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Quarterly Update

April 19, 2022

Ready For Uncertainty

These are strange times indeed. War, a pandemic, high inflation, rising interest rates, fractured supply chains, fiscal consolidation, and central bank tightening – now that’s a messy combination. Yet through it all the stock market seems to have taken it in its stride, on a relative basis. Most markets are down this quarter except for Canada.  Volatility has returned which bodes well for active traders, not so much for long-term investors. 
 
All eyes continue to be on the unprovoked aggression on Ukraine and the suffering of its population. We never advocate profiting from human suffering but must also address the investment implications of this invasion. We continue to firmly believe that this shocking event has not created new trends but, rather, has accelerated pre-existing ones such as higher inflation rates, and a move away from globalization and toward higher defense spending. The silver lining for Canada and the S&P/TSX is that our country is very well positioned for higher inflation and the current geopolitical crisis.  While global economic activity remains robust for now, we think the rate of growth in activity is bound to slow in 2022, because of tighter monetary conditions and some inflation-driven erosion of consumer confidence. Historically, the market can post small positive returns in such an environment,
 
Where the most pain has been felt is the fixed income markets with the significant rise in interest rates in March and in the quarter overall, most bond indices returns were negative. This was the worst quarter on record and if this was the end of the year, it would be the worst year on record even beating 1994. At the end of last year, the 10-year treasury in the US yielded 1.5%. Today it is around 2.5%, same goes for Canada where 10-year rates have increased from 1.4% to 2.4%. While the pace of expected tightening has significantly increased, the expected terminal policy rate has not, with the consensus anchored around the U.S. Fed/Bank of Canada targeting a neutral rate ranging between 2.25 to 2.75%.    Inflation linked bonds could not keep up either as higher inflation adjustments were not enough to compensate for the rising real rates. The Canadian Real Return bond market was down more than 9% and in the U.S. they were down 3%. 
 
For clients, this is the second year in a row of underperforming bond markets, rarely seen and it is taking its toll. However, while temptations will be to liquidate, we must look at it with a different lens. In particular, the default rate has not increased so for most holdings, investors will be made whole at maturity (no permanent capital impairment).
 
The S&P/TSX outperformed other major markets up as the index returned 3.8% for the quarter.  Despite global efforts to stabilize key commodity supplies, prices continued to experience intense volatility in March. West Texas Intermediate crude, the U.S. benchmark, peaked at over US$123 per barrel before retreating to US$100 on optimism about peace talks between Russia and Ukraine.  Broader indices continue to experience volatility, no sector was harder hit than high multiple technology stocks as concerns about rising inflation and associated higher interest rates took center stage.  It’s important to note that the fundamentals of U.S. companies remain strong. In the final quarter of 2021, an impressive 77% of firms in the S&P 500 reported earnings per share above expectations, one of the best quarters on record.  These strong earnings helped lift the S&P 500 by 3.7% during March, paring back losses to 4.6% for 2022.
 
On the balance, we still favor equity as post-Covid recovery continues and global growth is expected to stay above trend. We remain cautious of taking on rate exposures as the pace of the rate hikes is likely to increase. With that said, we believe it is prudent to take some risks off the table. During the quarter we did take steps to reduce the equity over weight in the portfolio. trimming U.S. Growth exposure. We used the proceeds to increase the cash weight.  At the margin, we are reducing duration of the fixed income portfolios modestly to reduce the sensitivity to higher interest rates.
 
Aggressive interest rate increases and inflation are resulting in a ‘reversion to the mean’.  History is a great teacher. That suggests stock and bond markets are vulnerable as are property prices and all the other bits and bobs that have benefited from the crazily lax financial conditions of the last few years. Fundamentals are starting to reassert themselves in bond and equity markets. Perhaps the rest may soon follow.
 
Investment Strategy: Ready for Uncertainty