This week, Cut the Crap Investing founder Dale Roberts reviews the notable financial headlines and provides context for Canadian investors.
The round-up of returns for the year
First, a look back at asset returns for 2022. Using data popularized by Liz Sonders of Charles Schwab, sector performance in the U.S. showed a wide divergence: energy led the pack while defensive sectors like utilities and consumer staples also held up relatively well.
Energy outperformed all peers and retained its position as the year-to-date leader; utilities and consumer staples ranked second and third, respectively. There was mixed performance across sectors, with some areas bouncing back and others lagging.
By late December, U.S. large-cap stocks were down more than 21% year-to-date in price terms—on track to be the worst year since 2008 and among the worst in decades.
Here are representative 2022 returns for key markets measured in Canadian dollars using common exchange-traded funds (ETFs):
- U.S. stocks: down about 12%
- International developed stocks: down about 8.7%
- Emerging market stocks: down about 14%
My view—consistent with guidance earlier in the year—was that energy would be a top performer. Defensive equity sectors such as utilities, consumer staples and healthcare also worked for investors in 2022, and value stocks outperformed growth to an extent as actual earnings mattered more than lofty expectations.
Commodities continued to perform for Canadian investors in an inflationary environment. For example, broad commodity exposure was strongly positive in 2022 following a large gain in 2021. Commodities remain a useful inflation hedge and have a role in diversified “all-weather” portfolios.
Below are Canadian sector returns for 2022, using iShares ETFs for sector performance (figures shown after fees). The Purpose Real Asset ETF (PRA) represents commodities and resource-related stocks on the TSX:
- Canadian stocks: down about 5.0%
- Real estate (REITs): down about 17.0%
- Financials: down about 9.4%
- Utilities: down about 9.3%
- Consumer staples: up about 11.2%
- Materials: up about 2.8%
- Energy: up about 50.6%
- Commodities/commodity-related stocks: up about 15.4%
- Gold: essentially flat
- Canadian high-dividend strategies: up about 1.0%
Bonds
Fixed-income markets were weak in 2022 as yields rose sharply. The U.S. bond market fell roughly 11.8% while the Canadian bond market declined about 10.6% for the year. A typical Canadian 60/40 balanced portfolio was down around 9.8% in 2022.
Although no one can predict the future, I have recently discussed what worked in 2022 and which asset classes might fare reasonably well in 2023. Given higher yield levels, bonds could be among the assets that do “OK” in the year ahead, depending on the economic path.
On the higher-risk side, cryptocurrencies had a very poor year. Bitcoin moved from being a top-performing asset in 2021 to one of the worst in 2022. I continue to hold and modestly add to my position; my thesis remains that a scarce, non-printable digital currency addresses a real need. For most investors, however, exposure should remain small—often in the 1%–2% range.
Fiat currency: effectively unlimited creation
Bitcoin: limited to 21 million coins
Incredible volatility
Volatility was unusually high in 2022. The VIX, the market’s widely used “fear gauge,” showed an elevated number of volatile days. S&P Global noted that a very high percentage of trading sessions saw the VIX close above 20, a behavior more typical of crisis years. After such a turbulent year, investors and markets could certainly use a return to calmer conditions.
Canada’s inflation—are we not going back to 2%?
Canadian inflation surprised a little on the upside in late 2022. The Consumer Price Index (CPI) rose 6.8% year-over-year in November, a slight pullback from October but still well above the Bank of Canada’s 2% target. Excluding volatile food and energy items, core inflation remained elevated at roughly 5.4% year-over-year.
Mortgage interest costs and shelter-related items were major contributors to the headline reading. Mortgage interest costs rose dramatically year-over-year—one of the largest annual increases in decades—and the rent index also climbed strongly. Food prices continued to put pressure on household budgets as well.
While the headline rate was higher than some economists expected, monthly and short-term trends showed signs of slowing. Several core inflation measures were trending lower, which is encouraging, but volatility in these indicators means the Bank of Canada must weigh data carefully.
University of Calgary economist Trevor Tombe has pointed out that month-over-month and three-month trends indicate inflation is moving down in a meaningful way. Nonetheless, he and many market economists expect the Bank of Canada to remain cautious and possibly raise rates again if inflation does not show clearer, sustained improvement. The Bank of Canada’s next policy decision was scheduled for January 25.
How sticky is the 2% inflation target?
Bank of Canada Governor Tiff Macklem has reiterated commitment to a 2% inflation target, but he has also acknowledged that structural forces—such as global demographics, labour supply dynamics and persistent commodity price pressures—complicate the return to that goal. Some analysts argue central banks designed the 2% framework for a different economic era, and that the post-pandemic world, with tighter labour markets and elevated commodity prices, may make 2% more difficult to achieve.
These are important policy debates to watch in 2023: will central banks cling strictly to a numerical target, or will they allow more flexibility in the face of changing global conditions?
Sector earnings estimates for 2023
Heading into 2023, analyst estimates show energy leading again in projected earnings changes, and utilities as another sector with improving earnings expectations. Last year energy was a large contributor to overall S&P 500 earnings growth; without energy’s gains, aggregate earnings were closer to flat or slightly negative.
Investors should be aware that earnings are not yet adjusted fully for recession risk. Historically, corporate profits can fall materially during a recession—often by around 20%—so markets that assume robust earnings may be vulnerable if economic activity slows sharply.
And bad news might be bad news, again
Throughout 2022, markets sometimes cheered signs of a softer economy, interpreting “bad” economic data as a pathway to lower interest rates. If inflation behaves differently, that relationship could flip: weaker growth could become clearly negative for corporate profits and for stock valuations. Some market analysts expect profit margins to be squeezed in early 2023, and if central banks maintain restrictive policy settings, bad economic news could hit equity markets hard.
The investment stories of the year
Looking back across 2022, two stories dominated: the war in Ukraine and the global fight against inflation. The conflict in Europe disrupted global trade and energy markets, while rapid central bank rate hikes—designed to curb inflation—created one of the fastest tightening cycles in modern history. Those twin forces reshaped markets, sectors and investor positioning throughout the year.
Here are ten key takeaways from this year’s “Making Sense of the Markets” coverage:
- The invasion of Ukraine acted as a black swan event and helped fuel inflation.
- The war forced a redesign of some global trade flows and energy relationships.
- In mid-March, the U.S. Federal Reserve began its aggressive rate-hiking cycle.
- Inflation dominated household and policy conversations through the spring and summer.
- Russia was removed from many emerging-market indices and funds.
- By mid-year, equity markets were experiencing one of their worst starts in decades.
- Recession risk became a central theme for personal financial planning.
- Canada’s major banks updated their guidance to reflect tougher economic conditions.
- For much of the year, the market treated bad economic news as potentially “good” because it might slow rate hikes.
- Later in the year some inflation measures showed signs of stabilizing, offering cautious hope.
Damage from the fastest rate-rising episode in modern history is likely to be a dominant story for 2023. Investors should prepare for more volatility and be realistic about how earnings, interest rates and inflation may evolve.
Happy holidays, and best wishes for 2023.
Dale Roberts advocates low-fee investing and writes at cutthecrapinvesting.com. Follow him on Twitter @67Dodge for regular market commentary.