CWB Wealth Management Investment Team
Going into 2022, many observers (including us) had a positive view on the economy and markets in general. This was predicated on a receding pandemic – which appears to be playing out. On today’s economic horizon, a different view emerges.
Economic outlook gets hazy
As the economy reopened, growth was expected to be well above pre-pandemic levels. The switch from our stay-at-home economy to a more normal one was expected to bring down high levels of inflation as the year progressed. This was also a robust outlook for corporate earnings growth, and thus, the stock market. The Russian invasion of Ukraine, however, has caused a partial reset of this rosy economic view. Let’s walk through how quickly the outlook has changed.
Russia is a key exporter of oil and Ukraine is a significant exporter of agricultural products. After rising substantially in 2021, commodity prices have continued their upwards trajectory, largely due to the conflict in Europe. For instance, oil and wheat prices have both risen more than 30% this year alone. Commodity markets are forecasting some relief from recent highs as the year progresses, but not much. For instance, oil is projected to be trading at around $90/barrel at year end which is still above 2021 levels. Sticky commodity prices mean inflation pressures will likely persist for longer than previously expected.
Inflation and interest rates heat up
Central banks will look to combat persistent inflation by raising interest rates at a faster pace, and to a higher level than previously forecast. Rates were cut to near zero due to the pandemic, and it was always expected that central banks would look to normalize once the global economy was back on its feet. But, instead of perhaps a 1% interest rate increase this year, the Bank of Canada is now expected to raise rates by around 2%. That’s a big increase in a short period of time.
Higher inflation and interest rates are a double whammy for the economy. Higher inflation, especially for essentials like food and fuel, acts as a tax on our disposable income. Similarly, higher interest rates increase our costs of borrowing on lines of credit and variable mortgages, for instance, and limit what we can spend elsewhere. Both will lower the growth forecast of the economy and, indeed, we are seeing economists start to talk about a more “normal” year of economic growth for 2022 in North America instead of the strong growth once anticipated.
Time in the market
Markets took the first quarter of the year to adjust to the changing and uncertain outlook detailed above and we saw a weaker period for returns. However, Canadian investors fared much better than most as our stock market is heavily weighted towards energy and materials – two sectors benefitting from the inflationary environment. Overall, Canadian investors in well-diversified portfolios weathered the volatility fairly well considering the high level of upheaval in the forecast.
Although slower economic growth is disappointing, we don’t think the revised outlook is all bad. The economy is still expected to grow as are expectations for corporate earnings, and if that holds it’s good for the stock market. Bond yields have risen substantially in the past three months and although the increase has hurt bond returns, yields are now much more attractive.
What could further change the outlook? In the short-term, the hostilities in Europe will be a key driver with a de-escalation obviously brightening the economic outlook, while an escalation will have the opposite effect. Looking out a little longer term, there’s no doubt that risks have risen in the economy with the main fear that rates will rise too high or too quickly, causing a significant slowdown or even a recession as early as next year.
We don’t know if this will come to pass. What we do know is that slowdowns and recessions are inevitable over time and that trying to time them is a risky strategy. The data shown in Figure 1 backs this theory, detailing the probability of losing money over different time periods for those invested in the U.S. market.
Figure 1: As time horizons grow, equity losses fall off (based on S&P 500 total returns from 1929-present)
As you can see, anything can happen in a day, month or year, but over longer time horizons your chances of success grows substantially. It’s confirmation that the best strategy is to stay focussed on the long term and to try to ignore the noise in between.
Sources: FactSet, Bloomberg
Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities
Though only three months have passed since we last wrote, the world seems a different place. A war has been forced upon the Ukraine in what’s proving to be a much more vicious fight than many had forecast. One of the immediate investment-related fallouts from this has been the supply side shock in commodities such as oil, natural gas, potash and ammonia, which have risen in price quite dramatically. This, in an environment where supply was already struggling to meet demand and has been for several quarters.
The much advertised and expected increase(s) in interest rates, by the U.S. Federal Reserve in response to high levels of inflation, have begun and are expected to continue at perhaps a faster rate than previously thought. This has dampened stock market enthusiasm for growth-oriented stocks and, combined with the economic sanctions, has resulted in equity weakness globally.
One notable exception to this was the Canadian equity market where, as measured by the S&P TSX index, a +3.8% return was realized for the quarter. As one might expect given the themes outlined so far, the energy and materials sectors were the strongest performers.
Canadian oil and gas producers have been generating healthy cash flows, with the price of oil consistently trading above $100. The sector was up over 28% in the quarter. Not far behind was the materials sector, which was up 20.1%. This was driven not only by precious and base metals miners, but also by strong fertilizer prices as a result of sanctions against Russian and Belarus production.
The war, and sanctions in particular, has resulted in wheat prices globally being up on the order of 30%, as well as potash fertilizer also being up a similar amount (see Figure 2). With such large increases in fundamental commodities, in both energy and materials, it’s not difficult to see that inflationary forces are likely to be more persistent than we had expected coming out of 2021.
Figure 2: Increase of wheat and potash fertilizer prices
The area of greatest weakness in the quarter was the technology space, which was down 35% in Canada. These companies are generally valued based on expected future earnings growth. The increasing macroeconomic and political risks have investors concerned that growth will be muted relative to recent expectations, and so have been selling stocks in which this future growth was priced in. The Canadian equity market, which has a relatively small weight in technology stocks and a large one in energy and materials sectors, has benefitted from both of these themes over the first quarter of 2022.
One final trend that’s caught our attention is the dividend increases we’ve been seeing year to date. The strong cash being generated by the energy sector has been flowing back to investors. Outside of energy, we’ve seen dividend increases as well and expect to see more throughout the year.
The developments of the past three months have certainly given us pause for thought. The inflationary pandemic-related forces of labour shortages and global supply disruptions, which were seen as temporary in nature, have given way to increasing commodity prices.
The drivers of these more expensive fundamental inputs, being years of pressure on oil companies to limit exploration and development, combined with the increasingly punitive sanctions on Russian production of just about everything, will likely be more persistent in nature.
As previously mentioned, Canada is well positioned for this environment. Furthermore, as geopolitical risk becomes more heightened, North America is seen as a safer place to invest and will attract international flows of capital. This can be a steady tailwind to our equity markets.
The macroeconomics of oil have been tilted by limited supply in the face of expected demand. Most energy producers are reluctant to invest in expanding either reserves or production, as shareholders have been focusing on environmental issues while also insisting on seeing the profits of higher oil prices flow back to them. This has been the case for some time, and the sanctions related to the Russian aggression in Ukraine have only exacerbated the situation. Until structural changes are made on the supply side, it’s likely that oil prices will remain relatively high.
Outside of international sanctions, the macroeconomics of the metals and minerals are much more balanced. Except for the rare earth metals used in advanced batteries, which are truly rare, there are ample supplies of copper, fertilizers, and natural gas (used in producing ammonia fertilizers as well as basic chemicals such as methanol). As such, the price strength in a number of these commodities is more at risk to political decisions regarding the nature of the sanctions on Russia, making them much less predictable.
Our energy holdings consist of Suncor (SU), Canadian Natural Resources (CNQ), Arc Resources (ARX), TransCanada Energy (TRP), and Pembina Pipelines (PPL). While we trimmed some of our CNQ overweight in January, as the supply/demand picture for oil became clear, we’ve been more patient in taking profits from this group. Conversely, the less fundamentally driven fertilizer picture has led us to take profits in our Nutrien (NTR) position this quarter, as the stock price rallied from $95 to $130 as shown in Figure 3.
Figure 3: Nutrien stock price rally
A new position to the portfolio this year is Shopify (SHOP). This company simplifies the process of having an on-line store for businesses. They’ve become a world leader at this, and continue to grow not only their customer base, but the services embedded in their offering, making them the go-to solution for this service. With the pullback in the technology sector stocks, we saw an opportunity to add Shopify to the portfolio at a more reasonable price. As March came to a close, we added to the position a second time. Given Shopify’s dominance, as well as the still nascent aspect of this industry, we feel fortunate to have been given the opportunity to get exposure here at a reasonable price.
Within the materials group, we’ve added CCL Industries (CCL) to the portfolio. This company develops and manufactures various packaging solutions for non-durable consumer goods. Being less affected by the commodities cycles, we expect this position to be less correlated to our Nutrien and Methanex positions, thus helping diversify our materials sector.
Stantec (STN) was also added this quarter. This engineering firm headquartered in Edmonton, Alberta, has a global presence in design engineering within infrastructure, buildings, water, environmental services, and energy and resources. The company has been growing through acquisition, with a recent focus on environmental and sustainability expertise.
Our consumer staples sector was enhanced with the addition of Saputo. Saputo is an international producer of cheese and dairy products. Having grown through acquisition, the company has recently embarked on a structured plan to drive efficiencies and improve margins. A prolonged bottom in the dairy cycle, combined with increasing labour costs, has had the stock under pressure for almost a year. With recent reported improvements in operations and signs that the cycle may be turning, we feel that the stock has bottomed and are trusting management’s long-term track record to turn things around in the coming year.
Despite the mass of uncertainties sprung upon us this quarter, our equity market has been resilient. This is yet another example of the wisdom of thinking longer term in equity investing. Though there’s likely a period of high volatility ahead, investing across different markets can help manage that volatility as it did this quarter.
Sources: Bloomberg, CWB Wealth Management
Liliana Tzvetkova, CFA
Portfolio Manager, U.S. Equities
Saket Mundra, CFA, MBA
Portfolio Manager, U.S. Equities
U.S. equities ended Q1 2022 down about 5% (6% in CAD). This decline follows an almost uninterrupted rally that began back in Q1 2020 after the brief COVID-19-induced bear market. While COVID-19 cases declined sharply during the quarter and the economy reopened as expected concerns around inflation intensified with headline numbers coming in worse than feared.
The Russia-Ukraine war that emerged mid quarter has made the inflation situation worse as the region is a sizeable exporter of energy and other major raw materials. The result has been a huge spike in commodity prices. The impact on the supply chain is less talked about but has added fuel to the fire. Short supply of metals such as nickel are compounding shortages in the already tight auto components markets.
During Q1, the Fed embarked on a tightening cycle with a 0.25% rate increase in March marking the first of many planned hikes over the next 12 to 18 months. While this was a well telegraphed event, the expectations for the number of rate hikes increased substantially thereafter. Monetary conditions remain accommodative for now, but the bond market seems to be worried. The yield curve even inverted slightly at the end of March.
That aside, U.S. corporations posted another strong quarter (Q4 2021) and earnings expectations for 2022, in fact, increased slightly during Q1 leading to a P/E multiple contraction following this quarter selloff. Consumer and businesses balance sheets remain in good shape and the labour market continues to strengthen.
Looking at market performance, it was a risk-off quarter with a wide divergence in sector performance. Only two sectors managed to post positive returns in Q1: energy (due to the spike in oil and gas prices) and utilities (due to a flight to safety). Consumer staples also outperformed on a relative basis due to its defensive nature.
The worst sector was communications services, with Facebook being a huge drag after missing expectations and guiding lower during the last quarter earnings release. Overall, growth underperformed value and sectors that are more growth oriented, such as technology and consumer discretionary, underperformed. Pandemic winners, such as Netflix and Zoom, lagged as well.
While we’re not throwing the baby out with the bathwater, we acknowledge that risks have risen over the past three months. The increase in inflation and energy prices is likely to force a cut in spending elsewhere, leading to demand destruction and/or margin compression for some corporations.
With earnings expectations for 2022 slightly up, we run the risk of downward earnings revisions – the opposite of what we’ve experienced over the past two years (see Figure 4). Stock selection becomes very important at this point in the cycle and our focus on companies with strong brands, pricing power and/or scale and low leverage is helping.
Figure 4: Number of companies with positive earnings revisions on decline
The significant revision of interest rate hike expectations and the Fed members’ recent comments suggest increased inflation worries and commitment to tightening. With the yield curve flattening and the inversion of the 2/10 curve, we’re starting to hear more investors worry about a policy mistake or the Fed raising rates too much too fast, thereby shortening the cycle and eventually causing a recession.
The yield curve inversion has typically been an early but reliable signal for recessions in the past, although significant amounts of quantitative easing could be distorting the curve. Despite that concern, we also don’t want to lose sight of the possibility of a soft landing, which means that the Fed will be able to tighten just enough to tame down inflation without causing a recession.
On the other hand, considering the strong labour market and how healthy both consumer and businesses balance sheets are, we could see the cycle prolong further. It’s difficult to predict which of these outcomes will materialize.
Events from the past three months have once again reminded us of how quickly things can change. A common theme among the Russia-Ukraine war, 7.9% February inflation rate, and expected eight to nine interest rate hikes for 2022 is that they were all assigned near zero probability at the end of last year. Yet, they all happened.
So, even though we attempt to forecast the short term, our focus lies in the long term where we feel things are more predictable and fundamentals really matter. As for the short term, we as investors are not willing to bet on any one outcome. Rather, we prefer to invest in a balanced portfolio of high-quality stocks exposed to different drivers so that the portfolio can fair well in the variety of scenarios that could play out.
During the quarter, the U.S. portfolio performed better than the S&P 500 despite having no direct exposure to the energy sector, which cost us approximately 1.2%. Generally, commodities have been on a tear which was further accentuated by the ongoing geopolitical turmoil. We feel comfortable with our positioning and continue to execute on our investment process by deploying capital in areas that we deem attractive over the long run.
We’ve introduced two new positions in the portfolio: Intel and Southern Copper. Intel needs no introduction, and we deem that under the current management it’s on the path to put its execution issues behind it. In our experience, turnaround situations don’t follow a straight path and usually take longer than anticipated with hiccups along the way. However, we find the strategy to be logical and the risk/reward lucrative at the current price.
Southern Copper is one of the largest and lowest cost copper producers in the world, and it’s a name that we’ve owned in the past and followed since. The company has a stellar track record of generating positive returns even at depressed copper prices, and has allocated capital intelligently. Again, we found the risk/reward to be conducive for initiating a position in the name.
Further, we added capital to several high-quality businesses that were trading at attractive valuations and offered better risk reward. We added to our positions in Amazon, MasterCard and Booking while reducing our exposures in J.P Morgan, Wells Fargo, and Dollar Tree. With respect to the names that we trimmed, we found that the risk/reward was more balanced as the stock prices rallied as our thesis played out. Nevertheless, these names remain big positions in the portfolio.
In our U.S. portfolio, we focus on long-term investing in high-quality companies with strong returns, healthy balance sheets, and stable cash flows. Staying true to our process, we continued to deploy capital in such businesses whenever risk/reward was in our favour.
Ric Palombi, CFA
Senior Portfolio Manager, International Equities and Alternative Income
The most significant event dominating headlines this quarter was the Russia-Ukraine war, and this had ripple effects on global markets including the Chinese and European markets where the international invesments has material exposure.
Chinese equities represent about 15% of the International portfolio and they’ve seen volatile swings due to Beijing’s close ties to Russia (and speculation whether China would support Russia in the war), a growing COVID-19 outbreak and the ongoing regulatory headwinds. Investors appear to have sold Chinese equities (see Figure 5) and while the relative magnitude doesn’t appear as large compared to recent selloffs, their effects have been exacerbated by deterioration in liquidity conditions. Short interest is also approaching record levels.
Figure 5: Flows into onshore and offshore Chinese equity ETFs, cumulative flows as a % of AUM
However, in our longer-term view, investors are getting adequately compensated for risks at these levels (see Figure 6). The MSCI China Index traded as low as single digit earnings this month, before a two-day rally brought valuations back to around 10 times. That compares to 17 times forward earnings for global developed markets.
Figure 6: Valuation gap between Chinese shares and global peers at record
While the current environment is characterized by a lot of uncertainty and volatility, it’s also great for active stock pickers like us (see Figure 7).
Figure 7: Market structure for active managers is much better compared to 2012
The Chinese government’s push to stabilize the market helped in the short term. Longer term, we believe investors will want to have exposure to the world’s second biggest economy. China has also clarified that it doesn’t want to be impacted by Russian sanctions, with Foreign Minister Wang Yi saying that Beijing is ‘not party’ in the war.
China’s policy pivot should further support the economy and equities. This is expected to come in many forms including lower policy rates, higher TSF (Total Social Financing) growth, RRR (Reserve Ratio) cuts, lower mortgage rates and down payment amounts for property, eliminating quantitative targets for decarbonization.
When we heard the term “uninvestable” in early March, we took notice. It’s not a word that’s used often – especially to describe the second largest economy in the world, China. Since then, however, the world has become a different place.
Following a string of dramatic interventions by Beijing, the worst selloff in Chinese markets since 2008 turned into an historic surge, catapulting stocks like Alibaba and other U.S.-listed Chinese tech firms into a rebound not seen before. The verbal intervention caught many investors off guard as China’s top financial policy committee vowed to ease the crackdown on technology firms, support the battered real estate market and stimulate the economy.
Then, we have “common prosperity.” The initiative which roiled the markets due its opaque nature of how China is going to reduce inequality and redistribute wealth has suddenly become absent in Chinese propaganda. Last year, the term “common prosperity” was everywhere. This year, it turned up only once in a 17,000-word government document delivered by Premier Li.
What do we make of this? We expect that China will prioritize economic growth over regulations, and the Chinese economy will go into expansionary mode with stimulative monetary policy and looser fiscal policy. As for Chinese stocks, to reiterate what we discussed in the ‘watching’ section: we see opportunity.
For Chinese e-commerce giant Alibaba, China’s regulatory onslaught has affected them both directly and indirectly. Direct measures aimed to erode Alibaba’s strong competitive positioning through actions such as limiting Alipay’s role in the Alibaba ecosystem, tighter regulation on Alipay’s operations and data collection, and anti-monopoly rules helped competitors take market share.
Indirect impacts were felt through the rules aimed to cool the Chinese property market, reduce income inequality, and contain COVID-19. These measures slowed down GDP growth to below 6% and started a decline in property prices. As consumers naturally feel less secure in such an environment, total retail sales slowed to 2% annualized growth rate at the end of 2021. These factors collectively hurt Alibaba’s topline growth and profit margins considerably.
Over this period, we’ve heard many phrases like, “the fundamentals don’t matter” and “portfolios must be de-risked” etc. Understandably, it’s been a rough ride for many investors. An analyst at one of the largest banks in the world cut his rating on the entire sector to Underweight (sell rating) just recently. While we have a great degree of respect for these analysts and investors, we believe this episode has shown the emotional side of investing. Through the COVID-19 correction and subsequent boom, we’ve seen both sides of the emotional roller coaster, but this phase is punishing as Chinese stocks have declined for quite some time.
For Alibaba, we concede that the competitive and regulatory landscape has changed, but we don’t believe that it’s impaired to such a degree that the shares should trade at single-digit, price-to-earnings multiples, where 30% of the market capitalization is in cash. Aside from the core domestic e-commerce business, where we believe profit margins will expand again from next year onwards, Alibaba has a number of other business lines we expect will add value. For example, Alibaba’s e-commerce business in Southeast Asia, as well as in their international marketplace platforms such as AliExpress. Also, Alibaba operates China's largest cloud services business (similar to Amazon's AWS).
More importantly, we’ve seen various actions from the Chinese government which confirm to us that they’re not intent on destroying the sector and, in fact, want and need these firms to succeed. The most recent announcement, a very significant signal, was to allow U.S. auditors to have deep access to data of Chinese firms. This has been an outstanding issue for over 10 years now and its resolution under the current geopolitical environment carries weight.
Through this challenging phase, our team has turned to our investment philosophy and process to guide us. We talk often about “seeking the truth” and have done so by taking advantage of the fear and panic and adding to our Alibaba position.
Ric Palombi, CFA
Senior Portfolio Manager, International Equities and Alternative Income
The investment world has been obsessed with shape of the U.S. Treasury yield curve and its implications for interest rates and the economy in the future. More specifically, it’s the fact that the yield on the 2-year U.S. Treasury bond has surpassed that of the 10-year bond (see Figure 8).
In bond parlance, they call this a yield curve inversion and it has sent shock waves through the investment community. Economists and strategists alike are raising warning flags that this inversion is a signal that economic growth will slow, and a potential recession lies ahead.
Figure 8: U.S. 10Y-2Y yield curve
The reasoning goes something like this. In normal times, the longer it takes to pay back a loan the higher the interest rate charged. Lending money (or buying bonds) over a longer duration thus demands higher interest rates. In other words, the interest rate on shorter bonds should be lower than on longer-term bonds. When this relationship inverts, it can signal turbulence on the horizon which is usually brought about by the U.S. Federal Reserve.
Investors expect the Fed to push up interest rates so much in the short term to fight inflation that it will choke off credit, thus impacting aggregate demand and potentially causing a recession, which will cause a subsequent drop in inflation allowing the Fed to then cut rates later. This is, in essence, the boom/bust economic cycle.
In practice, of course, the real world is never that straightforward. The trouble is, yield curves can be measured using interest rates across a wide spectrum of maturities from the overnight rate to 30 years, and they do not all tell the same story. For example, the 3-month to 10-year yield spread (which is the Fed’s preferred spread and is seen in Figure 9) is not inverted and has, in fact, steepened.
Figure 9: U.S. 10Y-3M yield curve
So, what does all this mean for fixed income investors? In the short term, it has turned everything upside down as it pertains to interest rate risk or duration. Normally, taking less interest rate risk or lower duration means that a fixed income portfolio is more protected from interest rate movement. Not so this year as the pain has been felt more in the shorter-dated maturities than in the longer-dated ones. This is counter intuitive, but such is the inverted yield curve.
As we began 2022, the 2-year Treasury bond was yielding approximately 0.75%. It’s now approximately 2.44% and because bond prices move inversely to yields, it’s been painful to say the least. By comparison, the 10-year bond has moved from 1.55% to 2.40%, still down in price but not nearly as bad as the 2-year bond.
For a shorter-duration portfolio like ours, the interest rate move has been acute, but because of our very low exposure to government bonds and relatively high exposure to corporate bonds, we’ve managed to ride out the volatility nicely. This is because corporate spreads, in general, have been very well behaved.
As seen in Figure 10, in comparison to government bond yields, corporate spreads have barely budged. This is due to strong corporate balance sheets and corporate defaults near historical lows.
Figure 10: U.S. high yield and high grade credit spreads
As mentioned, the majority of the sell-off in corporate bonds has been interest rate driven and not due to corporate spread widening. In addition, the yield back up has been concentrated in the shorter end of the yield curve which is normally the “safest” part of the curve. We’ve been keen to take advantage of this phenomenon to enhance the income and capital gain potential of the portfolio without taking undue interest rate risk.
For example, we initiated a position in the AERCAP 5.875% bond which is callable in September 2024. In essence, it’s a bond with a potential 2-year maturity. The yield to the call date is over 7%. If it was not called at par at that time, which we believe has a high probability, the next coupon is set by adding 4.53% to the 5-year U.S. Treasury which, at current levels, puts the next coupon at over 7%.
Source: Bloomberg, JPM, Bernstein, FactSet