It was a turbulent quarter for assets as aggressive monetary tightening rippled through markets. Bond yields rose to levels not seen in over a decade, equities reached new bear market lows and the USD rose rapidly, reaching a 20 year high relative to other developed market currencies. After a short-term bounce for equities to mid-August, risk-off became a persistent theme into quarter end. Investor sentiment deteriorated as central bankers showed no sign of flinching from their inflation snuffing stance that accelerated in earnest in June. The US Federal Reserve implemented two additional 75 basis point increases during the quarter, raising the Federal Funds rate at a near unprecedented pace. During the last rate hiking cycle (2015-18), it took 3 years for rates to rise as much as they have in the past four months. After being too slow to initially react to inflation, markets are increasingly signaling that the Fed’s assault on inflation is now moving too fast.

Canadian equities outperformed other developed markets during the quarter. Canada is benefiting from its rich natural resources and being an ocean apart from the war in Ukraine. European markets struggled as they face the realities of being short energy and near Russia during these tumultuous times. In recent years, Canadian equities had underperformed US and global markets, but in the current backdrop, the benefits of Canadian exposure in a diversified portfolio have been increasingly evident.

INFLATION TRANSFORMATION

Inflation measures remain high but have been evolving quickly. On one hand, consumer goods inflation appears to have peaked as retailers and distributors that were recently struggling with supply chain management have stocked up and now ironically face the risk of an inventory glut. Look no further than Nike, which saw its North American inventories surge 65% in its most recent quarter. There are plenty of shoes out there but is anybody running to buy them? To incentivize demand, consumer facing businesses are likely to lean more on price as we enter the critical holiday season. Gasoline prices have also peaked with WTI retrenching over 20% in the most recent quarter. On the other hand, the cost of shelter has swelled. Families with variable rate mortgages have been hit particularly hard with ballooning monthly interest costs.

PASSING THE BATON

In some ways, the inflation baton is being passed from the consumer to the corporation. With rampant wage inflation, consumers are finding some reprieve from higher day-to-day living expenses. Most recently, wage inflation in the US reached levels not seen in decades, reflective of a tight post pandemic job market.

Source: Federal Reserve Bank of Atlanta, Current Population Survey, Bureau of Labor Statistics

Wage inflation data should ease alongside decelerating economic growth and the lapping of comparable inflation statistics which really started to rise around this time last year. Although job market data has thus far been resilient, we witnessed more companies slow hiring plans in the third quarter and, in some cases, implement job cuts. To date, most layoffs have been stemming from pandemic highflyers, ranging from Netflix to Robin Hood to Shopify, as consumers pivot from virtual consumption back to in person purchases. Corporate profit margins have been very impressive, reaching record highs during the summer. Record profit margins now appear to be clearly in the rear view. Stock market weakness has been signalling a much more fragile outlook. US leading economic indicators and persistent inversion in the bond yield curve are also indicative of deteriorating economic conditions.

MIND THE GAP

Companies are now facing the pinch from wage inflation, rising interest costs and slowing demand. This is occurring while developed countries are governing on a mountain of debt. Bond investors are growing impatient. Fiscal credibility needs to be on full display from governments or bond investors will walk. Nowhere is this more apparent than in the United Kingdom. As we approached quarter end, fierce gyrations in UK financial markets occurred in reaction to an inadequate mini budget that even the IMF has criticized. UK gilt yields swiftly rose to a 30 year high. In response to the rapidly developing financial trainwreck, the Bank of England became the first central bank to flinch on monetary tightening, announcing they will carry out temporary bond buying of long dated gilts as they stand ready to restore market function. The situation in the UK supports the notion that central banks have likely gone too far and too fast. Importantly, it also demonstrates sound government policy is required to stimulate growth while supporting the citizens most impacted by rising inflation. In the short term, a slow down in the pace of monetary tightening from central bankers, combined with moderating inflation expectations could provide welcome relief for equities after a growing list of challenges year-to-date.

PORTFOLIO POSITIONING

We held our asset mix steady in the quarter after reducing our exposure to equities steadily starting in the spring of last year. Although we have maintained a more cautionary stance towards equities during this volatile period, the inflation protection that equities can provide investors over an economic cycle is appealing to us. While our strategies are in no way immune to recessionary risks, we believe our risk managed approach to investing will be helpful in navigating through recessionary parts of the economic cycle. Within equities, we continue to be circumspect when it comes to business models that benefited from an outsized boom during the pandemic. We have seen some evidence of normalization of corporate earnings in the most recent quarter, but consensus estimates for next year still appear to be too rosy.

We are also mindful of interest rate risk, as the regime of ultra-low interest rates enjoyed over the past decade appears to be no longer. Companies that have haphazardly relied on large amounts of cheap debt are increasingly vulnerable in a rising interest rate environment. For the first time in years, having a strong balance sheet may be a significant strategic advantage. Throughout our portfolios, we own numerous businesses with cash rich balance sheets. For the first time in a long time, they are generating a return on this cash while assessing opportunities for thoughtful capital deployment. Our pooled funds have above average cash weights as we too look to thoughtfully reinvest.

Strength in the US dollar appears to be more of an opportunity than a risk for our Canadian strategies. We own numerous Canadian businesses with US assets. These assets and operations are increasingly more valuable when translated back to Canadian dollars. In our return expectations for equities, we are relying on income growth and return of capital to shareholders. In an environment where interest rates remain elevated compared to the past decade, multiple expansion may be harder to come by, and we are not relying on this as a significant driver for our equity returns. Within our bond strategies, interest rates have risen to a point where they offer greater income than the dividend yield provided from our equity strategies, providing a reasonable stream of income in an unstable world. We also expect that our bonds will provide for more downside protection in the case of further deterioration in economic activity. At our core, QV operates with a risk managed investing framework. 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 foundation for long term wealth creation.