April 19, 2023

The Reporter – First Quarter 2023

FINANCIAL MARKETS HAVE GROWN COMPLACENT

In a 2004 interview with the New York Times Magazine, renowned astrophysicist Stephen Hawking was asked, "How do you keep your spirits up?" Some context: for the past 40 years, Hawking had been living with amyotrophic lateral sclerosis (ALS), a neurodegenerative disease causing respiratory failure and reduced mobility. He answered, "My expectations were reduced to zero when I was 21. Everything since then has been a bonus."

It's a quote that sums up the market's state of mind at the close of this quarter. After delivering solid returns up to mid-February, the S&P 500 and S&P/TSX saw the year's gains wiped out after two negative shocks. The first was expectations of a potential 50 basis point (0.50%) key rate hike from the US Federal Reserve (Fed), which was due to be announced on March 22. The second was the collapse of the 16th largest US bank, Silicon Valley Bank, which ended up taking Signature Bank and Credit Suisse down with it.

By mid-March, expectations of a year of positive returns had been reduced to zero, opening the door to positive surprises, which is exactly what happened. With increased risk of a recession, the financial community began to expect not just the end of the Fed's monetary tightening cycle, but the start of a cycle of rate cuts. This unexpected bonus helped raise investors' spirits, resulting in strong financial market performance in the first quarter of the year. Expectations are high that the Fed will cushion the blow if economic activity begins to contract.

Q1 2023 PERFORMANCE SUMMARY

Q1 2023 PERFORMANCE REVIEW

LAST PLACE TO FIRST PLACE

An interesting detail about the year's performance so far is that the worst-performing stocks of 2022 were those topping the charts on March 31. And vice versa: last year's big winners were Q1's biggest laggards. That might explain the performance gap between the NASDAQ and the S&P 500 for the quarter. The reversal is reminiscent of 2020 and 2021, when risk-taking had become attractive after complacency set in as a result of ultra-accommodative fiscal and monetary policy.

Source: Jeffrey Buchbinder. First Quarter Market Observations. LPL Financial Research, March 31, 2023.

OUR PORTFOLIO MANAGEMENT

What's interesting is that our Growth Portfolio generated a more than respectable return for the quarter despite the surge in growth stocks and our high cash position. But that raises a question: knowing that the financial markets are reacting favourably to expectations of easing US monetary policy, should we adopt a more optimistic stance for our portfolio management? In our opinion, it's still too early to say whether the current stock market rebound will last, for the three reasons outlined below.

#1: The fear index is down

The S&P 500 volatility index (VIX) is used as a measure of the market's state of mind: a high reading suggests market fear, and a low reading indicates a certain amount of comfort. The VIX ended the first quarter at 19, well below its 2022 average of 26 and just under its all-time average of 20. That's rather surprising considering the uncertainty surrounding the size, scope and duration of the effects of a potential recession on corporate earnings growth. At March 31, expected 2023 earnings per share for the S&P 500 stood at $220, above last year's actual earnings per share of $218. That suggests the market is confidently optimistic about companies' ability to generate satisfactory earnings despite more difficult conditions.

But historically, there's been an average of 14 months between the warning from our forecast model and the start of a recession. The model issued a warning signal for a potential recession in the fall of 2022, which means there's still some time to go. In our 2023 outlook, we discussed the concept of a transmission delay—the time it takes for the cumulative effect of interest rate hikes to have a negative impact on the economy.

#2: This isn't a repeat of 2008

No one can predict exactly what the outcome of the recent banking turmoil will be. But we don't think the situation is at all comparable to the 2008 financial crisis. First, it was mainly US regional banks that were affected this time around, as opposed to the entire US banking system in 2008. Second, central banks and regulators stepped in much more quickly this time to stanch the bleeding and restore confidence in the banking system. Until proven otherwise, the worst seems to be behind us, whereas after Lehman Brothers declared bankruptcy in September 2008, it took a month for a rescue package to be announced. Lastly, the big US banks are in much better capital shape than they were 15 years ago, thanks to the Dodd-Frank reform requiring them to keep a higher percentage of assets in cash and undergo annual stress testing. Stress tests use hypothetical scenarios to assess banks' ability to withstand extreme economic and financial conditions.

That said, during past banking crises, credit conditions have tended to tighten, and new regulations have been introduced to further limit financial institutions' business strategies in order to reduce risk taking. Since the banking sector is the backbone of the economy, providing credit to fund economic activity, the possibility of a sharper than expected slowdown shouldn't be ruled out. It's another reason to skew more cautious in our portfolio management.

#3: Inflation is still high

The US benchmark rate is currently sitting in a range of 4.75% to 5.00%. At quarter-end, there was a 30% chance that the Fed will cut its rate by 25 basis points (0.25%) at least three times before the end of the year. That would mean the inflation rate is finally under control and on its way back down toward the target rate of 2%. To get there, Fed Chair Jerome Powell needs to see a much less strong labour market, something that's taking a while to happen. He's said he wants to see about 100,000 net jobs being added a month in order to restore balance to the labour market, in turn reducing inflationary pressure on wages. But with the first three months of the year recording an average of 345,000 new jobs and annualized wage growth above 4%, the job market looks anything but weak. Given that price stability is currently the Fed's primary concern, it's possible interest rates won't come down as quickly as expected, which would be a big disappointment for the market.

CONCLUSION

Despite the sense of optimism in the financial markets, the fact remains that the S&P 500 is still trading within its infamously well-defined range (between 3,600 and 4,300 points), a detail we've mentioned more than once in the past few months. Skeptical that stock prices will continue to rise, we decided to further reduce our exposure to common shares in our management models. For example, the allocation to cash in our Growth Portfolio is 16.5%, about 4% above where it was when we published our 2023 outlook in February. In the Appendix, you'll find a summary of recent portfolio trades.

Note that early in the year, we sold off our position in ZUB (Equal Weight US Banks Hedged to CAD Index ETF). As the saying goes, timing is everything. We're not saying we can predict the future, but we're confident there will be a better opportunity to deploy free cash given how complacent the markets are.

APPENDIX

First, we reduced our exposure to Manulife (MFC.TO) for the simple reason that the Growth Portfolio was heavy on the stock after a strong performance in 2023. Second, we sold off our position in Germany ETF WEG. After returning roughly 10%, it was presenting a much less attractive risk/return ratio than it did when we picked it up in March 2022 at the start of Russia's war against Ukraine.

It was the opposite situation for CVS Health. According to the 3-in-1 quantitative analysis tool we use to guide our investment decisions, the 5-year target price is $116 with a floor of $63. We saw an opportunity to add to our existing position while the stock was trading under $80, given the favourable risk/return ratio.

Sources:

Deborah Solomon (2004). The Science of Second-Guessing, The New York Times Magazine.

Jeffrey Buchbinder (2023). First Quarter Market Observations, LPL Financial Research.

Sarah Sermondadaz (2018). La longévité de Stephen Hawking, un mystère de la chance. Sciences et Avenir.