INVESTING IN UNSETTLING TIMES
Thursday, April 21, 2022
Our recent Quarterly Commentaries have focused on the market impact of inflation, interest rates and the Covid pandemic. As the economic impact of Covid recedes, a terrible new event in the first quarter of 2022 has captured the world’s attention – Russia’s attempted invasion of Ukraine. With financial and military supply assistance from the Western world, Ukraine has at least temporarily thwarted Russian President Putin’s plans to unseat its Western-leaning government; however, military analysts expect a fierce and renewed Russian military effort to seize at least some eastern regions of the country. Expectations now are for a protracted bloody conflict and for the West’s ongoing relations with Russia to be affected for years to come.
In this article we’ll assess the impact of these world events on investment markets and our investing strategy.
The Impact of Russia’s Actions on the Global Economy
Although it represents only about 1% of global economic output, Russia has a significant impact on three key global commodities markets:
1. Oil - Russia produces about 10% of the global oil supply, 50% of which is exported. This translates into a potential supply shortfall outside of Russia of 4 to 5 million barrels per day. To counter this, countries around the world are working to make up any shortfall and reduce further reliance on Russian energy.
2. Natural gas – Russia is the largest exporter of natural gas in the world, with three-quarters of its exports going to Europe. This dependency is significant for electricity, particularly in the wake of the shutting down by some European countries of nuclear and coal-fired plants.
3. Potash – Russia produces about 40% of the world’s total potash supply, which directly affects agriculture production.
In addition, Ukrainian production of a significant portion of the world’s supply of neon gas, used in making computer semi-conductor chips, has halted because of the conflict with Russia.
It is important to note that Canada is a significant producer of oil, natural gas, potash and neon gas.
The international sanctions being applied against Russia will impact supply chains, creating dislocations and the shifting of supply and demand further away from equilibrium, adding to global inflationary pressures.
Russia’s invasion of Ukraine may have indirect consequences for relations between major global powers. China’s and India’s passive reactions to date to the Russian invasion may contribute to an expansion of future military action beyond Ukraine and damage international relations and global economic growth.
Inflation and Interest Rates
In January, annual inflation rates among developed countries rose to about 7%, reaching the highest levels in the last 30 years. We’ve discussed in past newsletters the reasons for the increase in inflation, many of which resulted from the economic impact of the pandemic.
Here in North America, after nearly two years of keeping their overnight lending rates at historic lows, both the U.S. Federal Reserve (“the Fed”) and the Bank of Canada (“BOC”) increased interest rates during the first quarter of 2022, a first move to reset rates to within an “acceptable range” and to address inflationary pressures. Markets are anticipating up to six additional hikes in 2022 and possibly three more in 2023. These most recent moves by the Fed and the BOC, and the tone of their communications, indicates a clear shifting away from the pandemic-induced “stimulus at any cost” mindset to one of tempering the economy and reigning in inflation. The BOC may have a little more latitude than the Fed given the economic boost provided to the Canadian economy by rising commodity prices.
The Impact of Ukraine, Inflation and Interest Rates on Financial Markets
As the financial markets absorbed information on Ukraine, inflation, interest rates, forward growth rates, and the strength of the consumer, the first quarter of 2022 saw substantial changes to valuations in the equity and fixed-income markets.
Many growth stocks, where valuations are based more on future-based earnings flows than current inflows, experienced notable declines. Corporate earnings across the board are beginning to reflect slowing top-line growth (although this is not totally unexpected due to rapid drop and then rise in earnings in the first 12 months of the pandemic). Some industries and companies are less able than others to pass on rising labour and borrowing costs.
The economic environment has also impacted the normally “boring” bond market, which suffered losses in the first quarter due mainly to rising interest rates and a rare occurrence known as the “flattening yield curve.” While long-term rates are increasing, they are doing so at a slower pace than short-term rates, resulting in a flatter curve when plotted on a graph. In the past, this inversion has been an often-reliable leading indicator of economic decline or recession.
Investing in this Unsettling Environment
History has shown us that economic shocks, for the most part, are unforeseen and their duration and impact difficult to project. As a result, we invest our clients’ savings in a way that we believe will best respond to such unpredictable disruptions. Nevertheless, as events unfold, we adapt to new information with tactical adjustments to our investing strategies. Here are some of the guiding principles our portfolio management team is following:
• While rising interest rates have had an impact on the bond market, we maintain a relatively short bond ladder (1-to-5-year issues, held to maturity) for our clients, which ensures a locked-in yield despite some price volatility. We do not pay large premiums for bond purchases, which helps protect our clients from large swings in the price of their bonds as they come to maturity.
• We continually monitor the shape of the yield curve. Analyzing the spreads between various fixed-income instruments, equity markets and overall economic growth rates helps to guide us in our strategic allocation of our clients’ investments.
• We carefully select the companies that our clients own. We look for companies and industries that have pricing power, that can pass increased costs through to their customers. These companies can sustain earnings and dividend growth and provide a partial hedge for our clients against inflation.
• We assess the changing profile and outlook of the overall economy. To paraphrase a Wayne Gretzky quote: “Focus not on where the puck is, but where it is going.” The economy is evolving faster than ever before: new technologies, consumer preferences, a renewed awareness of our vulnerabilities, social responsibilities, and future global growth and prosperity means the “economic pie” will look different in the future than it does today.
Although we employ tactical shifts to navigate the changes, challenges and opportunities the world continually presents, we do not abandon the disciplines of diversification and fundamental asset valuation. A properly diversified strategy during such turbulent global events remains paramount.
All graph and chart statistical data contained in this report has been supplied by Refinitiv and National Bank Financial. Sources used by Refinitiv and National Bank Financial to compile the data include: Global Insight, Thomson Financial, CPMS, Bloomberg, S&P/TSX Index Services, S&P Index Services, TSX, NYSE, NASD, and company reports. The views and opinions expressed in this newsletter are based on historical company fundamentals and market statistics. No guarantee of outcome is implied and opinions may change without notice. Investors should not base any of their investment decisions solely on this report.
This report is produced entirely by Independent Accountants' Investment Counsel Inc. Although the information contained in this report has been obtained from sources that IAIC Inc. believes to be reliable, we do not guarantee its accuracy, and as such, the information may be incomplete or condensed. All opinions, estimates and other information included in this report constitute our judgment as of the date hereof and are subject to change without notice.
Please contact your IAIC representative if you have any questions regarding this newsletter.
©Copyright 2022 Independent Accountants’ Investment Counsel Inc. All rights reserved.
IAIC Market Communication
Friday, December 3, 2021
Omicron, Inflation and the Impact on Our Investment Strategy
After bouncing off new all-time highs in early November, the past two weeks saw markets make a U-turn back towards late September levels on news of a new Covid-19 variant and indications from the US Fed that inflation may persist.
With the early reports of the new Omicron variant spreading to Canada and around the world, the markets were reminded that we have not yet put Covid behind us. The uncertainty about Omicron’s transmissibility and severity, and whether current vaccines will be effective against it, has shaken markets, at least temporarily.
Persistent inflation continues to be a concern for the markets, as treasury-bond yields and the US dollar surge higher. U.S. Federal Reserve Chair Jerome Powell said earlier this week that if inflation proves not to be transient the Fed will have to prepare to end its bond-buying program ahead of schedule next year. This action would normally mean interest rates will rise. Fears of higher interest rates, combined with the Omicron variant news, resulted in the S&P 500 experiencing one of the biggest bouts of volatility it has seen in over a year.
On other fronts, the price of oil has been correcting over the past several weeks as the US seeks to release oil stockpiles and China is also said to be tapping into emergency reserves. Closer to home, the Bank of Canada warned there is a risk of a sudden price drop in housing prices as Canadians continue to look to purchase homes before interest rates rise.
Further volatility ensued following the recent scandal involving Bridging Finance. As a result of this, we thought it prudent to remind you that IAIC does not have any direct exposure to private debt or private debt funds. For our debt instruments, we purchase investment-grade corporate, government bonds, or GIC’s in client portfolios.
S&P 500 over the past 6 months is still up over that period, despite recent volatility.
The future is impossible to predict and these recent events are reminders that investors should avoid reacting emotionally to daily news updates. As investment managers, we remain focused, stick with quality investments that can ride out economic uncertainties, and resist deviating from our long-term investment strategy.
We focus on valuation, fundamentals and facts. We assess the impact of new information and events on the value of our core names and their long-term prospects. We do not believe the intrinsic values of great businesses are fluctuating nearly as much as their stock prices have recently. We continue to scan the markets for additional opportunities to grow our core pick list of ideas. It is markets like these that can create dislocations between price and value, and as a result, new opportunities can emerge.
Monday, October 18, 2021
Inflation and Interest Rates... The Story Continues
Following the Fed’s meeting in September, Fed Chairman Jerome Powell provided reassurance that monetary policy will remain accommodative until its dual goals on employment and inflation have been achieved. In essence, the Fed is walking a tightrope, allowing inflation to continue by delaying its policy response under the presumption that some of the inflationary impacts we are observing are transitory. This delayed response allows more time for the economy and employment to recover. Once these transitory impacts have worked through the inflation data, if the economy and employment are nearing full capacity and the recovery is entrenched, the Fed can more safely ease off on stimulus and increase interest rates.
Investing For the New Normal
Tuesday, April 20, 2021
The current Covid-19 wave reminds us that we’re not out of the grip of the pandemic just yet. The Canadian Government projects that by early fall most of our adult population will be vaccinated. Perhaps by then we will begin to learn what the post-Covid “new normal” will look like.
In this quarter’s feature article, we discuss how we are investing our clients’ savings as we look ahead to a post-Covid world.
There are many questions about life after the pandemic:
From a macro-economic perspective:
As investment managers we consider past history but also the impact of the unknowns on capital markets and our investment strategies. Starting with recent history, does anything over the past year change our investing beliefs and practices?
A Quick Look Back
Let’s remind ourselves of some of the key themes that impacted both stock and bond markets in 2020:
Many of these trends have been emerging for years, but out of necessity, the pandemic accelerated the pace of change.
Meanwhile, governments implemented large stimulus programs and central banks lowered interest rates to record lows. The US Federal Reserve has commented that it is willing to allow inflation to exist at higher levels for an extended period of time in its pursuit of full employment. The future path of inflation and interest rates is something we are watching very carefully. In the meantime, we need to consider the implications of near-zero interest rates on our clients, particularly for those who have capital preservation as their primary objective.
Valuation of Securities Still Matters
During the pandemic there were many examples of dramatic stock price performance from some newer, less-proven businesses. Some names seemed to advance almost every day without any fundamental reason. Some made headlines, and with so much capital on the sidelines, certain segments of the stock market enjoyed valuation escalations based mainly on the momentum of investor sentiment and speculation.
Some of this ‘speculative excess’ has quickly unwound in 2021 and some of the same stocks that produced remarkable gains last year have seen dramatic declines as the market reassessed the fundamental developments (or lack thereof) at the company level. Reality sets in eventually. Profitability, growing revenue and the price you pay for a company continue to be important for long-term success.
Warren Buffett, paraphrasing Benjamin Graham (his mentor/teacher), wrote in his 1993 annual letter to shareholders:
“In the short run, the market is a voting machine – reflecting a voter-registration test that requires only money, not intelligence or emotional stability - but in the long run, the market is a weighing machine.”
It seems every generation has a different way of learning this same lesson.
It is still, and will always be, prudent to spend time researching company fundamentals and to assess future prospects. We also believe that paying a reasonable price for a business rewards investors over the long term.
Maintaining Our Investment Philosophies While Adjusting for the Future
We are generally considered to be “value” managers, meaning that we invest in companies with established track records and strong balance sheets positioned to weather unpredictable events. With a few exceptions, these stalwarts did not catch investors’ attention during the market rebound in the last three quarters of 2020. Nevertheless, we remain confident in our strategy and believe these companies will provide favorable returns for our clients over the long term. In the past two quarters (see the “Value vs Growth” chart) there has been a cyclical rotation between the value and growth investment styles.
We have not been tempted to join the rush to invest in companies whose valuations are predicated on sustaining extremely high growth rates for many years into the future – growth rates that we believe are highly unlikely ever to be achieved. In the past few months, we have seen some of these valuations pull back – whereas long-established companies such as Canadian banks, Berkshire Hathaway and Diageo have in many cases beat earnings expectations, translating into healthy price gains.
At IAIC, we feel that it is prudent to consider what the economy will look like in the future while not getting caught up in current “noise” or short-term market trends. As always, there are consequential headwinds and tailwinds for investors in both equity and fixed income that we consider carefully when making tactical adjustments to our investing strategy. As a result, we have begun making tactical changes to our clients’ portfolios (changes will vary based on each client’s specific circumstances) in several areas including:
Tactical adjustments are always made to adapt to the environment we are in and align with future expectations for the economy. We do not chase yesterday’s winners or speculate on which sector will be the next to heat up beyond any reasonable rationale. Instead, we continue to emphasize diversification in our clients’ portfolios in order to navigate the uncertainties of the future. In all cases, we take each client’s personal objectives and comfort with market volatility into account when selecting the appropriate investments for the client.
2020 - It Started Out Well
Friday, January 1, 2021
As 2020 began, the economy and stock markets were doing so well there was widespread expectation that the U.S. Federal Reserve would boost short-term interest rates to moderate growth and contain inflation. Unemployment was approximately 3.5%, a record low in the US. Concerned that with full employment, wage inflation was on the horizon, the Federal Reserve seemed to be prepared to pre-emptively use monetary policy to keep this in check. Despite the potentially overheating economy and possible Fed response, stock markets rose to record highs in February.
The Virus Outbreak
News of a virus originating in China and migrating to other parts of the world spooked markets in late February. The virus outbreak quickly became a reality, and to contain the spread governments began mandating shutdowns of many parts of the economy. With unprecedented speed – in less than one month – economies stalled, unemployment rose from record lows to levels not seen since the Great Depression and the major stock markets plunged by more than 30%.
Ten months after the virus outbreak, with markets now exceeding their pre-COVID highs, it might be easy to forget the turmoil that gripped the world in those tumultuous early weeks of the outbreak. We might not remember that the prospect of the development an effective vaccine or treatment was completely unknown. The length of government shutdowns was uncertain. Would the virus “disappear” in the warmer weather as summer came to the northern hemisphere?
While economists and analysts began to evaluate various probable scenarios and the paths to economic recovery, equity markets around the world quickly fell by 30% to 35%. Although we didn’t know it at the time, the markets bottomed out in late March, slowly rising after that due to government stimulus programs and a growing understanding of the virus itself and how to combat it.
Government Stimulus, Market Recovery and Vaccine Development
The extent of the market recovery in the last nine months of 2020 has provided relief for panicked investors but seemingly defies logic. The economy has not yet fully recovered – the U.S. unemployment rate at the end of November was 6.7% (8.5% in Canada) – and COVID-19 cases and hospitalizations hit record highs over the year-end. Nevertheless, stock markets have recovered and surged past pre-COVID levels.
How to explain the apparent disparity between the market rebound and the incomplete economic recovery due to resurging virus levels? First, while unemployment surged and then only partially recovered, total aggregate income has actually increased due to government relief measures placing cash directly in the hands of consumers. Secondly, some sectors and industries have fared extremely well as a result of the virus outbreak, and those gains have somewhat outweighed the challenges incurred in other parts of the economy. Thirdly, the development and distribution of effective vaccines has given markets the belief that the economic impact of the virus will be behind us as we progress through 2021.
Uneven Market Impact
As 2020 ended, stock indices were reaching new highs, fueled in part by the approval and rollout of vaccines to combat COVID-19. Many investors figured that the new highs for stock markets would translate into a year of higher investment returns. But as with different economic sectors, stock performance was not evenly distributed.
In 2020, the weighting and performance of “Big Tech” was a major factor contributing to U.S. markets outperforming most other markets around the world. In Canada, the TSX, heavily weighted by the financial and resource sectors, saw a very modest gain of just slightly over 2% for the year. The DOW index, made up of large cap U.S. names, fared better, posting a gain of over 7% in 2020. The S&P 500, a more broadly diversified index, saw a gain of over 16%. The Big Five technology stocks (Amazon, Microsoft, Apple, Facebook and Google), which make up 22% of the index weighting, drove the performance of the S&P 500. Without these five names, the remainder of the index saw more modest gains inline with the DOW. The relative appreciation of the Canadian dollar vs. the US resulted in a 3% drag on performance from U.S. holdings of Canadian investors.
Canadian preferred shares, which experienced sharp value declines in March, gradually climbed back to their pre-COVID values by the end of 2020. Investment grade bonds laddered out over five years, normally placed in portfolios for income and safety, were now yielding returns of about 1% per year.
Canadian clients with a balanced portfolio – for example with 50% invested in bonds and preferred shares, 25% in Canadian equities, 12.5% in U.S. equities and 12.5% in international equities -- would have experienced a strong recovery from the March lows, but nothing like the returns they see in the media about the performance of the U.S. stock market and in particular the Big Five tech companies.
As we put 2020 behind us and move forward into 2021, we see record-high virus-related hospitalizations, a wobbly start to vaccine distribution, stalling re-employment levels, a turbulent transfer of federal power in the U.S. and governments hesitant to inject more deficit-swelling stimulus into their economies.
The way people live, work and socialize may be altered permanently as a result of the COVID-19 outbreak and as investors we need to adapt and adjust. We at IAIC consider how various industries or economic sectors will be impacted in both the short and long term by the pandemic. What do we see for 2021 and beyond and how does that affect our investment strategies for our clients?
Before the virus outbreak, the technology and healthcare sectors were poised to grow and occupy a larger part of the economy over the coming decade. COVID-19 did not ignite these sectors but it has accelerated emerging trends and growth. Some analysts speculate that consumer and business adoption of technologies such as online shopping and video communications advanced by five years in 2020. The growth potential of the healthcare sector has been boosted by the interest in eradicating COVID-19, a focus on mitigating the spread of new viruses or mutations, and an aging population that will stoke an increased demand for quality care, medications and research.
On the other side of the coin, many industries may have been permanently impacted in a negative way or seen their declines accelerated. The service, travel and hospitality industries will have a long and hard climb back. Some of this business will return quickly but is unlikely to reach pre-COVID levels in the short term. Bricks-and-mortar retailers, who were already feeling the pinch from the growth of online shopping, saw that trend accelerate in 2020 and now face the daunting challenge of how to lure shoppers back to their floors.
Similarly, it is unclear how deeply the commercial real estate industry will be affected. Will the “work from home” trend be permanent or only temporary? Will businesses and their employees evolve away from congested city centres?
Home improvements, a sector much larger than service and travel, surged throughout 2020. It is widely anticipated this trend will subside somewhat as it becomes safer to leave the house, socialize more and return to our workspaces.
Meanwhile, analysts expect the Fed to maintain its overnight lending rate at current levels in the range of 0 – 0.25% for an extended period into 2022 or even 2023. Long-term interest rates are also expected to stay very low, making it difficult for investors to earn sufficient income from “safe” investments in investment-grade bonds or GICs.
Our Investment Decisions Heading into 2021
Despite the volatility and uneven market performance that characterised 2020, we will continue to implement well-diversified portfolios for our clients, investing in companies with sustainable cash flows and strong balance sheets that will help these businesses ride out future disruptions. Looking ahead to 2021 and beyond, we expect to continue making adjustments to client portfolios in the coming months.
The low interest rate environment continues to impact the income-producing component of our clients’ portfolios. For longer term investors where income and growth are priorities over capital preservation, and near-term volatility is less of a concern, we may increase the allocation towards preferred shares and/or equities given the increased spread in yields between riskier asset classes and the relative safety of investment grade bonds provided the clients can tolerate the risk.
We plan to continue to increase our clients’ targeted exposure to technology and health care, not in response to performance in 2020, but because of their increasing impact on our daily lives. Investing in a “basket” of names in this space – through ETFs and/or large cap names with established dominance – helps to mitigate volatility and risk while providing potential growth in the economy of the “new normal.”
We are also setting a lower target allocation on oil and gas. Given ongoing political considerations and the difficulty oil producers have in adjusting to decreasing demand, we feel that a reduced allocation to this sector is warranted. We also feel that governments looking to stimulate their economies will invest in renewable energy and support an accelerated move to a “green economy.” This is not to suggest that oil and gas will not remain relevant in the years to come, but the historic and continued increase in demand year after year, regardless of the cyclicality of the economy, has been disrupted. Growth within the industry has stalled and without equilibrium in the supply of and demand for oil, we expect to see continued pressures on oil prices and the profitability of the industry.
2021 promises to be an eventful year. In our ongoing effort to provide reasonable risk-adjusted returns for our clients, we will continue to monitor the markets and adapt to events as they unfold. Our bias to large capitalization, strong balance sheets, and dividends reflects the conservative nature of our client base and our investment philosophy.
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