market prices.

The U.S. Consumer Price Index (CPI) measures changes in the price level of a weighted-average market basket of consumer goods and services purchased by households. A consumer price index is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.

The MSCI ACWI Index is a market-capitalization-weighted index composed of over 2,000 companies, and is representative of the market structure of 46 developed- and emerging-market countries in North and South America, Europe, Africa and the Pacific Rim. The Index is calculated with net dividends reinvested in U.S. dollars.

The U.S. Personal Consumption Expenditures (PCE) Price Index is the primary inflation index used by the Federal Reserve when making monetary-policy decisions

The S&P 500 Index is a market-capitalization-weighted index that consists of 500 publicly-traded large U.S. companies that are considered representative of the broad U.S. stock market.
































SEI Investments Canada Company, a wholly owned subsidiary of SEI Investments Company, is the Manager of the SEI Funds in Canada.

The information contained herein is for general and educational information purposes only and is not intended to constitute legal, tax, accounting, securities, research or investment advice regarding the Funds or any security in particular, nor an opinion regarding the appropriateness of any investment. This information should not be construed as a recommendation to purchase or sell a security, derivative or futures contract. You should not act or rely on the information contained herein without obtaining specific legal, tax, accounting and investment advice from an investment professional. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. There is no assurance as of the date of this material that the securities mentioned remain in or out of the SEI Funds.

This material may contain "forward-looking information" ("FLI") as such term is defined under applicable Canadian securities laws. FLI is disclosure regarding possible events, conditions or results of operations that is based on assumptions about future economic conditions and courses of action. FLI is subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from expectations as expressed or implied in this material. FLI reflects current expectations with respect to current events and is not a guarantee of future performance. Any FLI that may be included or incorporated by reference in this material is presented solely for the purpose of conveying current anticipated expectations and may not be appropriate for any other purposes.

Information contained herein that is based on external sources or other sources is believed to be reliable, but is not guaranteed by SEI Investments Canada Company, and the information may be incomplete or may change without notice. Sources may include Bloomberg, FactSet, MorningStar, Bank of Canada, Federal Reserve, Statistics Canada and BlackRock. All data as of 6/30/2022 and in U.S. dollar terms unless otherwise noted.

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