Making Sense of the Volatile Markets

Without a doubt, it has been a difficult year so far for the financial markets. Both equity and fixed income markets have seen significant volatility throughout 2022. After a relatively consistent climb of equity markets for almost two years that began in the depths of the pandemic, we have seen a rapid reversal in direction and sentiment this year. The equity markets have experienced significant pullbacks, with major indices entering correction territory at the time of writing.

What is Happening in the Markets?

It was anticipated that 2022 would be a year in which we largely returned to normal from the pandemic. Central banks were expected to gradually increase key interest rates from their artificially low levels and begin the process of quantitative tightening by ending their asset purchases. However, this has proven more challenging. The significant influx of capital from government fiscal stimulus programs during the pandemic, alongside supply chain disruptions due to the economic shutdowns, created higher-than-expected levels of inflation. Many thought inflation would be transitory and would ease as things returned to normal. Instead, we have been faced with new inflationary headwinds, both from the war in Ukraine and the ongoing Covid shutdowns in China.

It was anticipated that 2022 would be a year in which we largely returned to normal from the pandemic. Central banks were expected to gradually increase key interest rates from their artificially low levels and begin the process of quantitative tightening by ending their asset purchases. However, this has proven more challenging. The significant influx of capital from government fiscal stimulus programs during the pandemic, alongside supply chain disruptions due to the economic shutdowns, created higher-than-expected levels of inflation. Many thought inflation would be transitory and would ease as things returned to normal. Instead, we have been faced with new inflationary headwinds, both from the war in Ukraine and the ongoing Covid shutdowns in China.

Reasons for Perspective

For those paying attention to the financial markets on a regular basis, it may feel like all doom and gloom. However, there may be reasons to keep perspective. Let’s not forget that we have come from a two-year period in which the markets continued their upward climb largely without interruption. During this time, valuations for many equities became quite high by historical standards and the pace of the price appreciation of many securities wasn’t sustainable. Consider that the S&P/TSX Composite Index and S&P 500 Index had average annual returns of 11.96% and 21.58% during this time, respectively, and this does not include reinvested dividends.¹

From an economic perspective, coming into this year economic growth was expected to slow. However, there are still positive factors to support growth. Consumers and businesses continue to hold a significant amount of excess cash. Labour markets are robust, with low unemployment levels and moderate wage growth. Canadian markets have been relatively insulated due to our strength in resources and materials sectors. And, while the inflation we are experiencing is more than just transitory, it also won’t be permanent. Recent readings suggest that inflation appears to be peaking, with some of the more transitory components beginning to moderate. Even if a recession – often defined as two consecutive quarters of declining GDP – may be ahead, consider that it may be short-lived. Let’s not forget that the most recent recession during the depths of the Covid pandemic lasted only three months.²

It is, therefore, not surprising that some analysts are suggesting the rapid decline in the markets may be partially due to over-reactive pessimism. Over recent weeks, many companies that have reported earnings misses have been considerably punished with significant declines. Similarly, the technology sector has experienced substantial declines. Although valuations had reached very high levels more recently, the pullback in some circumstances might suggest to an outsider that the sector has a critically diminished future. Longer-term investors should remember that the technology sector will continue to be a driver of future economic growth, innovation and advancement.

Most importantly, we shouldn’t forget that this time is not different. The media is having a field day suggesting that today’s challenges are insurmountable. However, we have seen periods of high inflation, recessions, war, credit and debt crises and many other surprise black swan events in the past. Despite these setbacks, the markets have continued their upward climb over the longer term. The chart below may be a reminder of the enduring ability of the equity markets to overcome and persist.

What We Are Doing

While it may be difficult to look beyond today, this period of market volatility and economic uncertainty will eventually pass. As advisors, we have navigated through periods such as these before. Market pullbacks are uncomfortable, yet they are an unavoidable part of investing. Portfolios positioned for the longer term are built with the expectation that economic and financial markets will experience both ups and downs.

This is one of the reasons why risk management practices are incorporated into portfolios. Diversification can help to spread risk and may help protect against the downside when various asset classes or sectors perform differently. Quality companies with strong balance sheets, lower debt and healthy cash flows are often better placed to endure prolonged periods of market weakness. Dividend-paying stocks may help to provide a degree of downside protection for investors, with some quality companies even raising their dividends through challenging periods. We can also look to make portfolio adjustments to take more defensive positions during difficult times.

However, equally important is maintaining patience. Some investors may feel inclined to sell investments during market pullbacks for fear of a greater loss. This may create two issues for longer-term investors – selling at lower prices and the subsequent need to re-enter the markets. Market timing is difficult, if not impossible; perhaps one of the most convincing reasons being that the biggest up and down days have historically tended to cluster together. Selling low to buy higher is the opposite of the desired outcome in investing.

While we can expect periods of volatility as the many uncertainties are resolved, we remain confident that better times will emerge. Often, when you are in the middle of a storm, it is difficult to see beyond. However, we suggest investors remember that successful investing involves having trust that your wealth plan has been put in place to benefit your future, while staying invested and maintaining confidence that better days lie ahead.

While we can expect periods of volatility as the many uncertainties are resolved, we remain confident that better times will emerge. Often, when you are in the middle of a storm, it is difficult to see beyond. However, we suggest investors remember that successful investing involves having trust that your wealth plan has been put in place to benefit your future, while staying invested and maintaining confidence that better days lie ahead.

<sub>1. Based on annual returns for 2020 and 2021.
2. While a recession is often defined as two quarters of declining GDP, economists categorized the recession in 2020 based on one quarter of declining GDP due to its significance.</sub>