Disinflation and Other Platitudes

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.