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Disinflation and Other Platitudes

Montreal, January 13, 2023 The last quarter of 2022 was choppy across asset classes. To be specific, market participants were initially encouraged by a relatively strong US earnings season coupled with signs of decelerating inflation and labor market resilience, causing broad equity markets to jump by more than 10% between October 1st and November 30th. However, sentiment turned when Federal Reserve Chairman Jerome Powell reiterated that it was premature to consider materially slowing the pace of interest rate hikes and new COVID lockdown measures were implemented in China. Both headlines were seen as hurting the odds of a growth recovery, leading equity markets to pare some gains later in the quarter. In the end, the MSCI All Countries World Index[1], S&P 500 Index and the S&P TSX Composite advanced 7.36%, 7.42% and 5.96%, respectively, during the quarter. Still, this performance leaves a sour taste given as MSCI All Countries World Index, S&P 500 Index and the S&P TSX Composite ended the year 2022 with declines of -15.98%, -18.51% and -5.84%, respectively, their worst outing since 2008. From a stylistic standpoint, Value oriented stocks outperformed Growth stocks by a margin of nearly 10% during the quarter, and 25% for the year in a sharp reversal of a paradigm that persisted for the prior 10 years. The major cause of the outperformance of Value over Growth is the performance of the Energy sector whose constituents tend to be more heavily represented in Value indices relative to the Consumer Discretionary and Technology sectors whose constituents tend to be more heavily represented in Growth indices. To this point, the energy sector is the one that gained the most during the quarter as the prospect for a looming energy shortage in Western Europe in the winter months would help oil producers and refiners preserve margins in spite of a decelerating global economy. In contrast, the MSCI World Consumer Discretionary Index and the MSCI World Technology Index were laggards as an increasingly blurred holiday season picture for retailers and automobile manufacturers took their toll on those sectors. The recovery in fixed income was less pronounced as market participants attempted to reconcile the evolving inflation and growth headlines with the not so reassuring guidance coming from central bankers. Aided by a relatively benign corporate bond default picture and lack of issuance, the high-yield market, as proxied by the ICE Bank of America Global High Yield Index, was well bid and performed best with a gain of 5.03% during the quarter. Investment grade corporate bonds, as proxied by the ICE Bank of America Global Corporate Index also partly reversed prior quarters woes with a gain of 3.22%. Sovereign bonds underperformed due to their higher interest rate sensitivity as central banks maintained their aggressive tightening stance. To this point, the ICE Bank of America Global Government Bond Index posted a loss of -0.31% during the quarter. As short-term interest rates relentlessly inched upward, floating rate fixed income instruments, whose coupon payment rate increases with increases in interest rates, generally performed better in an otherwise difficult year. In fact, the ICE Bank of America Merill Lynch Floating Rate Treasury Index appreciated 1.01% in the fourth quarter and 2.08% in 2022. Notwithstanding the generally positive performance across most fixed income markets in the closing quarter of the year, with the exception of floating-rate debt which posted a modest positive return and short duration instruments which posted mid-single-digit losses, virtually every fixed income market strategy recorded losses ranging between -10% and -15%. Pierre Elliot Trudeau and René Lévesque were respectively the Prime Ministers of Canada and Québec the last time such horrendous performance was observed on what is generally perceived as a defensive asset class. Commodities markets, as proxied by the S&P GSCI Commodities Index, gained 3.44% during the quarter and finished the year with a performance of 25.98%. A look at the different component reveals a mixed picture with the metals groups posting strong gains while the energy segment and the agricultural sectors were nearly unchanged in the quarter. CRYPTO: LAST MAN STANDING Many entrepreneurs have been attracted to the digital assets industry[2] since its establishment a little over ten years ago. Unfortunately, not all of them were well intentioned or well organized. Starting with the failure of Mt.Gox[3] in 2014, the industry has demonstrated an unusual propensity of fraud, embezzlement, theft and mismanagement. There have even been curious disappearance cases that remain unresolved to this day. The industry’s resilience has been tested on many occasions and survived, but it realized that improvements were needed for it to emerge from the financial markets fringe and gain the seal of acceptance of institutional investors. Then came along Sam Bankman Fried (“SBF”), a Massachusetts Institute of Technology (“MIT”) graduate, son of two Stanford Law School professors and adherent of William McCaskill’s effective altruism movement[4]  who seemed to be a pro-regulation prophet by actively welcoming the Secutities and Exchange Commission’s (“SEC”) scrutiny of the industry. SBF’s awkward demeanor somehow made him seem more authentic. As such, merely two years after founding FTX, the 30 year-old former Jane Street[5] trader quickly acquired the status of crypto’s “good guy,” a role that came with ancillary benefits that took the form of celebrity endorsements from the likes of Golden State Warriors point guard Stephen Curry, Shark Tank’s Kevin (“Mr. Wonderful”) O’Leary and then power-couple Tom Brady and Gisele Bundchen. SBF used sums amassed in various FTX financing rounds to buy rights to the Miami Heat stadium in Florida and became a top 10 individual contributor to the US presidential campaign for the 2022 cycle[6] . SBF made everything look like crypto gamblers should trust FTX above all else. Yet, in early November, FTX imploded in a whimper, the company filed for bankruptcy and SBF resigned as CEO. Valued at 32 billion US$ a few months prior, according to the testimony of John J. Ray III[7], FTX may be the biggest corporate fraud since Enron. After incomprehensibly appearing to be starting a media tour by participating to a long fireside chat with the New York Times and various podcasts in the ensuing days, SBF was summoned to the Manhattan federal court and was released on a 250 million bail. If you have any doubt about the seriousness of the accusations, consider that Bernie Madoff’s bail was only 10 million… In hindsight, there were red flags everywhere. First, FTX and its affiliates employed inexperienced and unqualified personnel in key roles, some of which with questionable background. This may have been acceptable for a small organization but atypical of a company valued at 32 billion US$ serving over a million customers. Second, it may transpire that SBF had been romantically involved with an FTX C-Suite executive. Third, the use of record keeping and HR management systems typically seen in much smaller organizations was unusual. Fourth, the prevalence of risks of conflicts due to transactions with affiliates (FTX and trading affiliate Alameda) and with firms having previously provided funding to FTX was problematic, as were loans to employees. So the question is: if so many bright and well-advised people failed in their due diligence of FTX and SBF, how could we have avoided it? The sad reality is that for many people, the concept of due diligence consists to sit for a couple of hours and to listen, unprepared, to a high-level sales pitch by a promoter who cold-called them a few weeks earlier. The reality is that due diligence is like the work of a police investigator. In fact, the due diligence practitioner looks for signs that invalidate the story that he/she is being told. A good example, in my opinion, is the character of Inspector Columbo, which was played by Peter Falk and which aired on NBC in the 70s. Columbo had a  famous catchphrase which was particularly annoying to suspects: “just one more thing!” Sometimes, suspects gave up or inadvertently incriminated themselves. But that was the idea. The approach should be designed to spot inconsistencies, contradictions and missing pieces of information in the story before the suspect is taken out of the penalty box. It sometimes means to be persistent at the risk of being borderline annoying. But it is necessary, because the cost of being wrong is too high. In a way, the due diligence practitioner is the Inspector Columbo of the financial world. Bitcoin lost approximately two-thirds of its value in 2022. Many participants relying on low borrowing costs to establish speculative positions have deserted the space. Some viewed SBF as the last man standing at the end of a crypto winter. Now that a mighty prophet is down, the question is whether there will be someone standing at the end or if the digital assets industry is beyond repair and therefore destined to irrelevance. ESG’S NEEDED REBOOT A few years ago, I wrote about the concerns I had about investment strategies that apply Environmental, Social and Governance (“ESG”) related filters in the stock selection process[8]. I argued that their performance was more attributable to coincidental factor exposure shared with other strategies than to the ESG metrics utilized and that ESG investment strategies were little more  rebranded large-cap growth strategies. These assertions were confirmed by an all of our quantitatively driven investment managers who are failing to develop insights from ESG filters that are not already captured by an existing, traditional filter. Another concern I highlighted was that it was possible for an issuer to be included in an ESG screened portfolio of stocks even though it scored low on one or two of the three pillars as long as it scores above market or industry average on the remaining one, which means that investors who choose to embrace the ESG concept may find compromises. So I had, let’s call it, philosophical concerns. Those investing in ESG strategies recently found themselves with more than simply philosophical concerns to address. First of all, performance of the majority of ESG strategies has been underwhelming relative to main indices since the third quarter of 2021. Incidentally, it has been somewhat in line with that of fundamentally oriented strategies emphasizing large capitalization tech sector stocks, as I had foretold. Fossil free strategies naturally fared worse in relative terms. Secondly, as he had hinted following his appointment in 2021, SEC Chairman Gary Ginsler instructed his team to pay particular attention to disclosures that investment advisers and funds make about the consideration of ESG factors when making investing decisions. As a result of these investigations, in late November, the SEC charged a subsidiary of Goldman Sachs for failures to follow policies and procedures involving two mutual funds and one separately managed account strategy marketed as ESG investments. To settle the charges, Goldman Sachs agreed to pay a 4 million US$ penalty. Apparently, while Goldman Sachs had implemented a formal process for screening investments on certain ESG metrics but the process was not systematically followed. This naturally leaves investors wondering whether the ESG label on an investment product is something real or just a marketing ploy designed to extract more fees from them under the appearance of a value-add service. Thirdly, ESG came under attack from some state legislators late in the summer. For example, Governor Rick DeSantis had the Florida State Senate pass a resolution requiring that the state pension fund invests in companies that only consider “pecuniary factors” and “do not include the consideration of the furtherance of social, political, or ideological interests.” This effectively prevents state investment of any asset management fund that considers ESG criteria in their investment process. Texas took a similar approach when passing two separate bills which prohibit the state from contracting with ESG organizations that boycott the fossil fuel or firearm industry. Shortly after the bills passed, the state comptroller even released a comprehensive list of boycotted organizations. At the time of writing this, many other states are considering similar legislation. Blackrock, the largest investment manager in the world with just under 9 trillion in assets as of September 30, 2022, and which is widely recognized for its ESG credentials was the most often cited manager by legislators in their justification. To be clear, I do not believe that these efforts will stop ESG’s ascendency. If anything, these are painful yet necessary steps in order for ESG related disclosure to become standardized globally and for mandates to become more specialized and less subject to inner contradictions. However, this backlash may prompt some investment firms to roll back their ESG agenda to circumvent divestment by certain politically motivated groups or avoid losing their future share of a growing pie. A FEW WORDS ON OBESITY, ALZHEIMER AND HARD-CORE PHYSICS As we turn the page on a somber year that brought us a fistful of adverse geopolitical and macroeconomic developments, I thought it was worth discussing a few of the positive developments that caught my attention to brighten the mood. The first one was the US Food and Drug Administration (“FDA”) decision to give the “fast track” designation to Eli Lilly and Co.’s tirzepatide molecule for the treatment of adults with obesity, or overweight with weight-related comorbidities[9]. The drug could be approved for obesity treatment in the first half of 2023. The molecule which was already approved earlier in 2022 for the treatment of type II diabetes by the FDA and is sold under the name Mounjaro™, has aced a recent phase III clinical trial, yielding far better results than those provided by Wegogy and Saxenda, the blockbuster drugs previously approved for obesity treatment. This disease is known to promote the development of other conditions such as type II diabetes or cardiovascular diseases. This leads to and complicates the treatment of other diseases such as cancer and, as we have seen with the pandemic, respiratory diseases. Thus, not only does obesity increase the risk of death, it indirectly contributes to a considerable reduction in the life expectancy of patients. Obesity also imposes a significant burden on public finances and represents nearly $200 billion per annum in direct and indirect costs in the United States alone[10]. As such, Wall Street analysts estimate that the annual sales of tirzepatide for obesity treatment could exceed 25 billion[11], which would dethrone AbbVie’s arthritis drug Humira, the current record holder (excluding the mRNA vaccine of Pfizer/BioNtech which we dismiss as a one-off). The second positive development also came from the medical sector, this time related to the treatment of Alzheimer disease, which has eluded science for three decades. In June 2021, the FDA approved aducanumab, a drug developed by Biogen and sold under the name Aduhelm™, for the treatment of some cases of Alzheimer's disease. That said, because of the risks of significant side effects, including brain swelling and brain bleeding, and allegations of improper interactions between FDA officials and Biogen’s scientific team during the approval process, aduhelm™ hasn’t been widely prescribed to the despair of the Alzheimer community which has unfortunately grown accustomed to false hopes and controversies. Thankfully, another Alzheimer drug, lecanemab, developed by the Japanese pharmaceutical group Eisai (in partnership with Biogen) has shown promise. The drug, which is expected to be available as soon as January 2023 under the name leqembi™, has been shown to slow the cognitive decline by 27% in patients with early stage, mild cognitive impairments. This is not a recommendation to buy the stock of Eli Lilly, Eisai or Biogen. If anything, the positive developments associated with these therapies is already likely reflected in the price. The purpose of this discussion is to highlight the progress being made in the field of pharmacology, which will ultimately contribute to improving longevity and the quality of life of individuals who are suffering from devastating conditions. The third positive development took place at the Lawrence Livermore National Facility when, on December 5th when a team of nuclear physicists succeeded in producing more energy from the fusion of atoms than the laser energy that was used in the process. It was the first controlled fusion experiment to reach this milestone and the first real step towards the development of a potentially limitless, environmentally friendly energy supply. The concept of nuclear fusion was theorized in the early 1930s[12] when scientists realized that this was how the sun was powering itself. It is a process by which laser beams deliver a large quantity of ultraviolet energy into a fuel capsule that contains atoms (typically hydrogen isotopes like protium, deuterium and tritium) which the laser binds together while releasing energy. The main advantages of nuclear fusion over nuclear fission include reduced radioactivity and waste, fuel supply abundance (hydrogen isotopes) and safety. That being said, considerable challenges need to be resolved. For instance, the heat required to produce the atomic reaction is over 100 million degrees. That needs to be contained! As such, in the best-case scenario, the technology is probably still decades away. For this reason, it is too early to consider investing in the next SPAC (Special Purpose Acquisition Company) that has the word “nuclear fusion” in its business plan. Nonetheless, given the urgency triggered by accelerating climate change, this could be a logical source for large-scale government-funded research for years to come, a modern-day equivalent of the Manhattan Project or the race to the moon. PORTFOLIO TUNING FOR 2023 I believe that the year ahead will force investment management professionals to make various playbook adjustments. In effect, for the first time since the Global Financial Crisis (“GFC”) of 2008, ultraloose monetary policy is less likely to come to the rescue of risky assets during sharp drawdowns. As I have mentioned before, central bankers of the Western world, through their concerted actions, have been the largest single contributor to financial assets widening gap between their price and their intrinsic value and to the abating of volatility. While I fully expect central banks to continue to intervene during severe market disruption, I believe their actions are more likely to be less “open-ended” than they have been until recently. In normal times, I believe central banks will be more tolerant to drawdowns and that this will translate into faster movements and longer lasting trends across and within markets. Indirectly, it means that the latent level of risk present in the market is perhaps more elevated than at any other point since the GFC. From a portfolio construction standpoint, it means that if a portfolio’s asset mix was calibrated with a specific absolute risk profile in mind a few years back, it probably needs to be dialled lower. All else equals, we have reduced exposure to riskier assets in discretionary portfolios since late 2021 and are maintaining that stance entering into 2023 for that reason. We made similar recommendations for non discretionary mandates. When I ask myself what would make me want to adopt a more optimistic stance, again, yesteryears quasi-programmed action to rebalance in favor of risky assets every time they declined by 5% to 10% may not be appropriate. Instead, going forward, it is more likely to be a function of how much sentiment and consensus have deteriorated relative to what is happening in reality. As a matter of fact, this is how it used to work, pre-2008. The persistent increase in inflation that triggered the fastest increase in short-term interest rates in four decades caught almost everyone – myself included – by surprise in 2022. While inflation may remain well above central bankers comfort zone for a couple of years, the inflation story will likely shift from a focus from its absolute level in the short term to its possible range a few years down the road. Here is why. Central bankers are unwavering in their efforts to curb the drivers of inflation that are caused by unsustainable aggregate demand. They are raising the cost of money so that agents are incited to save and delay consumption decisions. Judging from the steep declines in new house prices, car sales and durable goods, the measure seems effective. However, there are variables that drive inflation on which central bankers have little to no control and which may play out in ways that are difficult to predict. First, the working-age population is set to decline in the developed world. This is likely inflationary as there will be fewer workers and that the ones entering the workforce are typically less productive than those exiting. If labor movements succeed in organizing themselves in the developing countries, it would be even more inflationary as it would impact import prices in the developed world. Second, persistent geopolitical tensions likely mean that globalization has peaked. This in turn means that complex supply chains will have to be rewired and multiple redundancies will have to be established. This is also inflationary but will vary greatly from sector to sector. Third, the transition towards a low-carbon economy is causing energy supply and demand mismatches. This too is inflationary and highly volatile from country to country. Overall, I do not dismiss the possibility that central bankers manage to cause enough damage for demand for goods and services to normalize at a level that result in inflation stabilizing around 2% as it has in the past 20 years prior to 2021, but I think this has become increasingly unlikely. Which brings me to what is priced in. Interestingly, in spite of this blurry supply side portrait, inflation expectations over the next five and ten years in the US are essentially at the same level as they were 2 years ago. In fact, in spite of having seen inflation reach levels not seen in forty years, Treasury Inflation Protected Securities (“TIPS”) did not do better than nominal government bonds in the past year. Indirectly, it means that the consensus is still counting for long-term levels of inflation to drop to historical levels within a couple of years. I think this is optimistic and as such, TIPS could represent a cheap option on potential un-anchoring of longer-term inflation expectations and outperform nominal bonds going forward. We are looking for ways to express that view tactically across portfolios to improve risk-adjusted returns. Speaking of nominal bonds, the yield to maturity on high quality corporate bonds with maturities before 2028 now exceed 5%. This is higher than the expected level of the discount rates at the end of this hiking cycle. Therefore, I believe there is minimal downside risk for this segment at this stage. It also represents an interesting alternative to cash with the potential benefit of capital gains should short-term interest rates decline over the medium term. Anecdotally, a year ago, it was nearly impossible to earn risk-free or quasi risk-free returns exceeding 2%, and nearly impossible to expect returns exceeding 5% without loading up on high yield and emerging market bonds. In fact, that was the case for most of the last decade during which there were no alternatives to stocks. Well, there are alternatives on tap nowadays. I am less enthusiastic about bonds of longer maturities, particularly government bonds. First of all, the term structure of interest rates is inverted both in Canada and in the United States, which means nominal yield on long-term bonds is lower than the nominal yield on short-term bonds. While this is often the case in the months leading to a recession, we note that the current level of inversion is close to an all-time record. For this reason, investors do not seem appropriately compensated for underwriting term risk. Additionally, as the Federal Reserve has recently started to reduce its balance sheet and no longer purchases bonds issued by the US Treasury, future issuance of US government debt will have to be absorbed without one of its most significant buyers. Considering that central banks purchase had the effect to artificially suppress interest rates by as much as 1%, the path of least resistance for long-term treasury yield should be higher. Ultimately, long-term treasury bonds should remain good defensive assets in the event that growth disappoints relative to expectations but are likely going to perform poorly in almost every other conceivable scenario. It is acceptable to have some for risk control purposes but we continue to recommend a significant underweight. Turning to equities, we are comfortable with the current range of managers employed and the general positioning. In discretionary managed portfolios, our roster is broadly diversified geographically, stylistically and from a market cap standpoint. Heading into 2023, we maintain minor value and low volatility tilts albeit in lower dosage than a quarter ago. When it comes to short-term performance expectations, we do not have strong conviction either way. That being said, we note that the majority of Wall Street strategists and prognosticators think that the S&P 500 will appreciate between 4% and 12% over the next 12 months. Given the level of the risk-free rate and that of the equity risk premium, this is possible. Nonetheless, since we forecast an annualized standard deviation of 12% for the asset class, it is safer to state that there are roughly two-thirds chance that equity indices will return between -5% and +20%. We would point out that the current consensus is for the aggregate earnings of the S&P 500 Index constituents to increase 4,4% . This may be challenged if a recession does materialize because earnings have tended to decline in excess of 10% in prior economic downturns. Equity markets have quickly recovered from prior doldrums. As mentioned above, a more painful hangover may induce a stronger policy response and lead to yet another v-shape recovery but that is not our base case. With regards to liquid alternatives, our fund of hedge funds, which was one of the few bright spots in absolute terms in 2022, welcomed its eighth manager on January 1, 2023. With the latest addition, we now have all grounds covered and we are comfortable maintaining a small overweight given its proven ability to deliver positive returns during market dislocations and because of the diversification benefits that it provides in a context where the likelihood of a joint rally in both equities and bonds is slim, in our opinion. Finally, on the side of less liquid alternative strategies, we continue to advocate an approach designed to achieve and maintain an allocation target several years following the establishment of a commitment program. Like every year, we plan to offer a relatively narrow range of funds spread across the main categories, namely private equity, real estate and infrastructure. Given the rise in interest rates, we plan to pay closer attention to private debt with a distinct emphasis on strategies or sectors where a capital shortfall is looming. Thank you for your support, Dimitri Douaire, M. Sc., CFA Chief Investment Officer   [1] Unless specified otherwise, index performance is reported on a total return, local currency basis. [2] For the purpose of this discussion, I consider the blockchain industry and the cryptocurrency industry as distinct. My comments pertain strictly to the cryptocurrency industry. [3] A bitcoin exchange headquartered in Japan which reportedly handled over 70% of bitcoin transactions in early 2014. [4] William McCaskill, Doing Good Better: How Effective Altruism Can Help You Make a Difference, 2015. [5] A proprietary trading firm. [6] Source: Opensecrets.org. [7] Bankruptcy lawyer who oversaw the liquidation and recovery of assets from Enron and Fruit of the Loom. [8] https://patrimonica.com/the-great-deconfinement/?lang=en, June 30, 2020. [9] Source : Eli Lilly [10] Harvard School of Public Health [11] Source : Bank of America Securities [12] Notably, Hans Bethe. Photo credit

Not so quiet on the East front – Thoughts on the Russia-Ukraine situation

Montreal, February 25, 2022 BRIEF NOTE FROM THE CHIEF INVESTMENT OFFICER[1] Let us preface this note by saying that our thoughts are with all Ukrainians whose Canadian diaspora is the largest in the world after Russia’s[2]. We are praying for a rapid de-escalation of the situation. One of my favorite music band at the moment is an Ukrainian folk quartet called Dakha Brakha. Many of Dakha Brakha’s songs are about the reminiscence of what life was in pre-communist Ukraine. The reason I mention this while some western media outlets are describing the situation that is unfolding in the eastern province of Donetsk and Luhantsk as something totally unexpected, it is worth noting that this is nothing new to Ukrainians who have been indirectly controlled or outright repressed by Moscow for centuries. In fact, the regions that are enduring Russian military strikes today have been under a state of emergency order since 2014. Admittedly, I didn’t think that Moscow would have to act on its open threats but despite this having escalated further than I thought, I still believe that Moscow is prepared to order a general cease fire and a withdrawal of its troops as soon as NATO agree to its demands. Moscow claims that the military operation was needed to protect civilians in eastern Ukraine but I believe this is an excuse as at the same time, it has made abundantly clear, repeatedly, that it wants NATO to promise not to expand into any more Eastern European countries that border Russia[3]. For the context, Russia already shares a border with five NATO members. NATO, on the other hand, refuses Moscow’s demands on the grounds that all countries have a right to self-determination. With that in mind, I believe that Moscow’s actions in the last 48 hours are designed to verify if NATO’s resolve to protect Ukraine independence is as firm as Moscow’s determination to bring it under its tutelage. Implicitly, Moscow’s actions also signal that it is prepared to have the Russian population and Russian international conglomerates face the cost of severe sanctions, thereby showing that is not constrained by public opinion at home in the way that NATO countries are. In fact, I believe Moscow’s is counting on the fact that the American public has little appetite for another foreign military campaign as it is finally figuring out how costly and difficult it is to help small countries secure independence from belligerent neighbors. Afghanistan, where the US failed to establish political order or a functioning national economy after two decades is just the latest example of that. Prior to that, there was South Korea (1948-50 – North Korea invaded south Korea with the support of China and the Soviet Union), Vietnam (1955-75 – North Vietnam invaded South Vietnam, Laos and Cambodia with the support of China and the Soviet Union). To summarize, I believe that Moscow has concluded that NATO has little willingness to engage in a new war and that in the interim, whatever Moscow does maximizes the odds of keeping Kyiv under its influence. INVESTMENT STRATEGY IMPLICATIONS If the omicron variant or the prospect of runaway inflation were insufficient, it seems that Russia’s invasion of Ukraine has finally provided the excuse to send capital markets into a tailspin. To this point, global equity markets are nearing double digit losses year to date and volatility indicators are on the rise again. This is the kind of scenario that is prompting investors to question their investment strategy. That being said, just like we argued against cutting dramatically the exposure to risky assets when the first cases of Covid-19 were revealed outside of China on the grounds that it was already too late, I believe that selling now, when so much fear and uncertainty is being discounted is not the best option. At the same time, I’m not suggesting to buy either. After all, while I don’t believe that the situation in Ukraine will deteriorate much further, an attack on the Russian natural gas pipelines that cut across Ukraine to supply Germany and other parts of Europe cannot be ruled out at this point. I also do not think that Russia will inspire Beijing to consider similar options for Taiwan but may it will. I would simply point out that while our models still suggest that broad equity markets will continue to appreciate by 5% to 7% per annum on average in nominal terms in our base case scenario, that does not mean that they will appreciate by 5% to 7% every year. We are reminded periodically, as we are now, that markets do not go steadily go up. There will be down years and there will be double digit up years. As we have mentioned on numerous occasions, the key is to ensure that the proportion of an investor’s capital that is invested in risky assets is consistent with such investor’s risk or loss tolerance. From that stand point, I am very comfortable with the positioning that we’ve adopted for our clients. For instance, through the managers that we have selected, we have largely avoided long term government bonds which are proving quite vulnerable to interest rate increases. We have also avoided the most speculative segments of the equity markets which are also proving vulnerable to monetary policy adjustments. We have entirely avoided crowded flavors of the day like companies that had recently IPOed and we never held cryptocurrencies. On the private markets side, we systematically declined opportunities to invest in start-up software firms on multiples not witnessed since the dot-com era. We were instead focused on establishing a portfolio of hedge funds in which underlying funds that would place bets primarily on relative value, higher volatility, higher dispersion and trend following strategies. We saw that as the best strategy to avoid being caught off guard in the event that equity and fixed income disappointed simultaneously. These little actions together contributed to enhance the resilience of our clients portfolios. Lastly, I remain optimistic that I will get the chance to appreciate Dakha Brakha live in Montréal in the not too distant future. Dimitri Douaire, M. Sc., CFA Chief Investment Officer   [1] The title is a paraphrase of the 1930 world war I themed movie “All quiet on the western front” based on the 1929 Erich Maria Remarque novel. [2] Census Profile, 2016 Census: Ethnic origin population, Statistics Canada, 8 February 2017 [3] Since the collapse of the Soviet Union, Russia’s western buffer has been reduced to Belarus   Photo credit

Rising Inflation: What Asset Owners Can Do About It

Montreal, October 13, 2021 THE LATEST ON INFLATION The U.S. Bureau of Labor Statistics recently reported[1] that the U.S. Consumer Price Index (“CPI”) had risen 5.3% in August from August of last year. The increase was smaller than the 5.4% increase reported year-on-year for July. Similarly, the Core CPI, which excludes more volatile energy and food items, had risen 4.0% in August from August 2020. The increase was also smaller than the 4.3% year-on-year increase reported last month. In Canada, the CPI accelerated to 4.1% in August year-on-year relative to a 3.7% increase in July[2]. When excluding gasoline, prices increased 3.2% year-on-year, up from 2.8% in July, the highest level in 13 years. Similar observations can be made for other parts of the world with Eurozone and Japan inflation hitting levels not seen in a decade. OF USED CARS AND CHIPS When we examine the price increases at the component level, we note that the principal contribution to core inflation[3] increase comes from the used cars and trucks component, which is up over 30% from August 2020. Used cars and trucks are more expensive due to the reduction in new car inventory, which caused surging demand in the used passenger vehicle channels. The reduction in new car inventory was largely attributable to a shortage of key components, including computer chips. To meet the needs of an increased percentage of the global population that started to work from home at the onset of the pandemic, the semi-conductor manufacturers were forced to reroute their foundry capacity away from automotive chips to cloud, home computer and peripheral chips. Things were slowly returning to normal earlier this spring when a fire broke out at Renesas Electronics’ Naka factory in Japan, where chip production did not return to full capacity until three months later. Elsewhere, the worst drought experienced in Taiwan during the last 50 years forced producers on the island to make production adjustments at their processing facilities which require large amounts of water. Interestingly, while the world has gotten used to the threat of inflation at the raw material level caused by the shutdown of an oil field in Saudi Arabia or elsewhere in the Middle East, by a strike at a copper mine in Chile or at a platinum mine in South Africa, it is the first time that shortage of a manufactured product has had such an impact. Given the fact that chips represent as much as 40% of the cost of an automobile[4], in a sense, computer chips are to 2021 what oil was a generation ago in terms of its strategic importance. Understandably, this risk is being addressed already. For instance, Intel announced that it would build two plants in Chandler, Arizona at the cost of 20 billion while Mudabala’s Global Foundries subsidiary announced that it would establish a plant in Singapore. We believe there will be other announcements as President Biden’s Infrastructure Plan has earmarked 500 billion for this sector. As such, we believe that the risk of lingering inflation rise from this component of the index will abate before the end of spring 2022. PERMISSION TO DOCK DENIED Going back to the sources of contributions to core inflation increases, beyond used cars, trucks and parts, we note significant year-over-year increases in the price of household furnishings and supplies, which includes furniture, home appliances and apparel. As the vast majority of these goods are imported goods, their prices have been directly impacted by container shipping costs, which have been booming. To this point, the Drewry World Container Index, which tracks the cost of shipping a 40-foot container over various routes globally is up 600% from January 2020[5] through late August 2021. Similarly, the Baltic Dry Index, which tracks the cost of shipping bulk commodities (like coal, iron ore and grains) is up 1000% over the same period[6]. Shipping costs are extremely volatile and the sector is famous for its boom and bust episodes. In fact, despite the spectacular run-up in prices that we have witnessed in the past 18 months, container and dry bulk shipping costs have not even reached half of the levels reached in the months leading to China’s Beijing Olympics Games in 2008 when enormous volumes of raw materials needed to be imported for all the infrastructure projects that were being developed in parallel to the Olympics. While the shipping market imploded shortly after the Beijing Olympics with the rest of the economy, the current price surge could be more lasting than it was 13 years ago. While global trade volume is not as effervescent as it was back in 2008 relative to the number of vessels, port congestion is causing long delays and constraining supply. A COVID-19 outbreak at a Ningbo-Zhoushan Port terminal which forced a partial shutdown of the port earlier this summer did nothing to alleviate price inflation. That being said, given the history of this sector, we believe that price pressures will likely be resolved through a combination of increased port capacity and a larger fleet. That could, however, take a while as the current dry bulk orderbook, measured in terms of deadweight ton on order as a percentage of the current fleet was recently observed at the lowest levels since 2003[7]. The prospect of shipping crew shortage also risks complicating the situation. In fact, UN-Secretary General Antonio Guterres, during an address on World Maritime Day[8], recognized the humanitarian crisis that hundreds of thousands of seafarers face as many became effectively stranded at sea, unable to disembark due to voyage delays caused by the pandemic. 139 MILLION[9] HOUSES FOR RENT So far, we have looked at the two principal components of Core CPI increases from August 2020 to August 2021 and have concluded that those increases will probably subside. Given that certain Core CPI components have seen muted price increases, could we witness a material impact in inflation should they start moving up? An obvious item to scrutinize, if only because it represents nearly one-third of the entire Core CPI measure, is shelter. Shelter, however, is misleading, to say the least. In effect, apart from minor items such as the cost of lodging away from home and household insurance, the Bureau of Labor Statistics considers houses as capital, not as consumption items. As such, instead of using actual home price variation as an indicator, the cost of shelter is the implicit rent that owner-occupants would have to pay if they were renting their own homes. It is referred to as owner equivalent rent or OER. To quantify it, the Consumer Expectations Survey simply asks consumers who own their primary residence the following question: “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” Surveyors then compile responses collected from their sample which is designed to be representative of nationwide housing dynamics. It is easy to see how this method for estimating variations in housing costs can be misleading. In fact, the Federal Reserve Bank of Cleveland itself, in a research conducted in 2014[10], suggested that OER did not appear to be influenced by vacancy rates, unemployment rates or the real interest rate. Furthermore, only lagged house price appreciation appears to have a statistically significant relationship with the Bureau of Labor Statistics’ OER. Actually, historical data shows that from 2005 to 2007, OER increases were trailing substantially the increase in the house price index and OER puzzlingly continued to increase from 2007 to 2009 when house prices were comparatively falling at near double-digit rates nationwide. In other words, it appears that the Bureau of Labor Statistics measure of shelter cost appears quite disconnected from actual changes in homeownership costs. From our perspective, this is rather important as OER represents more than two-thirds of the shelter CPI component, and one-third of the index. To the extent that it is implicitly a lagging indicator, as more surveyed homeowners realize what has been happening to home prices nationwide, they may adjust their response accordingly. And as such, even if the price of other items starts to decline, as lumber and iron ore have recently, it may take a while for the index to decline if the OER component starts to tick up. WHAT IF EVERYONE IS WRONG AND INFLATION IS STRUCTURAL At the moment, after having reconsidered the numbers, we continue to believe that the recent above-trend increases in inflation are transitory, rather than structural, and that by the second quarter of 2022, year-on-year inflation increases will have subsided to levels that are within the Federal Reserve’s comfort band. Our view is aligned with the current consensus. In fact, the U.S. 5-year expected inflation derived from the difference in yields between 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities has stabilized around 2,5%. Leaving aside questions about Central Banks‘ willingness and ability to raise the discount rate and end their bond purchase programs, we asked ourselves if assets owners’ portfolios are constructed to withstand unexpected increases in inflation and if not, what should be added or removed to improve resiliency? ASSET CLASS PERFORMANCE IN RISING INFLATION ENVIRONMENT: PERCEPTIONS AND REALITY In the following section, we will discuss the performance of broader asset classes during rising inflation periods historically and whether such performance is likely to be repeated. We will then summarize which asset classes an investor should consider to reposition his portfolio in order to make it more resilient should inflation unexpectedly increased further. EQUITIES The current narrative is that equities would do well if inflation was a little higher. The rationale is that corporations would be able to pass on higher costs to end consumers while a portion of their costs, such as labor-related costs, would not increase immediately. Additionally, higher inflation would tend to increase the replacement cost of existing assets and make those relatively more valuable. While these are reasonable assumptions, we believe that the ability to pass on higher costs to end consumers will vary greatly from one company to another. Our view is that companies with a relatively high proportion of their cost structure consisting of fixed costs will tend to do better. All else equals, value stocks should be favored relative to growth stocks. That being said, it is important to consider what is happening to growth and productivity at the same time. Unfortunately, inflation has been in a downward trend in the past 40 years. In fact, before 2021, there have been only three instances where the Core CPI increased by more than 1% relative to the prior year in the U.S., 1987, 2000 and 2008. We would highlight that these were not good years for this asset class even though there were clearly other factors at work. With that in mind, we accept that equities would probably do well with minor increases in inflation but that beyond a certain level, market participants will assume that inflation could persist and reflect those views by adjusting the equity risk premium higher and lowering price targets. FIXED INCOME The relationship between nominal bond yields and the rate of change in the CPI has been quite strong going as far back as the end of World War II.  They have tended to increase in tandem from the early 1960s to the late 1970s before declining together since 1980. Given the inverse relationship between nominal bond yields and bond prices, the empirical evidence is quite strong: rising inflation is detrimental to fixed income. That being said, not all fixed income instruments have similar characteristics. To this point, instruments with more distant maturities exhibit more sensitivity to changes in inflation expectations. Conversely, instruments like Canadian preferred shares and bank loans, whose distributions increase when short or intermediate government bond yields increase, may benefit in a rising inflation scenario. The condition for that to happen, however, is that higher inflation needs to trigger a monetary policy response, as distribution rates are linked to short or intermediate-term government bond rates, not to inflation specifically. In fact, these instruments have been negatively impacted by the various rounds of quantitative easing that have suppressed interest rates. As such, while these instruments would likely do better than government bonds and investment-grade corporate bonds in an inflationary scenario, we believe these instruments remain more responsive to changes in monetary policy than to changes in inflation. Furthermore, it is important to note that while these instruments might be effective for small increases in inflation that would drive small increases in rates, beyond a certain level, the relationship could break because default risk jumps . More direct exposure to inflation increases is possible via Treasury Inflation-Protected Securities (“TIPS”) in the U.S. which have been auctioned since 1997. In Canada, Real Return Bonds play an equivalent role. With TIPS, for instance, the principal value is adjusted for inflation. As such, if held to maturity, TIPS will have provided full indemnification for inflation increases. Before maturity, though, TIPS are impacted by future inflation expectations, which may cause them to appreciate or depreciate and potentially negate, at least temporarily, their inflation hedging properties. Another fixed income market segment to consider is emerging market bonds, and in particular, those denominated in local currencies. The logic is that the value of coupons and principal payments could be worth more in U.S. terms should the United States experience an extended period of elevated inflation relative to other countries, which could depreciate the U.S. dollar. The inflation hedging properties of emerging markets local currency bonds could become particularly interesting if inflation increases are driven by a surge in commodity prices, from which numerous emerging-market countries still derive a significant portion of their international trade revenues. Lastly, income generated from emerging markets fixed income tends to exceed the income generated from their counterpart in developed markets over time. However, the segment is not without risk. To this point, default risks and political risks tend to be elevated as compared to developed markets and we are doubtful that on aggregate, emerging markets fixed income would perform well in a stagflation scenario, characterized by higher inflation but comparatively low economic and productivity growth. COMMODITIES Commodities are generally thought to be decent inflation hedges. The principal reason is that demand for commodities tends to be relatively price inelastic. This is true for agricultural, energy and industrial metals. Commodities could be really effective hedges if supply and demand dynamics for a particular commodity are the cause of a broader increase in inflation, as was the case in 1973 when the Organization of Arab Petroleum Exporting Countries declared an oil embargo against nations that were perceived to support Israel during the Yom Kippur War. This embargo impacted the global economy for many years. However, one of the challenges with commodities is that the asset class is quite volatile and that, unfortunately, changes in inflation expectations explain only fractions of that volatility. In fact, one could argue that while the introduction of commodities in a portfolio might contribute to hedge against unexpected inflation increases, it could introduce a number of undesirable risks or compound existing risks. Some argue that gold and other precious metals are better inflation hedges than other commodities. Unfortunately, data going back to the days when Richard Nixon rendered the Bretton Woods regime inoperative in 1971, suggest only a weak relationship between quarterly spot gold prices and U.S. Core CPI[11]. While the relationship appears stronger for increases in inflation that exceed 5% per annum, this would indicate that like other commodities, the price of gold is largely driven by factors other than inflation, at least over the short term. In fact, a good portion of those arguing that gold can serve as a great inflation hedge also thinks that gold is a good deflation hedge. We believe that perhaps it is more a hedge against heightened uncertainty in general, not necessarily specific to inflation considerations. Another theory[12] suggests that gold prices are inversely related to the real expected return on other financial assets. In other words, the best environment to hold gold is one where negative real rates of return (that is nominal rates of return after inflation) are expected to be low. We think this theory makes intuitive sense as gold, an asset that produces no income, becomes an attractive alternative to assets whose income is not expected to cover the cost of inflation. This theory, however, has not proven very effective. Actually, in spite of the deeply negative real expected rates of return prevailing for most of the fixed income universe, gold has not meaningfully appreciated and has in fact lagged most other commodities. To be clear, gold’s behavior puzzles us. Admittedly, there seem to be more unknown than known factors at work. We even wonder if large-cap technology stocks have taken over gold’s role as a hedge against declining real rates of returns. INFRASTRUCTURE, COMMERCIAL REAL ESTATE, FARMLAND AND TIMBERLAND Real assets are often presented as natural hedges against rising inflation since the income generated from the underlying assets through rents, tolls and other sources tend to increase over time. As most investors approach the real asset sector principally through private markets funds that report net asset values infrequently, it is difficult to empirically validate this claim. Some researchers use publicly-traded market proxies, such as Real Estate Investment Trusts (“REITS”) or Infrastructure Equities[13] to estimate real assets sensitivities to various risk factors and then generalize finding to private markets. For us, this is a delicate exercise as the nature of publicly listed companies can be quite different from that of private companies or assets in the space. For instance, the public REITS side is largely comprised of core, stabilized properties while there is typically a larger content of development projects on the private side. In fact, public REITS are often buyers of assets developed in the private space. With regards to listed infrastructure, publicly listed indices include companies involved in engineering and construction, which may be quite a bit more cyclical than the infrastructure assets themselves. Ultimately, there are indeed assets that present superior ability to pass through cost inflation, like regulated power utilities, but it is not true for all assets. Real asset values change in response to several factors and we suspect that inflation is responsible for only a modest proportion of real assets price variations, not unlike the situation that we described for commodities. Moreover, changes in value related to local markets, supply/demand dynamics and the debt structure underlying real assets seem of capital significance. For instance, in a rising inflation scenario, real assets financed with fixed-rate long-term debt should appreciate more than comparable assets financed with floating rate short-term debt. The reason is that income matters more than revenues and having a fixed debt charge will be more beneficial than a floating debt charge as the latter will increase with inflation. With that in mind, we think that interest rates, specifically long-term interest rates, have a greater influence on real assets values than inflation itself. After all, real assets have been amongst the best-performing assets in the last decade, a relatively benign period from an inflation standpoint but one that saw long-term interest rates decline consistently. LONG/SHORT AND RELATIVE VALUE STRATEGIES As we have seen so far, the vast majority of assets which potentially have interesting inflation hedging characteristics are also sensitive to many other factors. As such, when introducing those assets in a portfolio, investors must weigh the other risks that are being introduced and in what proportion relative to the assets already held. Alternatively, investors could consider the introduction of long/short or relative value strategies in which the instrument that is sold short is designed to offset one or more of the undesirable characteristics of the instrument that is being held long. An example would be the introduction of inflation break-even strategies, which consist of a long position in an inflation-linked bond, usually a TIPS, and a short position in a duration equivalent nominal government bond. The intent of such strategies is to remove the impact of changes in inflation expectations during the holding period. This is important because, as we have discussed before, changes in future inflation expectations will cause fluctuations in the value of TIPS that are unrelated to the current level of inflation. In contrast, a long TIPS position hedged with a duration equivalent government bond will eliminate this risk and result in a purer, inflation hedging strategy. Another strategy could consist in establishing long positions in a basket of stocks with desirable inflation hedging characteristics like infrastructure or commodity-related equities, with a beta matched short position in the broader market of sector indices, thereby emphasizing the inflation hedging characteristics and removing the broader equity market risk. These are the type of strategies that are tactically implemented by global macro managers, often with significant leverage in order to compound potential benefits. The main challenge is to identify managers whose fund’s exposure to a rising inflation thematic would be large enough relative to other exposures to warrant an allocation on that basis. Unfortunately, such managers are scarce as the business of selling inflation protection has not been very lucrative in the past twenty years. Most of them turned to something else or diversified their portfolio to the point where the inflation hedging properties had been severely diluted. CONCLUSION We have discussed in detail the causes underpinning the increase in inflation and have concluded that the phenomenon is temporary. We also debated the idea that the shelter component of the Core CPI calculation may in itself be a lagged indicator of future inflation and that this component could cause inflation to persist. We then examined each asset class from the point of view of their respective inflation hedging characteristics and conclude that making an investment portfolio more resilient in the face of unexpected increases in inflation is challenging. For one, the reality is that the traditional fixed income and equity allocation do not tend to do well when inflation expectations accelerate too quickly. Secondly, the vast majority of assets or strategies that exhibit inflation hedging features also happen to bear other risks which are sometimes greater than the risks they are designed to reduce. The key is to find the appropriate balance in the choice of assets and their corresponding allocation, such that a portfolio does relatively well should inflation expectations increase while not doing too badly should inflation expectations remain stable. We believe that the solutions that we have deployed and the robust portfolio construction framework that accompanies it does improve expected outcomes in a rising inflationary scenario without compromising expected outcomes in other scenarios. Dimitri Douaire, M. Sc., CFA Chief Investment Officer   [1] Bureau of Labor Statistics [2] Statistics Canada [3] We focus on Core Inflation rather than broad inflation measures as the latter do not influence monetary policy. [4] Source : Alix Partners [5] Source : Drewry [6] Source : Bloomberg [7] Source: BIMCO [8] September 30 [9] U.S. Census estimate of the number of houses in the U.S. [10] Federal Reserve Bank of Cleveland, Recent Owners’ Equivalent Rent Inflation Is Probably Not a Blip, August 11, 2014 [11] Source : World Gold Council [12] Robert Barsky & Lawrence Summers, Gibson’s Paradox and the Gold standard, 1985 [13] Companies that own or that operate infrastructure assets.   Photo credit

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