AI Unleashed and Other Platitudes

Montréal, April 17, 2023 The equity markets overcame a slew of negative macro and fundamental developments and posted positive returns in the first quarter of 2023. In effect, equity investors seemed to be looking past the appalling trend in the ISM Manufacturing PMI most recent reading[1], lower IPO and merger activity, softening profit margins and earnings growth expectations[2] to conclude that the prospect of a near-term peak in interest rates was a catalyst for improving consumer and CEO sentiment, which would ultimately be conducive for long-duration assets, including equity markets. To be fair, investors are also likely looking past the shelter component measure of the US CPI (whose pitfalls we have highlighted before[3]) and assume that inflation is already much lower than the figure being reported. To be specific, the MSCI All Countries World Index[4], S&P 500 Index and the S&P TSX Composite advanced 7.02%, 7.36% and 4.55%, respectively, during the quarter. Interestingly, excluding issuers who became takeover targets during the quarter, the best performers included a collection of ancillary cryptocurrency and artificial intelligence plays as well as some of the most significant large cap technology and consumer discretionary losers of yesteryear like Facebook (Meta), Tesla and Nvidia. The laggards, in contrast, were concentrated in the energy sector due to the decline in the price of crude oil and natural gas and, for reasons that we have already written about extensively earlier this month, the financial sector. Fixed income markets rose in sympathy with equity markets as signs that higher rates were taking their toll on economy were multiplying, thereby sending bond yields lower across the curve. Movements in interest rate curves were particularly acute in the aftermath of the Silicon Valley Bank debacle as rates dropped by a record amount over a short period and implied volatility of interest rates, as proxied by the ICE Bank of America Merrill Lynch, surged to a record. While the US policy response, in particular the Federal Reserve’s Bank Term Funding Program (“BTFP”) was well perceived from a liquidity enhancing viewpoint, consensus is that the ongoing stress in the banking sector is leading to tighter lending conditions and the market’s response was to send credit spreads higher. Nevertheless, corporate bonds generally outperformed government bonds. To this point, the ICE Bank of America Global Government Bond Index and the ICE Bank of America Global Corporate Index returned 2,66% and 2,85% respectively. However, longer maturity bonds did much better than shorter maturity ones. At the time of writing this, deposits in the US commercial banking system were still flowing out albeit at a slower pace than they did earlier in March[5]. As such, it looks like the regulators did the right thing. That said, I personally find it ironic that the venture capital industry, which was the principal recipient of the over-investment and over-lending largesse of Silicon Valley Bank and the likes, did not contribute a penny to bail-in the fragile First Republic Bank[6]. For the moment, it appears that the risk of a credit crunch has been contained as capital evaporation seems to have been largely limited to the venture capital industry, SPAC and other highly speculative sectors. It would be arguably more worrying if capital disappeared from the hands of the capital providers themselves. That would be more difficult to contain. AI UNLEASHED On November 30, 2022, artificial intelligence laboratory OpenAI[7] officially unveiled ChatGPT, a highly evolved prototype software designed to simulate conversations with human users. Built on the Microsoft Azure’s super-computing platform and released freely to the public, ChatGPT only required 5 days to reach 1 million users, the fastest ever application to reach such a milestone, faster than Instagram (2,5 months), Spotify (5 months) or Facebook (10 months)[8]. On January 23, 2023, Microsoft, which had already injected capital in OpenAI in two successive rounds in 2019 and 2021, made an unconfirmed additional commitment of 10 billion US$ to further its development. The announcement came less than a week after Microsoft launched an Azure service that provides access to a managed version of OpenAI’s ChatGPT[9]. The positive reviews garnered by ChatGPT’s release and its potential to transform Microsoft’s derelict Bing search engine reportedly caused tremors in Microsoft/OpenAI’s bay area rivals’ headquarters and it turbocharged a nascent AI race as Google and Baidu respectively launched Bard and Ernie during the quarter, their own response to the Microsoft/OpenAI partnership which had already come up with ChatGPT-4, an improved version of the original. Let us take a step back to explain what ChatGPT is and why it matters. ChatGPT is a conversational software that uses large sets of text data to learn to predict the most plausible next word, or sequence of words, based on the first few words of a sentence or a context. It is also capable of applying the knowledge acquired by solving a task to a related task. This type of large language models is called generative pre-trained transformers, hence the acronym (“GPT”). The data sets on which it was trained are vast, ranging from entire digital libraries, user manuals, research papers, newspaper articles and user-generated social media content. The main advantage of ChatGPT over prior generations of conversational software is that it is extremely versatile. In effect, until recently, chatterbots were limited to provide answers to relatively narrow sets of questions. In contrast, ChatGPT is able to provide rapid, precise and coherent answers to complex questions in virtually every field. It is a revolutionary way to search the internet as instead of clicking through links for answers, ChatGPT does that exercise itself and returns the answer directly. ChatGPT is an indomitable Trivial Pursuit™ opponent. It is easy to understand why this newly available tool represents a serious threat to Alphabet’s ubiquitous search engine. But it goes well beyond that. ChatGPT remembers previous prompts given to it in a conversation and is thus able to fine-tune its responses based on prior questions. It can write long essays, summarize scientific articles, produce song lyrics, debug and create computer code and it is only a matter of time for it to be able to interact with other forms of media, like audio and video files. There’s no denying that the speed and accuracy of generative Artificial Intelligence (“AI”) could boost labor productivity in many fields. In fact, in a recent report, Goldman Sachs[10] estimated that it could raise annual US labor productivity growth by nearly 1,5% per annum over a 10-year period following widespread adoption and boost Gross Domestic Product (“GDP”) by 7%. Goldman Sachs further estimates that 300 million jobs globally could be exposed to AI-automation. Interestingly, in contrast with the first wave of automation which displaced principally manufacturing blue-collar jobs, generative AI stands to impact white-collar jobs in multiple industries such as sales and marketing support, legal, education, accounting, design and engineering and many others. In some specific cases, generative AI is bringing the marginal value of human expertise down to nothing. From that standpoint, generative AI could be the most significant deflationary shock since China joined the World Trade Organization in 2001[11]. The spoils derived from productivity gains are typically not evenly distributed in society. In some industries, corporations might be able to retain the lion’s share of incremental profits. In others, consumers might disproportionally benefit through reduced cost of goods and services. Nevertheless, higher growth and lower costs have historically tended to be a positive combination for financial assets. For this reason, we are already incorporating the advent of generative-AI in our medium to long-term inflation forecasts and by ricochet, our medium to long-term asset return projections. To be clear, we still think inflation could surprise on the upside over the medium-term relative to consensus expectations but not as much as we thought a few months ago. That being said, many people argue that generative-AI is not ready for prime time. They point to examples where ChatGPT failed to spot contradictions in a prompt, where it regurgitated misleading information, made defamatory claims or seemed to express certain political or cultural biases. Since ChatGPT is at its core a statistical model that makes inferences, it is normal that a small percentage of its responses will turn inaccurate. It will improve over time. Some critics are more fundamental. For instance, the iconic linguist and intellectual Noam Chomsky, in an interview with Open Culture[12] suggested that ChatGPT was nothing more than “high-tech plagiarism” and a “way of to avoid learning.” Along the same lines, songwriter Nick Cave, after having dissected lyrics written by ChatGPT in his own style simply said that it was “a grotesque mockery of what it is to be human.”[13] Others, alarmed by ChatGPT’s prowess go further, arguing that generative-AI has gotten close to the point where it poses a civilizational existential threat. In fact, over a thousand high-tech personalities have petitioned[14] AI research and development firms to pause their efforts to develop something superior to ChatGPT-4. I believe a voluntary pause is not a great idea because criminal organizations would never submit themselves to a voluntary pause. On the contrary, knowing that other generative AI developers were to submit themselves to a pause, the criminal ones would do everything to use the window to their advantage, the perfect recipe for AI development to go rogue. Anyways, I do not think that a development pause can be effectively implemented based on the historical adoption curve of some noteworthy revolutionary inventions. I note for instance that once Gutenberg rolled out his movable-type printing press, there was nothing that the masses of medieval monks who were tasked copying the Bible could do to prevent being disintermediated. Similarly, Karl Benz did not wait for three-way traffic light to make its appearance[15] or for Ralph Nader to push for the safety belt[16] to continue manufacturing cars safety belt[17] no more than Baltimore City authorities listened to gas lighting lobbyists after the incandescent electric lights were popularized in the 1880s, providing better quality light for one third of the cost[18]. Generative-AI has gone viral. Rightfully so as it offers a lot of promises. Notwithstanding that, it would be wise to remember what Sam Altman, ChatGPT’s creator, said about his offspring: “ChatGPT is incredibly limited, but good enough at some things to create a misleading impression of greatness. It's a mistake to be relying on it for anything important right now. It’s a preview of progress; we have lots of work to do on robustness and truthfulness.”[19] With that in mind, it is unlikely that I will delegate to ChatGPT the task of writing future newsletters. PROBLEMS FOR ZOMBIE AND VAMPIRE COMPANIES Most of you have heard the term zombie bank or zombie company. It is used to describe companies that are generating cash and that are able to cover basic running and fixed costs, including the interest on its debt, but that would be structurally unable to repay the principal on their debt without bailouts, subsidies or dilutive equity financing rounds. The term zombie was borrowed from Haitian folklore and refers to a man who is under the effect of a filter or a charm that takes away his personality. Zombies are often portrayed as slowly decaying, mindless, soulless thralls without real purpose. The concept was first applied to many recipients of the support from Japanese banks after the bursting of the country real estate bubble in the late 1980s but was later applied to US financials in the aftermath of the Global Financial Crisis (“GFC”) of 2008 and to Chinese state-owned steel, aluminum and cement, and paper producers around 2015. Corporate zombies have always been present in the public equity markets. From an economic standpoint, zombies have a negative influence because they inevitably consume more resources than they produce. If there are only a few, the negative economic effects remain manageable. But in a scenario where growth decelerates while debt servicing cost increase, zombies can quickly multiply and become a destructive force in the economy. At that point, the dilemma between maintaining zombies alive, by perpetually feeding them or letting them perish, is more easily resolved than when their number is a mere nuisance. To be clear, we do not think that a zombie apocalypse is imminent, but we believe that public policy towards zombie companies could become less complacent and their operating conditions might deteriorate rapidly. As such, existing and prospective zombie companies should rethink the long-term viability of their stupor. Beyond zombies, there is another type of company has taken its name from a dreaded mythological creature. This type of company appeared more recently and is less common than the zombie company: the vampire company. The term was first introduced a few years ago by Professor Michael Wade[20] of the International Institute for Management Development (“IMD”) in Lausanne to describe companies that are able to offer their products and services more cheaply than the incumbents and offer unparalleled customer experience on a global scale. Like the vampire of the late romantic literary period, these companies are seductive and are relentless in the pursuit of their mission. This is the opposite to zombie companies. According to Professor Wade, vampire company examples include Uber (taxi and ride hailing industry), Amazon (bookstores), Netflix (movie rental) and Alphabet (internet search). Vampire companies operate by diverting revenues and profits away from industry leaders to themselves. To employ a vampiric analogy, they are taking over the blood pool. The problem for vampires is that the blood pool ultimately runs out. For instance, the market share of Ford’s Model T went from 8% the year it was introduced in 1908 to 61% in 1921[21]. Although revenues continued to increase afterwards, growth decelerated because the pool was becoming empty and there were no more incumbents to displace. As it happens, the growth of vampire companies start to converge towards that of the broader economy. In the case of Alphabet and Facebook, the size of the blood pool is determined largely by the advertising budget of corporations who are paying to show up in internet searches. So, in order to survive, vampire companies need to tap into more blood pools, branch out into adjacent industries and categories. Some vampire companies have been incredibly successful at tapping into other blood pools. Amazon, who alone generates nearly 50% of all US e-commerce sales, is the vampire company overlord, in my opinion. Others have been less successful. In the past year, the top line growth of some of the better known vampire companies highlighted above disappointed and their stock price underperformed[22]. It is still too early to tell if this was just a blip or if the decline in the vampire companies’ stock price is a market’s call on the primary blood pool of these vampires running dry or worse, on their ability to find new blood pools, like the metaverse project for Facebook, the iCar for Apple or live-stream events for Netflix… What could get interesting is if two or more vampire companies were to set their eyes on the same blood pool. I wonder if a particularly fierce battle could cause a margin erosion to the point of turning both into zombies… GöTTERDäMMERUNG[23] ? At the Davos Word Economic Forum in January, Mohammed al-Jadaan, Saudi Arabia’s Finance Minister, mentioned that the kingdom was open to settling trade for oil and natural gas in currencies other than the US dollar and the Euro. This statement drew a lot of attention, so I decided to investigate a little further to see if this indirectly signaled that the world reserve currency status that the US dollar has enjoyed since the Bretton Woods accord in 1944 was undermined. If so, it could lead to structural US dollar weakness for years to come and upend the Greenback’s role as a portfolio hedging tool for non-US domiciled investors. Let us put a few things in perspective. First, consider that the US dollar’s share of the world’s central banks foreign currency reserves stood at roughly 56% in the third quarter of 2022[24]. It was approximately 70% at the turn of the century. The US dollar representation has been declining but the lost market share has been redistributed across a number of currencies, including non-traditional ones[25]. Second, consider that about half of the goods and service trade globally are invoiced in US dollars while the United States represents just 10% of the volume, both relatively constant figures over the last few years. Third, consider that according to the Bank of International Settlements, the US dollar is used in roughly 90% of foreign currency transactions (out of 200% as there are two currencies involved in a foreign exchange transaction). Also, a relatively constant figure in recent years. At first sight, if an alternative currency is ascendant, it is not showing in the data yet. It is worth noting that China, who took over the United States as the largest trading partner of Saudi Arabia since 2011 (thanks to the US shale oil revolution which no longer made Saudi Arabia oil essential), has been pressuring the Gulf State to accept payments in Yuan for its oil and natural gas imports for a while. Incidentally, the two countries have gotten increasingly close recently. In fact, in the first quarter, Saudi Aramco acquired a 10% stake in the privately held Chinese refiner Rongsheng Petrochemical Co., Ltd. for about $3.6 billion and separately agreed to supply 490 000 barrels of crude oil per day to a Rongsheng subsidiary[26]. So perhaps it is just natural for the two countries to move away from the construct of a settlement currency convention between the United States and Saudi Arabia dating back to the 1970s. It is also possible, from a Saudi vantage point, that this is merely a way for the Kingdom to express that it does not regard its alliance with the United States as important as before, that it can prevail without the United States. Still, if the promiscuity between China and Saudi Arabia led to the settlement of crude oil exports to China in Yuan, what would it mean? Well, it turns out that the value of Saudi Arabia petroleum exports to China was 38,3 billion US$. By comparison, the value of the global trade was 32 trillion US$ in 2022. Therefore, the value of Saudi Arabia petroleum exports to China represented approximately 0,12% of global trade volume. Based on the above, it does not seem that the US dollar term as the world’s reserve currency is coming to an end. It is likely just a slow-moving process by which central bankers aim to diversify foreign currency reserves and by which partners attempt to settle trade in their own currencies as opposed to an intermediary currency, something which has been made more possible with to the reduction in currency trading cost and other factors. Notwithstanding the above, it is possible that in a fractured geopolitical landscape, bi-lateral deals become frequent, and that the de-dollarization trend accelerates. But for the time being, the stability, depth and breadth of the US dollar and US dollar denominated assets coupled with the country’s military might and arbiter of conflicts history all lead me to believe that its demise is exaggerated. In fact, the US dollar index is only a few percentage points off last year’s peak. After all, Saudi Arabia might find some use for the Yuans it receives in exchange for oil, but I seriously doubt that the same approach can be extrapolated to the currency of trade partners like Indonesia, South Africa or Pakistan… If I am wrong and that demand for US dollars internationally falters precipitously, this could cause the borrowing rate of the United States to increase noticeably and for US imports to turn into a source of inflation for the first time in over 50 years. Thank you for your support, Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer [1] The University of Michigan indicator was at its lowest level since May 2020 at the end of February 2023. [2] Source: FactSet [3] [4] Unless specified otherwise, index performance references total returns denominated in local currency terms. [5] Source: Federal Reserve Bank of St-Louis, Weekly US Commercial Banks Deposits report. [6] It was a consortium of banks led by JP Morgan that provided a 30 billion deposit backstop to First Republic Bank. [7] Founded in 2015 in San Francisco by Sam Altman and a group of entrepreneurs including Elon Musk (Tesla, Space X, The Boring Company…) and Peter Thiel (PayPal, Palantir Technologies). The firm is also behind the DALL-E-2 and Whisper.AI applications. [8] Source: Statista. [9] Source: SiliconAngle. [10] Goldman Sachs Economic Research, The Potentially Large Effects of Artificial Intelligence on Economic Growth, Hatzius and all. March 26, 2023 [11] Accession resulted in the reduction of tariffs and barriers to free trade. [12] [13] The Guardian, January 17, 2023 [14] [15] Karl Benz is credited for the first functional four-wheeled automobile powered by an internal combustion engine in 1886. By contrast, the state of Connecticut was the first to install three-way traffic lights in 1930, 44 years later. [16] Ralph Nader, Unsafe at Any Speed: The Designed-In Dangers of the American Automobile, Grossman Publishers, 1965. [17] Ralph Nader, Unsafe at Any Speed: The Designed-In Dangers of the American Automobile, Grossman Publishers, 1965. [18] The Illuminating Engineer, Public Lightning in Baltimore, 1909. [19] Sam Altman’s twitter feed, December 10, 2022. [20] [21] Lacey, Robert. Ford: The Men and the Machine. Boston: Little, Brown, 1986 [22] According to Haver, the EV/EBITDA of companies involved in a digitization theme have derated between 28% (Healthtech) and 42% (Fintech) between November 2021 and October 2022. [23] Webster: a collapse (as of a society or regime) marked by catastrophic violence and disorder. [24] Source: International Monetary Fund estimates [25] Other than the Euro, the Japanese Yen, and the British Pound. [26] Source : Reuters.   Photo credit  

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: [7] Bankruptcy lawyer who oversaw the liquidation and recovery of assets from Enron and Fruit of the Loom. [8], 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

From Lagado Projectors to Modern-Day SPAC Sponsors

Montreal, September 23, 2020 FROM LAGADO PROJECTORS TO MODERN-DAY SPAC SPONSORS In Jonathan Swift’s Gulliver’s Travels,[1] Gulliver visits Lagado, the metropolis of the fictional island of Balnibarbi where he is given the privilege to examine the works of the Grand Academy’s scholars called Projectors. There, he is acquainted with Projectors that dedicate their life to futile studies such as the extraction sunrays from cucumbers, the transformation of ice into gunpowder or the softening of marbles to make pillows more comfortable. Swift was one of the most famous political satirists and pamphleteers of his time and this passage can be interpreted as a parody of the speculative excesses that were prevalent in the late 17th and early 18th century. It is worth noting that Gulliver’s Travels was published shortly after Swift’s generation had witnessed the collapse of two of the most notorious stock market bubbles in history. The first one took place in the mid-1690s. It involved a flurry of companies that had become public a few years earlier. Almost all of these companies were engaged in the manufacturing or distribution of diving apparatus and pumps, industries that had suddenly become ebullient after Sir William Phips and his associates, on a private expedition, were able to recover nearly 3,000 gold coins and three silver bars from the wreck of the Spanish armada ship Nuestra Señora de la Concepción. The view was that anyone with the right equipment could ‘strike gold’. Ultimately, most expeditions were ruinous and the companies supplying equipment for those ventures ended up worthless. The second one has a dedicated chapter in almost every financial market history book: the South Sea Bubble, which almost bankrupted England in 1720. This speculation mania centered of the South Sea Company which was founded in 1711 and enjoyed a British government monopoly to trade slaves with Spain controlled Central and South America. For many years, the South Sea Company’s stock languished, in spite of its guaranteed 6% interest, as the terms of the Utrecht Treaty with Spain in 1713 were less favorable than had been anticipated. In effect, an annual tax and a strict quota were imposed on slaves imported to the Americas. Confidence was restored in 1718 when King George I himself was nominated to the Board of Governors of the South Sea Company but it is only in 1720 that the South Sea Company’s stock took flight after the British Parliament accepted its offer to take over the National debt in exchange for an upfront loan. The company expected that the expansion of its trading activities would enable it to pay the government debt. Soon after the announcement, the South Sea Company stock went up eightfold. Business was lucrative for shylocks who were granting loans to Londoners who couldn’t get enough of the stock, and for swindlers and fraudsters who were promoting the stocks of other trading companies engaged in similar activities. One adventurer even set up a company whose prospectus stated “…an undertaking of great advantage, but nobody to know what it is.[2] Eventually, the stock market collapsed, dragging down the entire country with it, including notable members of the aristocracy. The collapse of the South Sea Company led Sir Isaac Newton – who reportedly lost a fortune in the debacle – to declare: “I can calculate the movement of the stars, but not the madness of men.” To be clear, we do not think that the global stock market as a whole is in bubble territory from a valuation standpoint. In fact, relatively speaking, developed markets government bonds, with maturities ranging between 5 and 20 years and with their yield to maturity standing at levels well below the expected inflation rate over the same maturity, appear to us in a far more precarious state. This is particularly true now that the Federal Reserve acknowledged that it will let inflation to overshoot above its long-term target of 2% before raising interest rates. Nonetheless, there are symptoms that bubbles may be forming in certain parts of the stock market, some of which would certainly draw Swift’s attention as a fertile source of inspiration were he alive today. For example, there are situations when dilutive stock offerings or stock split announcements are perceived positively on the grounds that more marginal buyers will now be able to participate. Other examples include the recent record high transaction volume on short-term single stock call options and, last but not least, the exuberance around Special Purpose Acquisition Companies, or “SPACs.” By way of background, a SPAC is a publicly listed company established with the sole purpose of acquiring another company, within a given time frame, typically 2 years. On its formation date, the SPAC does not own any assets and the money it raises from investors through its own initial public offering (IPO) is kept in a trust until the SPAC sponsor successfully consummate a merger with an operating company. Following the merger, the operating company becomes a publicly traded stock. Typically, SPAC sponsors receive a combination of shares in the SPAC (typically 20% of the outstanding shares), and warrants with an exercise price marginally above the SPAC’s IPO price, in exchange for small consideration. Importantly, the sponsor is compensated in shares once a merger is completed, not as a function of the company’s performance following the merger. In other words, SPACs sponsors tend to be incentivized more by the strict completion of a merger transaction itself than by the financial success of the operating company. If a SPAC fails to complete a merger within the time frame, it is contractually obligated to return capital to its shareholders. In 2020, more SPACs are raising IPOs than ever before. Separately, the amount of money raised by SPACs and the number of deals completed are also on record track. Our estimate suggests that SPACs are collectively sitting on more than 40 billion in cash raised from their respective IPOs. Once a tiny and obscure stock market niche attracting a number of unsavory characters, SPACs have gained notoriety as more sophisticated investors such as Bill Ackman are getting involved.[3] Celebrities and political figures are also surfing the wave. For instance, Billy Beane,[4] of Moneyball fame, is behind Red Ball Acquisition Corp. while Paul Ryan, the former Republican party house speaker, is the Chairman of Executive Network Partnering Corp. Some argue there are legitimate reasons that underpin the decision for an operating company to become public through a merger with a SPAC, as opposed to the more traditional IPO route. Rapidity of execution and certainty of proceeds probably rank amongst the most important reasons in comparison with the IPO process which is tedious and for which the value of the proceeds is usually not known until 24-48 hours prior to the IPO. From the vantage point of the SPAC shareholder, however, we do not see many good reasons, quite the contrary. First, as described above, there is an inherent misalignment between the interests of the SPAC promoter and the interests the shareholder. In effect, the SPAC promoter generally gets compensated simply for completing a transaction while the shareholder compensation is tied to the longer-term success of the company. Basically, unless the SPAC promoter manages to acquire a company that is undervalued by a greater percentage than the percentage of the company that he obtains for completing a transaction, SPAC shareholders tend to get a smaller fractional share of the post-merger entity than what they paid for. While some argue that IPOs are notoriously undervalued, given the lackluster performance of a large number of stocks post-IPO in recent years, we think the argument is debatable. Second, a SPAC shareholder does not have the same degree of regulatory scrutiny and transparency into the books and records of the operating company targeted by the SPAC as they would during the normal IPO vetting process. After all, investors that were contemplating the acquisition of WeWork shares were rewarded when the company’s IPO filing documents revealed its weak governance and aggressive accounting practices, ultimately forcing the company to shelve its IPO plans. Unfortunately, if history is a guide, in a world awash with liquidity and zero interest rates, while many SPAC sponsors are undoubtedly well intended, it is almost certain that many dramatically overvalued companies and potentially fraudulent ones will get the attention of SPACs. In many aspects, the SPAC promoters’ financial engineering approach to value creation may not be that different from the pseudo-science techniques employed by the Lagado Projectors which were dubious. Thankfully, signs of speculative excesses seem to transpire from relatively concentrated segments of the growth equity space. As such, the idea is not to eliminate growth stock exposure altogether. In fact, we find that certain growth stocks remain undervalued relative to value stocks. Therefore, from a portfolio construction standpoint, the key is to maintain a good balance between different types of stocks and between asset classes. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer    [1] Jonathan Swift, Gulliver’s Travels. Original title: Travels into Several Remote Nations of the World. In Four Parts. By Lemuel Gulliver, First a Surgeon, and then a Captain of Several Ships, Benjamin Molte, 1726. [2] Charles Mackay, Memoirs of Extraordinary Popular Delusions, Richard Bentley, London, 1841. [3] In July, Bill Ackman raised 4 billion for the IPO of Pershing Square Tontine Holdings Ltd., the largest SPAC IPO to date. [4] Billy Beane is the former General Manager of the Oakland Athletics professional baseball team from 1997 to 2015 whose attempt to assemble a competitive team is depicted in the movie Moneyball (2011, directed by Bennett Miller) based on Michael Lewis’s book Moneyball: The Art of Winning an Unfair Game (W.W. Norton & Company, 2003). Photo credit

Enters Plutus, the Greek God of Wealth

Montreal, July 30, 2020 ENTERS PLUTUS, THE GREEK GOD OF WEALTH Johann Wolfgang von Goethe was not a particularly prolific writer. The genesis of his magnum opus took over 30 years. Nowadays, Goethe might even be considered a mere “one hit wonder”. But what a hit it was! Written against the backdrop of the Age of Enlightenment and the Romantic period, Faust[1] is regarded by some as the greatest work of German literature. Faust marks the origin of the pact with the devil mythos, from which so many derivatives took their inspiration afterwards. Yet aside from the play’s main theme and its central character’s deal with Mephistopheles, there is a side story in Faust Part II which is particularly interesting in light of recent policy decisions. The story revolves around an emperor whose realm is afflicted by economic problems. In an early scene, at a reception at the court, the emperor is acquainted with an unlikely duo consisting of Faust, disguised as Plutus, the Greek god of wealth, and Mephistopheles, disguised as the emperor’s fool. Later in the evening, Plutus tricks the intoxicated emperor into signing a paper note. Unbeknownst to the sovereign, Plutus and the fool promptly print unlimited copies of the paper note which are then circulated throughout the empire, thereby eliminating economic problems. Later on, the emperor realizes that the shortsightedness of Plutus’ solution has created a false sense of prosperity in the realm, which in turn enabled greed and corruption, ultimately leading to a compounding of the economic problems that prevailed and bringing the realm on the verge of rebellion. We think there are striking parallels to be drawn between the money printing metaphor in the play with what happened in the last few months. In effect, by resorting to an unprecedented monetary expansion effort in order to avert an economic crisis that would rival the Great Depression, central bankers have turned into a modern version of Plutus. While we understand that there may have been no other choice, in their attempts to reduce short-term damage, central bankers, whose recent policy actions included massive intervention in the investment grade credit sector, have now socialized large swaths of the financial sector, the consequence of which has been the extreme distortion of the value of a broad range of financial assets. In doing so, they have made a remarkable entrance disguised as Plutus and consummated their own Faustian bargain. Even if the long-term outcome of this bargain may not be as tragic as in Goethe’s play, we prefer to be invested conservatively and to be diversified across a broad range of risk factors rather than chase the financial assets whose value may have been the most artificially inflated. ONE COUNTRY TWO SYSTEMS NO MORE Hong Kong’s current crisis can be traced to the implementation of the 1990 Basic Law, a constitutional law whose purpose was to give effect to the 1984 Joint Declaration between China and the United Kingdom that guaranteed the continuation of Hong Kong’s capitalistic and social freedom system for 50 years following its return to China in 1997. Article 23 of the Basic Law stipulates that Hong Kong is responsible for enacting laws to prohibit treason, secession, sedition and subversion against the Chinese government and bar foreign organizations to conduct political activities in the region. Indirectly, it meant that Hong Kong’s retained its independence but that China would ultimately dictate policy around security and foreign relations. Unfortunately, since its return into China’s lap, Hong Kong has tried and failed repeatedly to implement Article 23 due to public outcry. Its latest attempt, in June of last year, was met with daily widespread protests and demonstrations lasting through late fall. In retrospect, the COVID-19 pandemic provided the distraction that China needed to force the implementation of the missing legislation. To this point, diplomatic attempts to dissuade China from asserting more direct authority over Hong Kong have fallen into deaf ears. Similarly, since China has waited over two decades for this moment, we don’t think that calls for sanctions from countries with assets in the region will have an impact. In fact, a series of recent events suggest that China is less preoccupied by the image that it projects on the international scene than it was 30 years ago, in the aftermath of the Tienanmen Square events. Notably, China is particularly emboldened when it comes to pushing the limits of public international law in the South China Sea. This is an adverse development which few had foreseen. The widely held view was that Deng Xiaoping’s thoughtful “one country, two systems” formula was beneficial for China as it could draw inspiration from Hong Kong’s British heritage in the transformation of its state-controlled economy to a market economy. Evidently, China viewed the situation differently, which raises questions about what comes next. Firstly, what will China’s tighter grip mean for foreign companies operating in Hong Kong? Secondly, are Trump’s United States willing to militarily guarantee the Taiwan’s independence if China’s policy towards Hong Kong sparks the nationalist fervor on the island? Thirdly, how will China react should foreign countries offer fast track visas to the highly skilled citizens of Hong Kong who see China as a menace and choose to emigrate? Answers to these questions could have potentially serious geopolitical consequences. For this reason, our strategy is to approach China and the broader Asian region without taking too much directional risk. As such, we think that this in an area where hedge funds, whether they focus on equity or credit markets, interest rates or currencies, are worth considering. This is a key research focus of ours as a result. DEAD SHOPPING MALLS RISE LIKE MOUNTAINS BEYOND MOUNTAINS The title of this section is a line that we stole from a song by the internationally acclaimed Canadian indie-rock band Arcade Fire[2] . While the decline of the suburban shopping malls had already been chronicled, as COVID-19 rampaged through the world, forcing business closures, their problems only worsened. In retrospect, Arcade Fire was prescient. The reason we mention the shopping mall situation is because the broader commercial real estate sector – publicly listed Real Estate Investment Trusts (REIT) aside[3] – typically comprises a core portion of ultra-high net worth (UHNW) investors allocation to alternative investments and that many UHNW are attempting to assess whether the recent carnage witnessed in the space as an opportunity to increase their exposure. After all, they argue, from a Canadian investor’s vantage point, the commercial real estate sector, has been largely immune to recessionary shocks in the past three decades and until the pandemic hit, it had generally outperformed both equity and fixed income over relatively long periods. While these arguments are undebatable, they are backward looking. To this point, we believe that there are fundamental reasons that underpin the weakness experienced by commercial real estate since March. Firstly, in many sectors, rent collections are at risk. In effect, while such risk appears contained in the traditionally more defensive multi-family residential sector as well as the industrial and storage sector, it is particularly acute in the hospitality, office and retail sectors. We further suspect that even the student housing sector could face problems if college and university campuses do not re-open this fall and that foreign students are frozen at the border. To date, real estate owners and operators have engaged in proactive discussions with their tenants, which have led to the implementation of various rent relief measures. Nevertheless, these measures are temporary and since the commercial real estate sector has not directly been targeted by government and central bank measures to date, we wonder how long can these voluntary measures last and what happens when they expire. Secondly, we note that a many nonbank real estate debt providers such as mortgage REITs, specialty finance companies and hedge funds have significantly curtailed their activities or effectively exited the space. As such, capital for development and repositioning projects has become scarce and more expensive. Ultimately, we think it will cause many commercial real estate owners, operators and developers to prioritize debt reduction over distribution payments and that major expansion projects will be postponed. To summarize, while the opportunity to uncover unique assets which will generate superior outcomes given the depressed valuations may very well be real, the level of uncertainty is unprecedented and the risks of making a costly mistake by increasing exposure too early is high. With that in mind, until we overcome the COVID-19 pandemic, we consider it prudent to focus on the most defensive sectors, use only conservative amounts of borrowing and more importantly, borrow on conditions that cannot be unilaterally amended by the lender. Reassuringly, while we did not deploy capital in the space anticipating a global pandemic, our recently completed investments appear well positioned to withstand the negative influence of the pandemic. To this point, to date, there has been little deterioration in vacancy and rent collection metrics and developers indicate that construction projects remain on time and on budget. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer    [1] Johann Wolfgang von Goethe, Faust Part I, published in 1808, and Part II, published posthumously in 1832. [2] Sprawl II, the Suburbs, released by Merge Records in North America in 2011. [3] We do not consider publicly listed REITs as alternative investments. We view REITS as equity market investments. Photo credit

The Great Deconfinement

Montreal, June 30, 2020 One of the most acclaimed role-playing video game from the genre’s golden era is Fallout[1]. In the game, the player’s avatar is tasked to leave the relative safety of an atomic shelter, in which he spent his entire life, to retrieve an essential piece of equipment in the above ground wasteland, one populated by humanoid and animal mutants and where radiation poisoning is a constant threat. Covid-19 is not anything like Fallout’s romanticized wasteland denizens that keep respawning but like them, it is a serious threat about which little is known other than the fact that it has not gone away. For this reason, while deconfinement is vital, immunology and infectious disease experts argue that the process of re-appropriating the outside world should be slow and guarded, or else the lockdowns of the last two months will have been wasted. The Shape of the Recovery has been ‘unmasked’ In a prior post, we noted the growing dissonance between the swift recovery trajectory that the global equity markets implied and the underlying economy. In effect, since the late March lows, broad equity market indices have rebounded substantially while economic activity remains severely impacted. In retrospect, suggesting that the markets were implying a “V shaped” recovery may have been a premature conclusion. To this point, the stocks that had been leading the market advance comprised of a relatively concentrated group of large capitalization information technology, on-line communication and healthcare stocks. The common characteristics of those stocks were that their revenues were not expected to be overly impacted, their net debt was low, and they had high variable cost structure which could sustain a lower level of activity for longer. More recently though, most of these same stocks seem to have reached a plateau while the broader market is now carried higher—at least temporarily—by financials, industrials, consumer discretionary[2], and, to a lesser extent, by energy firms. The stocks in this second group are more sensitive to the prevalence of social distancing measures, are sometimes heavily indebted and have little to no flexibility to reduce cost rapidly. We note, interestingly, that this shift in sentiment is happening at the same time as European and North American countries have started to ease lockdown restrictions and that the number of deaths keeps declining in spite of a resurgence in the number of Covid-19 cases. In fact, there are encouraging developments on the therapeutic front. At the same time, higher frequency indicators measuring air traffic, passenger car miles driven, public transportation capacity factors, box office receipts, and restaurant and hotel bookings all suggest that the economy has bottomed. Lastly, while weekly unemployment claims remain elevated, continuing claims have started to decline, which means that corporations have started to rehire workers. In a sense, these positive developments justify the transition of market leadership away from companies which are less Covid-19 sensitive, to companies which are more sensitive to it. As it stands, we do not know whether a sudden increase in Covid-19 cases would cause the group of stocks that benefitted in the early stages of the recovery to start outperforming again. Nonetheless, we do not think it is prudent to assume that large cap information technology stocks and ancillary plays will always constitute sound hedges against a severe recessionary scenario. For that, we believe that the US dollar, long-term government bonds and precious metals are better suited. Ethical and Environmental, Social and Governance (ESG) strategies having their day Asset owners have become increasingly interested in the ESG profile of their holdings. To this point, Morningstar[3] reported that net inflows into sustainable mutual funds and exchange-traded funds more than quadrupled in 2019 from 2018. In addition to the general concern with climate change, we believe that the adoption of ESG conscious investment principles has been partly sparked by the strong performance of ESG strategies recently, which is seen as the confirmation of the premise that an ESG approach to investing does not force investors to sacrifice return. However, an investigation into the approach utilized to construct ESG indices reveals that performance may have more to do with factors other than ESG factors themselves. In effect, taking for instances the popular MSCI ESG Leaders[4] range of indices, we note that two sets of filters are applied. One filter in the indices construction methodology is an ethical filter, which leads to the exclusion of certain industries outright, such as the tobacco manufacturing industry. Since the connection between smoking and terminal lung diseases has been established, the tobacco industry has been structurally contracting. Consequently, notwithstanding the high dividend that most tobacco manufacturers are still able to pay, their stock price has declined substantially in the past couple of years. Other groups of companies that tend to be excluded are those involved in the manufacturing of firearms and those that are subject to various controversies such as child labor. Coincidentally, many of those happen to be industrial conglomerates which are facing their own challenges ranging from balance sheet stress to fundamental changes in the way contracts are attributed. The stock price of members of this industry subgroup has also trailed the broader indices considerably in the recent years. As a result, the decision to exclude a subset of stocks which happen to have been experiencing a secular decline on the grounds that such stocks do not meet socially responsible investing criteria, would have been enough to generate a noticeable positive contribution to performance. Furthermore, the other filter applied consists in altering the weight of the remaining stocks, positively or negatively, as a function of their respective score on various ESG metrics. Invariably, companies with the highest carbon footprint tend to be penalized. Therefore, the energy and basic materials sector tend to be underweight and since the price of commodities such as oil and copper is hovering nearly their decade lows, all else equals, the underweighting of companies engaged in the extraction of natural resources has also been a positive contributor to performance. Conversely, companies in the information technology, healthcare and biotech industries which tend to have a low carbon footprint, tend to be favored and get overweight. Essentially, by construction, these ESG indices and the strategies that are derived from them tend to be naturally underweight industries which are facing secular headwinds, and overweight information technology and healthcare sectors. Interestingly, the same characteristics are present in large-cap growth focused strategies. In fact, we have found that many ESG strategies have behaved like diluted versions of large-cap growth strategies. More cynically, to the extent that investors choose to adopt ESG strategies, it will be more a consequence of their large-cap growth stocks driven performance than the desire to invest in companies that are doing more “good”. Moreover, we have another issue with ESG indices and strategies. It appears that in some cases, the E, S and G factors in ESG are mutually exclusive. For example, a Silicon Valley technology company may score highly on the environmental pillar because it causes little direct pollution through its activities but may score poorly on the governance pillar due to issues surrounding executive pay and ongoing questions about the protection of customer privacy. Conversely, a mining company that employs various chemicals that contaminate a nearby aquifer will score poorly on the environmental spectrum but may still gain index membership since it has a diverse board and pays its employees above average. In other words, it is possible for a company to score poorly on one or two of the three ESG pillars to acquire membership in an ESG index. Unfortunately, these are considerations that are not necessarily transparent to asset owners. Ultimately, we would conjecture that the E, S or G-only indices that have recently emerged—in an effort to target specific asset owner sensitivities and reduce the presence of inherent conflicts between the three pillars—may be the answer to an unfulfilled promise. On our end, we believe that ESG concepts have fundamental merits. That being said, we are conscious of the pitfalls identified above and do not want to rely on recent performance to build an investment case. With that in mind, we continue to scrutinize the universe search for an implementation approach without too much compromise. The Relative Passivity of Active Managers Active portfolio management is defined by an investment approach that focuses on outperforming a specific market index through security selection, sector allocation, or market timing. The marginal value of active portfolio management strategy has been intensely debated in recent years and we doubt that their performance during the first quarter of this year will do anything to cause the debate to recede. In essence, the performance of active equity and fixed income managers has once again disappointed in the first quarter[5]. Notably, the median active Canadian equity manager underperformed the S&P TSX Composite Index and the median international equity manager underperformed the MSCI EAFE[6] Index. On the fixed income side, the median manager underperformance relative to the FTSE TMX Universe was abysmal from a historical perspective. This has prompted many investors to question the purpose of active managers if, on aggregate, they largely failed to deliver superior performance in the years leading to the Covid-19 meltdown, and during the meltdown. Admittedly, the empirical data makes active managers harder to defend. To this point, apart from a reduction in the count of non-core portfolio positions, which led to minor increases in the level of cash present in some manager portfolios, there were no broad reshuffling of portfolio exposures. In other words, active managers have been, on average, uncharacteristically… passive. Nevertheless, we remain hesitant to condemn active managers based on the actions committed—or lack thereof—at the outset of the pandemic. We know that great managers may look temporarily out of sync when a new paradigm emerges. Please keep in mind that Warren Buffet’s Berkshire Hathaway had his worst performance in a decade versus the S&P 500 Index in 2019, and 2020 is not shaping up to be much better. We also know that mediocre or novice managers can look brilliant if presented with the right environment. Case in point, David Portnoy, the Barstool Sports founder who started to look at the stock market a few months back, is turning into an investment celebrity. We saw similar patterns in 1999 and again in 2007. It may be happening again. Currently, we are prepared to dismiss active managers recent performance on the grounds that the market decline ensuing the Covid-19 trauma was unprecedented. We are even prepared to excuse the underperformance of active managers early in the recovery, on the grounds that it was more liquidity induced than fundamentally induced. Nonetheless, we think that active managers have just been granted an opportunity to outperform markets not seen in a generation. More specifically, now that so many publicly listed companies have suspended the communication of guidance for revenues, margins, and earnings, the basic extrapolation techniques that so many still cherish may no longer work. As such, analysts and portfolio managers, who can develop a deeper understanding of public companies’ operating environment and have superior insights about the companies’ relative ability to endure revenue decline or withstand margin erosion, may have the high ground. In a way, the active managers’ current crisis could be sowing the seeds of their catharsis. Many industries have suddenly fallen in a precarious state. Restaurants, hotels, cinemas, airlines, theme parks, cruise line operators, and live entertainment content providers are among those. Sadly, Hertz Global Holdings, whose problems have become public recently, perhaps best epitomizes the situation. Hertz, which celebrated its centennial two years ago, successfully overcame numerous adverse scenarios since its foundation. Yet Hertz derives the essential of its revenues from short-term car rentals and is heavily indebted. From our perspective, given the Covid-19 outbreak and restrictions on business travels, a balance sheet restructuring became inevitable and indeed, the company filed for bankruptcy on May 22nd. Hertz is just one example of a company which saw its business model toppled by Covid-19 at a time when it did not have a sufficient financial cushion. It is not alone in this situation, as many companies face equally worrisome prospects. To reiterate our earlier point, we believe active managers have a unique occasion to redeem themselves by successfully identifying the winners and losers of the Covid-19 pandemic. As such, we have become more enthusiastic about the prospects of active managers than we have been in quite a while. To be specific, we are paying particular attention to managers who have delivered excess returns in episodes during which the distribution of financial asset price variation was wide and who have remained faithful to the investment beliefs and principles that have allowed them to outperform in the first place. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer   [1] Fallout™, developed by Black Isle Studios and published by Interplay, 1997. [2] Non-essential goods and services. [3] John Hale, “Sustainable Fund Flows in 2019 Smash Previous Records”, Morningstar: Sustainability Matter, January, 10, 2020. [4] MSCI, “MSCI Choice ESG Screened Index Methodology”, April 2020. [5] Patrimonica, eVestment data for Q1-2020. [6] Ibid. – Europe, Australiasia and Far East (EAFE). Photo credit

“The S&P 500’s Metamorphosis”

Montreal, April 29, 2020 Franz Kafka’s novel The Metamorphosis is about a travelling salesman who wakes up one day inexplicably transformed into a large insect. An analogy can be drawn between Kafka’s travelling salesman and the S&P 500 Index, which is turning into the often-mocked Nasdaq 100 Index. In fact, with the ongoing outperformance of large capitalization stocks in the technology and related sectors, the five largest constituents in the S&P 500 Index – Microsoft, Amazon, Alphabet, Apple and Facebook – now represent nearly 22% of the overall index. This is the most concentrated that the S&P 500 Index has been since the era. Interestingly, in contrast to 20 years or so ago, the five largest constituents of the S&P 500 Index are the same as the five largest constituents in the Nasdaq 100 Index. The only difference is that the five largest constituents comprise 44% of the Nasdaq 100 Index. While the degree of concentration is higher in the Nasdaq 100 Index than it is in the S&P 500 Index, similarities are becoming hard to dismiss. What this means is that the S&P 500 Index is getting more closely related to an index which is portrayed as a poor representation of the United States stock market due to its excessive sector or single stock concentration and its looser profitability criteria for inclusion. Nevertheless, if the Nasdaq 100 Index is seldom accepted as an adequate benchmark for those reasons, how long will it take before investors question the appropriateness of the S&P 500 Index for benchmarking purposes when such an index is itself becoming, keeping with Kafka’s sudden metamorphosis theme… buggy? While we are not suggesting that the lack of market breadth is synonymous with an imminent market crash, strictly for risk management purposes, we would conjecture that the proportion of the top five S&P 500 Index constituents will not get much higher before alternative benchmarks are considered by both institutional and individual investors. It would not be the first time that such considerations take place. In Canada for instance, subsequent to the fall from grace of Nortel in 2002, which represented over 30% of the index at its peak, S&P has been maintaining its S&P TSX Capped Composite in 2002, limiting the weight of any constituent to 10%. If that happens for the S&P 500 Index, the most widely tracked equity index in the Western hemisphere, it could have deep implications on performance outcomes for various investment strategies which have intentionally or accidentally been benefitting from the ever-increasing concentration of capital in the largest S&P 500 Index constituents. To this point, growth, momentum, and even low volatility strategies – which ironically often overweight large capitalization technology stocks with low net debt and thus exhibit low market sensitivity – could see a reversal of fortune. Also, strategies that have been developed to consider environmental, social and governance (ESG) metrics and which have been performing well partly due to their structural underweight in industries such as mining and casinos, could also suffer should investors preferences change. About Negative Oil Prices and Other Platitudes Most market observers were stunned when interest rates turned negative in Europe a few years back. As time passed, we have come to accept negative rates as normal for the eurozone and not so much of an oddity in other parts of the developed world. On April 20th, another asset class experienced a similar fate for the first time in its history when the price for a barrel of West Texas Intermediate (WTI) crude oil delivered at Cushing, Oklahoma fell well below zero, to as low as -37.63$ per barrel for May futures. Crude oil implied price volatility skyrocketed to almost immeasurable and never seen levels. This sudden, severe price drop is referred to technically as a “long squeeze”. It happened because financial participants, who comprise the majority of short-term futures long positioning in this market, have no intention to take physical delivery of the commodity upon contract expiry. As such, they must sell their contracts before expiry and buy new ones expiring later. This is what is called “rolling” positions. By some estimates[1], one exchange-traded fund (ETF) – United States Oil Fund LP (USO) – in particular, held as much as 25% of the long open interest in the May WTI contracts as of last week. But since these operations take place on a monthly basis, why had this never happened before? In fact, there are normally commercial and industrial participants that stand prepared to take physical delivery. However, in the current environment, as demand for crude oil and refined products evaporates, excess supply has been accumulating and crude oil inventories are approaching their physical limits. While it is widely expected that OPEC+ will cut production by as much as 10 million barrels per day starting on May 1st and since the United States production has already declined by nearly 1 million barrels per day, evidence suggests that demand is waning faster and that inventories will inevitably continue to build, likely maxing out storage capacity in the coming weeks. With that in mind, we might very well witness another plunge when the June WTI futures expire. If it is premature to assume that negative oil prices fall in the realm of normalcy, we nevertheless expect the petroleum complex to remain under pressure and prices to remain volatile until a post-Covid-19 supply and demand equilibrium is found. For the moment, we note that the stock price of oil producers did not fare much worse than the market as a whole on April 20th. Similarly, petro-currencies (including the Canadian dollar) did not weaken as much as the negative oil price headline would suggest. In other words, there is hope that this shock will be short-lived. This reaction, or lack thereof, reminds us of the unlikely hero in Kafka’s novel, whose first thought upon discovering his new appearance is to shrug it off as a bad dream and to try to fall asleep again… Unfortunately, Kafka’s travelling salesman finds that his condition has not changed the next day. For those who think that increasingly politicized central banks are omnipotent, we are reminded that while central banks can be very effective facilitators, they cannot magically produce fuel-tank farms so that the crude oil oversupply vanishes. Similarly, central bankers cannot prevent rig count from falling, nor oil wells from being shut. They can neither coerce people to drive around their neighborhood without purpose to rekindle demand. To summarize, central banks have little control over commodities prices. No Middle Ground The Gross Domestic Product (GDP) in China collapsed by 6,8% during the first quarter. It was the largest decline since the end of the cultural revolution over 40 years ago. Without a doubt, for the developed world where the effects of the Covid-19 outbreak lag by roughly 6 weeks, the second-quarter GDP figures will be considerably worse. Given the sheer magnitude of those declines from a historical perspective, coupled with the hidden risks that may percolate, we find unsettling the fact that global equity markets are down less than 20% from their mid-February peak. In fact, we see a growing rift between the “V-shaped” recovery (a quick return to the initial state) that the capital markets seem to imply and the “U-shaped” (a slow recovery) or “W-shaped” (a recovery with many ups and downs) recovery trajectories that economists foresee. At the moment, the “V-shaped” recovery camp is winning this tug-of-war, the logic being that for central banks, there is no middle ground between perpetuating an asset bubble and an economic depression. And as we’ve learned since the Great Financial Crisis (GFC) a little over a decade ago, for central banks, however absurd, the asset bubble is the lesser evil. At the moment, market observers seem comfortable with this. Incidentally, the most troubling aspect of Kafka’s stories from a reader’s perspective is not the absurdity of the situation in which characters find themselves[2].  Instead, it is that they slowly accept it and become comfortable with it. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer   [1] Bloomberg [2] The Castle, The Trial Photo credit

Two ways. Gradually and then suddenly

Montreal, April 20, 2020 This is what one of the protagonists in Hemingway’s 1926 novel The Sun Also Rises responds when asked how he went bankrupt. In many respects, this is how the Covid-19 crisis unfolded; gradually, until February 20th, and then suddenly. In fact, it sliced the quarter in two nearly equal parts. In the first part, from the beginning of the year through February 19th, markets continued to rise on the back of renewed growth optimism following the signing of the Phase I of the US-China trade agreement. As Covid-19 was barreling through China, the attack ordered by the US President against a top Iranian general in charge of the country’s foreign policy and ongoing money market dysfunctions were dismissed. In the second part, once outbreaks were revealed elsewhere in Asia and in Italy, things happened quite suddenly, sending risky assets reeling. The result was that many equity markets experienced their fastest 30% decline in history before stabilizing in anticipation of immense stimulus programs. Still, at the end of the quarter, the MSCI All Countries World Index[1] had declined 19.97% while the S&P 500 Index and the S&P TSX Composite lost 19.72% and 20.90%, respectively. Stocks outperforming were the large capitalization, higher quality and secular growth names who stand to benefit from the acceleration of the economic digitalization theme. Stocks underperforming were smaller capitalization with higher perceived cyclicality and those excessively leveraged. Separately, credit markets also fell dramatically from their highs even though the downward movement occurred a couple of weeks after a similar move in the equity markets took place. In fact, it is only when the markets moved from a “risk-off” environment – an environment during which the behavior of safe assets tends to offset losses experienced on risky assets and where the premise of a diversified asset allocation policy works – to what we would characterize as a “risk out” environment, where even safe assets lose value as a synchronized deleveraging takes place across all asset classes, that the credit markets cratered. Over the quarter, the ICE Bank of America Merrill Lynch Global Corporate & High Yield Index and the ICE Bank of America Merrill Lynch US High Yield Master II Index declined 5.83% and 13.12%, respectively. Many markets broke daily and weekly records during the quarter, up and down, as the CBOE Volatility index surged to an intraday high of 85.47 and stayed above 50 for most of the month of March. This index oscillates between 15 and 20 normally. A Recession by Decree and a Patchwork of Programs For the first time in history, governments all over the world have imposed travel restrictions and self-confinement recommendations, called for the cancellation of large public gatherings and ordered the closure of a number of businesses providing services deemed “non-essential”. The immediate effect was a cascade of simultaneous sudden supply and demand shocks which were ultimately leading to near economic paralysis. In order to offset the effects of having large parts of the global economy being shut down by decree, central bankers and governments responded by quickly assembling a patchwork of programs targeted to large and small corporations suffering from an abrupt drop in revenues and to the large number of individuals having to suddenly lost their employment. In the developed world, the magnitude of the programs announced range between 2% and 11% of the prior year Gross Domestic Product. In many countries, the legislation followed equally unprecedented actions by central bankers which are now engaging in open-ended quantitative easing and introduced their own economic backstop mechanisms[2]. While these announcements seemed to have the intended effect on the financial markets, at least temporarily, we remain concerned about the longer-term unintended consequences of these large scale Modern Monetary Theory (MMT) experiments, where central bank finances budget deficit by purchasing government debt issued to finance tax cuts or public spending increases. For those unfamiliar with this left-leaning theory, MMT holds that countries with their own central banks and with their own currencies do not need to worry about budget deficits and spending to spur economic growth so long as their central banks can purchase all the debt that the government issues. Opponents of MMT have decried it as oversimplified and exaggerated in that it supposedly offers great benefits without imposing a burden on anyone. Among other things, opponents argue that unrestrained budget spending could translate in a loss of confidence in a country’s central bank, which could lead to a severe depreciation in the value of the country’s currency and high domestic inflation. So far, inflation break-even have not moved much but we suspect that MMT is about to get tested. With that in mind, it may be relevant to start watching closely the evolution of the price of gold (which made a multi-year high on April 6th) as well as the spread of Chinese Government bonds over US Government bonds for an update on the status of the American exceptionalism dogma. The other issue we are concerned with is that there is always a lag between policy announcement and its implementation. Since backlogs and errors are a normal feature of any government administration during normal circumstances, isn’t it likely that backlogs lengthen, that the frequency of errors increase and that citizens find it difficult to navigate through the innumerable programs being temporarily made available to find which one may apply to them? Dividend and Interest Scarcity Notwithstanding the various relief measures discussed above, as was the case following the Great Financial Crisis (GFC) we expect that many companies will be forced to cut dividends and that the percentage of companies that will default on their corporate bond payments will be greater than in recent years as Covid-19 hits free cash flow generation capacity. While those cuts might be temporary, this is important for investors who are dependent on dividends and coupons as sources of income supplement. This is a situation we will be monitoring closely over the next couple of weeks because with short-term rates back to virtually 0%, it leaves few options to investors. Further down the road, if the large-scale bail-out of national champions becomes the norm, as an example Boeing, we expect governments will want to have their say over corporate dividend payouts and share buyback practices. To this point, Germany already announced that companies requiring assistance will have to pause dividend payments. We believe other governments will be inspired by Germany. In Canada, while the rise in unemployment numbers is more significant than during the GFC, that western Canada’s economic activity is curtailed more dramatically due to record low crude oil price and that consumer debt is even more elevated than it was 12 years ago, we are not overly concerned about the risk of seeing Canadian banks cutting their dividend. However, given the various measures they have voluntarily put forward themselves (suspension of mortgage payments, lower interest charges on credit cards, etc.) we think they are more likely to issue more shares than resorting to dividend cuts. That being said, the prospect of dilutive equity offering is already, at least partially reflected in the bank’s share prices. Ultimately, we are not in the business of making stock specific or sector calls. We empower active managers whose investment process we trust. That said, we are wary of the risk of falling into the recency bias trap and looking to acquire stocks that benefit from Covid-19 or that are seen as less vulnerable as this will come to pass. Are all Bad News in Yet? At the time of writing this (April 7, 2020), risky assets have staged an impressive recovery from the March 23rd intraday lows. The recovery seems driven by positive developments on the spread of Covid-19 with daily new cases having seemingly peaked in the worst-hit countries in Europe (Italy and Spain) and showing signs of peaking in the state of New York, the epicenter of the US outbreak. This is welcome news as it means that even though California, Michigan and Florida appear a couple of weeks away from peaking, temporary relief for the health care system and a slow return to normal life may be in sight. The peaking of daily new cases is one of a series of indicators that we track but we do not feel it is sufficient to green-light risk taking yet. After all, we remain unsure of the consequences if the virus returns in the fall and whether large parts of the economy will have to endure rolling lockdowns until a cure is found. As such, we do not know if the consensus third quarter recovery will indeed take place, if such recovery will be delayed or if the various backstop programs will be sufficient. Additionally, we find that a number of predictable secondary effects do not get a lot of media attention. First, the havoc that low oil prices is wreaking on oil exporters who need prices to be in excess of US$50/barrel for them to balance their budget. Second, there are dire consequences that countries such as Mexico and Brazil potentially face with their quasi-business as usual approach when it comes to dealing with the pandemic. Third, we are concerned with the situation in India, a country where basic sanitary needs are not available to everyone and where “social-distancing” is simply not applicable. Fourth, there is also the impact that the bear market has on the numerous municipal and public pensions plan funded status whose portfolios are declining in value at the same time as their tax receipts are either reduced or postponed. Early Thoughts on Post Covid-19 Capitalism Crises like the ones we are going through have the tendency to trigger profound changes in the behavior of various economic agents. For instance, as mentioned above, we already know that governments globally are taking a closer look at corporate dividend payouts and share buyback policies for companies seeking relief. We would not be surprised to see governments forcing enhanced corporate responsibility and come after companies that are using independent contractors disguised as employees. These independent contractors are facing a revenue collapse but it is unclear if their status allows them to apply for one of the many programs recently announced. Lastly, given the unprecedented pace at which fiscal deficits are set to increase, we cannot think of a scenario under which corporate income taxes do not increase and exemptions are not eliminated, which would represent a reversal of the liberalist doctrine championed by the likes of Ronald Reagan in the United States and Margaret Thatcher in the United Kingdom. In the corporate world, we expect to see broad attempts to improve working capital positions, the establishment of to establish higher treasury reserves, to build-up supply chain redundancies and, last but not least, to embrace broader and more permanent work from home policies as a way to reduce costs associated with excess office space. With respect to the last point, we would not be surprised that once seen prime office space in certain areas might become stranded assets. Our view is that all else equals, these reactions, which we view as sound risk management response, are nonetheless likely to impact negatively corporate profitability. We do not think that this view is currently mainstream. Back to Hemingway One of the central themes in The Sun Also Rises is the apology of the lost generation, the generation that came of age during World War I. In contrast to the broad perception that members of this generation were generally decadent, disoriented and profligate, Hemingway depicts them as strong and determined. Judging by how people over the world have come to accept major restrictions to their civil liberties as necessary countermeasures to the most significant public health crisis it witnessed in the past century, Hemingway would probably come to the same conclusions today as there are indeed more discipline and resilience than consternation and discouragement. As such, the sun will rise again. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer   [1] Returns refer to the index total return in local currency terms, unless stated otherwise. [2] In the US, the Federal Reserve’s charter only allows it to purchase or lend against securities that have government guarantee. As such, for many of the new programs that it is instigating, The Federal Reserve will instead finance special purpose vehicles (SPVs) and it is the US Treasury, using the Exchange Stabilization Fund, that will make an equity investment in each SPV and be in a “first loss” position. The US Treasury is the buyer with the Federal Reserve acting as lender. Separately, BlackRock Inc. has been hired to purchase these securities and handle the administration of the SPVs on behalf of the owner, the US Treasury.

The Wuhan-coronavirus and the financial modelling of unknown unknowns

Montreal, January 30, 2020 In 1951, American author George Stewart was awarded the first International Fantasy award for his novel, Earth Abides. The novel told the story of a student working on an ecology research project in a remote mountain region who returns to the city to find that civilization has collapsed due to a deadly virus outbreak. Many years later, Stephen King drew inspiration from Stewart’s novel and took the idea further in the Stand (1990), which depicts an epic battle amongst survivors of a global epidemic that decimated over 99% of the world’s population. Movie studios also jumped on the bandwagon and created thrillers in which the antagonist was an elusive deadly virus or bacteria, rather than a monster or a deranged individual of some sort. This led to the not too fabulous Outbreak (1995) and the much more successful 28 Days After (2002). Since then, the world has been attuned to the threat that a global pandemic could unleash. This is why the presence of a new strain of coronavirus in China (Wuhan, in the Hubei province, to be precise), has many wondering whether this outbreak could be worse than the SARS episode of (2003) as the coronavirus is in the same family. If this is the case, the outbreak could have an adverse impact on global economic growth and force policy makers to revisit their policies. What do we know about the Wuhan coronavirus? The virus was first reported in late December 2019. It remains unclear, as of January 30th, whether transmission originally occurred by touching or by eating an as yet unidentified animal but we do know that the virus is being transmitted from human to human through close contact and that transmission is possible prior to the first symptoms showing. Officials indicate that approximately 7,700 cases have been reported. Most are in China although the virus has crossed the border as its presence has been confirmed elsewhere in Asia and at least five cases have been confirmed in the United States. Preliminarily, the good news is that while the virus is highly contagious, potentially even more than the SARS, it is not as fatal. To this point, the Wuhan’s coronavirus is responsible for 170 fatalities, which translates into a mortality rate of roughly 2% based on the number of confirmed cases. This is roughly half the mortality rate of the SARS (10%). It is also much lower than that of the MERS (Middle Eastern Respiratory Syndrome) which killed over 30% of the 2,450 affected in the Arabian Peninsula in 2012. How have authorities responded? While the disease is similar to the SARS virus, the response of the Chinese authorities has been markedly different this time around. In 2002, China concealed the virus from the rest of the world and from its own population for many months. The press was prevented to report on it. This time around, China alerted the World Health Organization (“WHO”) within days after having identified the first case of a pneumonia of unknown cause and posted the virus’ gene sequence in the open domain immediately after having isolated it. On January 22nd, in spite of the upcoming China new year, as the disease was spreading rapidly, the government announced a quarantine, cancelling outgoing flights and trains from Wuhan, and suspending public transportation in Wuhan, effectively stranding 11 million people and a further 50 million elsewhere. As such, while some argue that the Chinese authorities could have acted more quickly, there was no cover-up attempt this time around. On its end, the WHO held an emergency meeting to determine whether the coronavirus should be classified as a public health emergency of international concern (“PHEIC”), a decision not to be taken lightly. It decided against it. The WHO labelled 5 diseases PHEICs in the past decade. Those were the H1N1 (2009), the Poliovirus (2014), the Ebola (2014 and 2019) and Zika (2016). The latest data on the speed of propagation of the disease lead some experts, including former FDA head Scott Gottlieb, to argue that the WHO might reverse its decision shortly. In effect, as illness is less severe, many people falling sick may have dismissed symptoms as regular flu symptoms. As such, many more people could be affected. It is just impossible to tell. What about the economic impact? If the Chinese authorities succeed in containing and quashing the disease, the economic toll should be short lived and muted. In the interim though, we expect commodities and commodity-related stocks, which have declined modestly, to remain volatile. The Yuan should also show signs of weakness, as would China--centric travel and leisure related names such as airliners hotel operators and retailers. What blurs the picture is that the outbreak coincides with the China new year, a two-week period during which the country nearly shut down entirely. Because of that, it may take a while before we have more clarity. On the other hand, the economic cost could be more significant should the transmission potency of the virus turn out to be underestimated or that the virus itself mutates and turns deadlier. On that note, our desire is not to sound like a bad omen but many Canadians born two generations ago lost a family member to the Spanish Influenza outbreak of 1918 or know someone who has. 55,000 Canadians died and a further 50 million globally, or 2,5% of the world population. The creation of the Canadian Ministry of Health in 1919 is a legacy that we can directly attribute to the Spanish Influenza. But what few remember is that there were multiple waves of Influenza. The first one, in the spring of 1918, was relatively benign. But in the fall of that same year, the virus mutated and it is then that it became lethal. Should clients adopt a more defensive asset mix stance, at least temporarily, in response to the virus outbreak? We believe that the markets are generally decent discounting mechanisms, quick at taking into consideration any new information that surfaces. It does not appear to be different this time around. Until the second half of last week, financial markets were continuing on their upward trajectory. Then the news of the coronavirus outbreak hit mainstream and markets shivered but based on the initial reaction, a mild decline, consensus is that the novel-coronavirus is not as damaging as the SARS, and certainly not as bad as the Spanish Influenza episode of 1918. That said, this interpretation might evolve rapidly. Every day, cohorts of pundits and prognosticators talk about the various risks that they think will affect the financial markets. The list typically includes potential conflicts arising between countries, changes in macro patterns such as growth, employment or inflation or changes in sentiment or liquidity. All fall into the category of known unknowns. Those are generally easier to quantify and more easily incorporated in a portfolio construction framework. What we’re talking here, the prospect of a severe global pandemic, like the prospect of a grave natural catastrophe, are unknown unknowns. Our view is that unknown unknowns are so improbable that they should not be considered for modelling purposes. However, once we become aware of their existence, we think it is prudent to monitor them and determine if they are likely going to cause a worsening of existing conditions as they evolve, or, on the contrary, improve, or stabilize. In the current situation, as we are not epidemiologists or virologists, we simply do not have enough information to tell. As such, we do not think that a major adjustment to portfolio asset mix is warranted. Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer

What to make of the US-Iran escalation…

Montreal, January, 23, 2020 One of our objectives in 2020 is to engage more frequently with our stakeholders when an event that is perceived to have a significant impact on global capital markets takes place. It is our view that such an event took place when the United States struck Iran by eliminating Qaseem Soleimani on January 2nd. It may be worth taking a step back and discuss the importance of Soleimani, whom the western media outfits may not have adequately described. For decades, General Soleimani was responsible for implementing Iran's foreign policy. According to US officials, he masterminded the country’s backing of Hezbollah in Lebanon, propped up and provided the fighting forces for Bashar al-Assad during the brutal Syrian civil war and developed the Shiite militias in Iraq. As head of the Islamic Revolutionary Guards Corps Quds Force, Soleimani established networks all over the region. Importantly, Soleimani is also responsible for repelling ISIS from Iraq after the US withdrew in 2013. To sum it up, he was an important character. As such, our initial reaction was that markets were unnaturally calm, even more so than after Iran’s proxies attacked the petrochemical facilities in Saudi Arabia last September. A small drop in the first day, a recovery on the next. Basically, markets shrugged what could have been an important catalyst. Some argue that the timing of the event, while President is under a formal impeachment inquiry, is an attempt to divert attention but experts argue that this action must have received presidential sanctions awhile back, certainly before the impeachment process was initiated. This was intended to be a deliberate signal in response to Iran’s attacks of the US and its allies via proxies since last summer. Iran is accused of hitting Saudi oilfields. A US drone before that. Oil tankers in the Persian Gulf before that. And this week they directed attacks at the US Embassy in Baghdad. The good news is that Trump drew the line by signalling what Iran must do to avoid retaliation, hinting that it was ready to strike over 50 Iranian sites. The next day, Iran signalled that it was rolling back its commitment to the multilateral nuclear deal. At first sight, one could argue that this was an alarming development as it implicitly means that Iran could restart their military grade uranium enrichment program. But on second thought, this is perhaps the smartest response from Iran. Here's why. After all, Trump’s United States already pulled out of the deal. In fact, this is what triggered the initial escalation. So while it may make a major media headline, pulling out does not cause direct harm to the United States. It is unlikely that the United States retaliates for that. The Iranian regime is used to all this. It has been under an embargo for multiple decades. Our guess is that unless there is a ‘rogue agent’ amongst their ranks, they will be very careful not to strike American interests in the region. That said, nothing prevents them from continuing to attack assets of United States allies in the region, including Israel and Saudi Arabia, or try to influence the Iraqi government to force the full withdrawal of American troops. What to make of all this? Well, judging from the initial reaction, the market does not think that war with Iran is probable. I do not disagree. If Trump wanted war with Iran, he’s had numerous opportunities to justify a military action it since last summer (see above). Also keep in mind that we know, in retrospect, that the Trump Administration tried to set up a meeting with the Talibans at Camp David. Instead, Trump only responded with a military action after the United States embassy in Baghdad was hit. The Iranians may have underestimated his resolve, but now they get it. They understand where the line has been drawn. Case in point, shortly after, Iran launched two dozen ballistic missiles against allied operated air fields in Iraq, causing minimal physical damages, and no casualties. This was an intentional miss. As such, and notwithstanding the fact that the United States is entering in an election year, we don’t think that the prospect of a war with a Middle East nation with nuclear capabilities is likelier than it was a week before. The markets seem to have priced the risk accordingly through their inaction. Similarly, we don’t see this geopolitical development as cause to adjust meaningfully portfolios allocations. So, to the extent that we don’t think a military escalation between the United States and Iran is probable, what are the biggest risks that may not be appreciated adequately? We have three in mind. Firstly, we think a big risk this year is what might come after the United States presidential elections in November. We are concerned about what could happen to the greenback and to the interest rates should a constitutional crisis erupt if the party who loses refuses defeat. Secondarily, we are concerned about the emergence of a rift of the internet into two blocks in what could turn into a new Cold War opposing the US and China for the control of the technology that will harness 5G and future developments. If de-globalization and protectionism occur in the technology space, it could stress, if not break supply chains in ways that could awake the spectre inflation. Thirdly, we are worried about the impact of a Federal Reserve policy mistake. In effect, the Federal Reserve’s balance sheet has started to grow again in September of last year after having been progressively reduced in the prior twelve months. To be specific, for the first time in a decade, the Federal Reserve injected cash into the short-term money market in response to a repo market seizure. The repo market matches up banks that would need short-term cash with other banks with cash to loan out in the short term to earn interest. It was supposed to be a temporary operation, driven by an unusual confluence of tax and technical considerations. However, four months after the initial intervention, the Federal Reserve has continued to provide liquidity to depository institutions and had not reverse course. It appears that the renewed ability of banks to refinance their operations by pledging their assets to the Federal Reserve may have triggered the buoyant mood we’ve seen in risky assets globally. The question is as capital markets appear addicted to permanent quantitative easing in one shape or form, what happens if the Federal Reserve underestimates the impact of its own action and that a significant selloff in risky assets occurs following a policy reversal given how precarious liquidity conditions are? Dimitri Douaire, M. Sc., CFA Co-Chief Investment Officer

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