January 21, 2022

Financial letter, Spring 2021, 56^th edition

Déjà Vu All Over Again!

 

Although 2021 ended on a not-so-pleasant note of déjà vu due to a new variant, it was marked by a certain return to normalcy thanks in part to the large-scale vaccine rollout. The latest data indicates that 55% of the world's population has received at least one dose. Canada is among the most vaccinated countries, with 76% of the population fully vaccinated. The next challenge will certainly involve enabling less developed regions to follow suit in order to limit the emergence of new variants.

 

These vaccination efforts, coupled with government assistance programs, have led to an impressive economic recovery. North American growth surpassed its pre-pandemic level during the year, and labour market recovery continues, even as labour shortages are impacting several sectors of the economy.

 

Strong consumer demand along with supply chain issues have driven inflation to levels not seen since the 1980s. Although higher than anticipated, inflation is likely to decline in the coming months. Wage growth will have to be closely monitored, since it is this component of inflation that will either support price increases in the longer term or not.

 

Our 2022 scenario

 

Although expectations should be somewhat lowered and more volatility should be anticipated, we foresee  another great year for the stock markets in 2022. It is still too early to position portfolios for a recession, which will likely occur in 2023 or 2024.

 

Economic growth in the G7 countries, which will likely reach 4.5% in the last quarter of the year, will definitely slow down in 2022, but it will do so from a very high level. The return to full employment along with inflation will prompt central banks to ease off the gas pedal, but financial conditions will remain highly accommodating. 

 

With a booming job market and a massive savings surplus at their disposal, consumers will likely continue to stimulate the economy and businesses will want to add to their production capacity, rebuild their inventories and automate their production in order to tackle the labour shortage problem.

 

As the last few days of the year have revealed, the pandemic is still not over and this remains one of the main risks to our scenario again this year.  

 

Interest rate increases by central banks are not a concern as long as they do not reach a level sufficient to dampen the economy, which is not likely to be the case in 2022. In the last four interest rate hike cycles, the average yield on the S&P 500 12 months after the Fed’s first ^rate hike was 9.5%.

 

As long as a recession is not looming, we don't expect a significant and sustained decline in equity markets. However, the volatility that will result from a combination of slower economic growth and the beginning of the monetary policy normalization cycle will generate volatility and opportunities in the markets.

 

 

Portfolio positioning

 

Asset allocation

Overall, the backdrop remains favourable for a continuation of the investment cycle in 2022. Therefore, in a balanced (50-50) portfolio, we adopt a target allocation of 40% fixed income, 50% equities and 10% real assets. While this positioning may seem optimistic, it is mainly a relative positioning, as several asset classes are currently expensive and bargains are becoming scarcer.

 

 

Fixed Income

Interest rates will rise, which is why we are underweight this asset class and we continue to promote short maturities to limit volatility and protect portfolios. We will have the opportunity to roll over certain bonds during the year at significantly more attractive rates. The closer we are to the next recession, the more we will increase the duration and quality of the portfolio's issuers.

 

Equities

Our positioning going into the new year is a little more cautious than our 2022 target. The balanced portfolio currently consists of 46.5% equities. We believe that volatility will return in 2022 are aim to bring our weighting of equities back to the 50% target due to the weakness of the stock markets. We are closely monitoring several securities that are still trading at a reasonable valuation.

 

Geographic and sector diversification

 

Over the past 10 years, the growth style has been driven by its technological components. However, the gap between the technology sector's price/earnings ratio and the rest of the S&P 500 is at its greatest since the tech bubble era. While some companies' ratios can be justified based on fundamentals, in many cases, unrealistic valuation multiples can lead to sharp declines at the slightest disappointment. We underweight the sector and limit our selection of securities to the strongest companies. In contrast, the cyclical components or values are still trading at the largest discounts in the past 10 years.

 

 

Geographic: For the time being, the economic recovery and strong growth in corporate profits continue to favour North American equities at the expense of European or emerging companies. That is why we remain slightly overweight U.S. companies in the portfolio.  We will stay abreast of a reversal of this trend before increasing our exposure to global companies, trading at valuation multiples much lower than U.S. equities.

 

Sector: As in 2021, financial company securities will remain a prime portfolio, which should benefit from a robust credit application cycle, particularly at the commercial level. Moreover, rising rates and a steepening yield curve will generally benefit banks.

 

As the economic cycle continues, the situation should be favourable for industrial and energy companies. We maintain exposure to renewable energy producers since we reached a point of no return in the energy transition. The opportunities for growth in this sector are enormous. For instance, Boralex expects to double its energy production by 2025 and double it again by 2030. However, 2021 reminded us that "energy transition" includes the word "transition" and that it will take time.

 

Other sectors to watch in 2022 include copper-producing companies, which will be at the heart of energy transition efforts. It takes 4 times as much copper to build an electric car versus its combustion counterpart. The balance between supply and demand is already precarious, and since it takes 8-10 years to launch a new copper production site, the fundamentals point to a sustained price in the coming years.

 

Healthcare is still our preferred defensive sector, given its weaker valuation, strong profits and solid growth. The upcoming midterm elections in the United States should limit the regulatory risks for this sector.

 

Real assets:Real assets will become an important part of portfolio allocation. Diversification, reduced volatility and the regular income they provide are key assets in achieving your long-term objectives. The private infrastructure investments we may be able to add to the portfolios in the coming months have all of these features.

 

Financial markets are evolving at lightning speed. Our role is to help you optimize and manage your wealth by building solid portfolios. To do this, we believe it is essential to adopt a focused, measured and balanced approach.

 

Despite its many challenges, 2021 will have been a year of exceptional growth for the team. We would like to welcome all the new clients who joined us and also thank all those who have chosen to trust us again this year.

 

On behalf of the entire team, happy new year 2022! 

 

Sources:

• BCA Research, Strategy Outlook – 2022 Key views: The Beginning of the End, December 2, 2021
• Credit Suisse U.S. Equity Strategy, Taper and Tightening but No Tantrum, December 13, 2021
• Desjardins, Quarterly – Winter 2021
• Desjardins Economic Studies, A Look Back at 2021, December 17, 2020