As the effects of the pandemic faded early in the year, rising inflation, interest rates and geopolitical instability became the dominant themes driving equity markets and the economy. Inflation surged to the highest level in more than four decades, peaking above 9% in June. The US 10-year government interest rate rose 152% to 3.8%, reaching the highest level since 2008 at its intra-year peak. After initially failing to respond to growing inflationary pressures, the Federal Reserve embarked on one of the most rapid rate hiking cycles in history. Assets repriced sharply in response. The S&P 500 had its seventh worst year since 1928, falling 18.1% in USD; the technology-heavy Nasdaq fell 33% with over 50% of its constituents falling more than 50%; and the 10-year US treasury declined by 15.2%, the worst return for US treasury bonds in data going back to 1928. Canadian stocks were much more resilient, falling just 5.8% in CAD as the TSX benefitted from its large exposure to energy and lower exposure to highly valued areas of the market. The great wave of speculation which rose in 2020 and crested in 2021, came crashing back towards reality in 2022 as rising interest rates injected reality into a mania that rivalled the dot-com bubble both in its ascent and its decline.
Source: Bloomberg, JPMAM. November 30, 2022
RISK MANAGEMENT PROTECTS CAPITAL
In a very difficult year for both stock and bond markets, QV’s risk-managed investment philosophy was on display. All of QV’s strategies outperformed their respective benchmarks for the second year in a row.
The importance of QV’s equity outperformance in 2022 was especially notable for balanced strategy investors given the pressure on bonds from rapidly rising interest rates. Typically, bond prices rise when equity prices fall, dampening volatility in a balanced portfolio. In 2022 however, deep losses occurred in both bond and equity indices. A portfolio split 60/40 between the S&P 500 and US government Treasuries fell nearly 17% in 2022. For context, this is the worst outcome for such a portfolio since 1937. Our investment process has always prioritized a balanced allocation of capital, both within our asset mix and through the duration and diversity of our bond and equity holdings. This is an important reason why our balanced strategy did a better job preserving client’s capital during the worst environment for bonds in modern history.
THE COVID ECONOMY IS GONE BUT IT IS NOT BUSINESS AS USUAL
Both the pandemic itself and the policies which arose in reaction to it severely distorted global economies and markets in 2020 and 2021. Unprecedented fiscal stimulus created a sugar high in consumer demand when supply chains were crippled, and the labour supply was constrained. The 43% rise in the US money supply since 2020 fueled a bubble in asset prices. These distortions have now been mostly digested however and classic late-cycle economic signals are now abundant.
The consumer looks increasingly fragile. Inflation-adjusted consumption is anemic and balance sheets are deteriorating as debt levels have been rising while excess savings from Covid related stimulus are on pace to be depleted by mid-year. Meanwhile, the price of major purchases has risen dramatically. In the US, the cost to service a new 30-year mortgage has risen 75% since the start of 2020 given the increase in house prices and interest rates. As a result, the US Pending Home Sales Index has fallen more in 2022 than in the two years prior to the collapse of the 2008 US housing bubble. Employment remains high but at peak-of-cycle levels. As layoffs have begun to rise, the ratio of job openings to job seekers, a late-cycle leading signal, is now declining. Manufacturing activity is also decelerating. Meanwhile, the yield curve, an indicator that has accurately predicted recession over 80% of the time, is in deeply negative territory.
Inflation has been falling since the summer, and given declines in commodity prices, shipping rates and money supply growth since June, it will likely drop meaningfully in 2023. As inflation falls, expect the Federal Reserve to pause rate hikes during the year. Market expectations currently anticipate the federal fund rate to peak at ~5%. While an end to rate hikes could cause some short-term optimism in markets, history suggests this is little reason to assume an all-clear signal. Recessionary concerns are widespread. Over 45% of economists now predict a recession in 2023, making it the most forecast recession in more than 50 years. The catch is that most generally expect a short, shallow recession. Few are predicting it could be deeper or more prolonged. While investors may think of 2008 when they hear the word recession, it’s important to remember 2008 was a unique anomaly driven by systemic issues. It’s altogether possible that rather than a deep drop off in economic activity, real growth remains elusive for some time while inflation remains structurally higher than in past decades.
How the Fed responds to declining inflation and decelerating economic activity is a crucial question. If the Fed eases too quickly, it risks reigniting inflation before it has been stamped out. In the 1970’s, this resulted in a violent seesaw pattern for both inflation and stock markets over a period of years. If the Fed remains staunch in holding rates high as Jerome Powell has signalled he would to ensure inflation fully reverts to the Fed’s 2% target, then investors may be in for an unwelcomed surprise after growing accustomed to central banks backstopping falling stock markets with lower rates.
GEOPOLITICAL UNCERTAINTY IS LIKELY A NEW REALITY
The outbreak of the Ukraine war appears to have signalled a new stage in the fracturing of the global geopolitical order. While a ceasefire is possible, it won’t negate the fact that after decades of relative peace, the world appears to be devolving into a much more unstable system of opposing regional powers. This suggests conflicts will become much more common, but these can take many forms. The recent US sanction on high-end semiconductors to China is a meaningful escalation of an economic and technological trade war. It comes at a time when China has become increasingly committed to assimilating Taiwan, home to TSMC, the world’s leading semiconductor company which manufactures many of the chips which power modern economies.
The repercussions to the fracturing geopolitical order are many. As TSMC’s founder recently said, “globalization is almost dead.” Companies were already re-localizing supply chains in response to the fallout suffered by Covid. Geopolitical tensions are now accelerating this trend. The rise of globalization has had vast benefits for global trade, profit margins, and disinflation. The world may find the inverse is also true. As the Ukraine war has shown, conflict can destabilize regional economies while driving shortages that spur inflation. In a more unstable world, such challenges and the associated volatility they cause look likely to persist.
MARKET OUTLOOK AND POSITIONING
In many ways, the current environment is reminiscent of the early 2000’s, which was characterized by decelerating economic growth and stock markets that were broadly expensive but had numerous pockets of opportunity where resilient businesses could be owned at attractive valuations. This period was a very attractive environment for value-conscious investors like QV. After a decade of underperformance prior to 2022, the TSX and several international markets look extraordinarily cheap relative to US stocks at a juncture where the trend in US corporate earnings is negatively diverging.
Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management,Guide to the Markets – U.S. Data are as of December 31, 2022
We believe our equity strategies stack up well in this context. They retain valuation advantages relative to their benchmarks. We have avoided big beneficiaries of Covid where valuations and earnings outlooks appear vulnerable, as well as balance sheets at significant risk from higher interest rates. Business quality and compounding rates remain attractive. Collectively these characteristics provide differentiation and downside protection. Our bond strategy now offers a 4.5% yield, the highest since 2008. It remains composed of a mix of government bonds and high-quality corporate credits. This positions it to provide stability in client portfolios in a weakening economic environment as well as a reasonable income stream. Our asset mix was unchanged during the second half of the year after having been steadily reduced starting in the spring of 2021. The current mix strikes a balance between the income generation and defensiveness of our bonds while still respecting the equities’ value and long-term compounding potential. Importantly, the current mix provides flexibility to increase our allocation to stocks should prices meaningfully diverge from underlying value.
Much as in 2022, we think risk management will drive differentiated outcomes in 2023. While we aren’t overly optimistic on the broader market’s prospects, we see value in our strategies.
Thank you for your ongoing support, we wish you all the best in 2023!
* QV Benchmark Information