It’s been another year dominated by fallout from the COVID pandemic. As the economy reopened, growth rebounded strongly, fuelling labour shortages, supply chain disruptions and a soaring real estate market.
Strong consumer demand and constrained supply led to a surge in inflation. In October, it was 4.7% higher year-over-year in Canada 1. The question that’s preoccupied governments, central banks and investors for most of the year is whether this bout of rising prices will be relatively short-lived or a chronic problem, leading to higher interest rates.
While high inflation has been painful for households, excellent returns from the stock market have provided relief this year.
The main stock markets have moved steadily higher since the pandemic crash bottomed out in March 2020, despite higher volatility since September.
We don’t know how the year is going to end, but to the end of November the main indexes were still well ahead of where they started the year. (S&P/TSX Composite Index +21.4%; the S&P 500 Index +22.9% in Canadian dollars; and the MSCI EAFE Index +6.5% in Canadian dollars. Only the MSCI Emerging Markets Index was in negative territory at -3.7% in Canadian dollars.)
A rebound in energy prices fuelled a stronger Canadian dollar, meaning returns on foreign stocks were tempered by the rising loonie.
Meanwhile, value stocks have provided a boost to portfolio returns after years of underperformance versus the large growth segment of the market. This is good news for our strategy of tilting portfolios to value—and there could be more gains ahead since the valuation gap between value and growth remains wider than it has at any time in the past 60 years.
On the downside, an uptick in interest rates in February and then again in September produced negative bond returns. (Interest rates and bond prices move inversely.) To the end of November, the FTSE Canada Universe Bond Index returned -4.1% while the FTSE Canada Short Term Overall Bond Index returned -1.3%.
Despite this decline, bonds have done just what they are supposed to do this year. Their job is to diversify the portfolio, acting as a shock absorber when the stock market hits a rough patch. We saw a dramatic example in March 2020 when bonds held their value during the pandemic stock market crash, mitigating some of the equity losses.
In fact, all parts of the portfolio have done pretty much what they are designed to do in 2021.
Higher stock market returns have offset the higher inflation we’ve seen in the economy. This highlights the fact that equities tend to be a good hedge against inflation over the long term.
Value stocks tend to perform better in inflationary periods than growth stocks because they are less sensitive to rising interest rates—something we’ve also seen this year.
As for bonds, their relatively mild decline is well in line with their intended role of lowering portfolio volatility.
We will have all the final numbers for you in January, but for now we can say the portfolio has performed very well given this year’s economic environment.
Source: BMO Global Asset Management
1 Consumer Price Index, 2000 to Present – Bank of Canada