The main story dominating the
markets in 2022 has been inflation and the reaction of central bank to try and
control it. The actions of the central bank, in particular in the US, combined
with geo-political turmoil in Ukraine as well as continued supply chain
disruptions, have made the last year a harrowing experience for most investors.
After seven interest rate hikes
in the US and Canada we began to see relief in the Consumer price index and the
job markets in both the US and Canada during the final quarter of 2022. As a result,
both central banks lowered the amount of rate increase in January of this year.
In the US Powell raised, for an eight time, by only 25 Bps while signaling
similar smaller hikes going forward while the Bank of Canada raised 25 Bps for
its eighth raise in January but has put a pause on further increases for the
time being. In a recent meeting with the US congress Powell observed that so
far in the new year economic data has come in stronger that expected and he has
raised the prospect of larger increases for longer in the US. This has tempered
a stock market rebound that began in January and we are returning to an
environment of uncertainty regarding the path of markets and the economy.
Despite the continued strength in the economy particularly in the US investors
are concerned about the future given that this has been one of the most
accelerated monetary tightening events to date.
This concern of investors is
reflected in the state of the yield curve which is steeply inverted. The yield
curve is closely watched by investors because previous inversions have preceded
recessions. When inverted the yields of short-term treasury bonds are higher
than yields of long-term bonds. It suggests that in the short-term investors
expect interest rates to rise but in the longer term, they believe that higher
borrowing costs will eventually hurt the economy, cause a recession, and force
the Fed to ease monetary policy in the future.
The current US treasury curve:
- Topline: TODAY
- Bottom LILE: 30 DAYS
PRIOR
This has made for a difficult
investing environment as many market participants are still waiting for the
next drop in the market and ensuing recession. The current inversion began in
July of 2022 and recently the curve has steepened the most since September of
1981. Historically the yield curve has inverted six to 24 months before each
recession since 1955. This situation is further is made more confusing because
we are still seeing the continued strong performance of the labour market and
solid financial performance of many companies that have reported earnings and
supplied strong forecasts in the first quarter of 2023. If a recession is looming
its arrival will be difficult to predict.
Areas of the market are still
seeing declining inflation. Commodity inflation continues to decline or stabilize,
in Canada energy costs, while still high have declined 17.2% since June, natural
gas after a brief spike in February has declined. Food input prices have been a
major headline through 2022 and into the new year, especially grain prices, which
spiked early last year after Russia’s invasion of Ukraine. Grain prices in the
US are down from last year’s highs and are continuing to decline at the time of
this writing.
Of particular note is the Baltic
Dry which has plunged approximately 77% since October of last year and reached
a bottom in February this year and has recently rebounded from its February low. This could be a
positive for the economy as the Baltic Dry is generally regarded as a leading
indicator for future growth. Another leading indicator for economic growth is
Copper, which has seen prices rebound since December. The bad news for the
markets is that recent new Job openings report in the US has come in stronger than
expected and that suggests that labour costs may continue to rise and may
contribute to the need for continuing the increase of interest rates in 2023.
As discussed previously, we are starting to see results of
the Federal Reserve’s restrictive policy in the money supply. The chart below
shows that the M2 money supply, which includes currency and coins held by the
non-bank public, checkable deposits, savings deposits under $100,000, and
shares in retail money market mutual funds, has returned to pre-pandemic levels.
Market strategists from Morgan Stanley, JPMorgan and Goldman
Sachs are still calling for a double digit drop in the S&P but have moved
their forecast for this to occur later in 2023. The general reasoning is that
forward Price Earnings ratio estimates are still too high and that the market
has yet to price in a slowing economy due to the FED’s interest rate hikes and
that the FED will not be able to navigate a soft landing. The thinking is that
quarterly earnings reports will be a huge disappointment to the market and so
far they haven’t been. So we remain in this frustrating position of waiting and
wondering.
To position for a possible recession and decline in equities
the portfolio continues to keep levels of cash elevated and looks for
opportunities to rebalance by trimming overweight positions that have
significant capital gains. Positions of its growth holdings have been reduced
to only holding the highest conviction stocks while directing more money
towards stable dividend paying stocks. By keeping cash levels high the
portfolio stands ready to act as buying opportunities present themselves. Further,
if strategist’s forecasts do not come to pass the portfolio has invested in
call options on attractive investments so that opportunity isn’t lost in the
case that the market continues to move higher.
Portfolio Highlights
The portfolio re-tested the October lows and declined by
-6.73% for the month of December versus depreciation of -5.32% for the
benchmark and declined 30% for the year end 2022 versus a decline in the
S&P of -19.44% and -8.66% in the S&P TSX composite. Performance drag in
December is attributable to the overweight holding in Apple which held its
value relative to the broader market for most of 2022 but declined more than
11% in December contributing more than -1.0% of negative performance to the
overall portfolio. Further underperformance came from Shopify which gave back
most of its COVID gains. The portfolio is overweight growth stocks in the
technology sector and this sector contributed to approximately 8% of the
portfolio’s overall decline.
Many of the growth and tech stocks such as Shopify and
Amazon contributed to the gains earned during the pandemic years 2020 and 2021
and much of these gains were taken back in 2022. This was due in part to the
rise in inflation and interest rates. Higher rates and inflation increase the
discount rate that these investments are valued with and thus reduce the value
of the discounted future cash flows. Looking deeper into the sell off in these
growth investments we find that there was an imbalance in the risk spectrum. Two
factors contributed to this the first and most obvious: the decline in interest
rates brought about by the COVID pandemic leading up to 2022 which lead to
lower discount rates and higher stock prices in general and for growth stocks
in particular.
The boom in the growth sector was fueled by the emergence of
new disruptive technologies such as AI, cloud computing and Fintech which had
been developing for years in the Venture capital markets and private equity
markets. At the same time many institutional investors were looking to
overweight higher risk assets to counter lower returns available in the stock
and bond market. The below graphic is a good demonstration of the risk spectrum
and the where various assets fall along the spectrum, many institutional and
HNW investors leaned heavily to the right side of this spectrum:
The next graphic shows the rapid and exponential rise in
private equity and venture capital leading up to 2022 as investors leaned
toward the right side (highest risk) of the risk spectrum. Many of the venture
capital investments find their payday as IPO’s in the public markets and this
period saw the largest amount of IPO activity since 2007. This led to a
condition ripe for a big pull back in these companies and when inflation
started to rise and investors began a shift to the left side into lower risk and
real assets. The graph below illustrates the rapid rise in VC private
investments from 2010 to 2021 many of which were released as IPO’s in the
public markets:
The fall in prices of growth and tech investments was
exacerbated both by rising interest rates and an oversupply of these types of
investments.
Now that we are through the initial collapse in value on the
growth side of the portfolio (we hope) it is good time to review why these are
good investments for the long term.
As mentioned earlier many of the growth companies we invest
in are at the vanguard of new technologies and many of these technologies will
be in demand in the future. One aspect
to consider is that world population appears to be entering a period of
decline. Fertility rates are declining throughout the world, for example South
Korea now has the lowest fertility rate .8 per woman - one full bay short of
the replacement rate of 2.1. China and the Philippines are experiencing similar
declines. Developed countries such as Japan, have been experiencing declines
for years now. Although countries like Canada are trying to keep up by
increasing immigration quotas this will become less effective over time as
world population declines and immigration levels decline with it.
Many of the technologies will assist with worker
productivity in the future as the work force continues to shrink. Companies set
to do are those that are in the fields of artificial intelligence, cloud
computing and cyber security. Companies that create CRM systems and companies
that develop technology that increase efficiencies should continue to have continued
business growth over time. The portfolio contains stocks that have exposure to
all these technologies.
In the decision process involved in choosing companies for
the growth side of the portfolio. We screen to look for stocks with high
possible future earnings potential as well as potential to capture large
proportion of market share in their given industry. Stocks chosen generally
will have revenue growth in excess of 10% - 20% or more per year. Additionally,
the fund screens for companies that are growing free cash flow. As well the
fund looks for committed management teams with personal wealth invested. The
growth stocks in the portfolio carry low to no debt, are either profitable or
they are incrementally closing in on profitability.
As the population decline plays out it will most likely pay
to have a portion of the portfolio invested in industries that will benefit and
not suffer as much as other traditional business might. The market may already
be recognising this as well. Many of the better companies in these areas have
fallen in price considerably in the last year and are considered to trading at
discounts. The NASDAQ has been starting to show signs of recovery and has been
having stronger days while other indices are declining. A key support level
will tell if this plays out over time:
In the chart above the QQQ ETF which serves as a proxy for
the NASDAQ the yellow arrow marks a key support level around the 200 day moving
average at about the 290 price point. The yellow arrow below shows a buy signal
given by the Stochastic RSI, one of the more reliable technical indicators. A
significant drop below this support would suggest that the market sell-off will
resume and that it is not time to increase weight in the tech sector. The risk
is that the resistance levels hold and we miss out on the potential gains. The
portfolio is hedging the risk that the NASDAQ will continue to outperform using
call options.
Besides technology another theme of the portfolio is
infrastructure. In the US the infrastructure rebuild will continue for several
years and some have noted that it is creating a stimulative effect and could be
contributing to the inflation and strong labour market. The portfolio has
exposure to this theme through three US stocks ( Carlisle, Valmont and Watsco)
that have had stellar financial results in the final quarter of 2022 all
companies are expecting to have strong results in the coming quarters.
Shares in Apple are the second largest holding in the
portfolio after cash. The Apple position
has been rebalanced to bring the weighting under 10% of portfolio assets and
the portfolio aims to rebalance any holding once it exceeds 10% of portfolio
value. The portfolio continues to keep cash levels high with its holding weight
10.61% in January. Until the inflation
problem subsides the portfolio still maintains a weighting in defensive sectors
such as utilities and consumer staples and discretionary. If, however interest
rates continue to climb it may be prudent to trim positions in Utilities as
similar yields could be found in debt instruments with less risk.
ASML Holdings which benefited from a change in market
sentiment for the semiconductor sector. ASML was up about 12.05% for the month
of December. ASML is based in the Netherlands and has faced headwinds from cost
inflation and supply-chain bottlenecks. For long term investors ASML represents
a strong growth potential driven by global megatrends in automotive,
high-performance computing, and green energy transition while at the same time
providing Canadian investors with European diversification. Further strength
was seen in the Materials sector with Teck Resources up 40% on the year and this
continues to be a favorite to benefit from the rising price of copper. Copper
is a key input into the manufacture of electric vehicles and TECK has ample
production with a strong competitive position there are no new mines globally
and it would take about seven years for a competitor to develop a new one.
Further weakness came from Amazon which has given back all
its “COVID” gains and was off 12% in December. Analysts feel that its sell off
is overdone and that could perform well into 2023.
Stocks saw a strong rally in January and tech stocks led the
way. The portfolio returned 7.34% versus its benchmark return 6.69%. Hopefully
as the year unfolds there will be continued improvement in market conditions
but there seem to be endless headwinds.
Going forward we are likely to continue to experience
volatility and declining markets if S&P earnings falter in 2023. At the
time of this writing Jerome Powell has taken on a more hawkish tone in terms of
intimating that the size of interest rate hikes could be larger and that the
ultimate interest rate could be higher than thought. Until there is continued
visible progress with inflation we will expect market conditions to be
difficult in the coming quarters.