“…no one expects that bringing about a soft landing will be straightforward in the current context—very little is straightforward in the current context.”
-Jerome Powell, Chair of the Board of Governors, US Federal Reserve, March 21, 2022
The invasion of Ukraine by Russia on February 24th added significant complexity to an already intricate economic backdrop. Before the invasion, inflation was running at multi-decade highs while the US labour market simply plowed through the Omicron wave. Last month, the US posted a record number of job openings for each person looking for work. Closer to home, before war erupted in Ukraine, Canada’s CPI inflation averaged 5.7% in February. This was the second consecutive month that headline inflation exceeded 5% and the largest year over year gain since 1991. Russia’s actions have exacerbated upward pressure on both energy and food related commodities. WTI, the North American oil benchmark, appreciated 33% in the quarter while wheat and corn prices climbed close to 30%. Persistently elevated and broadening inflation is in sharp contrast to what central bankers anticipated at this time last year. These pressures increase the risk that longer-run inflation expectations will continue to drift upwards. In response, central bankers have slowly begun to tighten monetary policy. The Bank of Canada began a rate hiking cycle on March 2nd, raising interest rates 25 basis points, with the US Federal Reserve following suit several weeks later.
LABOURING FOR MORE
As central bankers have been late to address inflation, we’ve seen increasing signs of labour taking action to combat the rising costs of living. During the quarter, Amazon workers won a battle to form their first US union while Starbucks employees also increasingly voted in favor of unionization. In Canada, CP Rail employees went on strike before agreeing to arbitration to end a multi-day work stoppage. While cost pressures persist in a very tight labour environment, one should expect further labour demands to continue supporting higher-for-longer inflation expectations.
In QV’s Q3 2021 update, we worried out loud that many investors were too far out on the duration curve in both bonds and equities without fully appreciating the risks. In short order, we have seen these risks come home to roost. Canadian 10-year treasury yields increased 98 basis points during the quarter. 0.98% by itself is not a large number but given the low starting point and degree to which bond benchmarks are long in duration, this jump produced the weakest quarter for Canadian bond markets in at least forty years.
The rising bond yield environment also wreaked havoc in equity markets, particularly for stocks that have relied on interest rates remaining very low to justify their current valuations. Consequently, investors that have been investing heavily in growth stocks at any price have faced substantial volatility and underperformance. On the flip side, resource companies that are facing strong near-term cash flow have outperformed considerably. Led by abundant resource representation, the year-to-date performance of Canadian equity markets has shone on the global stage.
An environment that is heavy in inflation while demand outpaces supply is supportive for Canadian resources. More importantly, with democratic values aligned with our Western allies, Canada can play an important role in providing secure energy and food supply. Although supply constraints remain aplenty, investors need to be mindful that the demand side of the equation is dynamic. Rapidly rising prices will reduce demand and have an impact on economic growth. We must respect the age-old adage that the best cure for high commodity prices is high commodity prices.
Russia’s markets were closed for nearly a month during the quarter and index providers have removed Russian stocks from their indices. QV has not had any direct investments in Russia in any of our strategies. For businesses we own that have assets in the region, our understanding is that the vast majority of these local operations have been suspended and/or shut down. Overall, we see our exposure to the region as manageable in the face of current events. However, contagion risks are serious, and the situation remains fragile. Investment risks associated with geopolitics are admittedly hard to determine and more susceptible to emotional influences.
We have also heard the bullish case for “buying at the sound of the cannons.” Those that hold this view argue that, as tragic as violent conflicts are, markets quickly marched higher after past Russian aggressions in Ukraine and elsewhere. This view appears biased and incomplete. The current situation has greater implications for global peace, energy, and food supply than any major conflict since World War II. During that period, US investors continued to face losses and heightened volatility for several years, from the fall of France until markets bottomed out in lockstep with victory at the Battle of Midway. While we hope for swift and diplomatic resolution of the current conflict, we must be prepared for more challenging outcomes. At a minimum, events of the last few months have accelerated calls for onshoring of supply chains, national security and energy independence while expunging Russia from the Western economy.
ESG (environmental, social & governance) based investing has been rightly criticized over recent months. One study showed that ESG funds in aggregate held more than twice as much Russian oil & gas production as Canadian production at the beginning of this year. The continued need to reduce global emissions in a thoughtful manner cannot be deemphasized, but it has become obvious that social stability, security, and strong governance need greater emphasis alongside carbon metrics.
The bond market’s yield curve has flattened swiftly, signalling a slow down in economic activity. These signals are prone to false starts but appear to make sense as stimulus from record low interest rates has abruptly faded while the cost of food, transport and accommodation has soared to new heights. Although central bankers will attempt a soft landing, we must recognize they are operating in an environment very different than any other point in the past thirty years. Investors should be prepared for the possibility that central bankers could induce a recession as monetary policy tightens, but also that they will have limited resources to provide market stability when a recession eventually does take hold.
Strength in our equity strategies over the past year and climbing bond yields led us to rebalance our asset mix in the latter part of the quarter. In doing so, we brought our equity target weight down slightly in QV’s global balanced fund model to just under 60%. This move provides more balance in an environment where the probability of higher risk outcomes, whether economically or geopolitically induced, have grown. For the first time in a number of years, bond yields are now competitive with equity dividend yields. Our bond exposure, which remains lower in duration (less interest rate risk) compared to market averages, should provide more stability if more volatile economic times take hold but won’t offer the same amount of inflation protection that we expect from our equity holdings. Within our equities, quality compounders that have been caught up in recent market volatility have been prioritized for investment consideration, while those reflecting lower quality or heightened valuation risk have been sources of funding for new purchases. Businesses with pricing power and opportunities to improve productivity appear best positioned to withstand near-term pressures while building lasting long-term value.
We recognize that most market participants, our investment team included, were not investing during the inflation-heavy 1970s and few people in today’s population were alive during World War II. To gain better perspective for investing during hardship, we have taken time to study these periods that indeed exhibited heightened volatility and challenging stock markets. Emotionally driven investing proved quite costly during these times. In combination with QV’s risk managed approach to investing, which prioritizes fundamentals over momentum and emotion, our portfolio construction in attractive businesses with diverse economic and geographic exposures should provide demonstrable benefits if inflation and/or geopolitical tension persist.