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.

Source: Factset

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.

IAIC Disclosures
This material has been prepared by Independent Accountants’ Investment Counsel Inc. (IAIC). The information presented herein, including forecast financial information, should not be considered as advice or a recommendation to investors and does not consider a client’s particular investment objectives or financial situation. Before acting on any information you should consider the appropriateness of the information and consult your portfolio manager.
©Copyright 2021 Independent Accountants’ Investment Counsel Inc. All rights reserved.
 

Inflation and Interest Rates... The Story Continues

In our previous Commentary we focused on inflation -- how inflation is tied to interest rates, why central banks focus so closely on inflation and why we as portfolio managers monitor it so attentively. Three months later, inflation and its impact on our clients’ investments continues to be front and centre for our portfolio management team at IAIC, so we thought it best to tackle the issue again in this quarter’s Commentary.

In the quarter ended September 30, 2021, we saw:

• inflation rates rise higher than most economists anticipated
• a general decline in stock market values during the month of September
• the Chinese Government become more actively involved in various business segments
• a federal election in Canada
• a ‘diplomatic hostages’ exchange between China and Canada; and
• a Federal Reserve (the “Fed”) meeting outlining how future monetary policy actions may unfold.

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.

Closer to home, the Bank of Canada (“BOC”) may move to reduce the amount of monetary stimulus sooner than the US Fed. In August, Canada’s annual inflation rate was running at 4.1%, a rate not experienced for almost twenty years. Add to this the perception that Canada is in the midst of a housing crisis (due partially to cheap credit) and these conditions may lead to the BOC acting before the Fed in removing monetary stimulus. However, such actions can have negative consequences in both government and consumer finances as well as the broader economy. We will be watching these developments very carefully.

Asset Valuations in an Inflationary Environment

One common question we hear from clients is, “How does inflation tie into the price of the investments that I hold?” Corporate profits and stock prices are impacted by inflation and interest rates in a number of ways:

Transitory vs. Permanent Inflation

First, it is important to differentiate between the impacts of transitory inflation and inflation that is more permanent and entrenched in the economy. Transitory inflation is usually the result of temporary economic dislocations due to the volatility in the prices of key economic inputs, such as commodities, basic materials and food. While very disruptive, the market often looks beyond the impact of these disruptions. For example, the market is unlikely to materially change its valuation of a grocery store chain due to a sudden, temporary increase in the price of fresh produce. Compare this to inflation that is more permanent and entrenched in the economy that has a longer-term effect. For example, rising labour costs due to a permanent shortage of workers has the potential to be a more permanent source of inflation. Wages increase when businesses compete for scarce labour resources. If businesses are unable to pass through these costs, margins will fall, and profitability will be negatively impacted. However, if businesses are successful at passing through their higher labour costs, this can create a more entrenched inflationary pressure in the economy. The determination of the type of inflation (transitory or permanent) is therefore very important to the market, as is the Fed’s assessment of which type of inflation it is fighting.

Interest Rates and the Cost of Capital

Rising interest rates will also negatively impact the cost of capital for businesses. An increase in interest rates will not only increase the interest rate on outstanding debt but can also lead to an increase in the cost of equity capital, all of which leads to negative pressure on stock market valuations.

Interest Rates and Future Cash Flows

Generally speaking, rising interest rates can have the effect of reducing the price-to-earnings ratio investors are willing to pay for stocks. This negative impact is more pronounced for companies that have more of their cash flows occurring further out in the future, such as high growth stocks, like technology companies, where the payoff of high profits is many years away. The valuation of these types of stocks is potentially more sensitive to rising inflation and interest rates despite having higher growth prospects.

Interest Rates and Fixed-Income Securities

Rising interest rates also negatively impact fixed-income assets. The contractual stream of cashflow generated by a bond or any other instrument that provides a fixed payment is discounted in the price of that instrument. In general, the longer the investor must hold the instrument until maturity, the more sensitive the price of that asset will be to interest-rate movements. Some income-producing assets may vary the payments they make based upon prevailing interest rates (floating rate instruments, for example). While the price of these assets may be more volatile, during a period of rising rates they can benefit from higher inflation.

Implications for Our Clients’ Portfolios

Even before the pandemic, wealth managers who relied on a mix of fixed-income assets with equities to mitigate market volatility for their clients faced significant challenges. With interest rates at record lows and relatively risk-free assets failing to keep pace with even modest inflation, the economic climate leading into the pandemic produced a widening gap in the spread between traditional fixed-income assets in favour of riskier assets such as stocks. With yields falling to under 1% for many high-quality corporate bonds, the propensity of many asset managers was to shift weighting away from bonds to higher-yielding asset classes including preferred shares, stocks and alternative assets. Of course, each client’s unique tolerance and capacity for risk and need for income must be considered before pursuing any such strategy.

With inflation rising in the latter stages of the pandemic, we are watching developments very carefully, including the central banks’ actions to keep inflation in check and the impacts of these actions on economic growth and its continued recovery. We continue to focus on mitigating the impact of rising interest rates on our client’s portfolios, maintaining the purchasing power of their assets so that the income they require from their portfolios keeps pace with inflation. All the while, we work to produce a reasonable rate of investment return in conjunction with each client’s financial planning objectives.

What strategies are we implementing in this economic environment?

• We maintain a short-term (e.g. generally, a five year maximum term to maturity) equal weight bond ladder to mitigate the negative impact of the potential for rising interest rates. Interest rate volatility has a relatively minor impact on short-term bonds and our strategy is designed so that about 20% of the bond allocation matures in any given year. Our focus is primarily on investment grade corporate bonds that offer yields that are higher than those offered by government bonds. If not needed by the client, the proceeds from maturing bonds can be reinvested back into the fixed-income class at prevailing rates or, where appropriate, moved into higher-yielding alternatives, including preferred shares, REITs and dividend paying stocks.
• We invest in profitable “value-based” stocks in industries that can adapt to inflationary pressures by passing on their cost increases to customers and maintaining their margins.
• We focus on stocks that have a track record of consistently paying and raising their dividends over time, effectively providing their shareholders with a ‘raise’ every year via the increasing dividend.
• We invest, where the valuation is reasonable, in growth opportunities (e.g. the technology sector) for the long-term. We look for sectors and companies that will benefit from emerging trends and shifts in the composition of the broader economy, providing capital gains despite potential higher volatility and sensitivity to interest rates.
• We invest in strong companies with a dominant global presence. These are companies that enjoy relative competitive advantages with operations that are not denominated in a single currency.
• We provide exposure to some sectors or assets, such as preferred shares and financials, that can benefit from rising interest rates and the economic climate associated with inflation.

Conclusion

We continue to believe that market conditions warrant cautious optimism and a balanced approach. We don’t make large, risky bets with our clients’ retirement savings that can create a binary outcome – a “big win” or a “big loss.” We believe diversification is critical, including exposure to asset classes that can perform well in periods of rising interest rates and inflation.

We believe in the maxim that, “Time in the market, not timing the market,” is what will help us build our clients’ wealth. We continue to monitor the markets and take actions that we believe will not only produce reasonable long-term returns but will also reduce risk in client portfolios.

 

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:

• How quickly will we (or will we ever) resume past vacation and travel patterns?
• How much of our online retail shopping due to the pandemic will revert to in-store purchasing?
• How much remote-from-home work will return to the office?
• Will businesses reconsider the technological alternatives to past spending levels on office space, travel, in-person meetings and conferences?

From a macro-economic perspective:

• How will government borrowing taken on during the pandemic affect future economic growth, taxation and interest rates?
• Will infrastructure spending accelerate a shift away from fossil fuels to a greener economy?
• Will the migration over the past few decades to global trade and open borders give way to nationalist protectionism?
• How long will interest rates remain at near-historic lows?

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: 

• More work from home than in offices
• Workers commuting less and businesses requiring less commercial space
• Technology became more highly leveraged by businesses and consumers
•  A reduction in business and personal travel
• On-line shopping became more widely adopted
• The closure of national borders
•  An increase in healthcare spending

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: 

•  Increasing exposure to technology given continued world demand
• Increasing our consumer sector holdings, given continued consumer confidence and strong household balance sheets
•  Increasing exposure to healthcare
• Reducing direct exposure to fossil fuels
• Increasing the use of passive investments to further complement our value style
• Increasing US equity weightings, as there is more opportunity in the US markets
• Increasing our use of ESG (Environmental, Social, and Governance) metrics in our investment theses
• Given the interest rate environment, seeking additional income yield when warranted by the risk-reward tradeoff between bonds and other asset classes    

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.        

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.

Looking Ahead

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.