January 20, 2023

Financial letter, Winter 2023, 62^nd edition

Not a Great Year

2022 was a difficult year for many Canadian households and investors. Jobs were plentiful and wage growth reached its highest level in nearly ten years. However, it was difficult to enjoy that when inflation was rising even more quickly and causing real wages to decline. Not to mention the interest rate hikes adopted by the Bank of Canada (BoC) in the hopes of bringing price growth back down to the low, stable and predictable target of 2%. These increases eroded asset values and hit the sectors of the economy most sensitive to interest rates. As most households' primary asset is their home, many saw the value of their nest egg shrink and had to contend with higher mortgage payments at the same time. As a result, consumer spending slowed, and will probably continue to do so as Canadians tighten their belts to hang on to their properties.

Persistently high inflation could only mean one thing—higher rates for longer.

Index		Level	3 months	6 months	1 year
S&P/TSX		19 384.92	5.97%	4.54%	-5.75%
S&P 500 (USD)		3 839.50	7.55%	2.30%	-18.13%
MSCI Emerging Markets (USD)		1 943.93	9.63%	-2.92%	-19.94%
MSCI World (USD)		2 602.69	9.89%	3.22%	-17.71%
CAD/USD Exchange Rate		0.74$	0.72$	0.78$	-6.75%
Bond yield Canada 2-year		732.95	0.67%	0.36%	-4.04%
Bond yield Canada 10-year		1 159.58	0.34%	1.19%	-10.29%
Oil (US$)		80.26$	79.49$	105.76$	6.71%
Gold (US$))		1 824.02$	1 660.81$	1 807.27$	-0.28%

 

A global recession on our doorstep

Some of the supply chain snarls that have been hampering economic growth and fuelling inflation appear to be easing. However, there are a number of signs that the global economy will dip into a recession in 2023. We expect real GDP to contract as early as Q4 2022 in the eurozone as energy uncertainty continues to keep inflation high.

While further growth is expected for the rest of 2022 in the United States, the situation is expected to deteriorate in 2023 as interest rate hikes and other factors really start to bite. The US economy may dip into a recession in 2023, posting three quarters of GDP contraction, job losses and rising unemployment.

In Canada, we're still forecasting a fairly short and shallow recession, albeit one that may extend into the third quarter. The risks associated with our outlook remain to the downside, as more and more households have to contend with the reality of higher mortgage payments.

The rate hike announced by the BoC on December 7 should be the last of the tightening cycle and we're forecasting rate cuts starting towards the end of 2023. In the United States, we think that the Federal Reserve will hike rates further in the first quarter of 2023 before pausing.

Asset allocation

Savers and investors will probably want to forget 2022. Among the asset classes considered, only cash and the US dollar provided positive returns. Home values, one of the main sources of savings for many households, are also expected to continue correcting. Worse yet, once inflation, which is expected to come in at 6.4% for the year, is factored in, asset returns are even lower. After two years of strong asset growth, this is the price we must pay to rein in inflation. 2023 could bring a rebound in returns, but we should keep our expectations in check given that a recession is very likely. Businesses will struggle to increase their earnings, while valuation multiples will be limited by uncertainty and the return of alternatives to equities.

We're maintaining a healthy dose of caution regarding the recommended allocation for 2023. We recommend overweighting cash, a neutral to slightly underweight position in bonds, and a neutral equity position.

Fixed income

The central banks' fight against inflation has rocked the global fixed income markets. Although asset class returns in 2022 were well below expectations, expected returns improved significantly. Even after yields edged down again, some bond market segments are offering their highest expected returns in ten or fifteen years.

Yields to maturity are higher, and tax efficiency has improved too. Since many bonds were issued when yields were lower, a number of bond prices are now discounted compared to their nominal values. As such, not only are bonds promising higher current returns, they're also providing capital gains, making them more efficient from a tax standpoint. In addition, the ability of bonds to protect a portfolio has also improved. When yields were extremely low, the potential value gains for bonds in the event of an equity market decline were very limited. As a result of higher yields, if the equity markets were to suffer a fall, the potential gains from the fixed income market are now more favourable. Of course, if inflation proves to be more persistent, fighting it could take longer and inflict further pain on fixed income investors. However, signs of an economic slowdown are piling up, especially in Canada, and so we believe that we're approaching the end of the monetary tightening cycle. In the United States, we may still see a few more rate hikes over the coming months.

If interest rates are expected to return to their recent peaks, overweighting bonds and opting for a longer duration than our benchmark could prove to be a wise choice.

Equities

Although substantial, the declines on the major equity markets in 2022 were nothing out of the ordinary. Drawdowns of 25%—or more—can certainly spook even the most seasoned investors. At one point in 2022, the S&P 500 was down 28% year-to-date. However, for investors with a long enough investment horizon, these dips are good entry points.

The financial markets are interconnected, so we shouldn't just look at equities in a vacuum. The possibility of a recession is limiting potential earnings growth, while rising interest rates are reducing equities' relative appeal. Expected returns, which are rather modest for the next twelve months, favour maintaining a neutral equity position.

In light of the economic outlook, our geographic allocation is as follows:

• United States: Overweight
• Canada: Overweight
• Europe: Underweight
• Emerging markets: Underweight

At the beginning of the year, we called for a humble approach in light of recent years' returns, and level-headed management of expectations in terms of future performance. Initially, most markets held up relatively well despite the pandemic shock. But then the extremely low absolute level of interest rates and equity valuation multiples above prepandemic averages limited the returns that could reasonably be expected. The current situation is much more promising. According to a study by J.P. Morgan Asset Management, expected returns for the coming years are at their highest level in a decade! Despite the short-term uncertainty, there seems to be much more potential than there was in early 2022 for investors with sufficiently long investment horizons.

Conclusion

A new year often comes with healthy resolutions and much hope for better days ahead. However, all the best intentions in the world won't help overcome inflation. That said, the central banks are promising to see this fight through, whatever it takes. Although the short-term cost of this crusade seems high, leaving inflation unchecked and potentially unmooring households' inflation expectations would cost so much more, and needs to be avoided at all costs. However, we're already seeing signs that the Canadian economy is slowing, which leads us to believe that we're close to the end of the monetary tightening cycle. How long rates need to remain at their current levels and how long households can handle the higher costs remains to be seen. Although a recession generally triggers deflationary forces, the labour market could turn out to be the final enigma. Ironically for investors, the greatest potential over the coming months could come from job losses. In contrast, a resilient labour market with widespread hiring and upward pressure on wages could push central banks to hike further and keep rates higher for longer.

Despite a volatile and uncertain backdrop, several asset classes are offering much higher expected returns than they were a year ago. Of course, the current volatility could rattle the convictions of many investors. But it's during uncertain times that the value of good advice is more important than ever.

We hope that this information helps you better understand the markets. Please don't hesitate to contact us if you'd like to discuss our investment strategies in more detail. We remain committed to working.

 

Louis Vazzoler
Portfolio Manager