October 15, 2023

The Reporter – Third Quarter 2023

GOOD NEWS GONE BAD

Surging interest rates were the big story last quarter. To put things into perspective, the 10-Year US Treasury rate spiked a whopping 80 basis points from 3.8% to 4.6%. The increase was caused in part by remarks made on September 20 by Jerome Powell, Chair of the US Federal Reserve (aka the Fed).

He signalled that rates would stay higher for longer than previously expected due to the strength of the economy. In June the Fed was forecasting 1.1% GDP growth and 4.5% unemployment for 2024, but now it's singing a much happier tune: 1.5% growth and unemployment down to 4.1%.

The Fed's rosy economic forecast was borne out early this quarter by surprisingly strong data from the ISM Manufacturing index, the Job Openings and Labor Turnover Survey, and nonfarm payrolls. As a result, the 10-Year US Treasury rate broke 4.9%, reaching a 15-year peak.

The same holds true for the Canadian economy, but to a lesser extent. The economy's strength has been on full display, even as interest rates have climbed. Household debt is becoming an even bigger concern, but the housing market has continued to shrug off the rate hikes and post solid numbers. In the US, where the average rate for a 30-year fixed mortgage^{note de bas de page 1} topped 7%, 62% of mortgages are still under 4% and 92% are under 6%. In Canada, many mortgage lenders have been forced to stretch amortizations beyond 35 years to manage skyrocketing rates. Royal Bank and TD have reported that nearly a quarter of their customers have opted for these extra-long amortizations.^{note de bas de page 2}

The stock and bond markets were clearly hard hit by the big jump in interest rates. In the bond market, it all comes down to the well-documented inverse relationship between interest rates and fixed-income security prices. On the equity side of things, the rise in the S&P 500's price-to-earnings ratio seen over the first half of 2023 hung on hopes that the Fed would cut the key interest rate multiple times next year. In that scenario, investors were projecting earnings per share growth above 10% for S&P 500 companies in 2024. But now that interest rates are set to stay high, stock prices have fallen as growth forecasts have darkened.

As you can see, investors have actually taken all this good economic news pretty badly since it's soured the 2 main asset classes. Oil was the only asset class that turned a profit in the third quarter. And that was the upshot of the agreement between Saudi Arabia and Russia to extend their oil production cuts, which put upward pressure on prices.

Q3 2023 PERFORMANCE SUMMARY

2023 PERFORMANCE SUMMARY

OUR PORTFOLIO MANAGEMENT

It can be hard for portfolio managers to stay on the defensive. That's been especially true as rolling waves of optimism have washed over the media, while financial experts have hailed stock market rebounds, especially the one earlier this year, leading to more buoyancy. Hence the reason we put capital protection front and centre in our investment decisions and tune out the emotional noise that pervades the market.

Our recession forecast model is advising caution. It's telling us that the full impact of monetary policy remains to be seen due to the lag effect^{note de bas de page 3} . Plus, the current risk premiums^{note de bas de page 4} are encouraging us to hold bonds. So we've actually been quite comfortable with our positioning. We've reacted by increasing cash holdings in the Growth portfolio by just over 4%, temporarily exceeding the 20% maximum in the second half of the last quarter.

Our strategy not only generated a positive return, it also outperformed our benchmark index (which has posted a negative performance for the past 3 months) by 3.17%. Thanks to gains on our preferred share and bond holdings, the Balanced Tax Efficient portfolio ended the quarter up 2.13%.

Q3 2023 PERFORMANCE REVIEW

2023 PERFORMANCE REVIEW

CONCLUSION

In a recent French-language video entitled "Un positionnement prudent qui n’a rien de pessimiste" (A conservative stance that isn't gloomy), portfolio manager Daniel Ouellet circled back on some of the concepts mentioned in our newsletters, including the lag effect and risk premiums. Even though we're taking a prudent approach in these uncertain times, our elevated cash holdings do give us the flexibility to seize attractive investment opportunities as they arise.

SUMMARY OF QUARTERLY TRANSACTIONS

Our moves are based on a method that combines quantitative analysis, including our trusty 3-for-1 principle, with qualitative analysis, which focuses primarily on analyzing fundamentals. All total and partial sales in the last quarter followed this logic. In the Appendix, you'll find a summary of these transactions, along with a memo explaining Johnson & Johnson's (JNJ) spinoff of Kenvue (KVUE).

After peaking at over 4,600 points in late July, the S&P 500 has fallen by about 10% and settled at around 4,200 points. That prompted us to invest nearly all of the excess cash accumulated in the third quarter (3.7%) in 3 new positions in the Canadian market in early October: BCE (BCE.TO), Telus (T.TO) and TC Energy (TRP.TO). Stay tuned—we'll explain the reasoning behind these transactions in a future newsletter. And then you'll see that a drop in financial markets can actually signal good news!

APPENDIX

To give the company more strategic flexibility, Johnson & Johnson's head office announced it was spinning off its consumer health unit, Kenvue, which is known for famous brands like Tylenol and Band-Aid. Johnson & Johnson shed some 80% of its shares in Kenvue, which has become a separate publicly traded entity. Johnson & Johnson shareholders were given the opportunity to trade some or all of their shares for Kenvue shares at a 7% discount.

We intend to maintain our position in Johnson & Johnson and sell off Kenvue once the shares are issued. We made transactions on both stocks in the registered accounts to avoid any tax impact. The good news there is that the move generated a 10.7% profit!

Sources:

Anderson, D. 2023) "Nearly Everyone With a Mortgage Has an Interest Rate Below 6%, Prompting Many to Stay Put," Redfin News, June 14.

Labby, B. 2023) "Longer amortization periods leave some mortgage holders 'stuck' and unable to get ahead financially," CBC News, September 4.