With a mandate of setting monetary policy, central banks have a profound effect on economic activity and personal wealth. Through the control of the money supply, interest rates, and regulation of credit and the banking system, central banks have the herculean mandates of maintaining price stability and maximizing employment.

While the job of central banks is rarely easy and often goes unnoticed, these institutions have played a critical role during the past two years by providing unprecedented levels of stimulus to limit the economic damage triggered by the pandemic. A side-effect of this stimulus has been outsized appreciation in real estate, equities, and consumer price inflation.

With economic activity now rebounding and inflation running at multi-decade highs, pressure is mounting on central banks to rein in stimulus measures by raising interest rates. Indeed, some economists go as far as stating that central banks like the U.S. Federal Reserve and Bank of Canada have fallen behind the curve. Knowing that interest rates are the fundamental driver in the valuation of most financial and hard assets, the prospect of higher interest rates suggests that the rate of asset price appreciation could slow in 2022. In addition to keeping return expectations in check, we have been gradually shifting to a defensive positioning over the past few months in anticipation of tighter monetary policy ahead.

At the time of writing, economists are expecting 3 to 4 25bps rate hikes for the U.S. in 2022, and 5 to 6 quarter percentage point hikes in Canada this year (this suggests that the Canadian Prime Lending Rate could be back to pre-pandemic levels by early 2023). Along with the uncertain path of the pandemic, the pace of interest rate hikes poses a challenge to capital markets this year. A rapid series of rate hikes could hurt the economy and asset valuation. Enticed by ultralow rates over the past two years, the accumulation of debt by individuals, companies, and governments means that the threshold to absorb higher interest rates will be reached at a lower absolute interest rate level compared with previous cycles. On the other hand, a leisurely pace of rate hikes could allow high inflation to become entrenched, thereby hurting consumer confidence and negatively impacting corporate earnings. Central banks will be walking on a knife’s edge this year and we anticipate above-average volatility as investors big and small adjust portfolios according to central bank actions.

Longer-term interest rates, which are influenced by market expectations of inflation and economic growth, have already rebounded to pre-pandemic levels. At the time of writing, the 10-year U.S. Treasury bond was yielding 1.78% and a 10-year Government of Canada bond was yielding 1.77%. Since equity valuations are influenced by longer-term interest rates rather than short-term ones, it could be argued that equity market valuation should also return to pre-pandemic levels. Indeed, we attribute the bumpy start to 2022 to the contraction in valuation multiples, especially among technology/growth stocks where valuation had become excessive. All else held equal, we believe many cyclical and value-oriented sectors (such as banks, commodities, industrials) and international markets are reasonably valued, while technology/growth may continue to underperform in the near term.

Our economic and interest rate cycle analyses inform us that equity weightings in portfolios should be below neutral levels. We have been gradually moving in this direction during the latter half of 2021 by trimming equity positions in our managed portfolios and temporarily holding higher cash balances. We expect to redeploy some cash into equities should valuation continue to normalize. We intend to redirect remaining portfolio liquidity into alternative asset classes that have low correlation to equity markets and more stable return profiles. Our alternative asset universe includes mortgages, private equity, structured notes, and hedge fund strategies.

Using asset allocation as the primary tool to optimize risk-adjusted returns, our team’s emphasis on valuation, fundamental research, and economic analysis will help guide us through what may be a bumpy year.