Q3 2022 - Market Review

ECONOMIC COMMENTARY

“When sorrows come, they come not single spies but in battalions.”

Hamlet, Act IV, Scene V

The above quote from Shakespeare’s famous play is an excellent summary of what happened during the quarter that ended on September 30th, 2022. Capital markets had already been dealt repeated blows earlier in the year but as concerns around weaker growth, persistent inflation, geopolitics and elevated market volatility reached the proscenium, worries were legion. Against this backdrop, and despite encouraging rebounds in July, the MSCI All Countries World Index and S&P 500 Index[1] fell -4.86% and -5.00%, respectively. As was the case during the first quarter, the S&P TSX Composite fared better than its World and US counterparts, ceding only -1.41% during the quarter. While the magnitude of the equity markets decline now exceeds 20% from the prior peak in most countries and for most categories of stocks, the selloff, which accelerated towards the end of the quarter, was generally orderly, not panicky. In a way, equity market participants seemed to be accepting that unlike they did in prior instances of sudden and severe financial market disruption, the cavalry of central bankers would not come to the rescue this time around. From a stylistic standpoint, if value meaningfully outperformed growth and other styles during the first semester of 2022, no specific style stood out as market declines were fairly homogeneous in the quarter. One exception was perhaps the MSCI Emerging Markets Index which retreated -11.57% after a particularly dismal decline from China and other Asian markets.

Fixed income markets had a third consecutive tough quarter. Specifically, the ICE Bank of America Merrill Lynch Global Government Bond Index declined -4.24%. Year to date mark-to-market losses on this index now exceed -10%. The last time such a dismal performance occurred on government bonds was in the 1970s. Separately, the ICE Bank of America Merrill Lynch Global Corporate Index and the ICE Bank of America Merrill Lynch Global High Yield Index declined -4.62% and -1.16%, respectively. These segments of the fixed income markets are on track to record their worst year outside of the Global Financial Crisis (“GFC”) of 2007-2009. The disastrous performance of fixed income markets continues to prompt many asset allocators to question the relevance of a balanced portfolio approach since it is happening at the same time as equities are also experiencing large double digit losses. While we are not prepared to give up on fixed income, we predict that the debate will go on well into next year. In fact, we would caution that the decline in the value of fixed income instruments has been predominantly driven by the increase in short term rates, while long term rates and credit spreads have not contributed meaningfully. It is unusual for investment grade credit spreads to stay below 200 basis points when equity markets are in a 25% drawdown. We should not be surprised if they widened more. We believe that at least two adverse developments have fostered further increases in the volatility of the fixed income markets during the quarter. Firstly, the divergence in the pace at which different central banks are hiking discount rates. To this point, the Federal Reserve has been hiking aggressively while others, like the Bank of Japan, have not moved or moved late. Secondly, we see significant divergence between monetary and fiscal policies, as central bankers have to implement increasingly tighter monetary policies to compensate for increasingly looser fiscal policies. A prime example of that phenomenon is happening in the United Kingdom.

Commodities markets, as proxied by the S&P GSCI Commodities Index lost -10.31% during the quarter, erasing nearly a third of the gains recorded in the first half of 2022. The decline in commodity markets was perplexing for many participants who wondered why commodities had peaked while various inflation readings kept increasing. The principal reason is that while the sudden supply shock that the Russian invasion of Ukraine caused commodities to lead increases in inflation earlier in the year, slower economic growth prospects, successful Ukrainian counteroffensive in the Black Sea and the dramatic reduction in the US Strategic Petroleum Reserve stock in the past few months had a negative impact on commodity prices in the third quarter. As for the reasons behind the persistence of inflation, it is simply because pressures have transitioned away from basic materials, production and manufacturing, to labor (wages) and services such as Owner Equivalent Rent (“OER”) measures which tend to be lagging and are now increasing at a faster pace in an effort to catch up.

At the time of writing this letter, as fixed income, equity and commodity markets remain stressed, the biggest unanswered question is what level of economic damage is going to be needed until the Federal Reserve and other central banks decide to give up their fight against inflation and attack collapsing aggregate demand and rising unemployment.

“HELLO, THIS IS YOUR MARGIN CALLING”

In the final week of September, the United Kingdom reportedly came close to witness a near-collapse of its defined benefit pension industry which represents approximately £1.5 trillion. What happened is that, following the exit of the scandal-prone Boris Johnson, the newly installed Prime Minister Liz Truss and her appointed Chancellor of the Exchequer Kwasi Kwarteng unveiled a plan set to reverse previously announced tax increases and provide new drastic tax cuts valued at nearly £50 billion over two years. The plan, which followed an energy bill relief package worth £100 billion over two years, caused the yields on gilts[2] to rise sharply and their price to fall precipitously. The falling of gilts values triggered margin calls for many defined benefit pension plans who had adopted a liability-driven investment[3] strategy (“LDI”). Ironically, the said defined benefit pension funds reportedly had to sell governments bonds similar to those that were falling in value to meet their margin calls, a situation that threatened the entire system. Left with no choice, the Bank of England instituted an emergency intervention and injected £65 billion in gilts over a few days. Ironically, this happened only a few days before the Bank of England was set to begin its quantitative tightening strategy but it later acknowledged that had it not acted swiftly, many schemes were at risk of going bust.

The averted United Kingdom pension crisis is a great example of the risks that arise when too many active market participants have borrowed to acquire similar assets and that the volatility of these assets increase or worse, that their value falls. Lenders call the borrowers requiring them to post more collateral. This is what happened to the United Kingdom’s gilt market and, by corollary, the British Pound. Incidentally, a similar situation occurred a few weeks earlier on the back of the spectacular increase in European power prices. To this point, many utilities that had sold forward their production[4] faced collateral calls exceeding €1 trillion on aggregate, as the price for a kilowatt-hour of baseload electricity increased by 500% to 1000% in some cases. Given the systemic risk that was developing, the German government had to jump in to provide emergency liquidity to Uniper, as have the Finnish government with Fortum and the Austrian government with Wiener Stadtwerke GmbH. Importantly, while this story had no villains per se, government intervention was nevertheless required to avert a liquidity crisis.

Given the violent movements experienced by one too many financial assets recently, it is possible that the risk of market disruption emerges in some area or some segment not currently on the radar.

HALLOWEEN BEFORE HALLOWEEN?

So since the near term seems so spooky and the sorrows so numerous, why not move everything to cash? Well, first of all, because as noted above, capital markets are already down substantially and that all else equals, from a pure historical perspective, the natural inclination should be to add risk rather than reduce it further. But beyond that, it is important to highlight two point. One, client portfolios have thus far weathered the downturn quite well, being less exposed to long-duration assets in both bonds and stocks. Secondly, inflationary pressures appear to be abating in many areas. To this point, the price of construction materials like lumber has come down hard, as have the price of used cars and microchips as inventories are rebuilding. This is percolating into freight rates which are also well below peak. Additionally, there is evidence that the rate of increase for new rents has peaked. As such, long-term inflation expectations have been falling. Also, key economic measures remain in good health such as strong labor participation, employment rates and corporate debt levels. The banking system also appears structurally strong, at least in North America, in spite of a lull in the mortgage sector. Last but not least, we believe that the Kremlin may have played its last card by calling up over 300,000 reservists[5] to fight in Ukraine. It is hard to imagine how a herd of untrained civilians with derelict equipment can succeed where evidence suggests that its professional army is failing. We believe that rather than mobilizing to try to win this war in Ukraine, Russia is mobilizing only to delay its defeat.

In conclusion, while a recession at some point in 2023 is increasingly probable, consensus is that it is going to be short and shallow. The capital markets have already discounted that. With that in mind, we believe that the opportunity cost resulting from a further reduction of risk in discretionary managed portfolios would be greater than the potential benefits. That said, we stand ready to react to changing economic and financial market conditions.

[1] Unless specified otherwise, index performance is reported on a total return, local currency basis.

[2] The name of government bonds in the United Kingdom and other commonwealth countries.

[3] Liability-driven investing refers to an investment strategy which instead of seeking to maximize the long-term return subject to a maximum degree of risk, seeks to maximize over the long-term difference between the value of assets and the present value of liabilities. Liability-driven investing has been broadly adopted by defined benefit pension plans for which the present value of liabilities (future benefit payments) varies as a function of the term structure of interest rates and inflation. So, when interest rates rise (fall), the present value of liabilities fall (rises). As such, a liability-driven investing approach will reserve a portion of the portfolio of assets to invest in financial instruments designed to closely track changes in the present of liabilities, typically long-term nominal or inflation-linked bonds. This is often referred to as the “hedging” portfolio. Depending on the initial funded ratio (value of the portfolio divided by the present value of liabilities) and the structure of liabilities, a significant portion of the portfolio may be required for the “hedging” purposes, leaving only a small portion for return seeking or growth investing purposes. For this reason, many pension funds have recourse to leverage. This way, de-minimis collateral is necessary to create the exposure needed for the liability-driven piece and more capital is freed up to invest in higher returning assets.

[4] A strategy that guarantees a given selling price at a defined future time.

[5] A year military service is mandatory for Russian males aged between 18 and 27. After their military service is complete, they become reservists.