Rising inflation, continuing labour shortages, the ongoing war in Ukraine and persistent supply chain issues weighed on equity and bond markets during the second quarter. Risk-off was a persistent theme as equities underperformed bonds, corporate debt underperformed government debt and cash held in best. Amidst growing expectations that inflationary pressures will persist, the US Federal Reserve increased rates by three-quarters of a percentage point in June – their most aggressive move since 1994. G10 central banks worked in near unison last month, with more rate increases than at any other point in the past two decades. Monetary authorities are clearly communicating to market participants that they will do whatever it takes – including increasing the risk of recession – to get a better handle on today’s inflationary pressures.

QV operates with a risk managed investing framework at our core. We construct portfolios based on the principles of strong balance sheets, valuation support, above average income generation and high quality. Although price declines are not entirely avoidable, retaining more value in challenging periods sets the stage for long term wealth creation. The importance we place on risk management was on display during the most recent quarter with all QV strategies meaningfully outperforming their respective benchmarks year-to-date.

LABOURING INFLATION

Consumers are getting squeezed. In May, the US Consumer Price Index (CPI) rose 8.6%, the highest since 1981, while shelter costs – which comprise around 1/3 of CPI – rose at the fastest pace in 31 years. Pent up pandemic savings are being used to fund daily living expenses such as groceries, gas and housing. Wages have been rising at an above average rate but not at the same pace as the rising cost of living. As a result, workers have less real income today than a year ago. Retail inventories of consumer goods – from clothing to hardware – appear well stocked but stickier aspects of inflation such as labour and shelter, combined with supply shortages and logistical challenges augmented by the invasion of Ukraine suggest to us that there is a real possibility that some components of inflation could remain higher for longer.

In an indebted developed world with rates now rising rapidly to combat inflation head on, risks have tilted towards economic deterioration at the expense of inflation getting further out of control. However, containing inflation at 2%, the explicit long-run inflation goal of central bankers, seems unrealistic without a substantial deterioration in housing, a marked improvement in labour dynamics, supply chain normalization and resolution to the conflict in Ukraine.

EXPOSED EARNINGS

In the most recent quarter, equity valuation multiples contracted swiftly. Looking back over the past fifteen years, the S&P 500 has only experienced forward P/E contractions of a greater magnitude during the Financial Crisis and the early stages of the pandemic. In an environment of 3-4% interest rates, market valuations no longer look that expensive using trailing 12-month earnings. Markets are forward looking and appear to be pricing in greater odds of a recession in the near term. As such, earnings – not valuation – now appears to be the greater risk. We have seen several notable cracks emerge in earnings estimates during the past quarter, from pandemic beneficiaries including Netflix to consumer bellwethers such as Walmart. We have also seen leading economic indicators deteriorate swiftly. Record earnings induced by unprecedented amounts of monetary and fiscal stimulus during the pandemic era appear increasingly vulnerable. In past recessions, aggregate market earnings have faced declines of approximately 20-30%. Investors should be prepared for the possibility of broader market earnings deterioration of this magnitude. While our strategies are not immune to recessionary risks, by analysing financial records of the businesses we own during recessionary periods and overweighting economically resilient businesses we believe we are relatively well positioned.

GEOPOLITICAL RISKS REMAIN

The outbreak of war in Ukraine has disrupted the prior world order while placing global supply for energy and agriculture in disarray. In early June, the OECD slashed its outlook for global growth from 4.5% to 3% and doubled its inflation outlook to nearly 9% for its member countries, citing the greatest change as the economic impact of the war in Ukraine. The latest Financial Stability Report from the Bank of England echoed these risks with an outlook for the UK and global economies that has materially deteriorated from prior expectations. Following Russia’s invasion of Ukraine, global inflationary pressures have intensified sharply. These pressures largely reflect the steep rise in energy and other commodity prices and continued widespread disruption to supply chains. What the report didn’t highlight but is being witnessed acutely in UK politics at time of writing, is that economic instability fuels political instability. It is realistic to expect augmented political instability as we move forward in an environment of negative real wage growth.

OPPORTUNITIES

For much of the post Financial Crisis era, we have often heard that there is no alternative to equities as bond yields approached record low levels. Individuals in need of income were forced further out on the risk curve to generate income they had previously been accustomed to in government bonds. During Q2, rapid increases in bond yields resulted in income offered from our bond strategies reaching levels not seen in nearly fifteen years. For those with more immediate needs for income and stability, fixed income markets are now offering a much more attractive alternative to equities than we have seen for some time.

Diversity is also an investor’s friend. Those that did not catch the bitcoin bug and go all in on what may be remembered as the tulip mania of this era are well positioned to take advantage of increasingly attractive long-term opportunities as they arise. 2021 was a record year for capital raises, IPOs, and cryptocurrencies. A number of interesting concepts received funding; some no doubt will provide lasting benefits but very few have earnings support today. As last year’s wave of speculation comes crashing to reality, fundamentally strong companies are increasingly getting caught up in the surf. Businesses with strong competitive positioning are more and more attractive from a long-term return perspective as broader market fear sets in.

PORTFOLIO POSITIONING

Higher fixed income yields and the rising risk of economic weakness caused a further tweak to our asset mix during the most recent quarter. QV’s global balanced strategy equity target is now 55% after having steadily declined from 66% since the spring of last year. The latest move augments both cash and fixed income. Within our bond strategy, we have increased duration, allowing for more protection in the case of economic weakness at a time when central bankers appear to be finally taking inflation risks seriously. Longer term, earnings yields and pricing power should allow for greater returns from equities, but at this time, there appear to be too many late cycle indicators mounting to warrant a greater allocation. Until we see signs that the economy can navigate successfully through the attempts to break inflation, a more cautionary stance towards riskier assets appears warranted. Within equities, we are circumspect when it comes to business models that benefited from an outsized boom during the pandemic. We are equally unnerved by those with too much debt going into a period where funding growth with external capital is becoming increasingly expensive. Companies providing desirable services and growth with internally funded cash flow appear increasingly compelling today for long term investors such as ourselves. Our equity strategies have been deploying capital in select opportunities as they develop.