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Jan 21, 2022

Q4 2021 Investment Commentary

We found that despite strong year-end results, 2021 was full of surprises. Although 2022 may not bring us fully back to normal, we think it will be another big step towards normalcy, which is positive for the economic outlook.

In this commentary:

The best and worst of times | Canada | U.S. |  International | Fixed Income

 

 

The best and worst of times

Scott Blair, CFA
Chief Investment Officer

One advantage of writing a monthly commentary on financial markets and the economy is that you end up with a library of real-time thoughts that you can later return to and learn from. In reviewing our 2020 year-end commentary, here’s what we found interesting.

Lessons learned in 2021
The commentary, An optimistic eye on 2021, reflected (as the title implies) that we liked the outlook. Economists were calling for strong global growth, rates were low, and the view on corporate earnings was very robust. All great signs for equities and, indeed, the forecasts were correct. It was a great year for many global markets, and the best of times for Canadian and U.S. stocks in particular, which gained well over 20%.  

Despite the strong year-end results, 2021 was full of surprises. For instance, economic growth was very robust (likely around 4.5% in Canada) but fell well short of forecasts at mid year, which called for over 6% growth. The COVID-19 vaccines were effective, but we still ended up with three waves and are now at peak case counts due to the Omicron variant (something few predicted, including us). Inflation spiked above most forecasts and supply chain issues became front-page news. The list of surprises goes on.

Our takeaway from 2021 is that the news flow is endless and easy to get caught up in. We’re bombarded with data points, most of which are not very useful. Staying focussed on the big picture instead is key. In 2021, the big picture was that strong economic growth coupled with low rates would lead markets higher. The precise numbers didn’t really matter.

Different year, same optimism
Although 2021 will be a hard year to beat for equity markets, we’re still positive going into 2022 but know there are more clouds on the horizon.  

On the positive side, economic growth is forecasted to be very robust again in 2022, with economists seeing 4% growth in developed economies like Canada and the U.S. This compares very favourably to the 2% growth rate we were experiencing pre-pandemic. Most economists believe 2023 will be a stronger-than-usual year, with Canada forecasted to grow close to a 3% rate. It’s hard to be pessimistic when looking at these growth numbers.

Perhaps the biggest potential headwind (outside of the pandemic) is inflation. Pre-pandemic, we were used to fairly stable prices with the annual inflation at or below 2%. Several factors have pushed prices up (supply chain issues, low rates, and government spending programs to name a few), and the debate is whether this is temporary or has become more structural.  

Figure 1 shows quarterly inflation numbers from the start of 2021 to mid 2022. The first three quarters of 2021 are actuals (A) while the rest are estimates (E). Current forecasts predict that inflation will more or less peak this quarter before starting to fall back towards more “normal” levels by the end of 2022. We agree with this view and if estimates are correct, inflation will be a fading concern. We’ll be watching it closely.

Figure 1: Consumer Price Index (YoY%)



One reason for optimism with regards to inflation is that interest rates are going to rise back toward more normal levels after being cut to record-low levels at the start of the pandemic. This should take some of the froth out of the demand side as consumers start to deal with higher interest payments on their debt.  

Higher rates could also cool down the torrid rate of price increases in the housing markets. We expect to see three rate hikes from the Bank of Canada this year, with the first being just months away. We think the economy and stock market can handle rates going back to a more normal level without too much pain.

Pandemic year 3
The pandemic is truly the worst of times. COVID-19 continues to be the biggest wildcard in the economic outlook. As shocking as the Omicron case count increases are, there’s reason to believe year three may be the last year of the pandemic.  

The contagiousness of Omicron means that more deadly variants (like Delta) are being replaced by this less deadly variant. Some experts believe the combination of high infection levels, booster shots and new medications will turn the pandemic into something more like the flu or common cold. In other words, something that’s still there but manageable in the context of normal society. We hope they’re right. We think the feasibility of lockdowns is starting to wane, as each new one is more difficult to implement. 

Although 2022 may not bring us fully back to normal, it should be another big step towards normalcy which is positive for the economic outlook. We continue to advocate for diversification in our client portfolios, focussing on strong and resilient businesses that can weather any storm.

 

Canada

Gil Lamothe, CFA
Senior Portfolio Manager, Canadian Equities

Watching
The Canadian equity markets had another great quarter in Q4 2021 with the key benchmark (S&P/TSX Composite) up 6.5% on a total return basis. The quarter capped off a fantastic year where the market gained 25.1%.  

The strongest performing sectors in Q4 were Materials and Financials. In the Materials space, our holding in Nutrien was up 16.4%. The strong global demand for fertilizer is continuing and looks to extend into 2022. Within the Financials sector, the Canadian banks had a strong showing in the quarter. Bank of Nova Scotia and Toronto Dominion led the way, up 17.5% and 16.7% respectively. Another contributor within the Financials was Brookfield Asset Management, which was up 12.8%.  

One positive event for the Financial sector was the removal of the restriction on Canadian banks and insurance companies from increasing their dividends or repurchasing their shares. At the outset of the pandemic, the Office of the Supervisor of Financial Institutions (OSFI) implemented this restriction as a capital safeguard in what was a very uncertain environment. Our larger financial companies have since demonstrated their resilience and quality, and the restrictions were lifted in November. As a result, we saw dividend increases from all of our banks and insurance companies. While the average increase was in the 10-12% range, BMO surprised with an increase to its dividend of just over 25%. All announced the intention to continue repurchasing their shares, in amounts of 2-3% of outstanding shares.

CP Rail (CP) received the approval of the Kansas City Southern (KSU) shareholders for its purchase of that railway. After a back-and-forth battle with CN Rail (CNR) throughout 2021, the deal has finally closed. Provided the company gains approval from the U.S. regulator, CP Rail will have an end-to-end, north-south corridor through North America.

Another noteworthy event in Q4 was the board-level dispute at Rogers Communications. When the dust had settled, Edward Rogers showed that he has de-facto voting control of the company through his control of the trust, wherein lie the majority of Rogers Communications’ voting class shares. While the dispute and its resolution didn’t put the proposed merger of Rogers and Shaw Communications at risk, it did demonstrate that one individual does indeed control the ultimate fortunes of the company.

Also of note, Omicron came to the forefront in the quarter. The market reaction late in November was decidedly negative, but as it became clearer that this variant was less harsh than Delta, the market recovered somewhat by year end. 

Thinking
At a high level, our thinking hasn’t changed much over the past six months. We still believe the pandemic will continue to subside through 2022. This latest variant, Omicron, may actually help speed up that process as it’s both more transmissible and milder than the Delta variant. This, combined with the wide availability of booster vaccines, has had a positive effect on the stock market’s outlook. We still view the recent higher inflation as more transitory in nature, being largely driven by accelerated consumer demand following the strict lockdowns earlier this year. As demand normalizes, there should be an alleviation on prices as well as less pressure on manufacturing and supply chain capacity.

Of greater importance to your portfolio was the Rogers Communications imbroglio. It’s now clear that one individual controls the company, and while Ted Rogers Sr. had proven himself an effective manager in building the company with that level of control, we’re uncertain as to Edward Rogers’ abilities. While we feel the dividend is secure and that there’s no imminent risk here, it’s something we will pay close attention to going forward.

The outcome of the of the KSU battle going in CP Rail’s favour wasn’t altogether surprising. This asset gives CP the opportunity to grow its railway network volume – perhaps significantly – over the coming years. On the other hand, the strategy at CN Rail is to increase its operating efficiency going forward, and thereby become more profitable. They’ve been attempting to do this for several years. From an investment perspective, we like the opportunity presented by CP versus that of CNR. 

Another important development in the quarter was BMO’s announcement of the purchase of Bank of the West from BNP Paribus. Bank of the West is headquartered in San Francisco, with branches in the central and western United States. At US$16.3 billion, this is a large transaction for BMO, greatly extending their presence in the U.S. from Illinois westward to California, and virtually doubling the number of branches they have in that country (Figure X). This is a bold move in the bank’s U.S. growth strategy, and one which we like the look of. It remains to be seen whether the price tag was too high given the opportunities.

Figure 2: BMO greatly extends U.S. presence through Bank of the West purchase
 


Doing
During the quarter, there were three new additions to the portfolio. We’ve decided to switch out of Manulife with Sun Life in the life insurance space. Manulife has a strong focus in Asia as a growth strategy. This tends to make the stock more volatile, while Sun Life has exhibited solid management for many years and has performed very well.

Another addition to the portfolio in the Materials sector was Methanex. They’re the world’s largest producer of methanol, which is widely used in making plastics, paints and adhesives. The company has executed on a sound growth strategy for decades and is among the world’s lowest cost producers. They’re currently completing a third plant in Louisiana, which will have an annual capacity of 1.8 million tonnes.

Boyd Group Service Inc. was also added. Boyd operates collision repair centers throughout North America. They’ve been consolidating the industry by purchasing smaller local and family-owned businesses. Figure 3 shows the spectacular growth in locations and revenues. The company has been challenged by both a shortage of skilled labour, as well as cost pass-through friction with the major insurance companies. We expect these challenges to be overcome through 2022, and therefore feel that the stock presents excellent value at current levels.

Figure 3: Boyd Group Service Inc. growth in locations and revenue
 


We’re looking forward to 2022 in the Canadian equity markets. As always, there will be challenges and opportunities aplenty. Maintaining a high-quality, well-diversified portfolio will see us through the former and allow us to take advantage of the latter.

United States 

Liliana Tzvetkova, CFA
Portfolio Manager, U.S. Equities

Saket Mundra, CFA, MBA
Portfolio Manager, U.S. Equities

Watching
U.S. equities finished the year strong, outperforming most global markets with the S&P 500 up 10.7% in Q4 and 26.7% for 2021. These returns are even more impressive considering the uncertainty around the impact of Omicron, multi-decade high inflation, supply chain disruptions and the expectation of Fed’s monetary tightening. That aside, we saw an unabated strength in the U.S. consumer, improving labour markets and very accommodative monetary policy continuing during the quarter. U.S. corporations also managed to post another strong earnings season with year-over-year (y/y) earnings growth of nearly 40%, exceeding expectations once again and surprising the market with resilient margins despite persistent inflation.

Omicron was the biggest negative surprise during the last quarter. What we know so far is this strain has a higher rate of transmission, but it also appears to be less severe than its predecessor. Preliminary data also suggest that it might be able to evade immunity more easily. Another hot topic in Q4 and in 2021 was inflation, which remained high with supply issues persisting, while demand did not abate. Headline CPI rose 6.8% y/y in November, the highest annual increase in decades, putting into question the transitory nature of inflation and evoking bad memories of the 1970s inflationary period.

From a sector perspective, we saw a wide divergence in performance but the only sector to decline in Q4 was Communication Services with weakness across the telecom, media, and entertainment industries. After Omicron emerged later in the quarter, there was a flight to safety and more cyclical sectors such as Energy and Industrials underperformed. Financials was also a laggard hurt by falling yields. REITs were the best performing sector, followed by Information Technology with strength across the board. 

Thinking
The recent increase in COVID cases and associated restrictions will surely have a negative impact on growth in the short term, especially in certain areas like travel. Looking past that hurdle, we see a strong case for a continued economic recovery in 2022 supported by strength in both consumers and corporations with the Fed being the wild card, as usual. Consumers are flush with cash saved during the pandemic and there is still pent-up demand especially in the service industries (Figure 4). Businesses are ready to replenish inventories and invest in capital spending now that supply chain disruptions are easing, and the labour market is improving. All that should support the ongoing recovery, despite the pace of growth slowing. Inflation is also not necessarily bad for equities, especially for certain sectors and for companies with pricing power. As for valuation, we think the U.S. market looks fairly valued at a benchmark level, but we still see lots of good opportunities within the market.  

Figure 4: Consumers are flush with cash saved during the pandemic and there is still pent-up demand, especially in the services industry




           
That said, the most recent developments in the markets and the economy have been another reminder to investors to expect the unexpected. Shortly before Omicron emerged, it seemed as though the market had almost forgotten about the risk associated with COVID, hence the initial selloff. Today, it seems that the market is pricing in a quick resolution partly due to the supposedly less severe outcome from this variant and partly due to the high transmissibility, meaning it would pass the population quicker and lead to herd immunity. But the reality is this scenario might not play out (Figure 5). 

For instance we could have another more deadly variant or maybe Omicron proves to be more severe than currently thought. 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 in 2022.

Figure 5: Global COVID-19 New Cases & Deaths
 


Doing
Our U.S. equity strategy had a very good year, posting strong absolute and relative performance to the S&P 500. While we’re aware of the quarterly and annual numbers, we don’t give much importance to short-term numbers. Instead, we focus on executing on our investment process to enhance the portfolio for the long run.

As has been the trend during the year, we further concentrated the portfolio by exiting a few of our positions wherein our thesis either played out or the risk/reward wasn’t as lucrative as other opportunities. During the quarter we exited our positions in Disney, Nike, Lockheed Martin and Cisco and redeployed the capital in several high-quality businesses that were trading at attractive valuations and offered better risk/reward. One such name that we initiated was Costco and we added to our positions in names like Amazon, MasterCard, Visa, Booking and TJX. Our thesis on these names is based on continuation of revenue and earnings growth, which is not yet being priced in by the market. With respect to the names that we exited, we will continue to monitor them, and should the risk/reward become lucrative again, we will not hesitate in taking a position.

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 truthful to our process, we continued to deploy capital in such businesses whenever risk/reward was in our favour.

 

International

Ric Palombi, CFA
Director of Research, International Equities

Watching
If there’s one word that would describe 2021 best, it would be volatility. The year started off with cyclical areas of the market outperforming as we recovered from the pandemic-induced downturn, supported by vaccine rollouts and central bank policy. As the year progressed, performance of various factors (e.g. quality, growth, defensives, value) was impacted which lead to back and forth market rotations, based on the rhetoric related to the emergence of COVID variants and confusion around the change in direction of monetary policy. 

One of the poster child sectors for this volatility was shipping. Shipping prices were driven to decade highs. Supply side constraints in the sector (too few ships) due to years of under-investment were exacerbated by the emergence of COVID variants which caused limited availability of port workers. The global economy re-awakening from the downturn drove demand for goods through the roof and the industry just could not keep up (Figure 6).

Figure 6: Jumping Ship – Ocean freight rates have surged for more than a year on strong demand 
 


While net shipping rates have risen, they have not been immune to periods of volatility. We have exposure to this sector through Maersk, one the largest container shipping companies in the world and one that fits our process and investment philosophy (the healthy balance sheet is worth mentioning in a sector that has historically been over indebted). The volatility story is similar when we look at how the Maersk share price has performed over the last year (Figure 7).

Figure 7: Maersk Share Price  
 


This is an area we will continue to follow closely, not only because of our investment in this niche area of the market, but also as it has broader ramifications for the global economy and inflation. 

Thinking
Despite the sizeable gains in most global markets in 2021, not everything worked. In fact, for Hong Kong’s Hang Seng Index (HSI) it was a year to forget. The Hang Seng trailed the S&P 500 by a staggering 41%, the most since the 2008 Global Financial Crisis. Fundamentally, with a trailing price-to-earning (P/E) of 9.3x, the HSI is trading at a 65% discount to the S&P 500, the cheapest since 1998. Furthermore, the HSI’s price-to-book (P/B) is 0.97x (Figure 8). The index has never started a January with a valuation below its book value.

Figure 8: Hong Kong Stocks’ P/B Ratio Falls to Historical Lows 
 


Two of our holdings, which are large weights in the index, Alibaba and Tencent are down around 57% and 43%, respectively, from their peaks in 2021. A triple whammy of higher regulatory pressure, weak domestic macroeconomic conditions, and high competitive pressures led to an investor exodus from the sector and from China in general. 

Looking ahead for the year, the signals coming out of China currently indicate that the incremental regulatory pressure should be lower, and that the government is more focussed on macro-stabilization and growth. Additionally, companies in the e-commerce sector, like Pinduoduo and Meituan, have indicated that they will reduce the level of user subsidies/incentives. Tencent fully offloaded their holding of another e-commerce company, JD.com. These measures should improve profitability for the entire e-commerce sector as the competitive pressure reduces. The combination of these moves means that the “triple whammy” of 2021 should have less of an impact this year. In fact, it’s possible that some of the headwinds actually become tailwinds in the coming year. These factors combined with the all-time low valuation for companies like Alibaba should put them in a position to outperform over the coming few years. 

Doing
In keeping with our process, we added to Alibaba on multiple occasions over the last year. The stock currently trades at 13x forward P/E, which is the lowest in its history. Once adjusted for the net cash on the balance sheet, we believe Alibaba trades at closer to 11x. This is astounding for a company with multiple growing streams of business and around US$15B of annual operating profit, which will continue to compound at >10% annually over the next several years. 

Also in 2021, we took some weight off Maersk to manage valuation risk. Having said that, the company continues to remain an above average weight, as in our opinion, a 1.8x P/B is not egregious given what is going on in the end market. For reference, Maersk traded well above 2x prior to the 08/09 downturn. 

 

Fixed Income

Ric Palombi, CFA
Director of Research, International Equities 

Watching
Looking back, 2021 was a difficult year for traditional fixed income investors as yields rose with COVID-19. Central bank and inflation headlines were also quite volatile. In the end, bonds succumbed to higher yields and posted a rare negative return, with the FTSE Universe returning -2.54%. Corporate bonds fared better, but they too were negative returning -1.34%.

There were, however, a couple of bright spots. First, Real Return Bonds, which benefit from higher inflation, returned 1.84%. Second, the much-maligned asset class, preferred shares, proved to be a boon for fixed income investors as the S&P/TSX Preferred Share Index (TXPR) was up 19.3% for the year. Floating rate preferreds, which are the most sensitive to rising rates, returned an eye-catching 53%.

Thinking
What about 2022? As we embark on this new year, we expect a couple of themes we spoke about last year to be amplified. First, we’ve been watching a yield curve that’s flatter today than it was a year ago. Figure 9 shows the difference in yield between the U.S. 10-year and 2-year bond. (We use this spread to illustrate the degree to which fixed income investors are pricing Fed rate hikes, and the potential for a Fed misstep in raising rates too far too fast.) We believe the probability that the Fed will raise rates is high, but also think the market is incorrect in its assertion that the Fed will be too aggressive in hiking interest rates. All in, this should mean that the curve is too flat and should steepen in 2022.

Figure 9: Yield difference in U.S. 10-year and 2-year bonds
 


Historically, there was a tight correlation between inflation forwards (the market’s expectation for inflation) and bonds. A notable break in this relationship was seen in 2012, where forwards moved higher, but bond yields didn’t follow. We think this was the result of the Eurozone crisis, where policymakers flooded the market with liquidity, keeping bond yields subdued. Eventually, the gap closed from both sides. In 2021, breakevens (future inflation expectations) remained stubbornly high as pervasive inflationary pressures kept investors on edge. 

As 2022 begins, we’re seeing signs that inflationary pressures are beginning to abate and breakevens should begin to roll over. This should also mean higher 10-year bond yields, and once again allow the gap to close from both sides (Figure 10).

Figure 10: U.S. 10-year breakevens and 10-year bond yield 
 


Doing
As 2022 begins, we think the economic impact of COVID-19 will continue to fade, and the global economy will continue to heal and return to its longer-term trend. In turn, interest rates will continue to normalize. Moreover, as inflation expectations recede, lowering the probability of central bank mistakes, bond yields will continue to adjust. We believe our fixed income portfolio is well positioned to protect and enhance client purchasing power, while balancing the need for income and capital appreciation.