Q4 2022 - Market Review

ECONOMIC COMMENTARY

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.

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.

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