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In The Later Innings

2022-12-09, Clement Chiang

As temperatures drop and holiday themed coffee cups roll out, we take stock of a historical year stuffed full of policy rate hikes. North American central banks have arguably been busier than Santa’s workshop in delivering jumbo sized hikes to cool down scorching hot price pressures. The economy continues to operate in excess demand with a strong labour market supporting robust consumer and business spending. Inflation needs to be controlled as headline inflation readings of 6.9% y/y in Canada and 7.7% y/y in the U.S. for October still remain well above their central bank targets of 2%. While inflation in both Canada and the U.S. look to be gradually slowing, their persistency at elevated levels have compelled the Bank of Canada (BoC) and the U.S. Federal Reserve (Fed) to thrust policy rates higher, even if it means at the cost of economic expansion. After all, they have a mandate to maintain an inflation target. This Wednesday, Governor Macklem announced another 50bps policy rate increase, raising the BoC’s overnight rate to 4.25%. Considering the policy rate started the year at 0.25%, 4% of cumulative rate increases over a span of ten months is a blistering pace when compared to past hiking cycles. Same goes for the U.S. Fed, 3.75% of rate hikes over a span of ten months is also an atypical pace, as shown below. While we are upfront about our shortcomings as macroeconomic forecasters, we acknowledge that historical precedent does not support a favourable outlook when central banks hike as much as they have.

Source: Bloomberg, QV Investors Inc.

Our indicators suggest that we are in the later innings of this business cycle. We believe a cautious stance is warranted, especially if central banks continue pressing ahead with their rate tightening agenda despite what looks to be an unsustainably high level. Businesses and consumers are simply not used to this higher cost of borrowing, particularly after such a long period of near zero interest rate policies. It appears like the rosy soft landing scenario may be a lower probability event after considering its poor track record in achieving this. A soft landing is when economic growth decelerates just enough that a recession is avoided, and inflation returns back to target. Akin to the perfect airplane landing when passengers barely feel the impact of the wheels touching the runway. Recall, monetary policy works with a lag, as rate hikes typically take around four to six quarters to flow through the system before showing a material effect on aggregate demand. Meaning that tangible signs of deceleration may not be experienced until later 2023 or even 2024. However, we admit that macro forecasting is a mug’s game, and one that is extremely difficult to get right consistently. We strive to reflect on our macro views but avoid allowing them to overwhelm our bottom-up fundamental convictions during our decision making. The compounding abilities of our quality franchises will continue to be our primary source of wealth creation. But if we recognize that there is a growing probability of a potential negative inflection point ahead, striking a prudent balance between the two may just be the sensible approach to take.

Thankfully, fixed income is finally a reasonably attractive asset class with bond yields back to where they were pre financial crisis. Investors do not have to take on much risk to earn a decent return. The higher yield potential (starting bond yields tend to be a good indicator of future returns) is not only inviting relative to what has been offered in the prior decade, but other benefits like capital preservation, portfolio diversification, and liquidity are all attributes that could be advantageous during a market drawdown.

Our asset mix committee continues to recommend a more conservative stance in the context of our balanced strategies. We remain confident in the durability of our invested businesses and the compounding characteristics they offer to long term investors. Furthermore, attractive buying opportunities do not come around very often. Markets tend to overshoot fundamentals when investor sentiment sours. In our experience, it is during these market events when thoughtful investment teams armed with both a prepared mindset and vetted opportunity set are in a prime position to capitalize on price dislocations.
It is important to understand that our strategies are not the market. Our investment process and philosophy has weathered market cycles in the past. But when accounting for historical precedent, the temperamental nature of markets, and the resilience of our franchises, we believe the prudent risk managed approach during these later innings is to remain invested, exercise patience, and be prepared for what could be better entry points to come.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Clement Chiang | VP & Portfolio Manager, Fixed Income

Clement oversees QV’s investment process and makes portfolio decisions for the fixed income strategies.