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Quarterly Update

July, 2022

The Wrap Up

A sea of red ink continues to flood across most asset classes in 2022 with the second quarter and in particular June being a period accounting for a significant portion of this drawdown.

Equity Markets:
It feels like we are seeing market corrections more frequently and the duration between events getting smaller.  Whether it be December 2018, March 2020 or now, markets today move very quickly to get ahead of the economic cycle.  I thought I would share some charts that are focused largely on our "big picture" indicators and why we feel we're very near to making a major bear market low. When put together they paint a picture of a market that's reached oversold/overly fearful extremes that don't occur very often, and only at major lows. 3 reasons we believe we are near a low include:
  1. Weekly momentum gauges for all the major averages are now deeply oversold. In fact, some of them are now more oversold than they were in March of 2020. Recall that the sell-off in the S&P 500 during the pandemic was the worst one month sell-off since the early 1940's and we're now more oversold than that.
  2. The same is true for breadth oscillators such as the percentage of stocks in the S&P 500 trading above their 50 and 200-day moving averages. On the 24th of June those gauges matched the deep oversold levels that they got to in March of 2020 where only 10 stocks in the S&P 500 were trading above their 50-day moving average.
  3. Finally, sentiment is also rampantly pessimistic to a degree that's only occurred twice in the past 15 years: at the end of the early 2020 pandemic sell-off, and at the March 2009 credit crisis low.


The question we hear most often these days is some variation of "how do you know we're not headed for a 2008-style bear market?" and our answer is "because credit market sentiment is not exhibiting the same sort of "systemic" risks that they were in 2008 and 2020." Bond market sentiment has deteriorated to an appropriate degree given the decline in equity markets, of course, but they're nowhere near the extreme readings that developed during those two bear markets. In fact, credit spreads and interbank overnight lending rates are still above the levels they got to in March. If the bond guys aren't worried, we're not worried.

Fixed Income Markets
Investors can understand that a war in Europe, plus China’s ongoing struggles with COVID-19, might bring weakness to equity markets. And, based on historical performance, many likely expected that fixed income would provide ballast when stocks fared poorly. Painfully, this has not been the case to date this year. Instead, markets have encountered a perfect storm the like we have not seen since 1994.
Figure 1: The Safety Trade in Fixed Income Drawdowns The following details select S&P/TSX drawdowns and concurrent Canadian fixed income performance:



We are truly in a period that is not normal with very low probability of occurrence over the past 40 years.  Since 1980 (169 quarters) only 8% of the quarters have both stocks and bonds both declined in tandem as we have seen these past 2 quarters:
• 77% of the time, bonds delivered a positive quarterly return;
• 70% of the time, stocks delivered a positive quarterly return;
• 56% of the time, bonds and stocks delivered positive returns in tandem; and
• 8% of the time, bonds and stocks posted quarterly declines in tandem.
 
Figure 2 below illustrates the historic 2022 plunge in fixed income. The chart also shows how fixed income has generally contributed to portfolio performance over the years while also acting as a risk-mitigation tool especially in 2001, 2008 and 2020.



The self-healing power of bonds
In looking at seven instances of consecutive quarterly declines for fixed income over 40+ years, a substantial rebound followed each of these declines.  Two other key takeaways: the rarity of consecutive quarterly declines for fixed income (seven instances in 40+ years); and the bounce-back return that immediately followed consecutive quarterly declines.



Outlook and Positioning
We feel the necessary adjustment in bond yields is much closer to the end than the beginning. Fixed income’s defensive qualities are not dead — they have just taken a time-out this year. While the adjustment in fixed income YTD has been painful, fixed income positions are more attractive now than they were three or six months ago. If financial conditions become too tight and sink the world into recession, bond yields will fall (prices up) and inflation talk will quickly fade. Rising rates and widening credit spreads have made the yields of most fixed income sectors more attractive. Many corporate bond yields are at their highest levels since the financial crisis. There is much less reason for alarm now that bond markets have moved a good distance toward pricing in rate hikes. This is an important point: six months ago, the bond market underestimated the extent of the current inflation pressure and the resolve of central banks to fight inflation. Today, these views have right-sized – and, in fact, may have swung too far the other way. In the near term, it’s probably too early to significantly increase fixed income allocations, but it is not the time to reduce or liquidate holdings, either. The perfect storm will eventually pass, as all storms do.