In this commentary:
CWB Wealth Management Investment Team
The first half of 2022 was one that most investors would like to forget. Oil, natural gas and some agricultural products were up over the period while almost everything else produced negative returns.
Nowhere to hide
Most investors have a mix of stocks and bonds in their portfolios. The diversification typically helps to ease the pain when one asset class turns in a negative performance. This year, so far, both stocks and bonds are down. This is incredibly rare.
In the last 94 years, the U.S. stock market (S&P 500) has only produced a negative return in any given calendar year 25 times. In all but two of those instances, U.S. investment-grade bonds posted positive returns. In other words, when stocks are down bonds are almost always up. Just not this year.
Where do we go from here?
In our last quarterly commentary, we discussed how the outlook for 2022 was becoming increasingly hazy. The picture is clearing but not necessarily in a good way.
Central banks are tripping over themselves to assure the market that they’ll do whatever needs to be done to bring inflation in line, even if it means increasing interest rates to levels that will push economies into a recession. Although not a foregone conclusion, many economists believe a recession is likely this year or next.
If economies tip into a recession, we will almost certainly see corporate earnings fall which is an additional negative for stocks. Also, the longer it takes for inflation to be reined in, the higher rates will likely go and the longer they will stay high. This would imply a longer recession.
The economists’ view is increasingly becoming the common view. Of course, it’s not easy to predict the future and forecasting what might happen since the pandemic has been a humbling experience. So, what conditions need to be present for the economy not to fall into a recession? It all comes down to inflation. The quicker we get inflation under control, the better chance rates won’t rise to levels that will totally choke off economic growth. That could help ensure a soft landing.
There are many signs that the economy is cooling which should lower inflation. Consumer confidence is very low which should impact spending. Many commodity prices have come down from recent highs. For instance, lumber prices are down over 50% since March. It’s a sign that rates are impacting housing demand which has been a big inflationary factor. Demand for many goods, which were inflation drivers last year, like motor vehicles, have also fallen dramatically.
What's priced in?
It looks like there’s a case to be made that a potential recession could be relatively mild with the employment situation being a big pocket of strength. Currently, Canada’s unemployment-to-job-vacancy ratio is 1.3 which means there are almost enough jobs for every Canadian looking for one. This is the most favourable number on record.
If we do have a recession, jobs will be lost but we’ve never entered a recession with an employment situation as good as the one we’re in now. People with jobs generally pay their mortgages and spend money, which helps to keep the economy going.
In any case, a recession seems to be already priced into the market (figure 1 shows S&P 500 returns in each recession since WWII). At its worst point in the first half of this year, the S&P 500 was down 24% from its high which is fully in line with a typical recession.
Figure 1: S&P 500 returns in post-war recessions (%)
Of course, things are changing rapidly and it will likely take until at least the end of next year for the economy, and perhaps society, to be somewhat back to normal versus pandemic times. Buying in a bear market (down 20%) has historically been a great investment over the long term, but it’s not always the best in the short term. We’ll only know that in hindsight.
Sources: FactSet, Fidelity, Bloomberg
Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities
The more aggressive stance in rate hikes recently adopted by central banks has led to fears of a recession in the coming months, and investors have been selling stocks as a result. The Canadian equity market, as measured by the S&P TSX Index, was down 13.2% in the second quarter. Our portfolio was a relative outperformer in the quarter. The classically-defensive sectors, consumer staples and utilities, were relatively strong performers in the quarter. This shows concern about possible slowing growth going forward and investors moving towards these more earnings-stable areas.
On the energy front, we continue to see oil in excess of $100 per barrel. We’ve mentioned in the past that there’s a supply issue side story, and we’ve yet to see significant investment in oil production from industry. Equilibrium at a lower price level will require significant demand reduction, which may be brought on by persistent high prices, combined with the effect of higher interest rates on consumer consumption. Recent weakness in energy stocks was a reflection of this concern, though they appear to be rebounding somewhat. The energy group was the strongest performer in Canada in the second quarter, being down only 1.9%.
Most commodities outside of food and energy have pulled back recently, consistent with an overall slowing in the economy, or anticipation thereof. This is shown in Bloomberg’s commodities index chart (see figure 2).
Figure 2: Commodities index chart Year to Date
Information technology and health care were the weakest sectors, down 30.7% and 49.6% respectively. We avoided the worst of that, having no health care stocks in the portfolio and holding CGI Group within the technology space, which was actually up 3.0% in the quarter. CGI offers IT services and consulting, allowing companies to outsource their technology needs. There was a concern that CGI’s European operations would be affected negatively by the turmoil there, however, they’ve demonstrated that’s not the case, and the stock has responded well.
The mood within the equity space has changed considerably since last quarter. We’re mindful of two things. The first is sentiment, which is driving the trading activity in the equity market at the moment. Market sentiment turned decidedly negative in June on the back of a surprisingly high inflation number. This happened very quickly. It’s entirely possible that sentiment will reverse just as quickly, as a response to an unexpected positive data point or event. These reversals of sentiment are not forecastable, and it’s important to be in the market when they happen.
We must also bear in mind that, by nature, the data describing economic growth refers to what’s already taken place. The equity market is forward looking and often looks beyond the latest data to where things will be in six months. It wouldn’t be unusual for the equity market to begin rallying as weak economic numbers come out, especially if the weakness was expected.
We had a fairly quiet quarter with respect to portfolio activity. We added to our TFI International position after hearing from management that trucking volumes were still very good. We also added to our Shopify position, which had continued dropping in the quarter but seemed to stabilize somewhat in late June. We continue to believe that maintaining exposure to the equity markets will result in full participation in the eventual recovery.
Sources: FactSet, Bloomberg
Liliana Tzvetkova, CFA
Portfolio Manager, U.S. Equities
Saket Mundra, CFA, MBA
Portfolio Manager, U.S. Equities
The current economic environment reminds us of Aesop’s fable, The Boy Who Cried Wolf. Just as the wolf in the fable showed up eventually, so did inflation, surprising economic and market participants. Over the past 6 to 12 months, we saw the inflation narrative shifting from “transitory” to “higher for longer” to now “we need to tame it at any cost”. It showed up when it was least expected, led by a confluence of factors. While many of these were unpredictable, one wonders how a decade-long underinvestment in resources and global supply chains went unnoticed.
Given all this uncertainty, it would be fair to characterize the first half of 2022 with the word “fear”. We saw fear across asset classes and markets. The first half of 2022 marks one of the worst performances for the S&P 500 since 1970, with markets yielding negative 20% total returns for the period. Within equities, defensive sectors such as utilities, staples and healthcare have been the best performing sectors. The laurels for the worst performance were shared by consumer discretionary, communication services and the information technology sector. The economically-sensitive energy sector remains an outlier with about 32% returns on a YTD basis, while bonds, commodities and even crypto all ended in negative territory.
In an environment where consensus is calling for a recession due to higher interest rates resulting from persistence of inflation, the odds of predicting any economic outcome with a degree of certainty are low. Our job, as stewards of capital for our clients, is to make decisions where odds are favourable and to act deliberately when the world around us seems to be falling apart. Our edge is in analyzing businesses thoroughly and taking advantage of prevalent fear by buying at lucrative valuations.
We’re fully focused on how long-term economic prospects of businesses are impacted by the current environment. Figure 1 shows the earnings revision trajectory for the S&P 500. It’s clear from the exhibit that more companies are starting to feel earnings pressure in the current environment, and the market seems to catching up to it. Averages, while great in certain aspects, can be deceiving, creating opportunities for investors like us. We don’t believe that earnings for all businesses will be impacted equally and it’s our job to find ones that will overcome the current environment and where the price is already discounting significantly.
Figure 3: S&P 500 Earnings Revisions Breadth
During the quarter and first half of the year, our U.S. portfolio showcased resilience versus the S&P 500 leading to relative outperformance despite having no exposure in the energy sector. We give little importance to short-term performance and focus on investing to enhance the portfolio for the long run.
Taking advantage of the ongoing fear, we initiated a position in Aramark, one of the leading catering companies in the world, with a mid single-digit structural growth profile and operational turnaround potential. We exited our position in Walmart and Rockwell as we deemed risk/reward to be more lucrative in other opportunities, and redeployed the capital in Costco, Nvidia and Microsoft. Overall, we continue to stay disciplined and focused on the long term by investing in high-quality companies at lucrative valuations which we believe will lead to superior returns for the portfolio.
Sources: FactSet, Bloomberg, Morgan Stanley Research
Ric Palombi, CFA
Senior Portfolio Manager, International Equities & Alternative Income
It’s been a difficult first half for European markets. The continuing war in Ukraine and the resulting geopolitical challenges have led to increasing fears about natural gas shortages. Germany, a heavy importer of Russian gas, is likely to be hard hit after Russia cut deliveries by 60% through a key pipeline. Germany is preparing to trigger the second of a three-part emergency plan which could mean passing higher prices to industrial and household consumers of the commodity. Naturally, this would have broad economic implications. Despite the negativity, unemployment in Europe is surprisingly low which should help temper some of the downside risks.
We’ve previously highlighted our belief that Chinese shares have been punished harshly. Investors pulled their capital from Chinese financial markets, believing the combination of unpredictable regulatory moves, zero-COVID policy, and geopolitical concerns make the market uninvestable. We continue to humbly disagree with that view and feel that the Chinese government and the Communist Party are not trying to break the economy.
We believe the risks of the natural gas crisis are manageable and companies we own with exposure are being overly punished. Two worth mentioning are:
- Lanxess, a specialty chemical company, that believes, in the case of a Russian embargo, it would only need to shut one plant and reduce the output at four others, leading to an EBITDA impact of approximately 10%. We believe that Lanxess has product pricing power which should allow them to pass on higher costs.
- EON, an integrated German utility, that has no direct exposure. Most of EON’s business – electricity networks and distribution – is regulated, inflation protected, and defensive in nature. The smaller gas supply division would be affected, however, it only represents 4% of the total EBITDA.
Turning to China, after a series of policy signals and moves which aimed to improve the operating environment and boost investor confidence, we’ve seen dramatic rallies in certain areas such as the technology sector. Shares of Alibaba have rallied 60% from the bottom and earnings expectations are now being revised upwards as extreme pessimism dissipates. Similarly, the technology sector benchmark has rallied by 38%. We’re benefiting from our purchases of some of these stocks earlier and continue to monitor the developments.
We’ve significantly increased our position in the German software company SAP, the world’s leading enterprise resource planning (ERP) software vendor. ERP software is used in most medium to large organizations in the world as it helps them manage key aspects of their business: accounting, human resources, supply chain, inventory, production, etc. Without ERP software, it would be impossible to manage complex organizations. SAP’s biggest competitor is Oracle, but it also faces increasing competition from Microsoft, Workday, and others.
The ERP sector has been slower than the other software sub-sectors in moving to the Cloud, but that transition is firmly underway now. Due to this transition, shares have been volatile over the past few years as the market frets over each quarterly result to assess whether the transition is going smoothly.
As the software sector has sold off heavily lately and recession fears increase, SAP’s shares have also sold considerably lower than their highs. Figure 4 shows that SAP is trading at 16.5x forward price-to-earnings ratio and 14.4x forward the enterprise value to earnings before interest and taxes (EV/EBIT) ratio. Both values are currently at the bottom of the 5-year range. This has given us an excellent price point to increase our position.
Figure 4: SAP price-to-earnings (P/E) and EV-to-EBIT (EV/EVIT) ratios
Sources: Bloomberg, FactSet
Ric Palombi, CFA
Senior Portfolio Manager, International Equities & Alternative Income
In the first half of 2022, global investors have been obsessed with inflation for good reason. With inflation at or near generational highs in many countries, central banks, led by the U.S. Federal Reserve, now have inflation in their crosshairs and are resolved to bring it back under control. This means interest rate increases, rising bond yields and tighter financial conditions were used to try and get ahead of the inflation curve.
Despite these actions, inflation has remained stubbornly high which has many investors wondering if it’s getting embedded in the economy and is, therefore, not so easily defeated. This is because CPI readings have continued to surprise to the upside.
We believe inflation and related inflation trade is yesterday’s news. We say this because the Fed and related central banks are focused and worried about inflation so, as investors, we don’t have to be. We don’t say this lightly, but the data is quite compelling.
Figure 5 shows one of the Fed’s favourite market-based inflation indicators, the 5-year forward inflation expectations. The chart goes back 2 years to get a sense of how 5-year inflation expectations have been trending since COVID-19. We saw a peak in the first half of 2022, just under 2.60%. Recently, however, inflation expectations have collapsed back to 2.07% which is very close to the Fed’s inflation target of 2%
Figure 5: Market-based inflation expectations
We also see this when we look at the 10-year breakeven, which is calculated by subtracting the real yield on 10-year inflation linked bonds and the associated nominal bond. This breakeven rate peaked at just over 3% in the first half of 2022 and has now dropped to 2.3%. This implies that investors believe the Fed will indeed do its job and get inflation back towards its 2% target.
Looking at the U.S. Treasury 10-year bond yield, we also see that investors believe inflation will be tamed. When investors believed the Fed was not fully engaged in inflation, fighting yields spiked dramatically. They moved quickly from 1.50% at the beginning of 2022, peaking mid-June at nearly 3.50%. Since then, the narrative has seemingly begun to shift as yields have now declined over 50 basis points as of this writing.
The narrative for the second half of 2022 has shifted from inflation to economic growth. Implicit in this data is that the Fed will sacrifice economic growth to get inflation under control. The biggest question facing investors now is whether the Fed will drive the U.S. economy into recession or not. As is always the case with investing, the answer is never black and white but usually found in probabilities. The market-implied probability of a U.S. recession is elevated, going from 0% at the beginning of 2022 to 38% now, but is not assured.
To capitalize on this increased probability, we believe there’s compelling risk/reward in shorter-term corporate bonds with interest rate optionality. For example, we’ve been adding to the Intesa 7.70% Contingent Convertible (CoCo) capital bond which is callable in 2025. At the recent price of $90, it yields 11.52% to the 3-year call at $100. If it doesn’t get called, the yield at the current interest rate levels is 9%.
Sources: FactSet, Bloomberg